Experiment - Is ignorance bliss or is a little bit of knowledge a dangerous thing?

I have only recently been introduced to EW analysis. My knowledge comes only second hand from reading Prechter’s Perspective and from reading Andy T, I-Man, CV et al on Traders Anonymous. After a complete lack of exhaustive study I have gleaned 2 insights – movements tend to happen in 3 and 5 waves and waves tend to retrace to Fibonacci ratios before continuing with trend.

Armed only with this knowledge I am going to experiment with some trade ideas on the GBPZAR cross in which I detect an EW type pattern. Apologies for the bad chart – still trying to work out the technology.



I have 3 scenarios in mind ranked in order of likelihood:
1. The recent move down to 11 completed 4 waves down from the Dec08 high. I therefore expect a retrace from 11 to around 11.8 before commencing a further wave down below 11. A close above 11.7 followed by a close below 11.5 would suggest this is what is happening.
2. The recent move down to 11 completes 5 waves down from the Dec08 high and the recent move off 11 is the start of a new uptrend. A close above 12 would suggest this is the case.
3. The move down to 11 was the bottom of a second wave down from the 13.54 high in Aug09. We would therefore expect a retrace to around 12.3 before commencing a strong P3 type wave down to well below 11.

The confusion between 1 and 2 is caused by the move between the Aug09 high at 13.54 and the Mar10 bottom at 11. There were 2 down waves ending at 11.58 and then 11.68. Given that the second low in Jan10 was higher than the Oct10 low I am not sure whether to count this as one wave or two.

The third scenario looks a bit unlikely as it would imply a blow off top in risk assets, although with the right circumstances in gold prices and UK elections for example, we could see a big move in this cross independent of a risk on blow off. A risk off trend in other markets would probably kill this scenario and given the recent congestion near the highs I see this as high probability and hence scenario 3 is low probability.

However I think there is a limited risk trade for all 3 scenarios so I have gone short ZAR 11,300 v GBP 1,000. Stops are set at 11. At present the plan would be to take half the position off at 11.7 but re-establishing at 12 if we continue up above 11.7. If instead we bounce off 11.8 like scenario 1 I will close the ZAR short at the second visit to 11.7 and initiate short GBP 1,000 v ZAR at 11.5 with stops at 11.8. If we continue to go up above 12 I would stay short ZAR until we hit 12.3 where I would tighten the stops to 12. A close above 12.3 followed by a close below 12.1 would bring scenario 3 into play so after a stop out of the short ZAR at 12 I will initiate a long at 11.8.

Let’s see how this little experiment works.