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Elliot
Wave Theory with Forex Markets
In the late 1920s, an accountant named Ralph
Nelson Elliott theorized that rather than being chaotic, the
stock market tends to trade in a certain up and down pattern
that is primarily affected by mass psychology. He referred
to this pattern as “waves”, and published his findings in the
book “The Wave Principle” in 1938, and also in a series of
articles in the magazine “Financial World”.
The basis for the theory is the idea that group
psychology moves back and forth between optimism and pessimism,
and prices
tend to reflect this by moving according to society’s current
mood. Elliott proposed that the pattern alternates between
five waves and three waves, where in the first five, waves
1, 3, and 5 move in one direction and are called “motive” waves
while the second and fourth waves move in the opposite direction,
acting to correct each of the previous waves. Hence they are
called “corrective” waves. In a bull market, when prices are
generally rising, the general direction of the first group
of waves is upward, and the trend is downward in a bear market.
At the sixth wave, the trend reverses itself, and heads down
in a bull market, and up in a bear market. There are only three
waves in this grouping, however, with the first and third traveling
in one direction and the second wave correcting the first by
traveling in the opposite direction. Each wave is driven by
certain predictable actions in the marketplace such as short
covering from the previous leg down, profit taking from the
preceding rally, and traders “piling on” when a major rally
is occurring. Traders who can develop a good understanding
of these events will hold the key to the theory.
One interesting aspect of Elliott’s Wave Theory is that each
wave is made up of another 5-3 pattern, and then each of these
smaller waves is also made up of a 5-3 pattern. When patterns
repeat themselves inside each other, this is known as a “fractal”
effect. By recognizing this price action, traders can narrow
the picture down and be able to visualize a more accurate picture
of what is going on with the currency.
Although it was developed based on the stock market, the Elliott
Wave Theory is also applied to forex trading quite regularly,
as the foreign exchange market has many similarities to the
market for equities. Some investors choose to base their analysis
on a candlestick chart of daily forex prices, which is a type
of bar chart that plots the high and low prices of the day
along with the opening and closing prices. The body of each
bar is denoted by the gap between the opening and closing price
and is white if the currency rose that day and black if it
declined. In addition, each bar is augmented by a “wick”, which
is a line representing the high and low prices for the day.
This chart is popular because it is very visual and extremely
easy to understand. By plotting the waves according to Elliott’s
theory, one can extrapolate the trend and try to tell the general
direction and length of the current and next waves. By doing
this, traders are able to make an educated guess as to where
the currency price is headed.
Although this information is valuable, the Elliott Wave Theory
is just one piece of the technical analysis puzzle, and the
smart trader will use this tool along with several others to
get a better picture of the forex market. No one method should
be relied upon by itself, but when combined with other indicators
such as the five-point pivot line system, the Elliott Wave
Theory can help the forex trader greatly.
# # # # # SolveYourProblem.com : 2007
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