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Ralph Nelson Elliott believed that the Forex market moved in waves or cyclic patterns based on the psychology of traders which he named "The Elliot Wave Theory". Elliot noticed this pattern in the stock market and saw that the markets were not as chaotic as one thought. Elliot noticed that the markets moved in emotional patterns as a cause of outside influences.
Elliot was able to spot unique characteristics of wave patterns and make market predictions based on the patterns he identified. Elliot believed the market moved in five waves on the upside and three waves on the downside. Picking out these distinct patterns, Elliot was able to successfully forecast price movement. The first three waves of the Elliot Wave Theory represent the "impulse," or up-waves in a major bull market, while waves two and four represent the "corrective" or minor downward waves within the major bull market.
In the Forex market we know that every action creates and equal and opposite reaction. As price moves up or down, it must be followed by a contrary movement. Price action is divided trends and corrections or sideways movements. Trends show the general direction of the market, while corrections move against the trend. Elliot labeled these, "impulse waves" and "corrective waves."
In the late 1970's the Elliot Wave Theory was adopted by Frost and Prechter who later wrote a legendary book on the Elliot Wave Theory. Using Elliot's methods, Frost and Prechter were able to predict the bull market of the 1970's and the crash of the stock market in 1987.
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Many Forex trades have had great success with Elliot's Theory on price movement. The only trouble found when using the Elliot Wave Theory is finding and physically labeling the waves. It's sometimes difficult to find where a wave starts and ends, leaving it up for revision over and over again almost rendering the theory useless. Traders that use the Elliot Wave Theory will tend to differ, claiming that in order to identify the waves correctly, one must follow a set of rules.
Elliot's theory has been based on emotional patterns that tend to repeat themselves over time. With this being said, in order to identify Elliot's waves there are some rules to follow. The rules are as follows:
1. Wave 2 should not break below the beginning of Wave 1;
2. Wave 3 should not be the shortest wave among Wave 1, 3 and 5;
3. Wave 4 should not overlap with Wave 1, except for wave 1, 5, a or c of a higher degree.
4. Rule of Alternation: Wave 2 and 4 should unfold in two different wave forms.
Many traders continue to use the Elliot Wave Theory to forecast price movement; however it can be challenging when it comes to identifying the waves.
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