It all began thanks to an accountant who saw stock market trends as being based on simple psychological principles. His name was Ralph Nelson Elliot, and he worked on his theory in the 1920’s. According to Elliot, who wrote the wildly popular book called “The Wave Principle”, the ups and downs of the market can be simply described in terms of financial waves. Elliot also penned a popular slew of articles in financial magazines.
The psychological principles that Elliot draws upon are based on various aspects of group psychology. Specifically, the rule of society moods holds that people swing between a positive outlook and a negative one on a regular basis. This behavior has a direct effect on the buying habits of consumers, and thus on the prices in the market. The pattern that Elliot discovered that the waves follow is as follows: there are five waves followed by three. The waves in one direction are the first, third and fifth. These are known as motive waves. The waves in the other direction are the second and fourth.
They correct the other type of waves, and are therefore known as corrective waves. There is a direct correlation between the directionality of waves and the strength of the market. Bull markets are characterized by motive waves that tend to go upwards. On the other hand, bear markets usually have downward motive waves. There are many different reasons for the directionality of the various waves, such as major rushes by traders on a specific area, or a swift movement from one rally to another. You will have a huge benefit in all of these transactions by grasping the concept behind the Elliot theory.
A special feature that is unique to Elliott’s Wave Theory is the make up of each wave. Each of the individual waves is made up of another pattern of five waves followed by another three, and then each of these smaller waves is also made up of a 5-3 pattern. When patterns occur again and again in a recursive manner, a phenomena known as a “fractal” effect. Once you are well versed at recognizing trends such as these, traders can narrow the picture down and be able to and form a more precise image in their minds of what is going on with the currency.
The Elliott Wave Theory was conceived at first based on the workings of the stock market and its unique mode of operation. However, the Elliott Wave Theory is also applied to forex trading without a problem, as the market of equity bears a strong resemblence to the foreign exchange market. Traders can choose from an array of data from which to make their assessments. For instance, they may choose a candlestick chart of daily forex prices, which plots the high and low prices of the day along with the opening and closing prices. The body of each bar is denoted by the gap between the opening and closing price and is white if the currency rose that day and black if it declined. In addition, each bar is augmented by a “wick”, which is a line representing the high and low prices for the day. This chart is popular because it is very visual and extremely easy to understand.
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