Ralph Nelson Elliott developed the Elliot Wave Theory in the 1920s as a means of predicting stock market trends. At the core of this theory is what is called fractal mathematics that aims to make predictions in market movements depending on crowd behavior. Although this theory has found acceptance in predicting the behavior of stock markets it is now increasingly finding acceptance in forex markets too.
Elliot Wave theory implies that forex markets move in a series of 5 swings upward and 3 swings back down. More importantly this process is supposedly repeated perpetually. A simplistic interpretation of this theory would mean that a forex trader could catch the wave and ride it and make profits until it (the wave) swings down. In reality it is a much more complex situation.
What makes the Elliot Wave theory fascinating is the aspect of “timing”. This is one theory that does not put a time limit on the upward and downward swings of the market. Or you could say that the theory does not restrict the time limit on the reactions and the rebounds of the currency in the market.
As explained earlier, the basis of Elliot Wave theory is fractal mathematics. And with reference to waves, fractal mathematics stipulates that there could be multiple waves several times within the waves you could be considering. However, interpreting these waves and finding the right tops and bottoms calls for a lot of ingenuity. If for example you ask several forex experts to do an Elliot Wave analysis of a particular currency, it is quite possible that all of them could turn up with different interpretations.
Earlier we talked of the correlation between crowd behavior and Elliot wave theory. What does this mean? Drop in currency prices will cause people to buy and when people buy demand increases with simultaneous decrease in supply. This causes the currency price to go up again. Every trend analysis in a currency market ideally aims to predict which actions will cause reactions that would indeed make a particular forex trade the most profitable at that point in time.
The Elliot Waves are characterized by five waves in the direction of the main trend followed by three corrective waves. It is a sort of “5-3″ move. So in other words, Elliot wave theory depicts that market activity could be predicted as a series of 5 waves that move in one direction (this is indicative of the trend) which is followed by three corrective waves that bring the market back towards its starting point. The 5 waves that constitute the trend are labeled 1,2,3,4 and 5 impulses. This “5-3″ move supposedly completes a cycle. This by far gives you a basic understanding of the Elliot wave theory in relation to currency markets.
Thereafter the theory gets more complex. Therefore a few words on that complexity would also be in order. In actual practice, each “5-3″ wave is never complete in itself. In other words, each “5-3″ wave is a superset of a smaller series of waves, and which is in turn a subset of a larger set of “5-3″ waves. So in theory a “5-3″ wave may take days to complete or it could be over in a few minutes.
It would be useful to remember that successful traders who have profited using the Elliot Wave theory attribute their success to the timing of their trades to coincide with the beginning and end of impulse 3.
Using the Elliot Wave theory in practice is very much a matter of interpretation. If you can follow the pattern of large and smaller waves and know when to do your trade based on those patterns, you would have got the Elliot Wave theory right. So firstly you have to figure out the patterns right, and decipher the correct starting point to make your trade. Eventually you will be able to use those patterns in your overall trading strategy whether you are doing day trading or you are intending to use it for long term trading.