ABCGlobal Research1

Trend-Wave TradingHarnessing the Power of the Elliott Wave Principle with the Discipline of Trend Following

Murray Gunn CFTeHead of Technical AnalysisHSBC Bank plc+44 20 7991 6797 murray.gunn@hsbcib.com

Technical Analysis

June 2011

View HSBC Global Research at: http://www.research.hsbc.comIssuer of report: HSBC Bank plcDisclosures and Disclaimer This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

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1

2(1)

1

(2)

(C)

(B)

(A)

(5)

(4)

(3)

3

42

1

C

B

A

5

43

2

5

4

53

4

2

1

C

B

A

5

3

2

1

C

B

A

5

4

2

31

1

3

4

2

1

C

B

A5

4

3

2

5

4

5

3

4

21

C

B

A

5

3

2

1

C

B

A

5

42

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(2)

(1)

(3)

(4)

(5)

(A)

(B)

(C)

1

2

Long Term

Medium Term

Short Term

The Full Cycle

Putting it all together

A Fractal Design

The Elliott Wave Principle – A Basic Guide

Elliott Wave Principle

Ralph Nelson Elliott

Price action occurs in regular patterns

5 moves (or waves) in the direction of the primary trend

3 moves (or waves) when the price action is correcting against the primary trend

Repeat at every time frame or fractal

Mass human psychology is patterned

Ratio analysis/natural mathematics (Phi, the golden ratio, 1.618, Leonardo Fibonacci)

Elliott heavily influenced by Charles Dow

Wave Principle is the purest form of TA

3

Waves Are Self Similar in FORM… …but they do NOT have to be self similar in TIME or depth (AMPLITUDE)

1

2 C

53

5

A

3

1

E

4

A2

1

B

D

C

B

5

4

3

2

(1)

4

(5)

(3)

(4)

(2)

Much more like REALITY

4

Elliott’s Wave Principle is technical analysis

Elliott heavily influenced by Charles Dow

Empirical observations confirmed Dow’s Theory

Refined Dow’s work into more detail

Price and volume = pure technical analysis

Edwards & Magee pattern recognition a derivative of Dow and Elliott

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Participationphase Increasing volume

Dow Theory

Confirmed end of bull trend. Previous low point broken. No more higher lows.

Accumulationphase

Distributionphase

• Charles Dow’s editorials in his Wall Street Journal around 1900

• Analysis of price action of the market averages (Dow Industrials, Transports, Utilities)

• Markets have 3 “movements” (value, primary and secondary movement). Concept of stock market “value”was important to Dow’s analysis.

• Trends have 3 phases (accumulation, public participation, distribution)

• The stock market discounts all news• Stock market averages must confirm each other. If it’s a Primary bull

market the Industrials must be making higher highs along with the Transports etc and vice versa.

• Trends are confirmed by volume (an uptrend on declining volume is an unconfirmed uptrend)

• Trends exist until definitive proof that they have ended (defined by a lower high and a lower low after an uptrend)

Source: istockphoto

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Cycles Of Psychology

Accumulation by strong hands from weak hands

Distribution from strong hands to weak hands

Mania, euphoria, complacency

Despair, fear

Despair, fear

4

5

3

2

1

A

B

C

Relief, hope, denial, lack of breadth

Shock, denial, “buy the dips”mentality

Denial, comfort that bear is back

Bubble, speculation, narrow breadth best “fundamentals” / news flow

Strongest, broadest move, “fundamentals” / news flow turn positive

“Fundamentals”/ news flow still negative

Consternation, impatience

Broad, destructive decline, “fundamentals”/ news flow turn negative3

Reference: Frost & Prechter “Elliott Wave Principle”, 1978

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Elliott’s Wave Principle is technical analysis

Head & Shoulders = Elliott A B C correction or truncated fifth

Flags = Elliott flats

Pennant = Elliott triangle

Double tops / bottoms = Elliott flat or truncated fifth

Rising / Falling Wedge = Elliott ending diagonal

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Rules & GuidelinesElliott’s empirical observations led to his conclusion that there were various rules and guidelines that wave formation held to. It is the existence of these rules that makes the Wave Principle relatively objective compared with other forms of market analysis. The rules must be respected. Guidelines point to tendencies.

Wave 2 Can Never Retrace More Than 100% Of Wave 1.

Wave 3 Is Never The Shortest Wave Wave 4 Can Never End In The Price Territory Of Wave 1.

Alternation: Wave 4 Will Usually Be A Different Corrective Pattern From Wave 2

When Wave 3 Is Extended, Waves 1 And 5 Will Tend To Equality Or A Fibonacci Ratio

Three (of many) cardinal rules of Elliott’s Wave Principle are:

Three (of many) guidelines of Elliott’s Wave Principle are:Wave 4 Usually Terminates Near The Previous Wave 4 Of Lesser Degree

1 1

2

2 CorrectIncorrect

1

2

3

4

5

1

2

3

4

5

Incorrect Correct

1

2

3

4

1

2

3

4

Incorrect Correct

1

2

3

4

5

1

2

3

4

5

1

2

3

4

5

1

2

3

4 (1)

(2)

(3)

(4)100%

100%

100%

161.8%

1

2

3

4

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2nd waves of a motive wave can be very deep but they cannot move beyond the start of wave 1.

3rd waves are usually the most powerful. They can be shorter than 1 or 5 but they must never be the shortest of 1,3 and 5.

The end of the 4th wave must never overlap the end of wave 1. Note that if wave 4 is a flat or a triangle the first correctivewaves could overlap wave 1 so long as the ending wave does not.

Zig Zag then Triangle Flat then Zig Zag

2nd waves tend to be zig zags and 4th waves tend to be triangles or flats.

When wave 3 is extended, wave 5 will tend to end when it equals the size of wave 1 or a ratio such as 1.618 times the size of wave 1.

A 4th wave will tend to finish in the price zone of wave 4 of the just ended wave 3.

The Elliott Wave Principle – A Basic Guide

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Extensions Extension (Nine Wave) Ending Diagonal

Leading Diagonal Expanding Diagonal Truncated Fifth

Motive Waves

(1)

(9)

5

(5)

(4)

(3)

(2)

3

2

1

(8)

(7)

(6)

(5)

(4)

(2)

(3)

(1)

(5)

(4)

(3)

(2)

(1)

5

4

3

2

1

(5)

(4)

(3)

(2)

(1)

The Elliott Wave Principle – A Basic Guide

(5)

(4)

(5)

(4)

(3)

(2)

(1)

(3)

(2)

(1)

5

5

4

3

2

1

5

4

3

2

1

4

3

2

1

Extensions occur when one of the motive waves is prolonged and subdivides into amplified waves. Frequently occurring in the wave 3 position, normally only one wave within a motive wave will be extended.

Quite rarely an extension will occur where each subdivided wave is of roughly equal amplitude. This results in the entire motive wave looking like a nine wave move.

Also known as a rising or falling wedge, the ending diagonal is a 5th wave that can subdivide into five overlapping waves of 3 waves each (zigzags). It is a sign of an exhausted trend.

The leading diagonal can also subdivide into five overlapping waves of the normal 5 motive 3 corrective waves. Divergence between price and oscillators are normal characteristics of diagonals.

Added to Ellliott’s original work after observations by Frost & Prechter, a diagonal can also occur in the wave 1 position and subdivides into five waves of three moves.

A 5th wave that subdivides into fives waves of three. The expanding nature of the price action points to increasing volatility that can signal the end of a trend.

Sometimes the trend is so exhausted by the time the 5th wave comes that the wave does not even move past the wave 3 top or bottom. It is a sign of a very tired market trend.

Motive (or impulse) waves are the trending part of the cycle. These waves are relatively straightforward to identify due to their dynamic, thrusting nature and volume normally increases during wave three indicating a market where the participants are motivated to participate. These examples show bull market motive waves. Bear market motive waves are simply the reverse.

Leading Diagonal

(5)

(4)

(3)

(2)

(1)

4

3

2

1

5

4

1010

Corrective Waves

ZigZag (5-3-5) Flat (Regular) (3-3-5) Flat (Expanded) (3-3-5)

Triangle (Symmetrical) Triangle (Reverse Symmetrical) Triangle (Ascending) Triangle (Descending)

Triangles (3-3-3-3-3)

The Elliott Wave Principle – A Basic Guide

1

(A)

2

35

4

(C)

(B)C

B

A

(C)5

4

3

2

1

(A)C

B

A

(B)C

B

A

5

4

3

2

1

(B)C

B

A

(A)C

B

A

4

5

3

2

1

(B)

(C)

C

B

A

(A)C

B

A

C

B

A

(C)C

B

A

(E)C

B

A

(D)

(E)

(D)

(C)

(B)

(A)

(B)

(A)

(E)

(D)

(C)

(B)

(A)

(E)

(D)

(C)

A sharp correction consisting of two motive waves (A) and (C) separated by a corrective wave (B).

A sideways correction where wave (B) retraces close to 100% of wave (A) followed by a motive wave (C) sharp move.

Also known as an Irregular Flat, this is a sideways correction where wave (B) retraces more than 100% of wave (A) followed by a motive wave (C) sharp move.

Triangles usually occur in the 4th wave position of a motive wave and represent periods of equilibrium between bulls and bears. They consist of five waves A-B-C-D-E each subdividing into three waves.

The reverse symmetrical or expanding triangle is relatively rare.

This pattern reflects a situation where there is equilibrium in the price but the bulls are increasingly gaining the upper hand resulting in an upward break in price.

This pattern reflects a situation where there is equilibrium in the price but the bears are increasingly gaining the upper hand resulting in a downward break in price.

Elliott observed a number of ways that prices consolidate. Zig Zags and Flats have three wave movements with the final wave C being an impulse or motive. The powerful nature of this C wave is a result of a crowd psychology panicking in either closing shorts or bailing out of longs. It clears the weak hands out of the market out so that the trend can continue. Triangles on the other hand exhibit five wave movements.

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Alternative Wave Counts

Two or more valid wave counts at any one time

Job of the analyst is to find the most probable

Not 100% sure what the wave is until it is over

But ALL analysis is EX-POST

Also gives us Plan A, B and C etc

Analysis is one skill

Trading is another skill

Charts Source: Bloomberg, Updata, HSBC

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Trend-Wave Trading

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The “Get It” Moment

Newcomers to Elliott initially like it

Then realise the existence of “alternative” wave counts

Most leave

The ones who stay struggle with how to actually use (trade) it

Then the light bulb moment

ELLIOTT IS NOT A TRADING SYSTEM

ELLIOTT DESCRIBES THE EVOLUTION OF MARKET PRICE

IT IS AN EXERCISE IN PROBABILITY

ELLIOTT SETS THE CONTEXT FOR THE PROBABLE NEXT MOVESource: istockphoto

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Trend-Wave Trading

High probability Elliott set ups

5 waves followed by 3 waves

Next wave is highly probable1

A

1

2

B3

4

5

C

2

B

A

3

4

5

C

(1) or (A)

(2) or (B)

(3) or (C)

(1) or (A)

(2) or (B)

(3) or (C)

Significant LowSignificant High

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Trend Following

A life philosophy

Run winners. Cut losers.

Disciplined

It works (John Henry)

Live in the moment psychologySource: istockphoto

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Keep It Simple

A trend is a trend

Moving Averages

Optimisation Shmoptimisation

No magic, just discipline

5, 40 and 200Source: istockphoto

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Tee It Up, Get In The Zone & Let It Happen

Psychology

Golf & The Markets

Pre shot routine

Automatic

Make the swing

Source: istockphoto

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Step 1: Identify an Elliott Wave Principle set up

Step 2: Switch on your automatic Trend Following routine

Step 3: Take the shot

Step 4: Trail stop and take profit

Pros: SimpleDefined risk management processMitigates cognitive dissonanceApplicable over all time scales

Cons: Not for top or bottom pickers

Tee It Up, Get In The Zone & Let It Happen

Source: istockphoto

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Trend-Wave Trading (Day Traders)

Source: Bloomberg, Updata, HSBC

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Trend-Wave Trading (Swing Traders)

Source: Bloomberg, Updata, HSBC

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Trend-Wave Trading (Swing Traders)

Source: Bloomberg, Updata, HSBC

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Trend-Wave Trading (Portfolio Managers)

Source: Bloomberg, Updata, HSBC

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Trend-Wave Trading (Asset Allocators)

Source: Bloomberg, Updata, HSBC

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Trend-Wave Trading

Counting 5’s and 3’s is not as objective as some like

Why not use moving averages as an objective proxy for waves

Short, Medium and Long (5,40,200)

A “Trend-Wave” positive signal is given when 5 crosses above 40 and price is above 200

A “Trend-Wave” negative signal is given when 5 crosses below 40 and price is below 200

Trading / investing in the direction of the bigger trend

Buying / selling pullbacks in a bigger trend (just like 5’s and 3’s)

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Trend-Wave Trading

Source: Bloomberg, Updata, HSBC

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Trend-Wave Trading

Results from 2000 – 2011 using daily charts / moving averages

Trend-Wave Trading produces higher Win / Loss Ratio than a Continuous system

Results show a small but significant edge

4.10%

7.61%

Continuous Return

(Variable Position Size,

5% and 20%)

1.17

3.02

Win / Loss Ratio

(Return)

45% of 119

42% of 85

% Winners (Trades)

6.88%

6.86%

Trend-Wave Trading

Return (20% Position Size)

3.44%

3.39%

Trend-Wave Trading

Return (10% Position Size)

1.2256% of 63-2.08%S&P 500

3.2849% of 454.95%US Dollar Index

Win / Loss Ratio

(Return)

% Winners (Trades)

Continuous Return (10% Position Size)

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Current Market Outlook

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Defender of the Dean…

Source: HSBC, Bloomberg

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The most important chart in the world…

Source: Bloomberg, Updata, HSBC

30

Breadth and sector rotation negative…

Source: Bloomberg, Updata, HSBC

31

Topping out…

Source: Bloomberg, Updata, HSBC

32

OBV worries…

Source: Bloomberg, Updata, HSBC

33

A very BULLISH chart…

Source: Bloomberg, Updata, HSBC

34

Korea also very bullish…

Source: Bloomberg, Updata, HSBC

35

Chance of a big shake out in Gold…

Source: Bloomberg, Updata, HSBC

36

The bell is rung…

Source: Bloomberg, Updata, HSBC

37

As it was here…

Source: Bloomberg, Updata, HSBC

38

And here…

Source: Bloomberg, Updata, HSBC

39

Oil near a top…

Source: Bloomberg, Updata, HSBC

40

Dollar bull market…

Source: Bloomberg, Updata, HSBC

41

A stirring in long end Gilts…

Source: Bloomberg, Updata, HSBC

42

Suggesting big changes to come…

Source: Bloomberg, Updata, HSBC

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Summary

Elliott Wave Principle is purest form of technical analysis

Price and volume create patterns of psychology

Natural proportionality to mass human behaviour

Elliott Wave is NOT a trading system

Running winners and cutting losers makes money

Combining Elliott with Trend Following makes sense

Zones in on high probability set ups

Live in the moment Zen psychology Source: istockphoto

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HSBC Technical Analysis

Day Traders Support & Resistance Levels(Daily)

Short Cycle Report(Twice per Week)

Wave Principle Letter(Weekly)

Trend-Wave Trading Signals(Ad-hoc trade ideas / portfolio)

…coming soon….

Long Wave & SocionomicJournal(Semi-Annual)

www.hsbcnet.hsbc/research

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Disclosure appendix

Analyst CertificationThe following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: Murray Gunn

Important disclosuresThis report is designed for, and should only be utilised by, institutional investors. Furthermore, HSBC believes an investor's decision to make an investment should depend on individual circumstances such as the investor's existing holdings and other considerations.This document has been prepared and is being distributed by the Research Department of HSBC and is intended solely for the clients of HSBC and is not for publication to other persons, whether through the press or by other means. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other investment products mentioned in it and/or to participate in any trading strategy. Advice in this document is general and should not be construed as personal advice, given it has been prepared without taking account of the objectives, financial situation or needs of any particular investor. Accordingly, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to their objectives, financial situation and needs. If necessary, seek professional investment and tax advice. Certain investment products mentioned in this document may not be eligible for sale in some states or countries, and they may not be suitable for all types of investors. Investors should consult with their HSBC representative regarding the suitability of the investment products mentioned in this document and take into account their specific investment objectives, financial situation or particular needs before making a commitment to purchase investment products. The value of and the income produced by the investment products mentioned in this document may fluctuate, so that an investor may get back less than originally invested. Certain high-volatility investments can be subject to sudden and large falls in value that could equal or exceed the amount invested. Value and income from investment products may be adversely affected by exchange rates, interest rates, or other factors. Past performance of a particular investment product is not indicative of future results.Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues.For disclosures in respect of any company mentioned in this report, please see the most recently published report on that company available at www.hsbcnet.com/research.HSBC Legal Entities are listed in the Disclaimer below.

Additional disclosuresThis report is dated as at 08 June 2011. All market data included in this report are dated as at close 07 June 2011, unless otherwise indicated in the report.HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBC's Investment Banking business. Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or price sensitive information is handled in an appropriate manner.

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