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Elliot Wave Theory was invented by Ralph Nelson Elliot in the 1920s, it is a method of projecting trends in the stock market. It uses fractal mathematics on fluctuations in the market to make projections that are based on the sentiments of the public. The Elliot Wave Theory is perhaps the least understood technical analysis theory in the foreign exchange market.
According to this theory, the market (in this case, the foreign exchange market) - moves in a series of five swings upward and three swings downward, which is repeated infinitely. But if this movement is easy, everyone will be making a large profit by grabbing the wave and mounting it until before it crashes.
Mounting the Elliot Wave is quite tricky because you need to choose the perfect timing. Among the primary wave theories, this is the only theory that doesn’t set a time limit on the rebounds and reactions of the forex market. As a matter of fact, the theories of fractal mathematics show that there are several waves inside waves. Understanding the data and looking for the right crests and curves could be tricky that even veteran traders and analysts may not agree on which direction to choose.
Each action is followed by a reaction. This is the standard rule of physics that may apply to the public sentiment on which this wave theory is based. When prices go down, people will buy. When people buy, the demand will increase and the supply decreases that drives the prices back up. Most systems that are using trend analysis to project the movements in the forex market is based on determining when the actions will cause reactions that could result to profit.
The Elliot Wave Theory is that the market activity could be projected as a series of 5 waves that move in a single direction and followed by 3 rebounding waves that will pull the market back to the starting point. A five-three move will complete a cycle. And here’s where the theory starts to get really complicated. Similar to a mirror that reflects a mirror that reflects a mirror, each 5-3 wave is not only complete, it is a superset of smaller wave series, and also a subset of a bigger set of waves.
In the notation for the Elliot Wave, the five waves that fit the trend are indicated as impulses. The 3 rectifying waves are referred to as corrections. Every wave is composed of a 5-3 series of waves. The usual cycle that you will likely to observe in a chart is the correction and impulse in the next upwards 5-3 series. The fundamental 5-3 wave will stay constant, although the time duration of each could vary.
The key is to understand the pattern properly by finding the correct starting point. When you learn to understand the wave patterns and figure them out properly, you will understand how the theory applies in forex trading.
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