Forex Elliott Wave Indicator Explained

Admiral Markets Dec 29, 2023 6 Min read

This article will provide you with everything you need to know about the Elliott Wave. We'll look at what it is, how to use the Elliot Wave indicator in Forex trading, what you need to know about the Elliott Wave principle, what is the Elliott Wave Oscillator, and more!

What is the Elliott Wave?

Elliot Wave is a theory that mathematically explains mass behavioral patterns. Nowadays, this theory is used as a part of the Elliott Wave indicator for trading platforms such as MetaTrader 4 Supreme Edition (MT4SE). This indicator gives you a decisive edge when it comes to trading Forex, thanks to its ability to show potential future moves.

Elliott's Wave Principle

An accountant by the name of Ralph Nelson Elliott was the sole creator of one of today's most widely known ways of analysing the markets. He created the Elliott Wave Theory in the late 1920s, thus breaking the idea that markets moved in a chaotic way. Elliott realised that market movements mainly consisted of investors' reactions to different macro-stimulus. Moves to the upside or to the downside can be seen repeating in the same patterns, regardless of the outside stimulus.

Also, it can always be divided and analysed into smaller moves known as "waves". Traders were then able to predict the repetitive cycles of the market for the first time – or so they thought, anyway.

Elliott's wave theory is partially based on the older theory of Dow. The difference between the two theories, however, is that Elliot discovered the more fractal nature of the Forex markets. So let's break down this Forex trading wave indicator further: The Elliott Wave stipulates that prices move in wave formations that can be seen as directing price movement. This allows you to categorise any given price movement into impulsive moves or retracements, before the price changes its overall structure.

Over the course of time, this complex form of market analysis has become wide-spread among professional traders. More detailed studies have been conducted by A.H. Bolton, Charles Collins, and later the theory was completely covered in Robert Prechter's book 'Elliott Wave Theorist'. In simple terms, Elliott wave analysis shows traders' behavioural patterns on a chart. It's worth noting that Elliott never intended to apply his findings to individual stocks, because the low-activity environment of the time caused inconsistent mass behaviour patterns.

This was aligned with Dow's views when he created the industrial average. And even when applying this methodology today, every decision has to be applied with caution when it comes to individual stocks and currencies.

Introducing the Elliott Wave Oscillator

After discovering that price moves in repeating patterns, Elliott noted that price moves can mislead the trader on whether a formation has occurred. He solved this dilemma thanks to a Forex trading wave indicator that he called the Elliott Wave Oscillator (EWO). The EWO allows a trader to see when one wave ends, and a new one begins.

This outstanding Forex wave indicator is widely known as the 5/34 oscillator, because it's a 34 period simple moving average subtracted from a five period simple moving average. The EWO's strongest reading is always a clear signal of the placement of the third wave. It's a great Forex wave indicator because it always has a strong correlation with Elliott wave patterns. This makes it ideal as a filter of fake ones.

How to Read the Elliott Wave Oscillator

Source: EUR/USD Wave Analysis - 4 Hour Chart - Awesome Oscillator

When correctly applied to a trading chart, the EWO is displayed with a histogram split of two areas – one positive and one negative. As a new wave starts to form, it will often begin by displaying a divergence between the EWO and the price. The rule of thumb is that the first wave can be always found where a change of the current trend has occurred. After that wave, there will always be a pullback to the already-changed direction of the price.

This retracement of the new move is usually the second wave. It is important to note that during wave two, the market will not reach a new extreme. However, in most cases, it will cover a Fibonacci percentage of wave one. This event is clearly identified with the Elliott wave indicator for Forex trading. When a correction is spotted, and then confirmed by the EWO, you will find that wave two and four are always the corrective ones.

Another rule of thumb is that good traders always combine the corrective waves with Fibonacci retracements. After the retracement of wave one has finished, you will see the strongest price move of the two before that. This move is wave number three, and it can be spotted easily.

The market will reach a new high or low depending on whether wave one was bullish or bearish. Represented with a Fibonacci extension, this move should have a profit target between 100% to 173.6% of the size of the move of wave one. Note that the Forex Elliott Wave Indicator does not provide exit points. In wave five, the price will usually make a new high, but the Forex wave indicator will not display a higher reading than it did on wave three. This will create a divergence between the indicator and the price.

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