- 2000: Volume 9, No. 3 Wave Charting and Commodity Trading

A trading technique which is remarkably useful and greatly overlooked, and one which is especially suited for commodities trading, is a charting technique developed by the technical pioneer Richard Wyckoff, which Jack Hutson, author of Charting the Stock Market: The Wyckoff Method, has called "Wyckoff Wave" charting.

Wyckoff, who revealed this technique in his now classic 1910 book, Studies in Tape Reading, spent his career as a stock operator and market technician on Wall Street and only rarely ventured into the commodities arena. Yet the little-known technique he developed for anticipating and forecasting stock prices is wonderfully suited for commodities and, I would argue, is one of the most accurate methods of predicting significant moves in a particular commodity since it incorporates an advantage which the stock trader has over the commodities trader, and that is, a more reliable method of forecasting trading volume.

Wyckoff called his method of price forecasting "Wave Charting," since it tended (and still works wonderfully) to isolate major movements in stock sectors and was less volatile and subject to whipsaws than merely following an individual stock. As this would imply, his technique was based upon making a composite average of a basket of stocks within a given sector.

The assumption behind wave charting is that the best way of identifying trends within a given stock market sector is to make a simple average (without giving unequal weighting to one stock over another) of the prices and volumes of five leaders within the sector the analyst or trader is following. The benefit of this technique is that it considerably lowers the risk of being deceived by a manipulation campaign in one stock while the other stocks are trading normally. With this method, it becomes almost impossible to lose sight of the immediate trend.

Jack Hutson, in his book, Charting the Stock Market: The Wyckoff Method (Technical Analysis, Inc., 1998), elucidated this technique, which he styled the "Wyckoff Wave" method as follows:

"A wave chart shows the psychological moment to buy or sell. It is the pulse of the market, a condensed picture of every vital development in every stock market session and an invaluable aid in determining the turning points of minor and intermediate swings—frequently days before the popular averages give an indication.

"Wave charts are graphs of the aggregate of the five leading stocks of an industry group over the past several months. This group of five is adjusted from time to time, so the wave chart shows the progress of stocks and continuous and real leadership. Every change in the aggregate price throughout the trading day is plotted, and a complete wave chart also shows volume and an index of activity, or intensity, of trading."

As an example, we have provided in Figure 1 an actual wave chart of the five leading U.S. industrial stocks (Bethlehem Steel, General Motors, DuPont, Exxon, and IBM) in which we averaged the high, low and closing prices for each stock as well as the daily volumes. Note how smoothly the chart tends to trend, as opposed to the widely followed Dow Jones Industrials. As noted previously, wave charts tend to eliminate much of the volatility and "whipsaws" that characterize the more popular averages. It also makes tape reading easier since it tends to isolate volume patterns better than the popular averages do.

Figure 1

Another benefit of the wave chart is that it allows for greatly improved forecasting of commodity price trends, since it allows the analyst to chart the cumulative price movement and volume pattern of a given industry related to whatever commodity is being traded. Let us assume, for example, that the trader wants to trade gold futures. Rather than analyze the chart for gold alone (which can be highly misleading at times, due to the nature of commodities trading volume compared to stock market trading volume, which must be interpreted slightly differently), he can construct a wave chart of the five leading gold mining companies that are publicly traded on the NYSE. In this example, illustrated in Figure 2, he might choose to average the highs, lows and closing prices, along with volumes, of the following mining stocks: Barrick Gold, Newmont Mining, Hecla Mining, Placer Dome, and Homestake Mining. This would give the trader a much improved picture of which direction the volume is flowing within this sector.

Figure 2

Indeed, as our wave chart for gold ably demonstrates, the gold stocks were providing a leading indicator for the physical gold market itself. In this case, the wave chart broke away from its trend to produce a very conspicuous price gap, which foretold of concentrated insider selling in advance of a sell-off in the gold futures market.

Note also how the wave chart labeled "Grains Index" in Figure 3 gave the trader a heads-up to the imminent rally in the wheat futures market by a couple of weeks. The wave chartist would have known in advance to expect a meaningful move in the grain futures markets based on the high-volume, upside close produced in this daily bar chart.

Figure 3

The reasoning behind the wave chart is simple: insiders and other large vested interests tend to know beforehand of any significant factors which may adversely impact the futures market, and they tend to act on this knowledge in the stock market before they act in the commodities market. This is the rationale behind wave charting as applied to the commodity markets.

On the philosophy of wave charting, Hutson further observed: "Just keep in mind that when you're charting, you're dealing with waves. Every swing in the market, no matter how many points it is, consists of numerous buying and selling waves. The waves last just so long as they can attract a following and when that following is exhausted, the wave ends and a contrary wave sets in. It's much like the tide moving to a higher or lower level through a series of surges." (Charting the Stock Market: The Wyckoff Method —Technical Analysis, Inc., 1998.)

By keeping wave charts on a number of commodity sectors, a trader can conceivably follow the trends more accurately in whatever commodity he may be trading. One need only to select the five leading, actively traded stocks in whatever sector one is following. The criterion I use to select these stocks for averaging is that they have the five highest daily trading volume averages. When these rules are followed, rarely will the trader be disappointed with the results.

Clif Droke is a popular technical analyst and author of two bestsellers, Technical Analysis Simplified and Elliott Wave Simplified. In addition, he is the editor of Leading Indicators newsletter.