Odds are you’ve heard of the Elliott Wave Theory, which is often discussed in the same breath as Fibonacci Patterns. The Elliott Wave Theory was developed all the way back in the 1920s by American accountant and author Ralph Nelson Elliott—hence the name. He believed that stock markets traded in cycles that were repetitive. This was a revolutionary way of thinking at the time because among 1920s traders, the stock market was considered to be chaotic. Since then, the Elliott Wave Theory has been able to gain traction as a market analysis method within the world of forex.
Here we’ll take a look at the history of the Elliott Wave Theory, along with how you can apply it to forex trading in an attempt to predict market swings.
Following the Wave
The Elliott Wave Theory proposed the idea that market cycles actually resulted from reactions of investors to outside influences, or the psychology of the masses at that time. The downward and upward swings of mass psychology, Elliott found, always had a repetitive pattern, which he termed “waves.” This theory is based somewhat on the Dow theory, which also purports that the market moves in waves. However, due to the fractal nature of the market, Elliott broke down and analyzed markets in detail far greater than Dow was able to. Fractals, it should be noted, are structures that infinitely repeat themselves as they get smaller, and Elliott discovered that the patterns of stock trading operated in the same manner. What this essentially meant for Elliott was that he could look at how these patterns repeated and then apply them as a predictive indicator.
Breaking Down the Principle
The Elliott Wave Theory can take the form of various wave degrees, but for now let’s look at the most common one; Minor waves effectively epitomize the foundations and principle behind the theory.
The theory dictates that the chart pattern will contain five waves in the direction of the trend (impulse waves) and three against (corrective waves). Moves in the direction of the trend are labeled 1 to 5, and those against are labeled A to C. Take the 5-wave impulse sequence and combine it with a 3-wave corrective sequence, and you have a complete Elliott Wave sequence.
Elliott Wave Theory Rules
The clue is in the name. Elliott Wave Theory uses waves to help you predict potential market swings—and it can be very effective. Elliott Wave Theory can be used within various market scenarios, but there are a few rules you must remember if you opt to implement it:
Rule No. 1: Wave 3 shouldn’t ever be the shortest impulse wave.
Rule No. 2: Wave 2 shouldn’t ever go beyond the formation point of Wave 1.
Rule No. 3: Wave 4 shouldn’t ever cross in the same price area as Wave 1.
When you take a long, hard look at forex charts, it will become clear that they really do move in waves. It isn’t always “textbook” in how this comes about, but the patterns are there. It will certainly take plenty of hours of practice to understand how to make use of Elliott Wave Theory patterns, but if you remember the rules, the process of predicting market swings can become a little easier.
Elliott Wave Categories
As we’ve mentioned previously, the Elliott Wave Theory is far from one-dimensional, regardless of how you may hear it described by some less-than-supportive traders. It organizes waves from smallest to largest and assigns them a series of categories:
- Grand Supercycle
In day-to-day forex trading, this theory can be used by determining the supercycle—or main wave—going long and then selling as the pattern runs out of steam, predicting a reversal. On paper, there are complications associated with using the Elliott Wave Theory, but that, in effect, is what makes this form of analysis so effective: it’s adaptable through a number of different wave categories.
Just like many other technical analysis-based theories in existence, the Elliott Wave Theory has its fans and its naysayers. A main weakness of the theory is that those who follow it are able to blame chart reading rather than theory weakness, while another is that the interpretation of the cycle length is open-ended. However, it should be noted that traders who follow the Elliott Wave Theory tend to be passionate about it, so maybe there is more to the waves than the skeptics think. Whichever way you look at it, when it comes to reading market swings, there is no denying that the evidence stands behind the Elliott Wave Theory and what can be achieved with it.
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