If you’ve decided to work on your forex trading strategy in 2024 using new technical analysis methods, the Elliot Wave theory is a good place to start. Despite being a hundred years old, many forex traders today use it to keep track of price patterns and predict trends. This, in turn, allows them to take advantage of both short and long-term trends. Because the Elliot Wave Theory is a prevalent concept in the world of stock and forex trading, it’s worth understanding to make better sense of different charts and spot favorable trading opportunities.
Let’s explore what Elliott Wave Theory is, the different types of waves involved, and how it can be used for forex trading.
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What is The Elliot Wave Theory?
In the 1930s, Ralph Nelson Elliott came up with a technique to analyze stock price movements. After looking at many decades of stock market data across different indices, the American accountant and author managed to predict the 1935 stock market nadir. At the time, many investors believed that stock markets behaved in an unpredictable and random fashion. On the other hand, he believed that markets follow recurring cycles or waves. He was able to identify specific fractal patterns, which he referred to as ‘waves.’
Price Movements in Waves
His theory is that you can predict stock and forex price movement by looking at the price history. But how? He explained that markets move in wave-like patterns that occur as a result of investor psychology. Traders who find a favorable opportunity and make a profit from a market trend are referred to as ‘riding the wave.’
Perhaps the most important part of the theory is that they’re fractal. That means you can notice repetitions of the wave pattern across any timeframe. If you pull up a one-year chart for any forex pair, you’ll be able to spot the signature wave pattern. And if you zoom in to look at a single tick chart, you can still see the basic wave pattern.
The Elliot Wave Pattern
Speaking of which, the Elliott wave theory is based on a specific wave pattern. It’s the set of movements that Elliott noted as the fundamental aspect of stock market price action. The entire pattern is made up of eight waves, and each one moves in the opposite direction of the last wave. So, if one wave moves upwards, the subsequent wave will move downwards.
The movement of the waves is dependent on the current trend, so it requires understanding whether the current trend is bullish or bearish. The first five waves in the pattern, which is called the motive phase, will always move in the direction of the overall current trend, whether it’s bullish or bearish. The last three waves make up the corrective phase, and they move against the overall current trend.
Once these eight waves are completed, the motive phase will become the first wave of a much wider pattern. The corrective phase will form the second wave, and so on, allowing the pattern to continue infinitely. This is what gives the Elliott wave pattern its fractal nature.
Types of Phases
In any Elliott wave pattern, you’ll see two types of phases: motive and corrective.
These are then made up of 5 waves that make a net movement in the same direction. It includes the most common motive wave, wave 5, making it easier to spot. Besides showing the highest possible price level, it indicates the lowest price level, allowing forex traders to take on favorable positions.
Among the five waves that make up this phase, three are motive waves, which means they follow the general market trend, while the other two are corrective trends. Therefore, they retrace the preceding waves and move in the opposite direction.
For a wave formation to be called a motive phase, it must meet three conditions:
- Wave 2 can’t retrace beyond 100 percent of wave 1. This means it can’t indicate a greater price movement than wave 1.
- Wave 3 can’t be the shortest of the 5 waves in the motive phase.
- Wave 4 can’t retrace beyond wave 3 in the pattern formation.
This phase is made up of three waves that move against the existing market trend. Typically, the first and third waves, A and C, move downwards, while wave B retraces A. If the market was showing bullish sentiment, it signals that the market is now correcting itself from the last trend. It also distinguishes the highest price level in the market, which is important for traders to sell their positions or take on short positions.
For a wave formation to be a corrective phase, it must follow three conditions:
- Wave A must be less than 50 percent of the last wave, wave 5.
- Wave B must be the smallest increase in the current wave formation.
- Wave C must be the longest to show the fall in price movement.
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Different Wave Patterns
Let’s take a look at the different wave patterns that these formations make:
If the market is currently showing an uptrend, a flat wave pattern shows a downward market momentum. This is usually a signal for traders to exit the market. And if the market is showing a downtrend, the flat wave pattern shows upward momentum and signals traders to enter the market.
This is a corrective wave pattern that indicates a strong upward or downward price movement. Waves A and C are motive waves that move in the direction of the market, while B moves against the market. During a continued uptrend, the zig-zag wave pattern brings down the price of a currency pair, signaling traders to sell. But if it’s a continued downtrend, it signals traders to buy.
The diagonal pattern has several waves that move in the direction of the market. It comprises multiple sub-waves with no specific count, and it shows traders that the existing momentum is strong. It also signals appropriate entry or exit levels depending on whether the market is bullish or bearish.
This is a corrective pattern comprising five waves that balance the existing market direction. It includes three corrective waves and two motive waves. In a contraction, the waves become smaller in length, while expansions show the waves increasing in length. In simple terms, this pattern indicates that the market is moving back to its previous position.
How Do Elliott Waves Work?
According to Ralph Nelson Elliott, the signature wave pattern follows specific rules.
- Level 5, which is where wave 5 ends and the corrective phase begins, is the peak of an individual wave pattern. In a bull market, this indicates the highest price, where traders get an exit signal. On the other hand, in a bear market, level 5 indicates the lowest price.
- Level 2, which is where wave 2 ends, is the lowest price for a specific forex pair, and it’s where traders get an entry signal. If the market is bearish, level 2 indicates the highest price.
Keep in mind that within each phase, certain waves move against the phase. So, in the motive phase, which moves upward in a bull market, wave 2 and 4 move downward. And in the corrective phase, which goes downward, wave B moves upward as it retraces from A. It’s important that these waves aren’t bigger than the preceding waves. Therefore,
- Wave 2 can’t be bigger than wave 1
- Wave 4 can’t be bigger than wave 3
- Wave B can’t be bigger than wave A
Interpreting the Theory
Here’s how you can interpret the Elliott wave theory: The first five waves of the pattern follow the overall market trend. So, if the market is showing a bullish or bearish trend, waves 1, 2, 3, 4, and 5 will follow this trend, even though waves 2 and 4 are retracements.
This is followed by three more waves, A, B, and C, which make up the corrective phase. The last three aren’t numbered because they move in a different direction from the first phase. So, if the first phase moves up, the corrective phase will go downward and vice versa in the event of a bear market. Then, the motive and corrective phase become the first and second waves of the next bigger wave pattern. Although the 5-3 pattern continues, the timespan of each wave varies.
All this talk about the Elliott wave theory begs the question, ‘Does it work for forex trading?’ Yes, it’s possible to use Elliott waves in Forex trading, as investors who apply it are able to take advantage of favorable opportunities.
What’s The Relationship Between Elliot Waves and Fibonacci Theory?
If you’re still a beginner, you may struggle to implement the theory as part of your strategy. At this stage, a strategy with more objective rules is much easier to track. That’s why many forex traders combine it with other theories for a well-rounded strategy. That’s where the Fibonacci theory comes in.
Since Elliott wave formations are highly subjective and fractal in nature, you can apply the Fibonacci theory for a comprehensive strategy. Using Fibonacci retracement levels, you can predict when the corrective waves 2, 4, and B will end. Similarly, you can use Fibonacci extensions to predict when impulse waves 1, 3, 5, A, and C will end.
According to the Fibonacci system, wave 2 can be 50, 61.8, 76.4, or 85.4 percent of wave 1 since these percentages are classic retracement levels over 50 percent. Since wave 3 is an extension of wave 1, it can reach 161.8 percent of the first motive wave. While it sounds a little complicated, rest assured that you won’t need to do this manually. Most trading platforms come with a Fibonacci drawing tool as part of their charting software. With this tool, you’ll be able to plot Fibonacci levels on an Elliott wave.
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Using Fibonacci Retracements and Extensions
In case you weren’t aware of what Fibonacci retracements are, here’s a quick rundown. These levels are horizontal lines on your chart that show the possible locations for support and resistance levels of a forex pair, stock price, etc. It indicates the extent to which the prior movement will be retraced while the direction of the overall trend continues.
Although Fibonacci retracements help predict support levels, extensions can narrow down possible price targets in the overall trend. They go beyond the usual retracement levels, and you can use these extensions to set stop-loss or take-profit orders.
Using Elliot Waves For Forex Trading in 2024
If you plan on using the Elliott wave theory for forex trading strategy in 2024, start by finding out if the current market is facing a bullish or bearish trend. Then, you must determine if it’s currently in the motive or corrective phase of the pattern. Of course, finding out the current phase also depends on the timeframe. It’s possible that a 30-day chart shows a motive phase while a one-year chart shows a corrective phase.
That’s why the theory has gained traction among swing traders, who try to capitalize on price movements in wider trends. They do so by finding out which wave the market is currently in and where it will move next. Let’s suppose the overall trend of the market is moving upward. One example is that they may buy while it’s in the motive phase and sell once the corrective phase begins.
That being said, it’s complicated to implement an Elliott wave strategy because it takes time to master the skill of identifying different waves and phases. Before you start trying your hand at using Elliott waves in forex trading, it’s recommended to read pricing charts for different forex pairs across different time frames. It’s an effective practice exercise that improves your ability to spot wave patterns and builds confidence in using the theory for forex trading.
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