What is the Elliott Wave Theory and How to Apply it in Forex Trading
Reading time: 9 minutes
Trading Forex is a great activity, as it can supply you with a lot of freedom in your life. This is why trading has become so popular. Most Forex traders are in fact day traders, and as a rule, they usually apply technical analysis to their trading, in order to understand how to trade Forex better. For this reason, many Forex traders are interested in technical analysis and the tools available for its improvement.
This is how you most probably came across the Elliott Wave Theory and decided to learn more about it. Let's take a look at the history of the Elliott Wave Theory, and see how it can be applied to your FX trading. Widely used in the financial markets, the Elliott Wave Theory holds great importance. It is a market analysis method developed by Ralph Nelson Elliott, based on the belief that many things happen in a five way pattern.
Learning all the technicalities of this wave can dramatically increase your skills and can be your ticket to Forex success. This article will provide you with a basic understanding of how one method of trading between foreign markets works, and will answer the common question among finance newbies: How do I apply the Elliott Wave Theory in Forex trading?
What is the Elliott Wave Theory?
Elliott Wave Theory basics are surprisingly straight forward. In the early 1920's, a man named Ralph Nelson Elliott discovered that stock markets actually traded in repetitive cycles, rather than in an unpredictable manner. Elliott wave predictions proved that these market cycles are directly correlated to the predominant psychology of the masses at the time, and investors' reactions to such outside factors.
Following this, Elliot soon found that the rise and fall of the mass psychology was always showing up in the same repetitive patterns; he called these consistencies 'waves'. Based somewhat on the Dow Theory, which states that the prices of stocks move in waves, Elliott was able to analyse and interpret the market to a much higher degree, due to their fractal nature.
What is a fractal?
A fractal is a never-ending pattern repeated over and over, making itself similar on different scales. Fractals are a mathematical pattern that repeats themselves infinitely - and with Elliott having found these patterns (or waves) in the market, he developed a means of making the predictions of the market itself. Today, we accept Elliott's wave theory, however the scientists of his time denied him the recognition for his wave theory, because of the principles and evidence he had based it on (evidence and principles that they too didn't recognise as science).
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The Elliott Wave Theory in Detail
Elliott's theory involves what he called 'waves' and each wave is a part of a fractal. For example, an 'Impulse Wave' (typically derived from a main/popular trend) always shows five other waves within its pattern; each wave in that pattern also shows five more waves within it, repeating this manner of a pattern infinitely. In Elliott Wave Theory predictions, Elliott identifies each of these smaller wave patterns as different degrees - but scientists didn't accept or recognise fractals until a much later time.
The Elliott Wave Theory Explained
When approaching the subject of a financial market, and the price action within that market, we must recognise and understand that for one action, there is always an equal and opposite reaction. For example, if the price of gold rises, you may see more people than usual selling gold. However, if the price for gold lowers, you may see people buying more gold than usual.
For Elliott, the balances and counterbalances came in the form of trends (also known as impulsive waves) and corrections (also known as corrective waves). These trends can show the main direction of prices, whereas corrections counterbalance or work against the trend. Each action and reaction has its place in the fractal - and Elliott used their specific place in the pattern to determine which classification of wave they held, further supporting and proving the unfalteringly, repetitive waves.
How to Apply Elliott Wave Theory Rules in Forex Trading
Forex trading is one of the most complicated, yet profitable areas in finance. As international trade becomes more intertwined, the relationship between currencies has to be defined, patterned, and understood for business owners and market analysts.
Application of the Elliott Wave Theory
The Elliott Wave Theory claims that prices move in five patterns. In an upward trend, a five way rise will be followed by a three way fall. In a downward trend, a five way fall will be succeeded by a three way rise. The five way patterns are referred to as the 'impulse waves' while the three way patterns are called the 'corrective waves'.
In the 'impulsive wave', the price rise is in phase one of the uptrend. This is the time wherein investors expect the trend to change. This brings a negative denominator on the prices. On wave two, prices don't fall much. It is in wave three that the trend rises, bringing positive news into the market. On wave four, prices decline because of profit booking, leading to an optimistic outlook from investors, who get positively inclined market news.
The Application of the Elliott Wave Theory for Profitability
Elliott Wave Theory analysis is vital for every Forex trader who wants to maximise the profitability of their venture. It is used to identify the direction of the market trend, the rise and fall of currency prices based on the psychological factors of brokers, and the trade participants. Applying the Elliott Wave Theory profitably is a good starting point to learn the tricks of the trade within the foreign exchange market. The technical concepts may not be explained fully in just one sitting, and may require thorough study.
As with any typical market theory, it contains pros and cons, yet the challenge is how to make its underlying benefits count.
It is important to note that Elliott Wave analysis should be implemented as a supportive measurement, since it can hardly provide valuable information on entry and exit points. Still, it is a great tool to be used in order to enhance and enrich your trading strategy. It could be used for the identification of stop-losses, and to predict the strength of possible market moves.
The EW oscillator goes perfectly when combined with such indicators as the MACD and the RSI, as such combinations can precisely define the exit and entry points for traders. During application of the Elliott Wave Theory in Forex trading, the rules are quite similar to the same ones that are seen in stocks. The main difference is that stocks are much harder to short, whereas with Forex trading, it is possible to benefit from this oscillator much more, due to the fact that you can actually go short on the trading instruments.
Is the Elliott Wave Theory Accurate?
As a theory, Elliott's waves are both strongly accepted, and strongly criticised in the trading community. While many traders base their analysis on this oscillator, there are some traders completely against using it.
It is important to note that this is just a theory and it has not been proven to work. This means that you should be using all of the EW trading recommendations at your own risk. Another important aspect to highlight is that out of so many trading indicators available on popular trading platforms, the EW oscillator is widely used. This is because it has given rise to a special type of analysis - EW analysis.
The best way to check if the EW oscillator and analysis can enhance your trading strategy is to try it out with extensive practice. Of course, if you are unfamiliar with these tools, it is recommended to use them while trading virtual funds on a demo account first. It may be a bit difficult for you to start comprehending the waves straight away, but with practice, you will be able to master it in time.
Once you have started using EW in combination with your regular trading setup, you will be able to see if this tool can fit your trading style, and whether you can benefit from it. We hope that this article has been useful for you and that you understand how use of the Elliott Wave Theory in Forex trading can help you become profitable.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.