Many Thousands of today’s forex traders consider the Elliott Wave Principle a vital part of their trading arsenal. Why? Because the Wave Principle’s rules and guidelines provide the context that helps traders identify the trend on any time frame, highs and lows in prices, find high-confidence trade targets and spot all-important points of ruin that tell you when you’re wrong.

The Elliott Wave Principle posits that collective investor psychology, or crowd psychology, moves between optimism and pessimism in natural sequences. These mood swings create patterns evidenced in the price movements of markets at every degree of trend or time scale.

In this article we will show you how you can put the power of wave analysis to work in your forex trading.

What is the Elliott Wave Theory?

Elliott Wave Theory basics are surprisingly straight forward. In the early 1920’s, a man named Ralph Nelson Elliott discovered that currency markets actually traded in repetitive cycles, rather than in an unpredictable manner. Elliott wave predictions proved that these market cycles are directly correlated to the predominant psychology of the masses at the time, and investors’ reactions to such outside factors.

Following this, Elliot soon found that the rise and fall of the mass psychology was always showing up in the same repetitive patterns; he called these consistencies ‘waves’. Based somewhat on the Dow Theory, which states that the prices of stocks move in waves, Elliott was able to analyse and interpret the market to a much higher degree, due to their fractal nature.

How Elliott Waves Work?

Some technical analysts try to profit from wave patterns in the market using the Elliott Wave Theory. This hypothesis says that currency price movements can be predicted because they move in repeating up-and-down patterns called waves that are created by investor psychology or sentiment.

The theory identifies several different types of waves, including motive waves, impulse waves, and corrective waves. It is subjective, meaning not all traders interpret the theory the same way or agree that it is a successful trading strategy.

Unlike most other price formations, the whole idea of wave analysis itself does not equate to a regular blueprint formation where you simply follow the instructions. Wave analysis offers insights into trend dynamics and helps you understand price movements in a much deeper way.

Picture – The Elliott Wave principle consists of impulse and corrective waves at its core.

The patterns link to form five and three-wave structures which themselves underlie self-similar wave structures of increasing size or higher degree. Note the lowermost of the three idealized cycles. In the first small five-wave sequence, waves 1, 3 and 5 are motive, while waves 2 and 4 are corrective. This signals that the movement of the wave one degree higher is upward. It also signals the start of the first small three-wave corrective sequence. After the initial five waves up and three waves down, the sequence begins again and the self-similar fractal geometry begins to unfold according to the five and three-wave structure which it underlies one degree higher. The completed motive pattern includes 89 waves, followed by a completed corrective pattern of 55 waves.

Trend and Consolidation Price Structures

Elliott found that, when a trend is underway, it typically has three large price moves in the direction of the trend, interspersed with two corrections. This creates a five-wave pattern: impulse, correction, impulse, correction, and another impulse. Traders often refer to these five waves by the number in which they occur. Therefore, if you hear a trader refer to “wave four” of a currency, they’re talking about the second correction (the one that comes after the second impulse).

A similar count of three movements can be measured within each correction. There will be a sharp move against the trend (the impulse of the correction), followed by a small movement back in the direction of the trend (the correction of the correction), and finally, there’s one last sharp movement against the trend (a second impulse of the correction) before the correction is over and the trend resumes. To prevent confusion with the numbered waves of the overall trend, corrective waves are labeled A, B, and C.

Remember, these movements are fractal, so the patterns occur on small and large time frames. For example, the first impulse wave higher within an uptrend on a daily chart may be composed of five waves on an hourly chart. Each corrective wave (waves two and four) is composed of three smaller waves (A, B, C), and there will also be larger A, B, C waves on a longer time frame as the broader trend ends (after wave five).

Typical Correction Size

When buying on corrections during an uptrend or selling on corrections in a downtrend, it is helpful to know how large the typical correction is. Unfortunately, there isn’t a set calculation, but there are some guidelines that can help you learn where to look for an impulse or correction to end.

In general, wave three is the largest wave of the cycle. Waves two and four cannot be larger than waves one, three, or five (or else it isn’t an Elliott wave cycle).

As he was developing his wave theory, Elliott made extensive use of the Fibonacci ratios. Traders may be familiar with these ratios from the Fibonacci retracement tool, which your brokerage will likely offer with its charting software. This means, when you’re measuring Elliott waves, you should keep an eye out for key Fibonacci percentages, such as 38%, 50%, and 62%.

For example, if you’re watching a correction after an impulse, you might use the Fibonacci retracement tool to draw lines on your chart at 38%, 50%, and 62%. As the price action approaches those lines, look for signs of weakness—that could be a sign that the correction is ending.

Conclusion

You can utilize the three concepts discussed here—How Elliott waves works and trend structures, and correction sizes—by only taking trades in the direction of the impulse waves. Take trades during the corrective waves and look for trade entry signals once the price has corrected the average amount. The correction isn’t likely to stop exactly at the percentage levels discussed above, so it’s better to use those as reference points and wait for the chart to confirm your suspicions before jumping into a trade.

Another important aspect to highlight is that out of so many trading indicators available, the EW oscillator is widely used. This is because it has given rise to a special type of analysis – EW analysis. While many traders base their analysis on this oscillator, there are some traders completely against using it.

As a theory, Elliott’s waves are both strongly accepted, and strongly criticised in the trading community. We hope that this article has been useful for you and we hope you understand how Elliott Wave Theory can boost your trading and it will help you to reach the target.