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Elliott Wave Theory on Forex Market
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Ralph Nelson Elliott (1871-1948) studied the stock market extensively. Back in the 1920s, he observed that both bullish and bearish market moves occur in three distinct phases. He began to develop theories and views that the overall prices in stock market averages move in waves. This was presumed to fall in line with the understanding of the work of Charles Dow as defined in the Dow Theory. Elliott was able to see patterns reoccur and reflected this in his work titled Nature's Law—The Secrets of the Universe (1946), in which he states, “Even though we may not understand the cause underlying a particular phenomenon, we can, by ob servation, predict that phenomenon's recurrence” (p. 4).

The purpose of this chapter is to give you an introduction to what Elliott wave theory is and how you can apply this method in the forex market in combination with what we have already covered—incorporating such traditional chart patterns as triangles and wedges alongside Fibonacci analysis. I believe it is important that traders have a complete understand ing of not only chart patterns, cycles, and trends but also phases or waves. Elliott wave principles can help you uncover just that and, more specifi cally, what phase, or wave, the market trend is in. As you may have already discovered, the forex market trades in phases, from periods of consolida tions to trending modes. With the knowledge of Elliott wave principles, this information may give you a better understanding of which side the market to be on and how to capture profitable moves with surgical precision. Hopefully, more times than not, you will be trading from the winning side.

THE WAVE CYCLE

Since many of the concepts explained already are great tools in themselves, combining them with Elliott wave is something that has been achieved and practiced even by Mr. Elliott himself. His discoveries were simply a com pelling phenomenon in the art of forecasting price moves. I will cover the basis for his discoveries and the overall strengths and weaknesses of his work. Keep in mind that Elliott wave is a fractal concept in which it works in multiple time frames; so it can truly benefit all styles of trading for day, swing, and position traders. Fractal concept is defined as cycles or pat terns that repeat in shorter-term and develop in longer-term time periods, meaning there are waves within waves.

A completed Elliott wave cycle from bullish to bearish or bearish to bullish consists of eight waves. There are two distinct wave definitions:

(1) Impulse waves are the ones moving with the main trend. Impulse waves have five primary price movements. (2) Corrective waves move against the main trend. Corrective waves are seen as having three primary price movements, which are lettered and run opposite to the direction of the main trend. A healthy long-term trend follows the indication of heavier volume during the impulse waves (1, 3, and 5). In forex, we do not have ac cess to volume studies or data; however, we can borrow this information once again from the futures markets or the stock market with the exchange traded funds, such as the Euro Currency Trust (FXE) as discussed in Chapter 1.

It is assumed that Elliott used some of Fibonacci work because a com plete wave cycle is composed of eight price moves, five up and three down (remember that 3, 5, and 8 are coincidentally Fibonacci numbers). The fun damental concept behind Elliott's theory is that bull markets have a ten dency to follow a basic five-wave advance, followed by a three-wave decline. Figure 7.1 best defines a bullish cycle. The exact opposite is true for bear markets. More experienced chartists would recognize that the end of a bullish-move fifth point could possibly be considered the number-one point of a 1-2-3 formation, or the top of a head and shoulders formation.

The one thing Elliott most wanted chartists to recognize is that his wave theory worked on long-term charts as well as on intraday charts. It does not matter what time frame you trade in; a wave is a wave. The idea here is that each wave is simply a subset of another wave, just to a lesser degree. Each wave is itself part of the higher-degree wave. We can define this by saying that waves of one time frame can be expanded to relate to a higher time period and that one time frame can be subdivided into a shorter-term time frame.

Figure 7.2 might help define that description. Another way of explain ing this concept is that you might see a five-wave count on a 60-minute chart that, when converted to a weekly chart, would be one full wave count for the weekly time period. Also we can see a five-wave count on a fiveminute chart that composes just one wave on a daily chart.

Elliott wave theory combines the best of traditional charting tech niques and price pattern formations, such as triangles and wedges. These are simply consolidation patterns within trends. These trend phases are considered waves. Price objectives from predicting possible highs or lows can be determined through the use of Fibonacci ratios and the corresponding rules associated with each wave description. I have had tremendous success identifying turning points as indicated by the maturity of a price move; for example, if it is the bottom of wave two or four, look for support targets using the Fibonacci ratios as well as the pivot point sup port targets.

When I see a confluence, or multiple cluster, of support targets from using both techniques, it heightens my assertion to go with a position be cause I understand which direction to trade from. I will admit there are times when an Elliott wave pattern is crystal clear and helps me trade on the winning side; then there are times when I don't have a clue and cannot make out any clear or distinct pattern. That is when I rely on other tech niques, such as trading in a short-term time frame within the direction of a higher-degree time frame. For instance, if the 15-minute trend is up, classi fied by the market trading above a set of moving averages (namely, pivot point averages), then I look for buy signals as defined by a series of higher highs, higher lows, and higher closing highs as prices trade above a set of moving averages on the five-minute time period.

Elliott wave relates well with the forex market and is a valuable tech nical tool. Trading is not about being rigid and sticking with just one method. Market conditions change, which requires using an assortment of tools to improve your market forecasting abilities. I believe studying and using Elliott wave will improve your chances for success. The fact that it is comprised of wave forms, Fibonacci correction, and projection ratios and has a time element as waves' magnitudes are concerned makes it a com plete and comprehensive analytical tool. The Elliott wave principle was originally applied for the stock market, but the core foundation of its deci pherable use was based on the premise of mass human psychology. Due to the exorbitant extent of trading on a global scale in foreign currency, I find it works well; when the patterns jump out on the charts, they really are a major asset, as long as you know what to look for.

In a world of chaotic and turbulent volatility, Elliott wave attempts to give a trader a better chance of interpreting what phase a market is in, a price objective, and, more important, a time duration as to when to expect a specific move to take place and how long it will last. It is considered a very subjective form of market analysis, and I strongly suggest sticking to the rules I will outline when applying these principles in your trading. Be sides wave counts and the interaction with Fibonacci extension and cor rection relationships, there is a time element and what is referred to as a proportionate and alternate relationship with the measurement of the waves. Elliott concluded that there was a “key” to predicting the variable or alternation in price move, such as, if wave two was complex, then wave four would be simple. This theory runs along the lines of not expecting the same magnitude of correction to happen twice in a row. Forex traders take heed to this observation because individuals tend to get complacent, expecting repeat or similar results with any given method. Trading requires a trader to be cognizant of historic moves but not to expect similar results each time. The alternate rule of not expecting the same magnitude is an im portant concept.

Remember that each wave has its own set of characteristics and rules. Here is a summary of these rules that you can apply in your trading approach.

Wave One

The first wave is the base or starting point derived from a consolidation trading phase after a prolonged price decline. It usually appears to be sim ply a small corrective bounce from a previous trend. It is the smallest in price moves as compared to the three impulse waves. This stage or wave is what technicians have discovered to be an accumulation phase. Using what we have learned with Fibonacci calculations so far, we can apply the ratio numbers to develop a technique to give price projections for a typical five wave pattern. In order to help determine the peak of a five-wave move, we can use several techniques. Using software that includes a Fibonacci correction and expansion tool, such as Genesis provides, we can easily determine a price objective with fairly good accuracy. If your charting software program does not have this feature, then the Fibonacci calculator that is in cluded with this book will come in handy. Here are the methods to employ. Figure 7.3 shows that once we have determined the overall measurement or amplitude of wave one, we extend that amount by 3.236 and add that sum to the bottom of wave one. I have seen a higher frequency of the 2.618 per cent ratio work as well.

Another method to predict the peak in wave five for a specific time pe riod is to take the measurement from the bottom of wave one to the top of wave three and multiply out by 1.618 percent. Figure 7.4 shows the variation that you should employ. The one drawback in using this method is the consideration of how long it takes for a swing measurement to reach its objective.

Using Fibonacci extensions just gives us an idea of a potential move; it does not give us a time frame in which the move will occur. The move could take days, weeks, or months to meet the objective. That is why I have included examples of integrating longer-term pivot point analysis, such as weekly and monthly time periods. These seem to be more effective in predicting both time and price turning points. Besides, they do help corroborate the Fibonacci extensions. Also, using both technical tools can help us nail down the potential timing of a turning point more effectively in the forex market.

Wave Two

The second wave usually retraces 0.618 percent of the sum of wave one. I stated earlier that a market that is in sync with Fibonacci stays in sync with Fibonacci, and this is one situation where it helps to anticipate when a mar ket will follow Elliott wave patterns and predictability. The 0.618 percent retracement in wave two is a big clue that a market may stay in a five-wave pattern sequence, as shown in Figure 7.5. Wave two can at times retrace 100 percent of the entire previous trend, or wave one, but not beyond the beginning of that wave—if it is a bullish cycle, wave two will not make a lower low; and if it is a bearish cycle, it will not make a higher high. This is what technicians generally consider the makings of “W” patterns (or double bot toms) or “M” patterns (or double tops). These are commonly referred to as 1-2-3 patterns and resemble a head and shoulders chart pattern. Traders have also been able to use the number-two point to predict the top of wave five by taking the sum of the price move in wave one, multiplying that amount out by 1.618 percent and then adding that figure to the price point of the bottom of wave two.

Wave Three

The third wave is one of the most important. This is where you will see your trend confirmation occur. This wave is the largest of the three impulse waves. It is accompanied with heavy volume. From a fundamental aspect, this is where you will start to hear more and more bullish news, which in turn will support the move upward. Generally speaking, the top of wave three equals a measurement of the length of wave one multiplied out by a factor of 1.618 percent. Another way to predict the top of wave three is to take the overall length of wave one, multiply that amount by 2.168, and then take that sum and add it to the price point of the low of wave two. Technicians jump on the trend and place market orders to enter a position from the breakout above wave one. You usually see a large increase in volume and open interest at that point. This is where breakaway gaps will occur. Here is one rule that needs to be followed and watched: For the third wave to be a true wave, it cannot be the shortest of the five waves.

Wave Four

The fourth wave is the corrective wave. It usually gives back some of the advancement from the third wave. One may see measuring chart patterns like triangles, pennants, or flags during the fourth wave. Triangles, pen nants, and flags are continuation patterns and generally break out in the same direction as the overall trend. The most important rule to remember about the fourth wave is: The low of the fourth wave can never overlap the top of the first wave. You will find tremendous trading opportunities once you can identify the fourth wave because old highs (resistance), once bro ken, will later turn into a new low (support) on a retest.

Wave Five

The fifth wave is usually the strongest for some commodities, such as gold, crude oil, and currencies. This is where the longest leg of the waves will be formed. It is also during this final phase that the price advance begins to slow. From the rule of using multiple analysis techniques, other indicators and oscillators, such as stochastics and MACD (moving average convergence/divergence), will begin to show signs of being overbought in a bull ish trend or oversold in a bearish trend. We notice during this period that the market is beginning to lose momentum and that the trend may be ex hausting itself. One classic chart pattern that is associated with giving clues that the peak in prices has occurred in wave five is the formation of a wedge pattern, as Figure 7.6 shows.

Lettered Waves

The lettered waves (A, B, and C) are shown in Figure 7.1.

• Wave A is usually mistaken for a regular pullback in the trend; but this is where you could possibly start seeing the makings of W or M ( 1-2-3 ) patterns, double tops or bottoms, or a head and shoulders chart pat tern.

• Wave B is a small retracement back toward the high of wave five, but it does not quite reach that point. This is where traders will exit their po sition and/or begin their position for a move in the opposite direction.

• Wave C confirms the end of the uptrend; and when confirmation is made by going beyond wave A, then another cycle begins in the oppo site direction.

There are more observations to understand, and they are quite subjec tive rather than absolute rules regarding Elliott wave theory. One is the concept of alternation. Such is the case that, when we have a five-wave pat tern, usually the corrective waves two and four will alternate in their com plexities. As I stated earlier, this means no two waves may have the same amplitude and/or time duration of a move.

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