4.48 Elliott Wave Theory


Before we study the theory of Elliott Waves, which by the way, have nothing to do with the sea beach, let’s look at the chart below:


Elliott Wave Theory representation. 


Do you seen anything common in everything shown in the above picture with the Forex chart in the center? Well, let's have another example without a chart. Have a look on the following:


Fractals in Elliott Wave Principle. 


Did you know that all three are natural examples of ‘fractals’? Fractals are shapes which can be broken down into parts, and each such part is a reduced-size copy of the whole. Fractals were discovered in 1975 by Benoit Mandelbrot who described them as shapes that are “self-similar”. To create a fractal, you take a simple shape and replicate it, again and again and again. If you looked closely at the patterns in pineapple, peacock feather and the whorls of broccoli, you would find this ‘fractal’ property.


Believe it or not, this fractal structure is also found in price movements of stocks and Forex pairs! We owe this discovery to an accountant called Ralph Nelson Elliott, who embarked upon a project in the 1930s to examine stock data spanning 75 years (whew!) and published his observations in the book, ‘The Wave Principle’. 


Elliott came up with the revolutionary theory (grandly calling it ‘The Elliott Wave Theory’) that in trading markets (stock, Forex or any commodities) prices actually behaved in fairly repetitive cycles, and that these cycles or waves were caused by swings in collective investor psychology. 


The 5-3 Wave Pattern - Fractals or Building Blocks of Elliott Wave Principle


In a nutshell the basic building block of Elliot Wave Principle is a 5-3 Wave pattern. What it summarizes is that during any trend the prices move in the direction of trend in five waves and then retrace in 3 waves. And then the cycle repeats till a complete reversal takes place.

5-3 wave pattern in Elliott wave theory.


During an uptrend a five waves advance will be followed by a three waves decline and during a downtrend a five waves decline will be followed by a three waves advance. The set of the Five-waves is an overall impulse wave or Motive wave and the set of the next three-waves is an overall corrective wave.


However, we extend the theory a bit more by saying that even if there is no trend and the market is running sideways, try to keep the 5-wave limit in your mind for any breakout


However please note inside the overall impulse wave, the 3 waves in the direction of the trend are impulse waves of lower degree and in the corrective phase, the 2 waves which are causing the correction are also known as impulse waves during the corrective phase. 


Elliott’s theory turned on its head the current thought that stock (or in our case Forex) prices behaved chaotically.


Most importantly for stock, commodities and Forex aficionados, Elliott claimed that the repetitive up-and-down movements triggered by psychological investor sentiments, such as greed and fear, were in fact, predictable.


Another key aspect of the theory is that like patterns within pineapples and broccoli, each Elliott wave can be broken down into further self-similar waves And that aspects brings the fractal nature into the picture.


According to the book "Elliott Wave Principle: Key to Market Behavior" by Frost and Collins, published in 2001, the Elliott Eave theory seems to work 50% of the times in Forex markets. 50% is not a very big number but it certainly calls for an understanding of the concept as it will also come handy while you are taking any trading decision based on any other technical basis.


In later chapters we’ll see how Elliott’s discoveries can help us navigate the Forex markets in our quest to enhance our pip wealth. 


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