Question of the Week: 9/1/2012

Mastering Elliott Wave was written before the internet or automated, computerized trading systems existed. Do such things as "high frequency trading" negatively impact the viability of Wave theory?


This is an intriguing question. While wave theory categorizes, and attempts to predict, the emotion-driven behavior of crowds, computerized systems are unemotional in their processing of data and their attempted execution of trades. So, theoretically, if only computers were allowed to trade, and if they could program themselves, and if they had endless supplies of cash, it's possible price action would no longer reflect human behavior so markets could no longer be categorized or predicted using Elliott Wave or NEoWave.

Fortunately, markets and computers do not exist without people. First, all programs are created by humans who possess specific beliefs, fears, financial limitations and goals which impact the design of an automated system. Second, if a computerized system loses enough money, someone in charge will eventually stop trading (or the system may stop loss at 20%, 30%, 40%, etc.; if no fail-safe is in place, trading will stop when capital runs out). If the stop in trading is "manually" instituted by an individual, the decision to stop trading will be partly based on past experiences and their personal level of risk-tolerance (or the risk tolerance of the investors who's money they are managing). Third, government regulation might enter the picture if public pressure (i.e., crowd psychology) forces the exchanges to change the rules of the game. This occurred when the Hunt brothers "cornered" the silver market in 1980; the futures exchange decided no new, open positions would be allowed in silver - only liquidation orders would be accepted for a while. The result was silver quickly collapsed in value. Even if trading is automated, humans initially decided if a trade is taken or not, how much risk is allowed on each trade (or tolerated overall for an account), how positions are entered, stops placed, targets calculated, how many positions are taken per trade, how long a position is held, and whether trading continues as losses accumulate. When the creator's goals, beliefs, financial limits and strategies are programmed, the trading system simply institutes predetermined human decisions.

In conclusion, automated trading programs reflect the personal beliefs, financial capacity and goals of those involved in their creation. When hundreds or thousands of human-created trading systems interact in a free market, collectively they produce a more disciplined, fast-acting version of their human counter-parts. As a result, the individual psychology that went into the creation of each system will, collectively, produce price action that reflects mass human behavior - what wave theory is designed to identify and help predict.

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