Once of the most popular, and least understood theories of technical analysis in Forex is the Elliott Wave Principle. Developed by Ralph Nelson in the 1920s as a method of trend forecasting for stocks markets, the Elliot Wave theory applies fractal mathematics to market fluctuations in order to create forecasts on how market sentiment will behave. In Essence, the Elliott Wave theory states the the market always moves in series of five upward waves, and three downward waves, which repeat themselves. However, if everything was as simple as that, virtually anyone would be able to easily benefit from this scheme, riding trends as they appear. Obviously, things are somewhat more complicated.
One of the factors, which make the Elliott Wave difficult to tame – the questions of time – among all wave theories, this is the only one that doesn’t put any timeframes on market reactions and corrections. In reality, the theories of fractal mathematics demonstrate that inside waves, there several more internal waves. The interpretation of these waves and the search for correct waves and their intersections – is a complicated process. So complicated, that you can put 20 experts in Elliott Wave theory in one room, and they will never come to agreement where the Stocks or Forex market is headed at this moment.
The basics of the Elliott Wave Theory
Any action is always accompanied by counter-action.
This is a standard law of physics, which can be applied to crowd behavior, which is the basis of Eliott Wave theory. If price are declining, people are buying. When people are buying, the demand increases, making the prices grow. Almost any system that uses analysis of trends to forecast fluctuations of currency prices, is based on trying to determine the moments, where such actions will breed counter-action, making trades profitable.
There are five waves in the direction of the main trend, which are followed by three waves of the correction (the “5-3” sequence).
The Elliott Wave theory claims that market activity can be forecasted in the form of five waves directed along with the trend, followed by a correction of three more waves, that return the market close to the starting point.
The 5-3 sequence creates a cycle. And here is where the theory becomes really complex. As a mirror, that reflects a mirror, each 5-3 sequence is not finite in essence, but is rather a set of smaller waves and a set of large waves of a similar type (5-3) – the next principle.
Such a 5-3 sequence then becomes two sequence sections of the next 5-3 waves.
According to Elliott Wave theory, 5 waves that constitute a trend are marked as 1, 2, 3, 4 and 5 impulses. The three waves of correction are called a, b, c. Each of these waves is made up of a sequence of 5-4 waves, each of which, in turn, is made of 5-3 waves. The 5-3 cycle that you are looking at currently is also an impulse or correction in the higher ranking 5-3 series.
The main 5-3 pattern is unchangeable, although the time frame changes every time.
The 5-3 sequence can go on for tens of years – or end in just several minutes. Trades that have succeeded with using the Elliott Wave theory for their trading say that the main aspect is making trades according to the beginning or end of impulse 3, in order to minimize risk and maximize profits from the 5-3 series.
Given that the time periods of the series can vary greatly, application of this theory is in most part a question of interpretation. The determination of the best moment for entry or exit depends on the ability to see and follow a pattern of large and smaller waves, as well as understanding of when to make a correct exit based on the patter that was identified.
The key to correct interpretation of the pattern – is identifying the starting point. As soon as you learn to see wave patterns and identify them correctly, you will see how they can be applied to every aspect of Forex trading and decision making in both intraday and long term trading.