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Elliot Wave Theory

One of the best known and least understood theories of technical analysis in Forex trading is the Elliot Wave Theory. Developed in the 1920s by Ralph Nelson Elliot as a method of predicting trends in the stock market, the Elliot Wave theory applies fractal mathematics to movements in the market to make predictions based on crowd behavior. In its essence, the Elliot Wave theory states that the market – in this case, the Forex market – moves in a series of 5 swings upward and 3 swings back down, repeated perpetually. But if it were that simple, everyone would be making a killing by catching the wave and riding it until just before it crashes on the shore. Obviously, there’s a lot more to it.

One of the things that make riding the Elliot Wave so tricky is timing – of all the major wave theories, it’s the only one that doesn’t put a time limit on the reactions and rebounds of the market. In fact, the theories of fractal mathematics make it clear that there are multiple waves within waves within waves. Interpreting the data and finding the right curves and crests is a tricky process, which gives rise to the contention that you can put 20 experts on the Elliot Wave theory in one room and they will never reach an agreement on which way a currency is going to behave.

Elliot wave theory enjoys massive popularity and being described as advanced technical analysis strategy by many brokers and publishers. Elliot wave theory has a huge and devoted following therefore its a shame the theory has no basis of sound logic that can help you make money! Let’s look at Elliott wave theory in more detail and then look at sensible market analysis. The theory was named after Ralph Nelson Elliott, who concluded in his book “natures law” that the movement of financial markets could be predicted by observing, and identifying a repetitive pattern of waves.

Elliott’s Profound Observation

Elliott came to the stunning conclusion that all natural phenomena are cyclical – and this includes the financial markets. This is true, but we know that anyway – we know that at some time in our lives, we will feel rain when we venture outside, the question is when exactly?

So, markets are cyclical – big deal! What we want from an investment theory, is the probability of the event – i.e. when is it most likely to occur. Elliott wave theory is an objective investment theory – but there isn’t any objectivity in it at all! It’s all a subjective interpretation of peaks and troughs, in any time frame you like! Does this sound a logical predictive theory to you?

The Theory

Based on rhythms found in nature, the theory suggests that the market moves up in a series of five waves and down in a series of three waves. The difference between the Elliott wave principle and other cyclical theories is that the theory suggests no absolute time requirements for a cycle to complete – well that’s a lot of help! The subjectivity is so great in Elliott wave, that like most theories, everything is explainable in hindsight – but the difficulty is actually predicting the future. There are so many interpretations of the actual peaks and troughs in various time frames, that everyone will see them differently, this is hardly the basis of a predictive theory. Elliott wave theory claims to be able to predict the market – but gives no objective way of doing it in practice.

Elliot Wave Basics

• Every action is followed by a reaction.

It’s a standard rule of physics that applies to the crowd behavior on which the Elliot Wave theory is based. If prices drop, people will buy. When people buy, the demand increases and supply decreases driving prices back up. Nearly every system that uses trend analysis to predict the movements of the currency market is based on determining when those actions will cause reactions that make a trade profitable.

• There are five waves in the direction of the main trend followed by three corrective waves (a “5-3” move).

The Elliot Wave theory is that market activity can be predicted as a series of five waves that move in one direction (the trend) followed by three ‘corrective’ waves that move the market back toward its starting point.

• A 5-3 moves complete a cycle.

And here’s where the theory begins to get truly complex. Like the mirror reflecting a mirror that reflects a mirror that reflects a mirror, the each 5-3 wave is not only complete in itself, it is a superset of a smaller series of waves, and a subset of a larger set of 5-3 waves – the next principle.

• This 5-3 move then becomes two subdivisions of the next higher 5-3 wave.

In Elliot Wave theory, the 5 waves that fit the trend are labeled 1, 2, 3, 4 and 5 (impulses). The three correcting waves are called a, b and c (corrections). Each of these waves is made up of a 5-3 series of waves, and each of those is made up of a 5-3 series of waves. The 5-3 cycle that you’re studying is an impulse and correction in the next ascending 5-3 series.

• The underlying 5-3 pattern remains constant, though the time span of each may vary.

A 5-3 wave may take decades to complete – or it may be over in minutes. Traders who are successful in using the Elliot Wavy theory to trade in the currency market say that the trick is timing trades to coincide with the beginning and end of impulse 3 to minimize your risk and maximize your profit.

Because the timing of each sequence of waves varies so much, using the Elliot Wave theory is very much a matter of interpretation. Identifying the best time to enter and leave a trade is dependent on being able to see and follow the pattern of larger and smaller waves, and to know when to trade and when to get out based on the patterns you identify.

The key is in interpreting the pattern correctly – in finding the right starting point. Once you learn to see the wave patterns and identify them correctly, say those who are experts, you’ll see how they apply in every facet of Forex trading, and will be able to use those patterns to trigger your decisions whether you’re day trading or in it for the long haul.

Who uses Elliott Wave Theory?

1. Investors who want an easy way to make money, and are attracted to the mysticism of such tools as the Fibonacci number sequence, to predict market retracements.

2. Investors who believe in the false assumption that you can predict market behavior in advance – and want an easy way to make money.

How Markets Really Move

Market prices are a reflection of the following:

Supply and demand fundamentals + human psychology = price action

This looks simple, but is in reality, complicated equation – which is impossible to predict in advance. Trading markets via technical analysis is all about putting the odds and probability in your favor, and no more than that. It is not a way of predicting the future. Are there better theories than Elliott wave around, for making money from the markets? – A good exercise would be to poll the entire top performing fund managers in the world and see how many of them take the theory seriously.

Predictive and subjectivity don’t mix!

The Elliott wave theory is a predictive theory that leaves everything to subjective analysis. If Elliott had worked out a predictive theory, why didn’t he give an objective way to make money from it? Like most predictive theories it doesn’t work. If all investors could predict the market in advance, we would all know what was going to happen – and there would actually be no market at all, as we would all know the market price in advance! Elliott wave theory is supposed to be a predictive theory, but the only thing you can predict with it, is you will lose your money.