The Three Wise Men and the Alligator

The Three Wise Men are 3 entry rules created by the Profitunity Trading Group, as described in the 2nd Edition of Trading Chaos by Bill Williams and his daugther Justine. In the rest of the article it will be explained how these Three Wise Men can make you profit.

Before the Three Wise Men: The Alligator

However, before introducing the Three Wise Men, an additional indicator must be mentioned first: the Alligator. The reason is that the Three Wise Men is nothing more than entry rules. You should also understand the philosophy behind the system, and nothing captures the Profitunity trading philosophy better than the indicator of Alligator, which actually is also invented by the Profitunity Trading Group.

Definition and facts

The Alligator is a collection of three moving averages, which are called the Lips, the Teeth and the Jaw and colored green, red and blue.

• The Lips (Green): smoothed moving average of 5 period, displaced 3 bars forward.
  
• The Teeth (Red): smoothed moving average of 8 period, displaced 5 bars forward.
• The Jaw (Blue): smoothed moving average of 13 period, displaced 8 bars forward.

How the Alligator works

The idea of the Profitunity trading strategy is to catch those big trending movements that occur for less than 40% of all time. Such moments can be identified by looking at the Alligator Lines.

Usually, before a big move happens, the price moves in a tight range and intertwines with the Alligator Lines. This is called a "sleeping alligator" because it is so quiet. Then it explodes into a big move. The price starts moving away from the Alligator, and the Alligator Lines are opening. This phase is dubbed the "hungry alligator" because it looks like an alligator wakes up from sleep and opens it mouth (distance between the lines) to chase the little fish (price bar) for breakfast.

In short, we are trying to catch the big trend which usually follows a quiet range, and it is pretty much how all other trend folllowing systems under the sun work. Conversely, when a trend starts to die out and starts moving in a range, we might consider taking a break or reduce lot size.

The Three Wise Men

Now onto the entry rules, i.e. the Three Wise Men. In order to understand them, you must have the following indicators on your charts:

1. Alligator (as described above)
   
2. Awesome Oscillator (details below)
   
3. Fractals (details below)
   

All are available in many charting softwares. Now let's meet the Three Wise Men below:

The First Wise Man: Divergent Bar

Definition and Facts (long)

1. The price is below the Alligator Lines.
2. The Divergent Bar must have a lower low than the previous bar.
3. The Divergent Bar must close on the upper half of the bar.
4. The flatter the Alligator and the further away the bar, the more reliable is the signal.
5. Opposite for short entry.

Entry and Exit (long)

1. Buy stop at top of the bar.
2. Stop loss at the bottom of the bar.
3. Take profit when opposite signal appears, or trail stop to 3-5 bars low.
   
4. Opposite for short entry.
   

Comments:

The divergent bar is basically what they call morning and evening stars in candlesticks. It is a way determining reversals in a ranging market. In earlier works by Bill Williams, the divergent bar was one of the five "magics bullets" that kills a trend, i.e. the five clues that signal the end of a trend.

According the 2nd Edition of Trading Chaos, Bill Williams said that with today's intraday volatility, it is important to get into a trend earlier at the reversal, instead of waiting for breakthrough of key level, which was the original entry method in the first edition of the book. The divergent bar is exactly what allows us to do this.

It must be noted that not all reversal involves the divergent bar. If that's the case, the two other Wise Men will be needed.

The Second Wise Man: The Awesome Oscillator (AO)

Definition and Facts:

1. The difference between a 5-period and 34-period median price moving average, which is actually the 5-34 MACD histogram.
2. Bars that are higher than the previous one are painted green, otherwise painted red.
3. Available in many technical software packages.

Entry and Exit (long):

1. Ideally it is preceded by the bullish divergence bar, or else must be preceded by a down fractal.
2. Buy when the AO shows three consecutive green bars.
3. Stop begins at the bottom the the bullish divergence bar or down fractal, then gradually trail up to the latest 3-5 bars low, or when a bearish divergence bar appears.
4. Opposite for short entry.
   

Comments:

The AO is actually a way to add on when the momentum is going into our favor. In the first edition of Trading Chaos, Bill Williams' choice of the 5-34 setting was for a very specific reason. It was based on some research of bar range and volume, and found that this setting has a very high correlation with the volume and range data which were necessary for identifying impulsion in the Elliot Wave Principle. Therefore, the AO can be very useful in forex markets when the volume data is absent.

It should also be noted that in another book, New Trading Dimensions, Bill Williams wrote 3 completely different entry rules with the AO. Perhaps this 3 consecutive same-color entry was a rule he newly discovered, which was intended as the fourth entry rule in addition to the 3 original ones. To know more about the other three entry signals with the AO, please read the above mentioned books.

However, the AO is more than just a provider of entry signals. The best use of it is to point out divergence in a trend. The divergence is the difference between price and momentum direction. For example, when a trend is showing higher highs, but the bars in the AO have lower highs, this is a case of divergence, and usually an end of trend will follow soon.

The Third Wise Man: The Fractal

Definition and Facts:

1. An up fractal is a high of a bar preceded by 2 lower highs and followed by 2 lower highs.
2. Signal of an up fractal is only valid if it is above the Alligator lines.
   
3. Vice versa for a down fractal.

Entry and Exit (long):

1. Buy on breakout of a valid up fractal (above Alligator).
2. Stop begins at the bottom the the bullish divergence bar or down fractal, then gradually trail up to the latest 3-5 bars low, or when a bearish divergence bar appears.
3. Opposite for short entry.

Comments:

The fractal is actually a breakout strategy on previous high or low. According to Williams, each fractal is an end of an Elliot Wave, and a breakthrough of each fractal marks a new impulsive wave, so that we are able to trade that wave even without knowing what wave we are in. Hardcore Elliot Theorist will never agree with him, but it is a good way to trade in any case.

The Three Wise Men in action

Here is a recent hourly chart in GBPUSD on 27th November 2009:

Keys:

1. A bearish divergence bar.
2. Sell signal by #1 taken (1.6687). Initial stop at the top of #1.
   
3. AO sell signal.
4. Sell signal by #3 taken (1.6691).
5. AO crosses zero line. (Confirming bearish momentum.)
6. Bullish divergence bar. Stop trailed to top of the bar, which was soon taken (1.6546). Buy signal not considered because Alligator is opening. Also a sell fractal.
   
7. Re-entry sell signal by #6 taken (1.6500).
8. AO sell signal.
9. Sell signal by #7 (1.6466) and #8 (1.6482) taken.
10. Another sell fractal
11. An up fractal. Stop moved down to here.
12. Sell signal by #10 (1.6412) taken.
13. All position closed by #11 (1.6430).

Total Profit: (1.6687 + 1.6691 - 1.6546 x 2) + (1.6500 + 1.6466 + 1.6482 + 1.6412 - 1.6430 x 4) = 424 pips.