Elliott Wave Theory Rules in Forex Trading
Over the last decade, forex trading has increased in popularity, and many people have taken Forex to be a full-time career. Most Forex traders are day traders who always use technical analysis to understand the movement of the forex market. Technical analysis has been said to help traders fully interpret how the forex market works. One of these mostly used methods by traders is the Elliott Wave theory. Most traders implement this theory when it comes to their trades. This article will be focused on analyzing the theory, and explaining in detail how it works.
What is The Elliott Wave Forex Theory?
Unlike other technical tools, this theory is straightforward to understand.
Elliott’s theory was founded in the 1920s by a man called Ralph Nelson Elliott, hence the name Elliott theory. This man found out that the stock markets moved in repetitive cycles, rather than in an uncertain manner. Elliott’s wave predictions verified that these market cycles are directly linked to the common psychology of the traders at that time and the relations of the investors.
With this theory, Elliott also discovered that the increase and decrease of trader psychology are always appearing in the exact repetitive pattern; he names these patterns consistencies waves.
Elliott was able to evaluate and comprehend the market to a much higher level by using the Dow theory which states that the value of stocks lives in waves, and airs all because of their factual nature.
What is Fractal?
A fractal is said to be a never-ending structure that is repeated over and over again, forming the same pattern on different scales.
Fractals are mathematical structures that occur over and over again infinitely. With Elliott noting these repetitive patterns in the market, he formulated a means of creating the predictions of the market itself.
In the past Elliott’s waves theory was not fully accepted by scientists, this is because the theory was not based on science but on evidence and principles that weren’t recognized by science. However, In recent times the theory has been readily accepted by individuals.
The Interpretation of The Elliott Wave Theory
The Elliott wave can be analyzed as follows;
Five waves stride in the direction of the original trend, followed by three waves moving in the opposite trend, thus forming a total of 5 to 3 moves. The 5 to 3 moves then form two subdivisions of the next wave move which is higher than the previous waves.
The underlying time limit of each wave may differ but the pattern remains the same.
The Principle of Elliott Wave
As mentioned in the above text, the prices of the trending markets move in 5-3 wave patterns. The initial 5 waves are also known as the impulsive waves while the last 3 waves are known as the corrective waves and they move in the opposite direction.
Elliott Wave Theory Rules
The interpretation given below is related to a bull market. However, the reverse is the case for a bear market.
The impulsive waves interest the sentiment of the trader as follows:
This is the beginning of the bullish trend. Prices are on the downside and the first contrarian traders estimate the market to be oversold and cheap. This leads to a slight increase in prices with little momentum thereby increasing demand.
This is the initial corrective wave of the impulsive stage. Wave 2 tends to correct the trend of the first wave. With investors still skeptical and fearful, and others striving to book profits for the first higher surge. This gives rise to the corrective move.
Note: the second wave can never move below the first wave.
This is the impulsive stage, and by this period, the investors who see the trade as being undervalued are already interested in purchasing the underlying asset. Investors are increasing the demand for the trade with great momentum, and the fundamentals and sentimental analysis are showing positive signals. This is the trending wave that attracts investors and it is one of the biggest waves.
Note: the third wave is always higher than either of the initial two waves, and it never goes below the high of the first wave.
This is the second corrective wave of the impulsive stage formed. After the first recorded high has been recorded, some traders are bound to start taking profits. This is what triggers the fourth wave. The sentiment still reads a bullish trend because the trend lacks the momentum to maintain a bigger bearish movement.
Note: The fourth have do not overlap with the first wave. This indicates that the high of the first wave cannot breach the low of the fourth wave.
This is the wave that marks the end of the impulsive stage. The sentiment is signaling a clear bullish trend, as traders have triggered a high demand for the trade.
After the 5th wave of the impulsive stage, traders now indicated the market to be highly priced and this leads to the corrective stage.
The waves describe investor sentiment as follows:
This is the initial impulse bear move of the corrective stage. Trader’s sentiment signals a bullish trend. The fear of the market being overpriced reduces the price of the trade.
This is the wave that corrects the impulsive bear trend by wave A. Most traders see this wave as an indication to return to the initial dominant bullish trend, but Wave B appears with low volume and lasts the momentum to surpass the high of Wave A.
The price of the trade reverses, and investors now note that the market is now bearish. Normally, Wave C stretches beyond the low of Wave A. An important thing to note about the Elliot wave theory is that waves can overlap each other, this means that waves can occur within waves.
The impulsive waves are made up of 1, 2, 3, 4, 5 while the corrective waves are made up of a, b, and c waves.
This theory also proves markets are fractal, and the waves can be estimated in any timeframe of the market.
The wave theory founded by Elliott is similar to the Dow theory. The similarity is the fact the two theories state that prices move in waves. Elliott also proposed that the price of an asset is influenced by the predominant psychology of the traders.
Additionally, he stated that the fractal nature of the markets gives rise to repeated wave patterns. He also deduced that fractal patterns are mathematical structures that tend to infinitely reoccur. Elliott noticed that the stock index price was illustrated the same way. He then started analyzing and seducing how these repeated patterns could be used to predict the price action of the market.
From Elliott’s theory, he specified that waves have a total of nine degrees, which are described as follows: ranging from largest to smallest.
Grand Super Cycle
Most Traders use this theory in their everyday trading. To use this trading theory the trader needs to open a long position when they spot an upward-trending impulse wave, and as the pattern completes the five impulsive waves indicating a price reversal the trader opens a short position.
Market signals based on Wave patterns show five waves moving in the same direction, this bi is called the impulsive waves. While the corrective waves are made up of 3 waves in the opposite direction of the first wave pattern formed.
However, on a smaller scale, more waves can be found in the impulsive waves.
This smaller pattern formed can carry on till infinity. This is known as the fractal structure that was established by Elliott in the 1920s. However, scientists ignored this theory till decades later before recognizing Elliott’s work and illustrating it mathematically.
In the trade markets, the law of supply and demand is applied. This means that what goes up will come down. As the price of a trade is increasing it is followed by a price reversal to the opposite side of the trend. The market’s trends are divided into bullish and bearish trends. When the market price is high it shows a bullish trend, and when the market price is low it shows a bearish trend.
Elliott Wave Theory’s Popularity
The Elliott wave theory became popular in the 1970s. The theory got popular through the work of A.J Frost and Robert Prechter after they published their book the Elliott Wave Principle.
Advantages of Elliott Wave Trading
Trading with the Elliott Wave comes with a lot of advantages and they are as follows:
- The theory acts as a diagnostic tool for specifying probable trade opportunities. The Elliott wave theory rules provide usefulness by offering a structure for regulating price action information into simple and understandable graphical representations. This theory is easy to use, even amateur traders can easily apply the theory once they have a broad understanding of how the theory works.
- Also, the popularity of the Elliott wave trading is a big advantage. This Is because it is included in traders’ psychology, its applicability to forex trading is outstanding when it is being utilized by various traders.
Disadvantages of Elliott Wave Trading
Even with its enormous advantages, the Elliott wave theory has a lot of disadvantages.
- First and foremost, the theory could be complicated and it could lead to false conclusions during trade analysis. This can be a drawback when other technical tools provide more precise and concise readings. Traders need to identify market trends on their own, and this leads to critics of the theory being too difficult to be used in providing constant trade guides.
- Also, the patterns might become too unnatural or too ambiguous and begin to look unreal. To curb the limitations attached to this trading theory, traders are adduced to not use this trading tool in isolation. This means that traders should use this theory in conjunction with other technical tools. Some numerous technical indicators or oscillators can be used together with this theory. They include the relative strength index and average directional index. When the signal generated from the Elliott theories coincides with the signals provided by the indications being used it means that the signal is more authentic.
Indicators used with Elliott Wave Theory
Just like every other indicator or chart pattern, the Elliott wave theory rules are not as authentic when used in isolation, this is why most traders use more than one or two indicators in a trade. Waves should be used in conjunction with other technical tools. This includes the use of economic data release, and fundamental analysis also.
Common indicators employed in confluence with the Elliott Wave Theory include:
Relative Strength Index (RSI)
When the signals given out by the Elliott Wave theories align with the overbought and oversold signals of the relative strength indicators it shows that the signal is a lot more authentic. Thereby increasing the trader’s confidence about the trade.
Simple Moving Average (SMA):
When a negative Elliott wave signal is noted and the 50-day SMA also signals a bearish trend, this means that the signal provided is strong and authentic. It shows that prices are about to decline. The same strategy is applied in a case where Seth Elliott’s wave theory shows a positive signal and the 50-day SMA signals a bullish trend. It means that the price will increase, therefore showing a more authentic signal.
Moving Average Convergence-Divergence (MACD):
When trying to set up your trade to identify a five-wave struct, the Moving average convergence divergence line can be used for easy identification of the third wave in the structure, which is the highest wave and the wave with the most momentum. This indicator assists traders in specifying a five-wave structure as it is forming instead of identifying the structure after it has formed.
This theory is very popular among traders in the financial industry. And it had proven to indicate accurate signals. However, traders are advised to not use this indicator in isolation. Signal confirmation is necessary to avoid making bad trade decisions.