The Elliot Wave Theory
The Elliot Wave Theory is one of the most common techniques used by experienced traders to forecast market movements. This technique was hatched by Ralph Nelson Elliot, a corporate accountant by profession, in the 1920-30s. Mr. Elliot analyzed market trends in the stock market and found out that stock markets do not move in a chaotic manner, but move in repetitive patterns. He called the repetitive patterns “waves.” This theory can be employed in predicting trends in any financial market, including the currency market.
The most distinctive aspect of the Elliot Wave Theory is that it employs the psychology of trading to forecast market movements. According to Mr. Elliot, markets would change based on outside influences (like those analysis made by news channels such as CNBC or Bloomberg) or the most prevalent psychology of the traders at that time. And, he illustrated that the market movements resulting from the collective psychology always showed up in the same recurring cycles that can be used in predicting where price will go (or not go) next.
Essentially, the Elliot Wave Theory is based on the fact that in a trending market, price move forward in 5s and then move backward in 3s. The initial 5-wave pattern is referred to as impulse waves in which the 3rd wave is normally the extended one. The second 3-wave pattern is referred to as corrective waves. In this pattern the 1st, 3rd, and 5th waves are composed of smaller 5-wave impulse patterns and they follow the overall trend in the market. On the other hand, 2nd and 4th waves are composed of smaller 3-wave corrective patterns.
After the 5th impulse in a bullish market, the downward waves will take place in impulses of 3s referred to as the ABC correction. In this case, impulse A moves downwards followed by a brief upward B, then a downward C occurs once more. It is important to note that letters, not numbers, are used to represent this corrective pattern.
In as much as the Elliot Wave Theory is an invaluable tool for navigating the forex market, its main weakness is that it does not spell out the amount of time the upwards and downwards waves will take. And, as most experienced traders know, time is very important in the financial markets. Nonetheless, with adequate practice, you can perfect the skill of correctly interpreting the waves and identifying the most profitable trading opportunities.
