I wrote recently that in order to overcome my obsession with Elliot Wave Theory I had to join a five step program (three steps in the right direction with two minor setbacks in between). I’m feeling much better now. But I am not entirely cured. One thing that still attracts my attention is when the daily and weekly wave counts agree. Don’t tell my sponsor. To wit:
Elliott Wave meets Crude Oil
The charts shown in Figures 1 and 2 show the weekly and daily charts for ticker USO (an ETF which is designed to track the price of crude oil). Figure 1 displays the weekly chart with the weekly Elliott Wave count as calculated by ProfitSource by HUBB. Figure 2 displays the daily chart with the daily Elliott Wave count, also as calculated by ProfitSource by HUBB.
Figure 1 – Weekly USO with Elliott Wave count from ProfitSource by HUBB
Figure 2 – Daily USO with Elliott Wave count from ProfitSource by HUBB
A few things to note:
1. I use ProfitSource to analyze Elliott Wave because it has a built in formula for determining the current wave count at any given point in time. For better or worse, I much prefer this to my previous method of determining the current wave count which basically involved staring at a chart until either:
a) the “wave” would appear to me, or;
b) my head started to hurt.
In either case I would draw numbers (or letters) and lines on the chart in a fashion that had to be at least 150% subjective (hence the five wave program).
2. As I mentioned earlier the only time I really pay attention to Elliott Wave counts these days is when the weekly and daily counts for a given security match up and are point to a Wave 5 advance or decline.
3. For the record, just because the two counts match up there is absolutely no guarantee that the expected move will play out. Still, I have seen enough times when it has that this setup still draws my attention.
4. In Figures 1 and 2 you can see that both the weekly and daily wave counts are threatening to break to the downside in a Wave 5 decline and if that happens both are projecting sharply lower prices for USO (assuming the breakdown does occur).
5. Finally, for the record, price needs to break down below the daily and weekly “blue line” shown in Figures 1 and 2 to fully suggest the beginning of a Wave 5 down move. So the trade shown below in Figures 3 and 4 is a hypothetical example and not a “recommendation.”
What to Do With This Information
What to do with this information depends on a few factors:
1. If you are a true “Elliott Head” then you start looking for a way to make a lot of money playing the short side of crude oil.
2. If you are not a true “Elliott Head” or (and I’m not naming any names here) if you are a “recovering Elliott Head” then you may be more inclined to consider a trade that could make a lot of money if crude does in fact plunge. But no way in heck are you going to “bet the ranch.”
If you fall into the former category then in all candor your best play is probably to sell short crude oil futures contracts as they offer the most direct play on a bearish scenario for crude oil. At $1,000 per a $1 move in the price of crude futures contract offer the most “bang for the buck” for a trader looking to play a particular trend in crude.
Of course, at $1,000 per a $1 move in the price of crude they also offer a lot of “bang” to the level of capital in your trading account if you get my drift if you get the trend wrong.
If you fall into the latter category then you may not be quite so interested in “playing the trend”, but you might be interested in “taking a shot” that the extremely bearish scenario suggested in Figures 1 and 2 might actually play out.
So let’s be clear:
What appears in Figures 3 and 4 is not a “trend trade”, but rather a (slightly premature) “pure, out and out speculative play” based on nothing but the possibility (hope?) that crude oil will experience another plunge between now and August option expiration. Any other scenario – an up move, a sideways move, a slight down move – will result in a total loss of the premium paid. So the key here is to put a maximum of about 1% of your trading capital into a trade like this and no more.
This trade involves buying 10 USO August 15 puts at $14 apiece.
Figure 3 – Long USO Aug 15 puts (Courtesy www.OptionsAnalysis.com)
Figure 4 – Long USO Aug 15 puts (Courtesy www.OptionsAnalysis.com)
In a nutshell this trade requires a capital outlay of $140. This also amounts to the maximum risk on this trade. So in terms of dollar risk, we are not exactly breaking the bank.
On the downside, ProfitSource is essentially projecting USO to fall to somewhere between $10 and $12. Please remember that this is simply a mathematical calculation – there are no crystal balls involved. And in general, one is usually best served to assume that the extreme case will not play out. Hence the reason we are risking $140.
Still, if by chance USO does fall to $12 or $10 a share prior to August option expiration, this position will generate a profit of somewhere between $3,000 and $4,800. Which – to put it into technical terms – “ain’t too shabby” for risking all of $140.
Summary
As always I am not “recommending” that you make this very speculative trade. Especially given the fact that:
a) As I write USO has technically not entered into a Wave 5 decline, and;
b) While the reward-to-risk ratio is high, this is what is known as a “low probability” trade, i.e., mathematically speaking, the probability of USO being at or below the breakeven price of $14.86 by August option expiration is about 6% (note that we are not relying on “probability” to trigger this trade. At least for the sake of this example, “We are all Elliott Heads now.”)
The example covered here merely illustrates the potential for using Elliott Wave to identify possible areas for speculation and how to use options to get the most bang for you buck.
In considering the hypothetical position highlighted here, a trader must ask and answer three key questions:
1. Are you comfortable speculating on crude oil using options?
2. Do you think it is at least possible that crude oil will plunge between now and August option expiration?
3. Do you have $140 bucks?
If you answered “Yes” to all three – you should still stop and think long and hard before potentially wasting your hard earned money on rank speculation. But if USO does fall to $12 a share……..
Jay Kaeppel
I had heard from a few different places that oil was making a desperate fakeout high and so bought into DTO (leveraged inverse oil ETF). But then after I was in it for a few days I thought, “what the heck am I doing?” Where’s my data to back this up? Total discretionary trade, which I’ve been trying to avoid doing these days. So I got out with a 2% profit and decided I had learned my lesson the easy way.
The difference between your proposed trade and mine is that you’re basing it on something you feel solid about (even if it *is* Elliott Waves… 😉 ). Even if it’s essentially the same trade, the rationale behind it makes all the difference with the psychology of the trade. When I trade a system that has tested well and with good real-world results, I don’t mind too much when a particular trade goes the wrong way. I can always point to the statistics and say “oh look, there’s one of the loser trades I should see 40% of the time” or whatever. But if I got in on a whim, then I get to kick myself twice (once with each foot) when it goes bad.
Matt, your mental approach is spot on. For the record, I would put the trade in the article in the “whim” category since Elliott Wave is, well, you know, Elliott Wave. But one of the points I try to make to traders is that – at least in my opinion – it is OK to trade “speculative whims” as long as you recognize two things, 1) that is is in fact a speculative whim and that there is a good chance you will lose money, and 2) you risk ridiculously small dollar amounts. If you get 1 or 2 huge winners a year it can make a big impact overall. The problem for most traders is that psychologically a losing trade is a losing trade – with all the negative baggage – even $140. So they would rather avoid risking $140 for the chance of making a whole lot more because they don’t want the baggage of another losing trade. Jay
Thanks Jay! And because your site said my comment was too short with just “thanks Jay!”, I’ll just say that your trade is way better than mine, because you would conceivably go into it knowing that it was “on a whim”. Makes all the difference when you wake up the next morning to losses.