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A Short Description of FOREX Operations
This foreign exchange market is an Over The Counter (OTC) market. There is no central exchange and clearing house where orders are matched...
Technical Analysis
Technical analysis assumes that all known important factors are embedded in the price movements of the curency pair...
Forex Trading Systems
Trading systems can use technical indicators such as stochastics, Bollinger Bands, Moving Averages, and candlestick charting patterns to formulate buy and sell signals...
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Forex And The Anatomy Of An Elliot Wave
FOREX traders try to predict the direction of movement of currency pair trades so that they can profit from the moves. One method of technical analysis that FOREX traders have found useful for that purpose is Elliott Wave Analysis.
Ralph Nelson Elliot observed that markets have strong trends that seem to follow a repetitive pattern, irrespective of the time frame being viewed, giving them a fractal nature. He analyzed a great number of charts and found that the market movements were not really as chaotic as they first appear to the casual observer. He reasoned that the repetitive cycles reflected the actions and emotions of humans, caused by exterior influences or mass psychology. Elliott contended, that the ebb and flow of mass psychology always revealed itself in the same repetitive patterns, which subdivide in so called waves. He did his work in the 1920's and his theories continue to have loyal followers due to their success in explaining market behavior.
Fractals are mathematical structures, which infinitely repeat themselves on an ever smaller scale of observation. The patterns that Elliott discovered had the same characteristic. He observed that an impulsive wave, which goes with the main trend, always shows five waves in its pattern. On a smaller scale, within each of the impulsive waves of the larger impulse, again five waves will be found. In this smaller pattern, the same pattern repeats itself ad infinitum (these ever smaller patterns are labeled as different wave degrees in the Elliott Wave Principle). Only much later were fractals recognized by scientists. In the 1980s the scientist Mandelbrot proved the existence of fractals in his book "the Fractal Geometry of Nature". He recognized the fractal structure in numerous objects and life forms, a phenomena Elliott already understood in the 1930s.
Price movements can be divided into trends on the one hand and corrections or sideways movements on the other hand. Trends show the main direction of prices, while corrections move against the trend. In Elliott terminology these are called Impulsive waves and Corrective waves.
The Impulse wave formation has five distinct price movements, three in the direction of the trend and two corrections against the trend.
Obviously the three waves in the direction of the trend are impulses and therefore these waves are also composed of five smaller waves, when viewed at a smaller scale. This trait illustrates the fractal nature of the waves.
The waves against the trend are corrections and are composed of three waves. The corrective wave formation normally has three, in some cases five or more distinct price movements, two in the direction of the main correction and one against it. The waves of the shorter term trend are impulsive and composed of five waves, when viewed at a smaller scale, again illustrating the fractal nature of the waves.
An impulse wave formation followed by a corrective wave, form an Elliott wave degree, consisting of trend and counter trend. Impulse waves trend up in a bull market, but they trend down in a bear market, indicating the major trend in both cases.
Some rules and guidelines to follow in helping you identify the impulsive (waves 1,2,3,4,5) and corrective waves (waves A,B,C) are listed below:
- Impulse patterns occur in waves 1, 3, 5 and in waves A and C of a correction
- Wave 2 cannot be longer in price than wave 1, and it must not go beyond the origin of wave 1.
- Wave 3 is never the shortest when compared to waves 1 and 5.
- Wave 4 cannot overlap wave 1, except in diagonal triangles and sometimes in wave 1 or A waves, but never in a third wave. In most cases there should not be an overlap between wave 1 and A.
- As a guideline the third wave shows the greatest momentum, except when the fifth is the extended wave.
- Wave 5 is normally the shortest, but it must exceed the end of wave 3.
- As a guideline the internal wave structure should show alternation, which means different kind of corrective structures in wave 2 and 4.
- The extended wave normally shows the highest acceleration.
The following points can help you integrate Elliott Wave Theory into your trading system:
- Determine what time frame (or wave degree) you would like to trade.
- Determine which patterns and alternative wave counts give the best trading opportunities, such as when several alternatives all produce a price movement in the same direction.
- Determine objective entry points based on patterns.
- Determine objective exit points, also based on patterns. You should for example exit a trade when a price movement makes your preferred wave count invalid.
An understanding of the five waves of the dominant trend and trader's general beliefs during each wave is very instructive.
Wave 1: Wave one is rarely obvious at its inception. When the first wave of a new bull market begins, the fundamental news is almost universally negative.
Wave 2: Wave two corrects wave one, but can never extend beyond the starting point of wave one. Typically, the news is still bad in a bull trend. As prices retest the prior low, bearish sentiment quickly builds, and "the crowd" haughtily reminds all that the bear market is still deeply ensconced.
Wave 3: Wave three is usually the largest and most powerful wave in a trend (although some research suggests that in commodity markets, wave five is the largest). The news is now positive and fundamental analysts start to raise earnings estimates. Prices rise quickly, corrections are short-lived and shallow. Anyone looking to "get in on a pullback" will likely miss the boat. As wave three starts, the news is probably still bearish, and most market players remain negative; but by wave three's midpoint, "the crowd" will often join the new bullish trend. Wave three often extends wave one by a ratio of 1.618:1.
Wave 4: Wave four is typically clearly corrective. Prices may meander sideways for an extended period, and wave four typically retraces less than 38.2% of wave three. Volume is well below than that of wave three. This is a good place to buy a pull back if you understand the potential ahead for wave 5.
Wave 5: Wave five is the final leg in the direction of the dominant trend. The news is almost universally positive and everyone is bullish. Unfortunately, this is when many average investors finally buy in, right before the top. Prices may shoot up absurdly during a bullish fifth wave. The knowledgeable trader will sell to reduce exposure at big surges to raise cash to buy in after the correction phase. Volume is lower in wave five than in wave three, and many momentum indicators start to show divergences (prices reach a new high, the indicator does not reach a new peak). At the end of a major bull market, bears may very well be ridiculed.
An understanding of the three waves of the corrective trend and trader's general beliefs during each wave is very instructive.
Wave A: Corrections are typically harder to identify than impulse moves. In wave A of a bear market, the fundamental news is usually still positive. Most analysts see the drop as a correction in a still-active bull market. Some technical indicators that accompany wave A include increased volume, rising implied volatility in the options markets and possibly a turn higher in open interest in related futures markets.
Wave B: Prices reverse higher, which many see as a resumption of the now long-gone bull market. Those familiar with classical technical analysis may see the peak as the right shoulder of a head and shoulders reversal pattern. The volume during wave B should be lower than in wave A.
Wave C: Prices move impulsively lower in five waves. Volume picks up, and by the third leg of wave C, almost everyone realizes that a bear market is firmly entrenched. Wave C is typically at least as large as wave A and often extends to 1.618 times wave A or beyond.
The classification of a wave at any particular degree can vary, though practitioners generally agree on the standard order of degrees (approximate durations given):
Grand supercycle: multi-decade to multi-century
Supercycle: a few years to a few decades
Cycle: one year to a few years
Primary: a few months to a couple of years
Intermediate: weeks to months
Minor: weeks
Minute: days
Minuette: hours
Subminuette: minutes
Understanding the repetitive nature of Elliot Waves and the fractal nature of the waves, can help you forecast future market movements and warn of impending turnarounds, giving you a big advantage over other traders who are not aware of the recurring nature of the fractal waves. The fractal nature of the waves enables you to trade the investment horizon, which is most suited for you, from very aggressive intra day trading to longer term investing. The same rules and patterns apply at all levels of observation for all times.
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