Elliot waves are a powerful form of market analysis used to forecast broad based stock indices such as the Dow or the Nikkei but they can also be used in the Forex markets. This article is just an introduction to what they are and their applications to trading Forex but for a fuller explanation there is a reading list at the end and links to interesting websites.
The Underlying Principles behind Elliot Wave theory
Elliot waves are literally waves i.e price movements in the market. The waves link together to form larger waves and patterns that repeat themselves in sequences over time. By studying these patterns and finding out the current position market analysts or Ellioticians as they are known can sometimes predict which wave will follow in the sequence and thus the future course of prices.
Elliot waves are a form of fractal, which means the larger waves are made up of smaller waves which are exactly the same in shape and form but smaller – and so the basic pattern repeats itself ad infintum both in form and time. The research underpinning the existence of market fractals was carried out by a physicist called Mandelbrot who won the noble prize for his discovery. There are slight differences in the fractals discovered by Madelbrot and Elliot Waves, however, because the latter were discovered independently by a convalescing railroad accountant called R.N Elliot in the 1930s.
It is thought that changes in social mood create the distinctive Elliot Wave pattern. The waves up mark the course of prices as participants in a market move from caution to optimism to euphoria and the waves down reflect their pessimism and despair.
The basic unit of the Elliot Wave is a wave sequence composed of 5 waves in the direction of the trend followed by 3 contra-trend waves. The 5 initial waves always look a little like the waves in the diagram below being further composed of 3 waves in the direction of the trend 1,3 and 5 and waves 2 and 4 which are corrections. The 5-3 is the most important rule, since the stronger wave in the direction of the main trend will always contain 5 waves and the correction always be made up of 3.
Waves 1-5 and then a-c in the diagram constitute a complete Elliot Wave, or fractal. The next sequence begins with a new wave 1 after wave C down has completed. The strength of this form of analysis lies in its leading quality as, for example if an Elliotician can safely say that the market is nearing the end of wave C he or she can safely forecast a rally will be on the horizon in the form of wave 1 up of the next sequence.
The diagram below shows the fractal quality of Elliot Waves. The larger waves are denoted by a bracketed number and the smaller waves within them are denoted simply by unbracketed numbers. In this way the waves create the complexity which is closer to a picture of real market behaviour.
Application to Forex
Elliot Waves work well in any heavily traded financial instrument where mass investor psychology – rather than the buying power of a few major players – is the deciding factor. Thus liquidity and participation are the major deciding factors. To that extent the Forex market is perfect for Elliot Wave analysis given it is one of the largest markets in the world, perhaps the largest given the huge volume of daily transactions and participants. This is especially true for the larger currencies where history is witness to the manifold failed attempts of the largest possible single market participants: Central Banks in trying to manipulate foreign exchange rates.
Further Complexity and Further Reading
In the explanation above I have outlined only the basic elements of the theory and application of Elliot Wave analysis. There are subtleties, complexities and rules which can only be learned from further reading. For example, one of the rules states that the 3rd wave is never the shortest wave in the sequence of 5 and a further rule is that wave 4 will never retrace into the territory of wave 1 – well with 1 caveat only. It is important to learn these rules before applying the theory to the market you are studying, and after that it is a question of application.
Whilst students can study the original texts written by R.N Elliot a good introductory book which compiles and explains the theory is “Elliot Wave Principle” by Frost and Prechter. One of the author’s Robert Prechter, is considered the leading proponent of Elliot Wave Theory today. He discovered R.N Elliot’s original texts whilst in London rescuing them from relative obscurity in the British Library whilst working as a market technician for Merril Lynch in the 1970s. He also holds the record for the largest win in the United States Trading Championships where he succeeded in recording a 444% profit on a real money Options account. He is also the president of Elliot Wave International (EWI) the largest market forecasting service in the world. The EWI website has a lot of useful free information for students of wave theory at www.elliotwave.com.
The author and trader Bill Williams has developed many excellent technical indicators and tools to help the Elliotician more accurately identify waves and verify wave counts. He explains how to use some of them in a complete trading programme called ‘Profitunity’ in his excellent book: “Trading Chaos”.
Recently many analysts have tried to scientifically verify the existence of the wave theory. Recent research by the Australian developer Richard Swannell used 100s of computers to analyse wave sequences and claimed to actually find proof of the existence of the wave theory although he only published an extract from the final paper and instead set up as an advisory cum trading signal provider, see www.elliotician.com.
Finally, the American Analyst Glen Neely also claims to have spent years studying Elliot Waves in detail and has developed a semi-objective method of analysis outline in his book “Mastering Elliot Wave”. This is the most complex method of Elliot Wave analysis I have seen and contains developments and subtleties not in the original texts – so it is probably only for the experienced.