This is probably what you all have been waiting for — drumroll please — using the Elliott Wave Theory in forex trading! This means that you will be labeling the waves to see how they conform to the Elliott Wave pattern, to try and anticipate future price movement. In this section, we will look at some setups and apply our knowledge of Elliott Wave to determine entry, stop loss, and exit points. Surfs up! You see that price seems to have bottomed out and has begun a new move upwards.
Using your knowledge of Elliott Wave, you label this move up as Wave 1 and the retracement as Wave 2. In order to find a good entry point, you head back to the School of Pipsology to find out which of the three cardinal rules and guidelines you could apply. So, using your superior Elliott Wave trading skillz, you decide to pop the Fibonacci tool to see if the price is at a Fib level.
Holy mama! Hmm, this could be the start of Wave 3, which is a very strong buy signal. Cardinal rule number 2 states that Wave 2 can never go beyond the start of Wave 1 so you set your stop below the former lows. In this article, we'll take a look at the history behind Elliott Wave Theory and how it is applied to trading. Elliott proposed that financial price trends result from investors' predominant psychology. He found that swings in mass psychology always showed up in the same recurring fractal patterns, or "waves," in financial markets.
Elliott's theory somewhat resembles the Dow theory in that both recognize that stock prices move in waves. Because Elliott additionally recognized the " fractal " nature of markets, however, he was able to break down and analyze them in much greater detail. Fractals are mathematical structures, which on an ever-smaller scale infinitely repeat themselves. Elliott discovered stock index price patterns were structured in the same way. He then began to look at how these repeating patterns could be used as predictive indicators of future market moves.
Elliott made detailed stock market predictions based on reliable characteristics he discovered in the wave patterns. An impulse wave , which net travels in the same direction as the larger trend , always shows five waves in its pattern.
A corrective wave , on the other hand, net travels in the opposite direction of the main trend. On a smaller scale, within each of the impulsive waves, five waves can again be found. This next pattern repeats itself ad infinitum at ever-smaller scales. Elliott uncovered this fractal structure in financial markets in the s, but only decades later would scientists recognize fractals and demonstrate them mathematically. In the financial markets , we know that "what goes up, must come down," as a price movement up or down is always followed by a contrary movement.
Price action is divided into trends and corrections. Trends show the main direction of prices, while corrections move against the trend. The Elliott Wave Theory is interpreted as follows:. Let's have a look at the following chart made up of eight waves five net up and three net down labeled 1, 2, 3, 4, 5, A, B, and C.
Waves 1, 2, 3, 4 and 5 form an impulse, and waves A, B and C form a correction. The five-wave impulse, in turn, forms wave 1 at the next-largest degree, and the three-wave correction forms wave 2 at the next-largest degree. The corrective wave normally has three distinct price movements — two in the direction of the main correction A and C and one against it B. Waves 2 and 4 in the above picture are corrections.
These waves typically have the following structure:. Note that in this picture, waves A and C move in the direction of the trend at one-larger degree and, therefore, are impulsive and composed of five waves. Wave B, in contrast, is counter-trend and therefore corrective and composed of three waves.
An impulse-wave formation, followed by a corrective wave, forms an Elliott wave degree consisting of trends and countertrends. As you can see from the patterns pictured above, five waves do not always travel net upward, and three waves do not always travel net downward. When the larger-degree trend is down, for instance, so is the five-wave sequence.
Elliott identified nine degrees of waves, which he labeled as follows, from largest to smallest:. Since Elliott waves are a fractal, wave degrees theoretically expand ever-larger and ever-smaller beyond those listed above. To use the theory in everyday trading, a trader might identify an upward-trending impulse wave, go long and then sell or short the position as the pattern completes five waves and a reversal is imminent.
In the s, the Elliott Wave principle gained popularity through the work of A. Frost and Robert Prechter. In their now-legendary book, Elliott Wave Principle: Key to Market Behavior, the authors predicted the bull market of the s. Elliott Wave practitioners stress that simply because the market is a fractal does not make the market easily predictable. In terms of practical application, the Elliott Wave Principle has its devotees and its detractors like all other analysis methods.
One of the key weaknesses is that the practitioners can always blame their reading of the charts rather than weaknesses in the theory. Failing that, there is the open-ended interpretation of how long a wave takes to complete. That said, the traders who commit to Elliott Wave Theory passionately defend it.
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Key Takeaways. The Elliott Wave theory is. The Elliott Wave analysis Forex includes two different wave patterns, which include the five wave pattern, as well as the three wave pattern. Elliott saw the same patterns formed in repetitive cycles. These cycles were reflecting the predominant emotions of investors and traders in upward and downward.