Elliot Wave Theory is a more advanced method of using technical analysis to trade the Forex market. Most traders have heard of the theory but find it a bit overwhelming or complicated to use in their trading. The Elliott Wave concept is indeed more complicated than other forms of technical analysis but it is among the best forecasting tools a trader can ever have.
The Elliott Wave Theory can be traced back to the beginning of the 20th century when an accountant known as Ralph Elliott discovered a key pattern in the markets. He found out that when the market price is trending, it generates five legs. Three of these legs are impulsive waves moving in the trend’s direction while the other two waves are corrective waves moving to counter the trend. Ralph Elliott further discovered that when the trend phase becomes exhausted, price action changes to a corrective phase that can be tracked in 3 moves. A trending phase, therefore, has 5 moves and the 3 corrective phase moves, which is what the concept called the 5-3 Elliott Wave count is all about.
To get a clear understanding of how Elliott Wave Theory works, it is important to first discuss the concept of price action. There are 3 basic price action phases on all Forex charts.
The three price action phases are:
- Trending move or the impulse wave. This can be referred to as the move that takes the direction of the trend. A trending move has a bigger price change and usually takes less time, which makes it quite appealing to trade. Impulse Waves are moves in the direction of the current trend.
- Corrective wave. This refers to how the price behaves in contrast to the impulse move. Correction moves tend to have a smaller price change and take a longer time to develop, which makes them less attractive to trade compared to impulse moves.
- Price consolidation. This is the phase of price in the absence of any visible trend.
Fibonacci ratios are important components of the Elliott Wave analysis. Fibonacci retracement is a very useful tool for traders who rely on the Elliott Wave. It is based on a key discovered by a mathematician called Leonardo Fibonacci. It is a sequence created by nature’s influence and also applicable to financial markets. Traders develop natural inclinations that become evident in the markets when the price gets to certain percentages. Some of the key Fibonacci levels include 0.00%, 23.6%, 50.0%, 100.0%, and 261.8% just to mention a few.
One way of trading using Elliott Waves is to have a Simple Moving Average in your chart. Open a trade as soon as a price confirms a specific wave and conforms to a particular Fibonacci level. Hold the trade for as long as it takes to break the Simple Moving Average (SMA) in the opposing direction. As you become more familiar with the Elliott Wave principle, you can trade using wave counts and Fibonacci levels without having to rely on other indicators.
The Elliot Wave Theory gives traders a framework for getting a deeper insight into price action and market structure. Fibonacci levels are useful in projecting Elliott Waves.