Applying the Elliott Wave Theory in Forex

Everyone hopes to gain an edge in the markets and develop their trading skills, and while various indicators, analysis tools and methods are available, it is impossible to know which ones will work for you and which ones are useful.

The Elliott Wave Theory is one example in forex that traders can use to identify potential price patterns. But what is it, and how can it be applied?

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What is the Elliott Wave Theory?

The Elliott Wave Theory was developed in the 1930s by Ralph Nelson Elliott, who believed that the stock market traded in repetitive patterns, despite arguments the market was random and volatile.

The technical strategy refers to waves as the primary form seen throughout the markets, with the same patterns seen across short-term and long-term charts.

Elliott’s argument was that every action is followed by a reaction, suggesting that every impulse move is followed by a corrective one. 

According to the theory, the first five waves form the impulsive move and go in favor of the trend, and the succeeding three moves form the corrective wave. The so-called 5-3 move is considered one single cycle.

How Does the Elliott Wave Theory Work?

When learning about the different strategies, it is crucial to understand the necessary jargon. For example, fractal, impulse and corrective waves all form part of the Elliott Wave Theory and are components to learn before diving straight in.

Fractals

A fractal indicator is a much smaller mathematical structure that repeats itself across the financial markets. Fractal indicators are constantly measuring signals and indicating a change in the trend.

They essentially show a potential U-shape in price and are seen for both bullish and bearish factors. When applying an Elliott Wave technical analysis tool on your charts, bullish fractals are marked by a down arrow, and bearish fractals are marked by an up arrow. 

A bullish fractal can only occur if there is a low point with two higher low candles on each side; for bearish fractals, it is the opposite.

Impulse Waves

Elliott identified an impulse wave as moving with the trend. The first five moves form the impulse wave, where the market trends in a set direction. 

Not all traders will interpret the theory similarly, but an impulse wave is seen as five moves, three consisting of motive waves in one direction and two corrective waves.

Its formation has specific rules which, if violated, ruin the structure of the impulse wave and means it cannot be classified as such. Much of this theory depends on the interpretation of the trader, but its analysis offers insight into different trends and price movements.

Corrective Waves

Elliott Wave Theory explains that corrective waves occur after the impulse waves and are a combination of three waves in the opposite direction. The corrective wave, sometimes described as a diagonal, consists of two waves against the original trend and one with the trend.

It is important to note that for Elliott Wave theorists, every action results in a reaction in the opposite direction.

How to Apply the Elliott Wave Theory in Forex

It is helpful to understand what the Elliott Wave Theory does, but can it be applied to forex trading and provide traders with benefits?

Example of the Elliott Wave Theory in Forex Trading

Examples of an Elliot Wave Theory and its outcome vary because traders interpret graphs and charts differently. 

However, an example would be if the first impulse wave in the EUR/USD is seen moving higher and is then countered by the second move, which moves in the opposite way. This action would be repeated for moves three and four before a fifth and final move higher.

Once the price has reached its peak, three subsequent corrective waves will take place, moving in a downward trend. The first move would be lower and would be followed by a second move in the opposite direction higher. Finally, the price will continue in its downward trajectory for the third and final move, completing an entire sequence.

The move will not always go exactly to plan, but the above example is the general trend for the strategy. Various factors can impact this theory when in action, such as the timeframe, macroeconomic and geopolitical events or the individual trader interpreting the chart differently. 

The variety in interpretation can cause issues when trading, as traders second guess or argue against an Elliott Wave forming or see a wave forming only to be taken out of its stride by a news release.

Is the Elliott Wave Theory Profitable?

Most people use the Elliott Wave Theory in conjunction with other forex technical analysis tools. The debate on whether Elliott Wave analysis works is fiercely contested. After all, any move in one particular direction will cause a market reaction. But, in real-time, it can be tricky to spot and can leave a trader wondering.

Some traders have successfully traded this strategy, and it can be profitable for many, but it can also be challenging and require much work to perfect.

Instead, the theory should be looked at as something to be added to an already-established strategy. It may be able to provide a slight edge and give a trader an advantage at certain times in the market.

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