Using the COT Reports to Predict Forex Price Movements

Before examining the COT reports and a few ways of using them, let us note two important details:

• One of the major problems with the forex market is the lack of a volume indicator. Since there is no forex exchange such as the Nikkei or the NYSE, volume statistics on the entire market are not available. The COT report, tracking the currency and commodity futures allocations of the major speculators and commercial hedgers, is an excellent substitute for the volume indicator, and it should therefore be an inseparable item of any technical trading scheme.
• The other point which we would like to emphasize is the lagged nature of the report. As it updates us on positions of the past week, it is a lot more valuable as a long-term indicator, with periods of weeks, rather than days being the field of its measurements.

The COT (commitment of traders) is a report issued by CFTC to update the public on the futures positioning of traders in commodities markets. In the US most futures trading takes place in Chicago and New York, and the institutions covered by the report are heavily concentrated in these locations.
Let’s examine the body of a COT report.
EURO FX - CHICAGO MERCANTILE EXCHANGE Code-099741 FUTURES ONLY POSITIONS AS OF 03/17/09 | --------------------------------------------------------------| NONREPORTABLE NON-COMMERCIAL | COMMERCIAL | TOTAL | POSITIONS --------------------------|-----------------|-----------------|----------------- LONG | SHORT |SPREADS | LONG | SHORT | LONG | SHORT | LONG | SHORT -------------------------------------------------------------------------------- (CONTRACTS OF EUR 125,000) OPEN INTEREST: 111,077 COMMITMENTS 33,657 42,696 548 37,055 34,864 71,260 78,108 39,817 32,969 CHANGES FROM 03/10/09 (CHANGE IN OPEN INTEREST: -69,201) -273 -1,466 -1,371 -67,685 -64,551 -69,329 -67,388 128 -1,813 PERCENT OF OPEN INTEREST FOR EACH CATEGORY OF TRADERS 30.3 38.4 0.5 33.4 31.4 64.2 70.3 35.8 29.7 NUMBER OF TRADERS IN EACH CATEGORY (TOTAL TRADERS: 99) 38 30 7 19 17 60 51
Open interest describes the amount of open futures contracts that are being held. In other words, it is the total volume of open contracts in the market, but not the transactions.
Reportable positions are the positions held by institutions that meet the reporting requirement of the CFTC. These are the major players in the CBOT, and their choices are usually backed by hordes of analysts and their studies.
Non-reportable positions cover everyone who do not suit the above criteria, and they are also termed small speculators. Of reportable positions, non-commercial includes all actors who do not possess any interest in making use of the underlying currency or commodity, such as hedge funds, brokerage firms, investment banks and other related firms. Commercial open interest is created by firms that have the desire to receive or deliver the underlying. Thus the roles played by the two categories of traders is quite different.
Spreading covers those trades who hold an equal number of long-short positions on the future contracts.
The report provides data on the percentage of long or short contracts to the total, on the number of traders in all three categories with positions on a currency, and finally the changes in open interest in comparison with the previous reporting period.
Over the years the COT report has become quite a popular tool for all kinds of traders. Here are a number of ways of exploiting the data provided by the COT report.

1. Creating a currency portfolio based on the COT report positioning.

We can use the COT report data to create a diversified currency portfolio. By examining the COT report, we can have a good idea of the attitude of major traders toward the USD, but to make real use of the the data we must create a portfolio of currency pairs, such as AUD/USD, EUR/USD, USD/JPY. Since the market can be, overall, long the USD, but can be short the USD against one or more currencies, we do not want to be caught holding a pair in which the USD will lose value, while the COT is still long. Let us now suppose that the non-commercial sector is overall long the USD in our example.
What should be the criteria in deciding the currency pairs that will be included in our portfolio in such a situation? In general, it’s a good idea to make our portfolio interest-neutral, so as to express in our currency allocations our USD-positive idea, while declining to say much about the currencies we will short.
For instance, we will short AUD/USD and EUR/USD (and the carry is negative) and long USD/JPY and then we will manage our currency pair ratios in such a way that the total interest received will not exceed the Fed rate. Why do we do this? Because all we want to do is to gain from the appreciation of the USD while limiting the volatility caused by the carry trade. By making our position interest-neutral, we will, we expect, be able to ride through such disruptions. This will reduce the volatility of our portfolio, and will also reduce the potential return from our investment, but it does create a longer-lasting, more resilient position.
Another, but much riskier way to create our COT-report based portfolio would be to simply long what the commercial sector is long, and to short the commodity or currency in which the non-commercial traders are long. Thus, for instance, if the commercial sector is long the EUR, and the speculative sector is long the AUD, the trader would simply arrange his portfolio to reflect the market’s choice by assigning a large part to EUR/AUD. And one can go on with this method, to create an interest-neutral portfolio in the previously described way, thereby limiting the volatility of the position, and ensuring a more successful long-term strategy.

2. Exploiting reversals in positioning to create a portfolio

It’s also possible to arrange the above mentioned portfolios to profit from trend reversals as signaled by COT reports, but we caution against this method, unless the trader carefully hedges his position by trading uncorrelated(or negatively correlated) pairs. Correlations statistics of currency pairs are available from most major forex brokers.
It is nonetheless true that major changes in the strength of a trend, or its reversal on a permanent basis, are indeed noted by changes in open interest, and institutional positioning. Our only suggestion is that the trader be aware of the potential of false signals, and, as per the usual principle, avoid trying too hard to catch bottoms and tops.

3. Using the COT report as a long term volume indicator

An exceptionally useful and prudent use of the COT report is regarding it as a volume complement to the price studies generated by conventional technical analysis. The trader can simply refuse to act when a technical signal fails to be confirmed by a similar movement (signaled in increasing open interest) in the COT report. For an uptrend, he would expect a corresponding rise in open interest, and for a down trend, a corresponding fall. It is also possible to devise indicators for this purpose, and MACD, Williams Oscillator, or Stochastics can all be drawn on the COT report data.
This approach is akin to using volume and price data simultaneously while exploring stock market charts, and those with experience in that field will easily grasp the importance of the COT report. Nonetheless, those with little knowledge of other markets can still greatly benefit from its utilization, especially when trading on a purely technical basis.

4. Using flips in positioning to predict market reversals

In the sample COT chart above, non-commercial net positioning for Euro is short, since 38 percent of traders are holding short positions, while thirty percent hold longs. One way of exploiting this segment of the COT report is by taking note when net positioning switches from long to short and vice versa, and predicting forex market reversals on that basis. In the above example, when net positioning of the non-commercial sector switches to long, we would use the development as a signal for buying euros, coupled with some input from other sources of technical analysis.
While this method can produce results that are much more reliable than those generated by pure technical analysis, the trader should still be aware of whipsaws and unpredictable spikes and collapses that can sometimes arise. Percentage values are easier to recognize, and are easier for recognizing position flips.

5. Using extreme positioning to gauge market exhaustion

Comparing long or short positioning with historical extremes can also be beneficial in identifying market extremums. Experience shows that there are absolute values which indicate a bought-out, or sold-out currency, and as the COT positioning hits these values, there’s a significant chance of a rapid reversal.
Extremums can also be termed bubbles, as they characterize a market that is already in an unsustainable phase of rise or fall. The problem with this method lies in the fact that it’s always hard to pick up tops and bottoms: there’s no reason to expect that positioning cannot exceed a previously registered high, before collapsing. Still, if one has the determination and the resilience, extremums reported by the COT report have much greater value than that reported by price based technical analysis.
It is possible to confirm the absolute extremes on the COT report with extremes on moving averages or oscillators on the price chart.

Summary

The COT report is a very useful tool which can be substituted for the volume indicators of stocks analysis. Absolute long and short positioning and historical comparisons can be useful for identifying market extremes. Percentage changes in open interest can be valuable in noting position flips and predicting market reversals in the medium term. If there ever were an ultimate technical indicator, its seekers have their greatest luck in COT data. But the old advice on not putting all eggs in the same basket is still valid: it’s better to confirm signals from the COT report with data from other aspects of TA, and of course fundamental analysis, before reaching decisions.

Trading Managed Currencies - Exploiting Central Bank Policies to Make a Profit

Managed currencies are those such as the Singapore and Hong Kong dollars, the Chinese yuan, the Russian ruble, where the Central bank doesn’t control the day-to-day fluctuations of the currency, but attempts to manage the direction of the trend by periodical interventions. The interventions are usually formulated through a floating or fixed currency band where the price is allowed to move within a range around a central point which are both set by the Central bank. Usually, only those central banks or monetary institutions with a significant reserve accumulation can aim to manage their currencies effectively, as countering the actions of the market can be costly.
The midpoint and the percentile range within which the price moves are sometimes held as a secret by central banks, and sometimes they are public. It is also possible that the central bank possesses no solid numerical long-term plan for the price range, but moves as the fundamental data flow and the political authority dictate. The policy choice is a secret in the case Singapore, is open in the case of the Hong Kong dollar and is partially public according to data in the cases of both the ruble and the yuan.
Before further explanation, let us say that the predictive power of government policies tends to diminish during periods of volatility and economic turmoil. Central banks are not run by wizards with crystal balls, and usually they do not possess confidence or willpower greater than that possessed by the experienced trader. As a result, policy errors, zigzagging, and conflicting signals generate a lot of noise through which the trader must wade his way to success.
The word “managed” in the phrase managed currency encapsulates the core of our strategy in trading currencies in this section of the market. The authorities make a commitment not to allow their currencies to move beyond the limits of a band, and they are ready to intervene when such a movement occurs as a result of chaotic market action. And, to the further benefit of the trader, newspapers, forex websites, and forex market news providers all declare the presence of central bank authorities when they do intervene. In many cases, the central banks also encourage the publication of their presence as they seek to intimidate and discourage those who want to counteract their policies. All that the trader would have to do to profit from such interventions is noting the direction of the intervention, and acting in accordance with it. Thus when we know that the technical indicators are showing extreme values (for instance RSI is at 20 or 80), there’s news flow speaking of intervention, and the central bank has already made its intention to prevent extreme price fluctuations clear, the trader can, with great confidence, make a counter-trend move with a reasonable stop-loss order, and expect to return a meaningful profit. This is a proven and well known method, with very high odds of success.
The behavior of the Monetary Authority of Singapore between October 2007 and April 2008 provides countless profitable examples for this method. In many cases where the RSI registered extreme values, the MAS would intervene, and as traders used the opportunity to pile in, large amounts of profits were made. Counter-trend interventions by MAS were usually easily detectable because of the very large movements in spot within seconds, and they were also noted by Bloomberg and financial news providers.
Conversely, between November 2007 and April-May 2008, the People’s Bank of China allowed the yuan to appreciate in a very regular, and predictable fashion, providing currency traders with a unique opportunity to register risk free profits. Because the central bank manages volatility in a punctual and strict fashion, the risk of any significant reversal was almost non-existent, and policy direction was communicated clearly and decisively by the chief of the institution.
Where do the pitfalls of this method lie? Obviously, the first and foremost obstacle to the success of a central bank is insufficient reserves, or lack of political will. Usually, a central bank will do all that is in its power to ensure credibility but if the market does not find its declarations credible, it has the power to invalidate the schemes of the institution. Similarly, markets are quick to punish those nations where financial policies are and improvised and revised in response to temporary developments. In spite of all this, given the very high level of uncertainty that the forex trader must be used to live with, following interventionist central banks can be a relaxing experience.
Currency interventions are especially difficult when they occur on an isolated basis against prevailing market conditions with insufficient reserves. Given how liquid and vast the forex market is, only exceptionally reserve-rich nations, like China or Singapore, or those with little need of external financing, like Saudi Arabia, can be confident that they have the clout to make their interventions work. On the other hand, markets treat those few Central Banks with respect, and they are unlikely to suffer from short term shocks, and their interventions and currency policies have credibility that is not found in other, less financially sound nations.
To repeat, managed currencies can be a source of great profit if they are traded with patience and consistency. The risks involved are usually much lower than those faced when trading floating currencies, with the one caveat that currency crises can quickly wipe out the gains of a long-time if the trader is not sensible with his stop-losses. The principles of sound money management, and low leverage are still valid when trading this type of market. One should avoid bubbles, and it’s not a good idea to chase excessive price movements, especially because the managed currencies tend to absorb a lot of tension by resisting market pressure, and if they break, the reactions can be very violent and fearsome.
We strongly advise the trader to concentrate on one or two managed currencies, if that is the method he would like to employ, to absorb the policy choices and principles of the Central Bank in question, and act in accordance with global developments. The transparency and independence of the Central Bank are both exceptionally important, because we would not want our guiding institution to zigzag or bow to political power, in essence invalidating its statements and policy declarations. Singapore and HK are good choices to begin trading this method.
Here is a list of some currencies with their Central Banks and their policy preferences.
USD/SGD: Controlled by the Monetary Authority of Singapore, this pair is one of the more predictable and easier for those who prefer this forex strategy. Because of the status of Singapore as an importer of necessities like food, the monetary authority of Singapore aims to control inflation through the currency rate, and its policies are regularly and clearly communicated at its website.
USD/CNY: Controlled by the People’s Bank of China, the yuan’s value depends on two important factors: the trade surplus of China versus the Euroland and the United States, and the unemployment situation of China’s rural regions. The central bank does not zigzag, however it’s policies are greatly influenced by the supreme leadership of the nation and their relations with the US government. PBoC allows the yuan to appreciate at times of economic boom and inflation, and generally holds it stable during recessions and economic turmoil.
USD/HKD: The HKD is pegged to the US currency at 7.8, but is allowed in a band of 7.75 to 7.85. Hong Kong’s economic policies are influenced greatly by developments in mainland China, but the nation has a currency board policy, and is mostly independent in its policy choices. The nature of the peg suggests an almost risk free trade in buying the HKD at 7.75 and selling it as it appreciates.
USD/RUB: The ruble is managed by the Central Bank of the Russian Federation. Its policy choices are determined by Russia’s external balance, and the price of oil and other commodities.

Trade Timing - How to Decide Entry/Exit Points

If money management is one half-of trading, determination of entry/exit points constitutes the other half. No amount of successful analysis will be useful if we can't determine good trigger points for our trades. Even if we know that the value of a currency pair will appreciate in the future, unless we have a clear conception of when that appreciation will occur, and where it will end, our knowledge is unlikely to bring us great profits. Similarly, even in the unfortunate situation where the analysis that justified the opening of a position is false, mastery of trade timing might allow us to register positive returns due to the high volatility in the forex market. Clearly, we need powerful strategies to help us calculate the best trigger values for a trade justified by careful and patient analysis.
We have discussed the various ways of creating stop-loss orders on this website, and in this article we'll continue on that theme by handling this subject in a more general way by identifying some principles for the management of our positions. The opening and closing of a position are the most frequent activities of any trader; it is obvious that this should also be the subject to which we devote the greatest attention. However, as in the case of a doctor or an engineer, the final task that is performed routinely and most frequently depends on certain skills, education and study which for the most part lack any obvious relationship to it. Thus, it is important to note that the study of trade timing is one of the final lessons for which the trader must prepare himself. The other courses that would lead us to this subject, such as technical and fundamental analysis, may not always have clearly definable benefits at first sight, but they pave the way to our ultimate goal of timing our trades successfully and profiting from them.
Before going into the technical aspects that complicate our trading decisions, we must say a few words on the necessity of emotional control in ensuring a successful and meaningful trading process. Let's repeat again, as we've done many times on this site, that without proper control over our feelings not a single word in this text would help us to trade profitably. The psychological endurance necessary for achieving a successful trading career is an important precursor to both money management and trade timing. Consequently, even before beginning the study of trade timing, we must concentrate our energies toward the goal of understanding and restraining our emotions, and gaining control over the psychological aspects of decision-making in a trading career. The Main Principle of Trade Timing
The first principle of trade timing is that it’s impossible to be certain about both the price and the technical pattern at the same time. The trader can base his timing on the actualization of a technical formation, or he can base it on a price level, and he can ensure that his trade is only executed when either of these events occur, but he cannot formulate a forex strategy where his trade will be executed when both of these occur at the same time. Of course it is possible that by chance a predefined price level is reached precisely at the time that the desired technical pattern occurs, but this is rare, and unpredictable.
Supposing that the trader is desiring to buy one lot of the EURUSD pair, he has the option of basing his entry point on the realization of a technical pattern, or the reaching of a price. For example, he may decide that he’ll buy the pair when the RSI indicator is at an oversold level. Or he may decide, for money management purposes, that he’ll buy it at 1.35, to reduce his risk. Similarly, he may choose to place his stop-loss order at the price point where the RSI reaches 50, or he may choose to enter an absolute stop-loss order at 1.345, to cut losses short. But due to the unpredictability of the price action it is not possible to define an RSI level, and a price level at the same time for the same trade.
We may examine this further on a chart.

This is an hourly chart of the GBPUSD pair between 5 December 2008 and 5 January 2009. We’re supposing that we opened a long position at around 1.5, where the RSI registered an extreme value at 24. In this case we expect to close our position when the value of the indicator rises above 50, to acquire healthy profits while not risking too much by staying in the market for long. We could have alternatively placed a real stop-loss order at 1.48, for example, but we decide not to do so because of the high volatility in the market. However we do expect that if the RSI rises, we will not need a stop-loss order, because the price would have been at a higher level indicating a profit, since it’s supposed to rise with a rising price.
But such is not the case, as we can see in the picture above. When the RSI had risen to 49.35 on the chart, which is a close enough point for our goal on the indicator, our position is, surprisingly, in the red. Not only do we fail to match our stop-loss to a lower price, but we actually match a lower price with our take profit point, which was 50 as mentioned. To put it shortly, the indicator converged on the price action, contrary to our expectation that it would move in parallel.

How to time our trades: Layered trade orders

What are the lessons derived from this example? First, the correspondence between technical values and actual prices is weak. And as we stated in the beginning, it’s not possible to base our trade timing on a price and an indicator at the same time. Second, technical indicators have a tendency to surprise, and how much a trader relies on them will depend on both his risk tolerance and trading preferences. Lastly, technical divergences, while useful as indicators, can also be dangerous when they occur at the time when we are willing to realize a profit.
So what is the use of technical analysis in timing our trades? Most importantly, how are we going to ensure that we don’t suffer great losses when divergences on the indicators appear and invalidate our strategy, and blur our power of foresight?
The potential of the divergence/convergence phenomenon for creating entry points has been examined extensively by the trader community, but its tendency to complicate the exit point has not received much attention. But it is just one of the many aspects of trade timing that is complicated by the unexpected inconsistencies which appear between price and everything else. So if we had the choice, we would prefer to exclude price from all the calculations made in order to reduce the degree of uncertainty and chaos from our trades. Unfortunately that is not possible, as price is the only determinant of profit and loss in our trades.
In trade timing, the trader has to take some risk. The best way of taking the risk and avoiding excessive losses is using a layered defense line, so to speak, against market fluctuations and adverse movements and we discussed how to do this in our article on stop loss orders. The best way of taking the risk and maximizing our profits is the subject of entry timing, and the best way of doing so is using an attack line that is also layered. What do we mean by that?
In ancient warfare, it was well-understood that the commander must keep some of his forces fresh and uncommitted to exploit the opportunities and crises that arise during the course of a battle. For instance, if the commander had run out of cavalry reserves when the enemy launched a major charge against one of his flanks, he might have found himself in an extremely unpleasant situation. Similarly, if he had no rested and ready troops to mount a charge at the time his opponent demonstrated signs of exhaustion, a major opportunity would have been lost.
The layered attack technique of the trader aims to utilize the same principle with the purpose of not running out of capital at the crucial moment. In essence we want to make sure that we commit our assets (that is our capital) in a layered, gradual manner for the dual purpose of eliminating the problems caused by faulty timing, and also outlasting the periods associated with greatest volatility. By opening a position with only a small portion of our capital, we ensure that the initial risk taken is small. By adding to it gradually, we make sure that our rising profits are riding a trend that has the potential to last long. Finally, by committing our capital when the trend shows signs of weakness, we build up our own confidence, while controlling our risk properly by placing our stop-loss orders on a price level that may bring profits instead of losses.
To sum it up, the golden rule of trade timing is to keep it small, and to avoid timing by entering a position gradually. Since it is not possible to know anything about the markets with certainty, we will seek to have our scenario confirmed by market action through gradual, small positions that are built up in time. This scheme will eliminate the complicated issues associated with trade timing, while allowing us great comfort while entering and exiting trades.
Of course, there are cases where the risk/reward ratio is so positive that there is no great necessity for gradual entries. In such cases, the exact price where the position is opened is not very important. So we will not be discussing such situations in this article.

Conclusion

In surveys on what traders find most difficult about trading, timing often comes up as the top issue. Since timing is the only variable that directly influences the profit or loss of a position, the emotional intensity of the decision is great. While it is expected that every successful trader will achieve a degree of emotional control and confidence, the pressures of trade timing are often so severe for many beginners that the process that leads to a calm and patient attitude to trading never has a chance to develop.
To avoid this problem, the role of trade timing must be minimized, at least at the beginning of a trader’s career. And this can only be achieved if the size of the position is built up along with the trader’s confidence in it, and stop-loss orders are created where the closing of the position may result in gains, albeit small. All these factors lead us to consider the gradual method to the best one for trade timing, while minimizing our risk.

Debate: Deadbeat Homeowner vs. The Banker

USD-JPY set to weaken

The current chart for the USD-JPY is strongly suggesting a fall in the USD back to 80yen. The USD has struggled to break out of the current trend, and we expect it to fall back to that support. This is the short term price action, though we do believe that the medium term outlook for the USD is stronger than for the JPY. The Democratic Party of Japan (DPJ) has allowed its fiscal reform opportunity to slip away with in-fighting over leadership. It is therefore expected that any sign of reform is at least a year away; perhaps under a new prime minister and some reinvention of the LDP.

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Andrew Sheldon www.sheldonthinks.com

Analysis of Interest

from analyst David Rosenberg of Gluskin Sheff...

So Ben Bernanke focuses on equity valuations and yet there is a wide array of other “asset classes” that have been affected by the Fed’s massive liquidity infusion. Just as equity wealth has an indirect impact on spending, higher commodity prices squeeze margins for many producers and pinch real purchasing power for those households who are not owners of equity but have to fill their kids’ tummies nonetheless and find a way to get to work if they live more than a mile away. Looking at what food and energy has done since August; it would seem a little circumspect to be fingering Asian demand as the primary reason for the latest leg in the explosive commodity price rally.

Here we are, with 91% of all equity holdings in the United States held by the top 20% income group in the country. The top 1% own 38% of all the equity valuation. The lower 80% of the income strata own the asset class that the Fed wants so desperately to reflate (and with unmitigated success to be sure!). That same 80% are now being crushed by the indirect impacts of monetary policy — the ones that Bernanke dismisses — and are also ones that are seeing their cash flow drained by the surging gas and grocery bill. Geez — real wages deflated 0.5% in November, by 0.1% in December, and by what looks like at least 0.3% in January. The last time real work-based income fell three months in a row was when the economy was plumbing the recession’s depths from April to June of 2009.

Then again, who cares? No hedge fund investor does that is for sure (we don’t intend to be mean — that comment only covers the hours that the market is open). As long as Bernanke is juicing it up for the equity investor, and Uncle Sam is looking after the poor sucker with 99 weeks of unemployment insurance, 43 million food stamp recipients, and a nice dip into the Social Security Fund to finance a payroll tax cut, then all must be good and we must therefore have a sustainable recovery on our hands.

As we have said time and again, there will be a reward for being patient. After all, this equity rally has already achieved in 20 months what it took 60 months to accomplish from 2002 to 2007. In other words, double from the lows.

Friends — there is going to be day of reckoning. Trying to time it is futile. Just know it is coming and sooner than many think. Stop watching the talking heads on bubblevision and start boning up on the history of how post-bubble credit collapses end up playing out, especially once the government runs out of gas. Please don’t be tempted into the same mistake you may have made in 2007 and 2008 by jumping in to the riskiest parts of the markets at this juncture. In our view, it is currently appropriate to be focused on long-short strategies where an investor can manage or hedge out market risk and at the same time generate significant risk-adjusted returns. We understand what the market did from the 2009 lows, but we also know what they did from the 2000 highs. And the 2007 highs. Don’t be burnt thrice.

Happy Trading and keep following the trend!!

On the Docket: The Case Against Diversification

By Elliott Wave International

Talk with an investment advisor, and what's the first piece of advice you will hear? Diversify your portfolio. The case for diversification is repeated so often that it's come to be thought of as an indisputable rule. Hardly anyone makes the case against diversifying your portfolio. But because we believe that too much liquidity has made all markets act similar to one another, we make that case. Heresy? Not at all. Just because investment banks and stock brokerages say you should diversify doesn't make it true. After all, their analysts nearly always say that the markets look bullish and that people should buy more now. For a breath of fresh air on this subject, read what Bob Prechter thinks about diversification.

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Excerpt taken from Prechter's Perspective, originally published 2002, re-published 2004

Question: In recent years, mainstream experts have made the ideas of “buy and hold” and diversification almost synonymous with investing. What about diversification? Now it is nearly universally held that risk is reduced through acquisition of a broad-based portfolio of any imaginable investment category. Where do you stand on this idea?
Bob Prechter: Diversification for its own sake means you don’t know what you’re doing. If that is true, you might as well hold Treasury bills or a savings account. My opinion on this question is black and white, because the whole purpose of being a market speculator is to identify trends and make money with them. The proper approach is to take everything you can out of anticipated trends, using indicators that help you do that. Those times you make a mistake will be made up many times over by the successful investments you make. Some people say that is the purpose of diversification, that the winners will overcome the losers. But that stance requires the opinion that most investment vehicles ultimately go up from any entry point. That is not true, and is an opinion typically held late in a period when it has been true. So ironically, poor timing is often the thing that kills people who claim to ignore timing.

Sometimes the correct approach will lead to a diversified portfolio. There are times I have been long U.S. stocks, short bonds, short the Nikkei, and long something else. Other times, I’ve kept a very concentrated market position. My advice from mid-1984 to October 2, 1987, for instance, was to remain 100% invested in the U.S. stock market. During the bull market, I raised the stop-loss at each point along the wave structure where I could identify definite points of support. If I was wrong, investors would have been out of their positions. The potential was five times greater on the upside than the risk was on the downside, and five times greater in the stock market than any other area. Twice recently, in 1993 and 1995, I have had big positions in precious metals mining stocks when they appeared to me to be the only game in town. In 1993, it worked great, and they gained 100% in ten months. Diversification would have eliminated the profit. And every so often, an across-the-board deflation smashes all investments at once, and the person who has all his eggs in one basket, in this case cash, stays whole while everyone else gets killed.

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Excerpt from The Elliott Wave Theorist, April 29, 1994

It is repeated daily that “global diversification” is self evidently an intelligent approach to investing. In brief, goes the line, an investor should not restrict himself to domestic stocks and bonds but also buy stocks and bonds of as many other countries as possible to “spread the risk” and ensure safety. Diversification is a tactic always touted at the end of global bull markets. Without years of a bull market to provide psychological comfort, this apparently self evident truth would not even be considered. No one was making this case at the 1974 low. During the craze for collectible coins, were you helped in owning rare coins of England, Spain, Japan and Malaysia? Or were you that much more hopelessly stuck when the bear market hit?
The Elliott Wave Theorist's position has been that successful investing requires one thing: anticipating successful investments, which requires that one must have a method of choosing them. Sometimes that means holding many investments, sometimes few. Recommending diversification so that novices can reduce risk is like recommending that novice skydivers strap a pillow to their backsides to “reduce risk.” Wouldn’t it be more helpful to advise them to avoid skydiving until they have learned all about it? Novices should not be investing; they should be saving, which means acting to protect their principal, not to generate a return when they don’t know how.
For the knowledgeable investor, diversification for its own sake merely reduces profits. Therefore, anyone championing investment diversification for the sake of safety and no other reason has no method for choosing investments, no method of forming a market opinion, and should not be in the money management business. Ironically yet necessarily given today’s conviction about diversification, the deflationary trend that will soon become monolithic will devastate nearly all financial assets except cash. If you want to diversify, buy some 6-month Treasury bills along with your 3-month ones.