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 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 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 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 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. 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:
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 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 and Disadvantages 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.
But there are also limitations to this theory, which can create complications and lead to inaccurate conclusions. 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 (RSI) and average directional index (ADX). When Elliott signals align with the indications offered by these tools, traders may have more confidence in these trade recommendations.
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.
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