Accountant and mathematical genius R.N. Elliot. Being already 66 year old in the 1920s, he collected enough evidence to bring his Elliot waves theory to the world. His finding were published in book Wave Principle.
Elliot believed that characteristic price structure in the market (waves, swings up and down) is created by collective psychology, that will always be represented in recognisable and repetitive pattern. What makes Elliots waves extremely interesting for forex trader is theoretical ability to predict price most probable reversal points.
According to Elliot, every trend on forex can be broken down to five characteristic waves.
Elliot wave number 1:
Price will initial rise without traders attention, almost always on negative news. Relatively few people are aware of new trend being born. Previous downtrend is still considered to be in progress. The rise was caused because impulsive group of traders (smart money) for some reasons (rational or irrational) considered price to be too low and therefore good opportunity to buy. This will cause first waver to rise.
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Elliot wave number 2:
At the top of the first wave, some traders will begin to consider price to be high enough for them to cash out. This will cause minor correction – second wave down. Price will not reach its previous low before rebounding. Fundamental news will still be bearish. Experienced traders may notice that the swing down was on low volume (signalising weakness of bears).
Elliot wave number 3:
Usually this will be the longest rise in the wave structure. Also, the strongest wave, as more trades notice and jump into the trend. News are finally positive. Price rises fast and steady with small and weak corrections. This makes it difficult to enter for anyone looking for major pullback formation. Previous price high reached by wave one will be surpassed.
Elliot wave number 4.
Lot of the traders are already in substantial profit and itching to get out (cash out) at the top of the third wave. This wave tends to be weak, as it is mainly created by hesitant traders and it is clearly corrective. Correction will happen on low overall volume. Wave four noticeably lack any price movement in what was a strong uptrend just a moment ago.
Elliot wave number 5.
At this point, mainstream media will start to inform about instruments price. Instrument will be talked about by most of the forex traders (most of the average investors and traders). Trading gurus will come up with various irrational reasons for investors to continue to buy into the trend. Price is at its highest. True strong holders (smart money, market makers) will start to massively sell into the buying of wide public – distribution (VSA) at the top of forex trend. Forex indicators such as MACD, RSI, CCI will begin to notice divergence in the market.
This will launch creation of ABC pattern that will lead to trend reversal.