Guide for Forex Traders

An Introduction to Elliot Waves

One of the major hurdles that a neophyte trader has to face is the seemingly chaotic action of the financial markets, including the forex. However, while the activity is virtually nonstop, it has been demonstrated that the currencies market moves in cycles.

What this means is that by analyzing these repeating patterns, a trader will be able to incorporate these patterns into his forex strategy. The market cycle, brought about by human behavior, was discovered by Ralph Elliot, after whom the Elliot Wave Theory is named.

The Elliot Wave Theory states that market movements, be it forex or the stocks, can be divided into the 5-3 Wave Patterns. The initial five waves are called the impulse waves, and the last three are the corrective waves. Although there are waves within these waves (sub waves), it is the 5-3 Wave Pattern that are important to most forex traders.

The first wave occurs when the forex currency drops in value, leading to an increase of buyers. The end result is that the value of the item will rise. The second wave takes place when the buyers take profits. This will cause the currency price to dip a little, but the bullish market will limit the fall.

The third wave is the longest in an Elliot Wave, and this is because a lot of people are getting on the bandwagon. At this point, the price of the forex currency (or shares of stock) goes up even more.

Wave four is a smaller and shorter version of the second wave. There will be those who will cash in as the price is high, but the lowering price will only be of a small amount, or even temporary.

The fifth wave is when the item becomes overvalued and overbought, something your technical tools will tell you. When the wave reaches this level, the price is being driven up not so much by financial or economic data but by the sentiment of the investors.

At this point, it will only be a matter of time before the corrective waves step in. These corrective steps translate to a lowering of the price, and the cycle will begin again.

For the forex analyst, the importance of this theory is that it will go a long way towards developing market strategies. What makes this tool even more useful is that they are not just applicable to the forex, but also to other financial markets. Incorporating the Elliot Wave Theory in your toolbox will pay off.