The Elliott Wave Theory was developed due to the fact that financial markets are traded in five distinct waves going in the direction of the main trend followed by three distinct waves going against the main trend that can be forecasted with an understanding of crowd psychology.
Understanding Elliott Waves
According to Ralph Elliott, currency pair prices move in waves, five impulsive waves and three corrective waves (a "5-3" move). Impulsive waves move in the main direction of the trend and corrective waves move against the main up-or down trend.
Let's take a look at the following Elliott Wave pattern for better understanding:
Impulsive and Corrective Waves
To fully understand the Elliot Wave Theory, it is important to understand the psychological rationale for each of these waves since the zigzag movement of prices represents the ebb and flow of investor optimism and pessimism. Given an uptrending market:
Wave 1 (Impulsive): Minor Upwave In Major Bull Move – In Wave 1, prices rise as a relatively small number of market participants buy a currency pair for either fundamental or technical reasons, pushing prices higher.
Wave 2 (Corrective): Minor Downwave In Major Bear Move - After a significant run-up, investors may get fundamental or technical signals indicating that the currency is overbought. At such time, Wave 2 develops when original buyers decide to take profits while newcomers initiate short positions. Price action reverses, but generally does not retrace beyond its initial low that attracted buyers at Wave 1.
Wave 3 (Impulsive): Minor Upwave In Major Bull Move - Often the longest wave of the five, Wave 3 represents a sustained rally, as a larger number of investors use the Wave 2 dip as a buying opportunity. With a broader range of
buyers, the security enjoys a stronger push higher, with prices extending beyond the top formed at Wave 1.
Wave 4 (Corrective): Minor Downwave In Major Bear Move - By Wave 4, buyers begin to become exhausted and again take profits in reaction to overbought signals. Generally, there is still a fair amount of buyers, so the retracement here is relatively shallow.
Wave 5 (Impulsive): Minor Upwave In Major Bull Move - Wave 5 represents the final move up in the sequence. At this point, buyers as a whole are motivated more by greed than any fundamental justifications to buy, and bid prices higher irrationally. Prices make a high for the move before a correction or reversal ensues. The high in Wave 5 often coincides with a divergence in the relative strength index (RSI).
This is a view including the correction wave that follows the basic Elliott Wave:
A-B-C Corrective Waves*
Wave A: Correction To Rally – Initially Wave A may appear to be a correction to the normal rally. However, if it breaks down into five subwaves, it indicates that a new market trend may have developed.
Wave B: Bear Market Correction – Wave B tends to give bears an opportunity to sell as others take profit on their short trades or exit their long positions.
Wave C: Confirms End Of Rally – Wave C is the last wave of the cycle. At this point, Wave 3 typically breaks key support zones and most technical studies confirm that the rally has ended.
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.
Below is an example of a five-wave move up in GBP/USD:
------- SBJ ---- by; Jim Fot ------
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