Odds are that 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 back in the 1920s by American accountant and author Ralph Nelson Elliott—hence the name. He believed that stock markets traded in repetitive cycles. 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 gained 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 the reactions of investors to outside influences or the psychology of the masses at that time. Elliott found that the downward and upward swings of mass psychology always had a repetitive pattern, which he termed “waves.” This theory is based somewhat on the Dow Theory, which also suggests that the market moves in waves.
However, due to their fractal nature, 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 foundation 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 it (corrective waves). Moves in the direction of the trend are labeled 1-5, and those against it are labeled A, B, and C. Take the five-wave impulse sequence and combine it with a three-wave corrective sequence, and you have a complete Elliott Wave sequence.
The EUR/USD chart below illustrates the Elliott Wave Theory at work:
Elliott Wave Theory Rules
The clue is in the name. The Elliott Wave Theory uses waves to help you predict potential market swings—and it can be very effective. The 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:
- Wave 3 shouldn’t ever be the shortest impulse wave.
- Wave 2 shouldn’t ever go beyond the formation point of wave 1.
- 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. As you work to identify those patterns, make sure you familiarize yourself with Elliott Wave Theory’s reliance on the “golden ratio,” which is the most common ratio of extension and retracement according to the Fibonacci sequence. This golden ratio is .618 and 1.618 for extensions and retracements, respectively, and they can help traders predict the formation and completion of impulse and corrective waves. (This is explained further below.)
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.
In the XAU/USD chart below, notice how the pattern meets these rule requirements and sets up a bullish situation in which the pairing’s price is pointing toward another rise:
Identifying Corrective and Impulse Waves
Impulse and corrective waves are the two types of waves that will develop in an Elliott Wave Theory pattern. The trick is identifying whether the waves developing are corrective or impulse because the nature of these waves will lead you to different insights and trading actions.
In contrast to larger impulse waves, corrective waves are smaller waves because they function as minor corrections within a much larger developing trend—the impulse wave, in this instance. While traders typically don’t trade to capitalize on the price movements within these smaller corrective waves, they will use the identification of corrective waves to detect larger impulse waves, where more significant profits are likely to be found.
Typically, traders will try to identify the end of a corrective wave, which represents a low point in price where a position can be opened ahead of the swing of the impulse wave. The trader can then ride the impulse wave and close out at its peak, maximizing their profit from that trade.
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
Keep in mind that since the above waves are fractal and proportionate to the size of the waves being created—which can occur within the span of an hour or even over the course of years—the size of these waves is defined by their relation to one another. In addition, fractals can be infinitely large or small, so categories of wave sizes exist both above and below the listed spectrum of categories.
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 wave categories.
It’s also worth noting that the Elliott Wave Theory offers value to both short-term trade research as well as long-term strategies. In fact, some experts argue that the Elliott Wave Theory suggests the stock market has been stuck in a bear market formation since 2000, which shows just how wide the potential scope of this tool can be.
Advantages of Elliott Wave Trading
As a diagnostic tool for identifying potential trade opportunities, the Elliott Wave Theory offers value by providing a structure for organizing price movement information into easy-to-understand, graphical representations. With a broad understanding of the rules of this theory, even beginner traders can start applying the theory to inform their strategies.
At the same time, the popularity of Elliott Wave trading is its own advantage: Because it is rooted in consumer psychology, its relevance to forex trading is greater when a large group of traders is observing these patterns and trading based on this information.
Disadvantages of Elliott Wave Trading
Despite its advantages, there are also limitations to the Elliott Wave Theory that may create complications and lead to inaccurate conclusions during trade analysis. Whereas Fibonacci patterns and similar tools offer clear ratios and thresholds that traders can watch for, the Elliott Wave Theory is more subjective in how patterns are identified. Traders must identify these patterns on their own, and the price movements that designate the start and end of a wave can vary from one trader’s interpretation to the next. For that reason, some critics argue that this theory is too arbitrary to offer consistent guidance in trading.
Additionally, the patterns themselves may become so contrived in the eye of the trader that they become disconnected from the real-world factors driving the price movements. To address these limitations, traders sometimes use Elliott Wave trading in combination with other oscillators, including the relative strength index and average directional index. When Elliott signals align with the indications offered by these tools, traders may have more confidence in these trade recommendations.
Indicators to Use with the Elliott Wave Theory
Like any indicator or chart pattern, the Elliott Wave Theory isn’t sufficient as a sole point of reference when identifying trading opportunities. Waves should always be used in combination with other types of analysis, including economic news and technical indicators that may affirm or dispute the suggestions of the Elliott Wave Theory.
Popular indicators used in conjunction with the Elliott Wave Theory include:
- Relative Strength Index (RSI): When overbought or oversold conditions converge with wave indicators, and both indicators are pointing in the right direction in terms of an anticipated price swing, this may increase a trader’s confidence in opening a position.
- Simple Moving Average (SMA): If a negative Elliott Wave indicator is identified at the same time the 50-day SMA is suggesting downward momentum, this could strengthen the inference that a price decline is coming. Conversely, a positive Elliott Wave indicator combined with upward momentum with the 50-day SMA could be encouraging a long position on that currency pair.
- Moving Average Convergence-Divergence (MACD): When looking for the setup of a five-wave structure, the MACD line can help identify the third wave in that structure, which is typically the longest and strongest wave. This can help traders identify a five-wave structure as it is developing rather than after the pattern has been completed.
Just like many other technical analysis-based theories, 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 the theory itself when they stumble, and another is that the interpretation of the cycle’s 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.
The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.