Elliott wave theory applied to FOREX trading
In nature every event has a characteristic ebb and flow to it. Any movement is always a result of application of energy in generic terms
The natural energy behind every happening in the universe tends to occur in waves. This can be observed from wind to tidal waves to cyclones to financial markets. A couple of brilliant human beings in our history delved into the subject of the natural phenomenon. One of them was Fibonacci and the other was R.N.Elliott . Fibonacci gave us the golden ratio which showed us the unmistakable relationships with in nature creations and natural progressions. The golden ratio of 61.8 is evident time and again in the financial markets. R.N.Elliott looked at various price charts of financial instruments for patterns and proposed the wave theory popularly know as Elliott Wave Theory . The price patterns time again depict fractals. A fractal is a geometric shape that can be split into parts, each of which is (at least approximately) a reduced-size copy of the whole, a property called self-similarity. Some of the most beautiful rendering of fractals are shown here
The price charts always show patterns unfolding in waves and can be discerned easily by a trained eye. The are is to find a pattern which will give us an entry with minimal risk and maximum reward probability. More on that later. The EW theory was further researched and propagated by Frost & Prechter through a life time work on this subject. For those readers who wants more on the theory can buy a classic written by Frost & Robert Prechter, Elliott Wave Theory . The summary of the theory is that waves unfold in either impulse or corrective patterns and the rules state that the impulsive waves show up as 5 waves and corrective as 3 waves. I will discuss briefly below the most important parts of the Elliott wave theory we need to have as the baseline. We are not going, nor is it essential, to go into the intricacies or end less wave counting, rules, guidelines, exceptions and history. My objective is to discuss only the essential parts as it applies to our objective of using it as a building block of our trading strategy to trade currencies profitably day in and day out.
If you notice in the picture the impulsive waves advance both in bull and bear markets(in Forex markets the Bull and Bear markets are anyway not very meaningful since it is base currency that is relevant ). The waves are denoted from 1-5 and the corrective waves, which essentially happens to correct the previous run, are denoted as A,B,C . So, Impulsives are always 5′s and correctives are always 3′s, this forms the crux of EW.It makes sense because nothing can run in straight lines and progress is only possible when the advance is more than the correction. Impulsive waves dont always point up and corrective waves always dont point downwards.
Now as mentioned briefly above, the waves would be unfolding in impulses and correctives at multiple degrees or time frames and the following classification mentions the different degrees of waves.
Grand supercycle: multi-century
Supercycle: multi-decade (about 40-70 years)
Cycle: one year to several years (or even several decades under an Elliott Extension)
Primary: a few months to a couple of years
Intermediate: weeks to months
Minor: weeks
Minute: days
Minuette: hours
Subminuette: minutes
However for our trading purposes we typically concern ourselves from Days(Minute) to Intraday(subminuette). Let me again remind here i wont be going in depth into the whole history and all the minutia of EW since i am here only to present strictly what we need . Please be cautious that waves do not happen in vacuum and that is where an overall awareness of the larger picture is essential. .
Like any other technical analysis, EW by itself can never be used in isolation and hence it has to be handled with a lot of caution. The 2 things i look for in EW are a) on a higher time frame is it an impulsive wave or a corrective and how does the wave look on the lower time frame b) Corresponding momentum
If we can simplify the concept of waves , the waves with the highest Risk/Reward possibilities are are waves 3,5 and C . This one simple awareness inspires us to find those waves in a pattern and fins an ideal entry point, so we could ride the wave . Our strategy always is to be in tune with the trend on the higher time frames. The typical time frames to spot larger trends are Day, 240 min and some times 120 min. Once you identify this, then zoom into a shorter time frame and find a setup to get in the direction of the larger trending wave and the ride will be smooth. The harmony would be so smooth when we catch the wave. Although i never rode the waves on the Seas as a surfer, i can surely imagine the feeling of riding those and yes i have surely been on the Forex waves and it is is sweet.
A typical example would be 1) I spot a wave 1 ending on a 240 minute time frame. 2) I shall wait for the retracement 3) Go onto a 5 or a 15 minute time frame and look for an entry at the end of wave 2 and we take a long position in anticipation of the wave 3 ride 3) If wave 3 unfolds all is well, if we are wrong our risk is very minimal since we will stop out just below the start of wave 1
All this needs to fit into the larger picture of the 4 tenets of our KISS strategy. The other 3 tenets need to validate this entry else we dont get in. So on to the the other 3 tenets .. Traditional technical analysis , Timing and Market sentiment . More to follow
