How To Use Elliott Wave Theory In Forex Trading: Ultimate Guide For New Traders

What’s up Traders, in this article, we’re going to be talking about using Elliott Wave theory in Forex Trading. The majority of Forex traders make judgments based on technical analysis. 

This sort of analysis uses sophisticated mathematical equations to identify market patterns and trends, which are then aggregated and put into the shape of a specific indicator. 

Although different traders utilise different indicators in their trading settings, there are a few that are more often employed.

One of these well-known indicators is Elliott Waves (commonly abbreviated to EW). It is so well-known that it has its own niche in Forex trading analysis. 

This article will provide an account of the indicator’s history and evolution, as well as instructions on how to use it. 

 

What does Elliott Wave theory mean?

 

• The Elliott Wave theory: An overview
• Elliott Waves and How does it work
• Particular considerations
• How does Elliott Wave theory work?
• What is the function of Elliott Waves?
• How does Elliott Wave theory help you Trade?

Elliott Wave theory is a technical analysis theory that is used to describe price fluctuations in financial markets. Ralph Nelson Elliott came up with the hypothesis after noticing and identifying fractal wave patterns.

Stock price movements and consumer behaviour both exhibit waves. Riders on a wave are investors who attempt to profit from a market trend. 

A refinancing wave is a huge, widespread movement among homeowners to refinance their existing mortgages with new ones with better conditions.

Elliott Wave theory is a type of technical analysis that looks for recurring long-term price patterns that are linked to persistent shifts in investor sentiment and psychology.

The idea distinguishes between impulse waves that establish a pattern and corrective waves that counteract it.

A fractal approach to investing describes how each set of waves is nested within a bigger series of waves that follow the same impulse or corrective pattern.

 

The Elliott Wave theory: An overview

Ralph Nelson Elliott developed the Elliott Wave hypothesis in the 1930s. 

Elliott wanted something to do with his time after being forced into retirement due to illness, so he began studying 75 years of yearly, monthly, weekly, daily, and self-made hourly and 30-minute charts across numerous indices. 

Elliott’s idea gained attention in 1935 when he correctly predicted a stock market bottom. Thousands of portfolio managers, traders, and private investors have used it since then.

Elliott outlined explicit principles for identifying, predicting, and profiting from these wave patterns. R.N. Elliott’s Masterworks, published in 1994, includes these books, articles, and letters. 

Elliott Wave International is the world’s largest independent financial analysis and market forecasting organisation, using Elliott’s model for market analysis and forecasting.

He was cautious to emphasise that these patterns do not guarantee future price movement, but rather serve to assist arrange the probability for future market action.

To discover specific chances, they can be used with other types of technical analysis, such as technical indicators. 

Traders may perceive the Elliott Wave structure of a market differently at any particular period.

 

Elliott Waves and How does it work

 

• Waves of Impulse
• Waves of Correction

Using Elliott Wave Theory, some technical analysts aim to profit from stock market wave patterns. 

According to this theory, stock price changes can be forecast because they follow a pattern of up-and-down waves caused by investor psychology or mood.

Motive waves (also known as impulse waves) and corrective waves are the two types of waves identified by the theory. 

It’s subjective, which means that not all traders will interpret the theory the same way or think that it’s a good trading technique.

The concept of wave analysis, unlike most other price formations, is not the same as a conventional blueprint formation where you simply follow the directions. 

Wave analysis provides insights into trend dynamics and aids in a deeper understanding of price movements. At the heart of the Elliott Wave Principle are impulse and corrective waves.

Waves of Impulse

Impulse waves are made up of five sub-waves that move in the same direction as the next-largest-degree trend. This is the most prevalent and easiest to recognise motive wave in a market.

It has five sub-waves, three of which are motive waves and two of which are corrective waves, just like all motive waves. This is referred to as a 5-3-5-3-5 structure, as illustrated above.

Its formation is defined by three unbreakable rules:

• The second wave cannot retrace more than 100% of the first wave.
• The third wave can never be shorter than the first, third, or fifth waves.
• Wave four can never reach beyond the third wave.

The structure is not an impulse wave if one of these rules is broken. The trader would have to rename the potential impulse wave.

 

Waves of Correction

Corrective waves, also known as diagonal waves, are made up of three — or a mixture of three — sub-waves that move in the opposite direction of the next-largest degree’s trend. 

Its purpose, like other motive waves, is to move the market in the trend’s direction.

Five sub-waves make up the corrective wave. The diagonal, on the other hand, appears to be either extending or contracting. 

Depending on the type of diagonal being seen, the sub-waves may or may not have a count of five.

Each sub-wave of the diagonal, like the motive wave, never completely retraces the previous sub-wave, and sub-wave three of the diagonal may not be the shortest wave.

To build larger patterns, these impulse and corrective waves are nested in a self-similar fractal. 

A one-year chart, for example, could be in the midst of a corrective wave, while a 30-day chart could be showing a growing impulse wave.

This Elliott wave interpretation could lead to a long-term gloomy prognosis with a short-term bullish outlook for a trader.

 

Particular considerations

The Fibonacci sequence specifies the number of waves in impulses and corrections, according to Elliott.

Fibonacci ratios, such as 38 percent and 62 percent, are common in price and time wave correlations. A corrective wave, for example, may retrace 38 percent of the preceding surge.

Other analysts have created indicators based on the Elliott Wave theory, such as the Elliott Wave Oscillator, which is seen above.

Based on the difference between a five-period and 34-period moving average, the oscillator gives a computerised technique of predicting future price direction.

EWAVES, an artificial intelligence system developed by Elliott Wave International, applies all Elliott wave laws and guidelines to data to provide automated Elliott wave analysis.

 

How does Elliott Wave theory work?

Elliott Wave theory is a kind of technical analysis that studies long-term price movements and how they relate to investor psychology. 

These price patterns, known as ‘waves,’ are based on precise criteria created by Ralph Nelson Elliott in the 1930s.

They were created specifically to identify and predict wave patterns in stock markets. Importantly, these patterns aren’t meant to be exact; rather, they’re meant to predict future price fluctuations.

 

What is the function of Elliott Waves?

There are various types of waves, or price structures, in Elliott Wave theory from which investors can get insight. 

Impulse waves, for instance, have an upward or downward trend with five sub-waves that might span hours or even decades.

They follow three rules: the second wave cannot retrace more than 100% of the first wave; the third wave cannot be shorter than waves one, three, or five; and wave four can never exceed the third wave. 

Corrective waves follow the same pattern as impulse waves and fall in threes.

 

How does Elliott Wave theory help you Trade?

Consider a trader who detects an upward trending stock on an impulse wave. They may go long on the stock until the fifth wave is completed.

The trader may go short on the stock at this moment, anticipating a turnaround. 

The assumption that fractal patterns reoccur in financial markets underpins this trading approach. Fractal patterns are mathematical patterns that repeat themselves infinitely.

 

Elliott Wave theory: An idea

 

• The Waves
• Wave pattern-based market predictions
• Interpretation of Elliott Wave theory
• Degrees of Waves
• Popularity of Elliott Wave theory

In the 1930s, Ralph Nelson Elliott created the Elliott Wave Theory. Elliott believed that stock markets, despite their reputation for being chaotic and erratic, traded in predictable patterns.

We’ll now look at the history of Elliott Wave Theory and how it’s used in trading.

Elliott Wave Theory is a type of technical analysis that looks for recurring long-term price patterns that are linked to persistent shifts in investor sentiment and psychology.

The idea distinguishes between impulse waves that establish a pattern and corrective waves that counteract it.

A fractal approach to investing describes how each set of waves is nested within a bigger series of waves that follow the same impulse or corrective pattern.

 

The Waves

Financial price movements, according to Elliott, are the outcome of investors’ primary mentality. 

He discovered that changes in public opinion usually manifested themselves in the same fractal patterns, or “waves,” in financial markets.

Elliott’s theory and the Dow theory are similar in that they both realise that stock prices move in waves. 

However, because Elliott also grasped the “fractal” structure of markets, he was able to dissect and study them in more depth.

Fractals are mathematical structures that infinitely replicate themselves on a smaller scale. Elliott noticed that stock index price patterns were similarly constructed. 

He then began to investigate how these repeated patterns could be used to forecast future market movements.

 

Wave pattern-based market predictions

Elliott developed detailed stock market projections based on the wave patterns’ predictable qualities. An impulse wave has five waves in its pattern because it moves in the same direction as the broader trend.

On the other hand, a corrective wave goes in the opposite direction of the main trend. On a smaller scale, five waves can be detected within each of the impulsive waves.

At ever-smaller scales, the next pattern repeats itself indefinitely. Elliott discovered this fractal structure in financial markets in the 1930s, but it would take decades for scientists to acknowledge and scientifically demonstrate fractals.

We know in the financial markets that “what goes up, must come down,” because a price movement up or down is always followed by a price movement in the opposite direction. 

Trends and corrections are the two types of price activity. Prices move along a trend, while corrections go in the opposite direction.

 

Interpretation of Elliott Wave theory

The Elliott Wave Theory is explained in the following way:

*Five waves advance in the main trend’s direction, followed by three waves in a correction (totaling a 5-3 move). 

The next higher wave move is divided into two subdivisions by this 5-3 motion.

*Though the duration period of each wave may vary, the underlying 5-3 pattern stays consistent.

Consider the following chart, which is made up of eight waves (five net up and three net down) and is designated 1, 2, 3, 4, 5, A, B, and C.

The impulse is formed by waves 1, 2, 3, 4, and 5, whereas the correction is formed by waves A, B, and C. The five-wave impulse, in turn, creates wave 1 at the next biggest degree, while the three-wave correction creates wave 2.

The corrective wave usually has three different price movements: two in the direction of the primary correction (A and C) and one in the opposite direction (B). Correction waves 2 and 4 in the diagram above. The structure of these waves is usually as follows:

Waves A and C in this illustration advance one degree in the direction of the trend, making them impulsive and composed of five waves. Wave B, on the other hand, is counter-trend and thus corrective, and is made up of three waves.

An Elliott wave degree consists of trends and countertrends formed by an impulse wave followed by a corrective wave.

Five waves do not always move net upward, and three waves do not always travel net downward, as shown in the patterns above. The five-wave sequence, for example, is down when the larger-degree trend is down.

 

Degrees of Waves

From largest to smallest, Elliott defined nine degrees of waves, which he named as follows:

• Grand Super Cycle
• Super Cycle
• Cycle
• Primary
• Intermediate
• Minor
• Minute
• Minuette
• Sub-Minuette

Because Elliott waves are fractals, wave degrees can theoretically grow and shrink beyond those indicated above.

A trader might recognise an upward-trending impulse wave, go long, and then sell or short the position as the pattern completes five waves and a reversal is near.

Because Elliott waves are fractals, wave degrees can theoretically grow and shrink beyond those indicated above.

A trader might recognise an upward-trending impulse wave, go long, and then sell or short the position as the pattern completes five waves and a reversal is near.

 

Popularity of Elliott Wave theory

The Elliott Wave theory gained prominence in the 1970s thanks to the work of A.J. Frost and Robert Prechter. 

The authors forecasted the 1980s bull market in their now-legendary book, Elliott Wave Principle: Key to Market Behavior. Days before the 1987 crash, Prechter would give a sell recommendation.

 

Final Thoughts

Elliott Wave practitioners emphasise that just because a market is fractal does not mean it is easy to anticipate. 

Although scientists acknowledge a tree as a fractal, this does not indicate that the route of each of its branches can be predicted. 

In terms of practical application, the Elliott Wave Principle, like all other analysis methodologies, has its supporters and detractors.

One of the major flaws is that practitioners may always blame their chart reading rather than flaws in the theory. 

If that fails, there’s always the open-ended question of how long a wave takes to complete. However, traders who believe in Elliott Wave Theory are ardent supporters.

 

Using Elliott Wave theory to Trade Breakouts

When he published The Wave Principle in 1938, professional accountant Ralph Nelson Elliott fired the first volley in a decades-long battle.

According to his pattern recognition theory, market trends unfold in five waves when moving in the direction of a major impulse and three waves when moving in the opposite direction.

This theory also states that each wave will be subdivided into three waves in the direction of the trend and two waves in the opposite direction. 

Finally, it discusses a fractal market, in which each wave produces comparable patterns over increasingly shorter and longer time frames.

Elliott Wave Theory (EWT) holds an unusual place in market lore, with devotees spending years learning its secrets and sceptics denouncing it as voodoo, preferring a more traditional approach to price prediction.

Over the years, Wall Street has been particularly sceptical of the technique, but conspiracy rumours abound, such as unproven reports that large players meet with wave theorists to make crucial market exposure choices.

To take use of EWT’s immense potential, we don’t need to join a secret society or spend a decade memorising a thousand rules and exceptions. 

In fact, we can use three simple wave principles to increase market timing and profit output right now by applying them to a popular breakout strategy. 

After a large low develops and a financial instrument tests a critical breakout level, we’ll check for particular Elliott Wave requirements.

Following a sustained rally, Aetna (AET) reached a high of approximately 86 in July 2014. It went through a regular ABC pattern, ending at 72 in October. 

In early November, the market soared back to resistance at the summer high, carving out two rallies waves before stalling out into mid-month.

Because the buying surge into resistance resembled waves 1 through 4 of an Elliott 5-wave rally set, three EWT concepts helped us predict what would happen next.

The first two of our three principles will be used to examine this hypothesis.

A. The bottom of the fourth wave (2nd selloff) cannot be higher than the peak of the first wave.

On October 27, the first wave finished at 79.64. After a brief dip to 76, the stock soared above 85 to test resistance. It halted at that level, potentially forming a fourth wave that found support near 82.

There is plenty of room between the two blue lines denoting the top of the first wave and the bottom of the fourth wave, at least so far. 

This increases the chances of a 4th wave consolidation leading to a 5th wave breakout and uptrend.

B. The middle of the third (2nd rally) wave frequently lines perfectly with a continuation gap.

A continuation gap occurs when a rising price prints a large gap and continues to move, doubling the length of the wave before to its appearance, as defined by Edwards and Magee in their 1948 book Technical Analysis of Stock Trends.

On October 31st (red circle), Aetna gapped up and kept going, marking the halfway point of the third wave. 

This is crucial information for our trade analysis since it increases the chances of a breakout and even higher prices from sluggish price action at resistance.

With this knowledge, we can buy the instrument on the fourth wave, anticipating a breakout. We can also put a stop below the trading range to limit our losses if we are proven to be wrong. The third and final principle is as follows:

C. The price gains of two of the three key waves are likely to be identical.

We’ve found and entered a 4th wave trade setup that’s likely to create an upswing of the same length as the first wave (7.84 points) or the third wave (8.81 points).

Using the third principle, we divide the difference and add 8.30 to the bottom of the fourth wave, which is currently at 81.93, resulting in a minimum reward target just above 90.

Final Thoughts

In mid-November, the stock broke out into a 5th wave rally, hitting a swing high of 91.25, well over our Elliott objective. 

Because it’s pointless to sell only because the increasing price has reached a hypothetical end point, good risk management is required.

Many Elliott wave rallies, especially during 5th waves, subdivide higher and higher as buy signals go off and momentum traders pile into positions.

 

Final words

Okay, so that’s it I’ve come to the end of this presentation, I hope you’ve enjoyed it and if you really do please write a comment and click the share buttons smash it right, and click to subscribe bell to Allow notifications be updated.

Whenever, I publish content like, this and finally any questions or feedback let me know below and I’ll do my best to help, so with this guide, I hope you got value out of this presentation, I wish you good luck and good trading and I’ll talk to you soon you.

 

About Author