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 MT4SE. This indicator gives you a decisive edge when trading Forex thanks to its ability to show potential future moves.
But let's not get ahead of ourselves. There's a lot of history for us to cover first.
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 plus analysed into smaller moves called "waves".
Traders were 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.
It stipulates that prices move in wave formations that can be seen as directing price movement. This allows you to categorise any given price move into impulsive moves or retracements, before price changes its overall structure.
Over the course of time, this complex form of market analysis has become wide-spread among 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.
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.
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 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 from 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.