The Elliot Wave Theory Explained

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The world of investment can mean different things to different people. For some, it offers a chance to earn some passive income, whereas others may feel that the marketplace is too chaotic to contend with. Both instances can be true, but many will have their own strategy when it comes to investing in stocks and shares.

There can be a series of factors to consider when buying shares. Some may luck out on some random investments, but for the most part, you will have to carry out some form of research in order to limit the risk involved with investments.

What is The Elliot Wave Theory?

Ralph Nelson Elliot was an American accountant who believe that stock markets traded in competitive cycles, and created a theory based on his beliefs, including the following:

Cycles and Waves

Stock market cycles are essentially price patterns that occur within the stock market. Elliot surmised that these cycles were due to the reaction from outside influencers, or the crowd psychology. Investing is effectively about buying stock and shares that will yield a profit when sold. Understanding the way of thinking within the market allows you to make more savvy decisions when investing.

The Elliot Wave Theory looks to highlight such occurrences of crowd psychology, and then dive these into waves.

These waves were then explored further and looked to create a way of using these waves, along with the fractal nature of stock markets, to use as a predictive indicator for future investments.

The theory dictates that waves unfold in a certain way. For example, once an investment reaches wave 4 or 5, it will retrace patterns of the first wave via a pattern showing two smaller-up waves, and one down-wave.

Using the Elliot Wave Theory to Invest in Forex

Now you have a better idea of how the Elliot Wave Theory works, you will be keen to know how it can be used when investing in Forex.

It’s important to note that although many may look at the Elliot Wave Theory in a similar way, many can come up with their own interpretation.

It’s also worth noting that there are several software options available for those who are looking to simplify the Elliot Wave Theory process when trading in Forex.

How The Trending Market Operates

  • The first five-wave pattern is known an impulse wave.
  • Out of the three impluse waves, 1,3 or 5 will be extended. For the majoritym this will be wave 3.
  • The next three-wave pattern is a correctivewave, and will use letters rather than numbers to show the correction, meaning you have more clarity when it comes to the value of your investment.
  • Smaller five-wave patterns will make up waves 1,3 and 5, while waves 2 and 4 contain the corrective pattern.
  • Although there are 21 types of corrective patterns, they are often made up of three easy-to-understand formations.
  • The three corrective waves are known as zig-zags, flats and triangles.

Setting Up a Plan Using the Elliot Wave Theory for a Short Trade

As advised there will be some who trade blindly, and while they can see some success, a plan is much more robust way of making an investment to ensure that their profit margin is maximised.

Select a Method for a Creating an Elliot Wave Count

An Elliot Wave can be created using our own analyis, or anaylisis software that creates waves. There is no right and wrong solution when it comes to which method you employ, it’s simply about finding what works for you.

Wait For Wave Five

This process can require a great deal of patience. Those who are using a single forex market may find that the setup we need only occurs a few times a year.

Search for Confirmation of the Trend

One the price bar changes to a wave 5, we need to confirm as to whether a long trade should be made or not. In some software the entry may be seen as wave 4, but this can be assumed to be wave 5. If you’re unsure of how some software interprates wave 5, then it can be advisable to check with the developer. 

90-Day Commodity Channel Index

The Commodity Channel Index (also known as CCI) was created by Donald Lambert in 1980. The oscilator was designed for use with commodities, it is also used for equities and currency trading. The indicatoes highlight the two point on a graph to show investments that are oversold or overbought. We should be confirming the 90-day CCI is positive.

The Relative Strength Index

The Relative Strength Index was developed by K Welles Wilder and measures the speed and change of price movements. Before placing a long trade, we should check that the RSI has reversed to the upside for one day.

While these actions don’t have to take place on the day the wave changes, it should be confirmed that both have occurred before the wavecount changes to anything other than four. Using this infromation we can then make a long trade.

A short trade works in a similar way, in that we still have to use the above indicators, but there are a couple of more steps we need to follow:

When making a long trade, we will subtract the three-day average, which shows the absoloute value of the current high minus the previous low.The more volatile the tradem the higher the ATR will be.

Making a short trade means we hae to add three times the three-day ATR to the high and this will be used as a stop-loss point.

There’s no denying that understanding the Elliot ave Theory takes time to learn, especially if you’re using it in real-life investment, so it’s worth finding a way of working that’s best with you, and becoming familiar with the method or software being used.

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