Elliot Wave Analysis Primer
by Thomas House
Elliot wave analysis is based on Elliot wave theory, which was created by an accountant during the 1930s by the name of Ralph Nelson Elliot.
The theory is a basic framework used to predict market swings based on a general theory of market psychology. It is treated with a good deal of skepticism among academics. However, many traders have more confidence in it.
The theory describes market movements as responsive to real-world events, but those responses follow a similar pattern that derives from the psychology of those trading and can be applied over a number of different time frames.
At its most basic, Elliott wave theory predicts a market will react to an event with a series of 5 distinct waves. In the 1-5 series, waves 1, 3 and 5, the price moves in the direction of the overall trend. Waves 2 and 4 are correctional movements that go against the current market trend.
So, if good news hits the market, Elliot wave analysts would expect three upswings in price seperated by two corrective downward movements. Bad news would lead to three identifiable down turns and two corrective upswings.
For example, if you think you’ve identified an Elliott wave pattern that predicts a large increase in the value of, say, EUR/USD, you simply place the appropriate buy order and protective stop-losses – in case you are wrong – just like you would when you believe you’ve spotted any other market pattern.
As you might be able to tell from this extremely general example, Elliott wave theory is one of the most broad and generally applicable ways of thinking about markets that traders use.
As noted, these waves can take place over different time frames. Elliott wave analysis applies itself from the very most short-term patterns to the longest. Here are the names of the waves by time frame, from least to greatest:
· Subminuette: minutes
· Minuette: hours
· Minute: days
· Minor: weeks
· Intermediate: weeks to months
· Primary: a couple of months to a couple of years
· Cycle: one year to several years
· Supercycle: a few years to a few decades
· Grand Supercycle: multiple decades or longer
Given that much of the trading on the forex markets is not driven by market psychology, but by firms that are buying and selling currencies for purposes of international trade, Elliott wave theory offers less explanatory power and predictive ability for the forex market than it does for stock markets.
That being said, it is a mode of analysis that many traders find especially useful – if not as an exact predictive tool, then as a useful framework to view market developments.
Interestingly, Elliott developed his theory without having been educated on either the Fibonacci sequence or other important breakthroughs in mathematics. Despite the appreciation of Elliott’s work as mathematically ahead of its time, social scientists remain skeptical of its usefulness.
The problem is the same as that of many so-called predictive theories: They are so flexible in their framework – there is so much “art” in their real-world application – that they can be made to look like accurate portrayal of how a market works in retrospect very convincingly. However, using the theory to predict the future is open to so many subjective points of analysis that two different Elliott wave analysts could come up with two entirely different projections.
Nonetheless, it is useful to keep the pattern in mind, even if it statistically can’t be proven to occur any more frequently then random patterns. By trying to fit the market’s movement’s into a pattern, you can get a sense of where the market will go.
In the end, the Elliott wave is a more generalizable example of a common chart pattern. Like a double bottom or any other pattern, a good trader can keep an eye out for a textbook case of the pattern, and use that framework to trade effectively. A good trader, however, never puts too much faith in these simple patterns – if the markets really were that predictable, everyone would be making the trades as soon as the pattern shows up, and the patterns would therefore fundamentally change.
About the Author - Thomas House
Thomas House has been creating and marketing websites for over a decade. He has successfully bought and sold a variety of websites in different industries, and learned about many of them along the way. Mr. House is learning about forex and trading as he creates a resource for others to do the same. Feel free to contact him about advertising opportunities on this site if you are so inclined.
