The Elliot Wave theory is a technical analysis method used to predict future market trends by identifying patterns in past market data. The theory is named after Ralph Elliott, who first proposed the theory in the 1930s.
The Elliot Wave theory states that market prices move in cycles, with each cycle consisting of five waves. The first three waves are known as the “impulse” waves, while the last two are the “corrective” waves. The direction of the impulse waves will determine the direction of the overall trend.
The theory can be applied to any time frame but is most commonly used on more extended time frames, such as daily or weekly charts. When applying the Elliot Wave theory to forex trading, traders will look for patterns in the currency pairs they are trading.
The Elliot Wave theory can be a helpful tool for traders when trying to predict future market trends. However, you must remember that no one technical indicator is perfect. The Elliot Wave theory should be used with other technical indicators and fundamental analysis.
You can use the Elliot Wave theory when trading forex through Saxo Bank.
Identify the market trend
The first step in applying the Elliot Wave theory is identifying the overall market trend. You can do this by looking at a price chart and seeing if prices are generally moving up, down, or sideways.
If prices are moving up, this is known as an uptrend. However, a downtrend refers to decreasing prices. A sideways moving price is known as a consolidation period.
It is important to note that the Elliot Wave theory can only be used during an uptrend or downtrend. Therefore, you cannot use it during a consolidation period.
Identify wave patterns
Once the overall market trend has been identified, traders will then look for specific wave patterns that they can use to predict future market movements.
There are three types of wave patterns that traders will look for:
- Impulse Waves: These are the first three waves in a cycle, and they move in the direction of the overall trend. For example, impulse waves will also move upward if prices are in an uptrend.
- Corrective Waves: These are the last two waves in a cycle, and they move against the direction of the overall trend. For example, if prices are uptrend, corrective waves will be downward moving.
- Triangle Patterns: These occur when the market consolidates, and prices are trading within a tight range.
Entering trades
Once a wave pattern has been identified, traders can then look to enter trades in the overall trend direction.
For example, should prices be in an uptrend and a trader identifies an impulse wave, they would look to enter a buy order. Alternatively, if prices are downtrend and a trader identifies a corrective wave, they would look to enter a sell order.
It is critical to know that not all waves will be clear and easy to identify. Sometimes it may be challenging to determine if a specific wave pattern is an impulse wave or a corrective wave. In these cases, traders may want to wait for prices to break out of the Consolidation Pattern before entering any trades.
Stop-Loss Orders
Once you have entered a trade, it is essential to place a stop-loss order if the market moves against the trader’s position.
You can place a stop-loss order with a broker to sell a security if it reaches a specific price.
For example, a trader buys XYZ stock at $100 and places a stop-loss order at $95. If XYZ’s stock price falls to $95, the trade will be automatically sold by the broker.
Stop-loss orders are essential because they help traders limit their losses if the market moves against them.
Take-Profit Orders
In addition to stop-loss orders, traders may also want to place take-profit orders.
A take-profit order is placed with a broker to trade security when it reaches a specific price.
For example, a trader buys XYZ stock at $100 and places a take-profit order at $105. If XYZ’s stock price rises to $105, the broker will automatically sell the trade.
Take-profit orders are essential because they help traders lock in profits when the market moves in their favour.