The Basics
Developed by Ralph Nelson Elliott in the 1930s, Elliott Wave Theory was originally designed to forecast stock price movement. Over time however, the theory has been applied to a variety of markets, particularly foreign exchange. It’s higher popularity in the foreign exchange market stems from the fact that 80% of the volume in the FX market is speculative. This is important since waves are based upon mass psychology. Elliott Wave Theory is now a very popular analytical strategy frequently used by the technicians of leading investment banks and intermarket players.
The Elliott Wave Theory is founded on the notion that markets are not perfectly efficient. As a result, prices from one moment to the next are not random but rather subject to changes in overall investor behavior—changes that can be predictable with an understanding of mass psychology.
Waves Within Waves
The primary reason why Elliott Wave Theory can be difficult to understand is because waves frequently occur at many different levels. In other words, there are minor waves within larger waves. That is why at many points in time, multiple correct wave interpretations usually exist. The major waves determine the direction of the trend, while the minor waves help to determine the minor trends. Used in conjunction, traders can apply Fibonacci ratios to Elliott Wave Theory to help determine when currencies will reach a top or bottom. It can also be used as a tool to identify points to trade within the trend or to participate in the shorter minor wave cycles. It is important for Elliott Wave traders to be aware of both the minor and the major waves that may exist. The following is an example of two minor waves within larger waves:
Minimize Forecasting Errors With Elliott Wave
Since many different waves can exist during the same time frame, increasing the risk of forecasting error, traders should follow certain rules to minimize risk. The most important of which is to follow the principle that the “the trend is your friend.” This means that it is more prudent to only look for opportunities sell into minor waves when the major wave is a downtrend and to buy when the major wave is an uptrend. More rules can be used though to determine levels for placing stop-loss orders or to exit the trade. Fibonacci ratios are one of the most useful ways of identifying possible peak or bottoms of wave cycles. A popular relationship that exists is that Wave 2 retraces 38% of Wave 1. 50% and 61.8% retracements are also frequently seen.
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