Why do people cut three slits on the top of an apple pie before baking it? To let steam escape while the pie is baking, to keep the juices from dripping out between the upper and lower crust, and – most likely, the real reason – because that’s the way their mothers always did it.
Analyzing commodity price charts isn’t anything like baking an apple pie, except in one important regard: most people use a certain kind of price chart because that’s the way analysts have always done it. But once you take the time to compare different types of charts, you may agree with me that it’s time to break away from adopted protocol, maybe not in pie-making but certainly when it comes to applying the wave principle to commodity price charts. [See sidebar: What Is the Wave Principle?] The convention used to compile long-term price data of financial markets is standard continuation. It means that as one contract month expires, the historical charts transition to the next month. And it is this transition, or compilation of data that results in the formation of continuation charts be they weekly, monthly or yearly.
The Nitty Gritty Behind the Data
Why is data compiled this way? Primarily because the front month contract of a commodity – more than other months traded – usually has the most volume and open interest (that is, the total number of futures contracts or option contracts that have not yet been exercised, expired or fulfilled by delivery). Also, many commodities don’t have a contract for each month of the year, which results in significant price gaps in many commodity price charts. Is standard continuation the only format available? No, historical price charts can be created using various methods – for instance, rolling contract data on the first trading day of the expiration month instead of at expiration. Other methods are based on volume and open interest, rolling contract data on a specified day prior to expiration or even from one calendar month to the same calendar month of the following year. In other words, there are multiple ways to view historical price data; including the one I want to focus on – active continuation. What exactly is an active continuation chart? It is a price chart of the rollover of contracts based on volume and open interest instead of rollover at expiration.
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What is the Wave Principle?
The wave principle is a form of technical analysis, based on crowd psychology and pattern recognition. Ralph Nelson Elliott first discovered it in the 1930s, after having spent many years analyzing stock market data. What Elliott observed was that stock prices trend and reverse in recognizable patterns. After naming, defining, and illustrating 13 such patterns, he went on to describe how they connect, forming larger and smaller versions of themselves – what he later called the wave principle.
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Figure 1a illustrates the basic building block of the wave principle. Elliott observed that when prices were rallying in a bull market, they did so in five distinct waves, which he called motive or impulse waves. Once a five-wave move was complete, prices would decline in three waves, correcting a portion of the preceding advance. Elliott used numbers to identify impulsive phases and letters for corrective phases of price activity. Once the sequence was complete, the pattern would repeat in larger and smaller versions of this same basic pattern. The same holds true for bear markets, in which case, this pattern is inverted – five-wave declines followed by three-wave rallies.
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Standard Versus Active Continuation Charts
When I began my career as an analyst almost 15 years ago, I always viewed price charts in the traditional standard continuation chart format because that’s the way everybody did it. And for the longest time, I never gave much thought as to why. But as time went on, the impetus to challenge this tradition stemmed primarily from my analysis of long-term price charts in the meat complex (pork bellies, lean hogs, live cattle and feeder cattle). Now let me show you what convinced me that there had to be a better way to analyze the meat complex. First, let’s examine the difference between Figures 1 and 2, which both show quarterly data for the same 35-year period for lean hogs. The only difference is that Figure 1 shows a standard continuation chart, while Figure 2 shows an active continuation chart. Clearly, the difference in the look of the charts is astounding. One is choppy, noisy and not useful for charting waves. The other – the active continuation chart – shows more typical wave patterns.
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Chart Type Can Be Important
The wave principle is a form of technical analysis based on crowd psychology and pattern recognition (five waves up, three waves down). So what type of data format do you think is best to use when charting prices: standard continuation, because that’s the way your mother did it? Or a price chart that more accurately represents the crowd psychology of a specific market (i.e., active continuation)? I am convinced that at certain times and in certain markets active continuation charts are more valuable, especially to Elliotticians. Let me back up this assertion with more examples. Remember, if active continuation charts reflect crowd psychology better than standard continuation charts, then they should show textbook examples of Elliott wave patterns more often than the traditional standard continuation chart format. In fact, they do, as I can show you in Figure 3.
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Figure 3 shows feeder cattle price action from the April 1979 peak to the April 1991 peak in standard continuation format. As you can see, the price action can still be labeled according to the rules and guidelines of the wave principle, although it’s unclear at best. Now let’s take a look at the same data for feeder cattle using an active continuation chart (Figure 4). In this chart format it’s much easier to see that the April 1979 sell-off unfolded in three waves, thereby implying that this was a corrective move that would eventually be retraced and then some – which it was. The same, however, can’t be said about feeder cattle in Figure 3, in which the impulse wave that began in April 1986 failed to fully retrace the prior corrective move. The active continuation chart for feeder cattle is also impressive because it more clearly shows the impulse wave that began in April 1986 and its extended fifth wave. These wave patterns in the active continuation chart data are much closer to textbook wave patterns than in the standard continuation chart format.
Moreover, Fibonacci relationships that are typically found within idealized Elliott wave patterns are more prevalent in active continuation charts than in standard continuation charts. For example, in Figure 5 we see that wave C, in the three-wave correction, ended moderately below the .618 multiple of wave A. The most common relationship found within zigzag wave patterns such as this one is equality between waves C and A. Even so, 1.618 and .618 relationships do occur and are quite acceptable. So Fibonacci relationships also tend to confirm the preference for the active continuation chart. The supporting evidence in favor of using active continuation chart data versus standard continuation chart data doesn’t stop there. Figure 6 shows the relevance of using standard fifth-wave Fibonacci multiples in identifying resistance for wave five. I hope that these charts have provided enough evidence to make my case that the rules and guidelines of the wave principle are more applicable on active continuation charts than on standard continuation price charts. They have certainly convinced me to offer my analysis of pork bellies, lean hogs, live cattle and feeder cattle charts instead of standard continuation charts from using active continuation now on.
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What about the other commodity markets I follow: will I change to an active continuation chart format in each of those markets as well? For right now, the answer is “no.” I will continue to use the standard continuation chart format for softs and grains for now because it doesn’t present the same difficulty inherent in analyzing continuation chart data of the meat complex. Even so, in the months ahead, I will continue to watch both standard and active continuation charts in each commodity market that I follow to help me ultimately decide which format is best to use for Elliott wave analysis.
Change in the Forecast for Meat Complex
So now that we have decided to change the number of slits in our apple pie crust, does that change the long-term outlook in the meat complex? Yes, it does, and that’s what makes the difference in the way the data is compiled and compared even more interesting. I haven’t written about pork bellies, lean hogs, live cattle or feeder cattle in quite a while in my futures forecasting service, Monthly Futures Junctures. That’s because, based on my analysis of the standard continuation data, my long-standing view was that the meat complex had essentially topped and was entering a months-long, if not a years-long, bear market. For example, Figure 7 illustrates my long-term Elliott wave interpretation for the live cattle market. As you can see, my long-term forecast was sideways to down.
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Now let’s examine live cattle using its active continuation charts (Figure 8). This price chart hints of a very different outlook in live cattle. In fact, wave patterns in this market now suggest that a significant tradable low is forming that will lead to new all-time highs in live cattle. The same holds true for the meat complex as a whole. Will this forecast come to pass in a few trading days or a few weeks? Of course not. But I do believe that the patterns in these active continuation charts provide strong enough evidence to suggest that recent selling in the meat complex will be more than fully retraced in the coming months.
Take A Fresh Look
Deciding to change mom’s method of cutting slits in an apple pie crust is not something I have done lightly. It is the result of countless hours of analysis over many months and years. Some people may see this change as welcome and long overdue; others may dislike the changing of a tradition.
 
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