Using Elliot Wave Theory

Background

Elliot Wave Theory was developed in 1934 to explain stock market movements. Ralph Nelson Elliott developed this theory as a tool to explain economic conditions and models but some characteristics of this theory could also be attributed to stock market conditions and trends in the foreign currency trading system. He was enthused by the Dow Theory and by observations found in nature and concluded that even human behavior is guided by principles of wave theory and masses constitute the market that reflects the same.

The Elliot theory is basically based on principles like:

1. The market is a true free market (here prices are not governed by the suppliers but are determined from consumer interactions and demand)
2. The market provides consistent and regular measurable metrics.
3. The market is controlled by masses i.e. a statistically significantly large group of individuals.

Elliott Wave Theory Assumptions

The basic assumptions behind a true free market are that of an inefficient market. In demand controlled markets the consumers decide the price through a continuous interaction. The masses overreact and the stocks and forex are either over priced or under priced.

This is in sharp contrast to the Business School theories where the market mechanism is considered to be quite efficient. Some school of thought still believes that the efficient marketplace theory is relevant to most market concepts.

Elliot’s theory rules out the possibility of an efficient market. So this gives an opportunity to conduct an independent stock/forex price survey assuming any other external factors do not have their effect on stock or forex prices. So this allows a chance to measure the global effect that masses have on stock/forex prices and foreign currency trading system.

Surprisingly it has been observed that stock/forex prices generally move in the opposite direction or independently as anticipated. So the news, the economy and the stock/forex would predict a movement and the real movement is likely to differ from the prediction. So this implies that people listen to that news that they want to hear and real movements are always independent of such situation.

Principle of Elliott Waves

Elliot waves feature a very significant study of correlation between human psychology and market trend. The e-wave study is basically based on stocks/forex. This study shows that it is extremely difficult to detach human emotions from the analytical capabilities that an individual possesses. You being the part of the market is also affected by the same fear, greed as the market itself experiences on the whole. It is quite difficult to achieve a neutral position to understand and gain from the sociological effects that you need to measure.

The basic mechanism of greed and fear is internalized in such manner that Elliot’s wave theory becomes the bible of human behavior study in stock/forex market. Most of the individuals could experience the same not even knowing or understanding the principles underlying Elliot’s theory.

The most important conclusion is that since Elliot’s theory measures and explains sociological performance of masses and most people do not understand the principle so they do not no how to dismiss these actions and the majority of the people thus fall into the same category where sociological functions are borne by individuals even without knowing them exactly.

The essential movements of stock/forex prices are depicted in Elliot’s wave theory. It describes 5 such waves that reflect stock/forex prices. Coupled with Fibonacci sequence this wave theory is elemental in determining the market trend and nature in foreign currency trading system.

Description of Elliot Waves

The whole wave theory represents two distinct patterns:

The impulse pattern
The corrective pattern

The impulse waves can be categorized into 5 wave patters i.e. 1, 2, 3, and the corrective waves are categorized into 3 patterns i.e. a, b, c.

These waves are fractal in character which implies that market structures are derived from similar wave patterns. To get a comprehensive market nature the long term charts yearly and short term market hourly charts should be considered.

The nature of the waves in an upwardly moving market and a market showing downward trend are almost similar, but the behaviors are reflected in a reverse pattern.

Wave 1

The stock/forex market moves in upward direction. This happens when a small section of the masses feel that stock/forex prices were cheaper previously and they start buying and hoarding stocks/forex resulting in substantial rise in stock/currency prices as more and more people buy stocks/currency.

Wave 2

At some point in time the same group will feel that stocks/currencies are overvalued and they step out of the market by gathering whatever profit they can and the stocks/currencies will go down. However the stock/currency market will not reach its previous lows until the stocks/currencies are considered cheaper again.

Wave 3

Wave three reflects the strongest stock/forex market trading conditions and is the longest wave. Here the same group has been convinced about the stocks/currencies and they want to secure more stocks/currencies even at a higher price. This drives the stock/currency prices higher.

Wave 4

The wave tends to weaken here as people again consider stocks/currencies to be overpriced and expensive and try to pull them down.

Wave 5

This is the point where stocks/currencies get extremely expensive. People are driven by hysterics to buy stocks or currencies and the masses never pay attention to the news or any reason that would inhibit them from doing so.

This is also the turning point or the point of reversal in the market where stocks/currencies either move to an a-b-c pattern or start afresh from wave 1. In an a, b, c corrective pattern the waves go down, up and down preparing for a new impulsive 5 way cycle. The market seems to be less volatile during this phase.

Length and Quantity of the Waves

Fibonacci sequence and ratios are widely used to measure the movement of stocks/currencies through a wave cycle. The Fibonacci fractions 5/8 and 1/5 and their inverse are decisive in measuring and predicting the waves.

The Fibonacci relationships with the waves, help the trader to anticipate and/or predict market conditions. This is particularly useful to locate trading opportunities in a forex currency trading system.