Sentiment in the Forex Market: Indicators and Strategies to Profit from Crowd Behavior and Market Extremes

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CHAPTER 7

Explanation of

Elliott Wave and

Fibonacci

I

n this chapter, I will cover the basic rules, of which there are just a few,

of wave formation and introduce setups for timing your trade. “A rule is

so called because it governs all waves to which it applies. Characteris-

tics of waves are called guidelines.”

1

Many guidelines of impulse formation

and many details pertaining to corrective patterns are not covered here.

Also covered briefly in this chapter is Fibonacci analysis. Many traders are

familiar with Fibonacci retracements but do not realize that Fibonacci was

first introduced as a method of technical analysis by R. N. Elliott. In fact,

Fibonacci is the mathematical basis for the wave principle.

If you long for a fuller understanding of Elliott (which includes

Fibonacci), then I urge you to read the books listed in the Notes section

at the back of the book. An experienced Elliottician has at his or her dis-

posal what I believe to be one of the most powerful market timing tools in

existence.

WHO WAS ELLIOTT?

Ralph Nelson Elliott was a successful accountant early in the twentieth

century and “held executive positions primarily with railroad companies

in Mexico and Central America.” His success in turning around troubled

rail companies attracted the attention of the U.S. State Department, and

in 1924 the department “chose him to become the Chief Accountant for

Nicaragua, which was under the control of the U.S. marines at the time.”

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152 SENTIMENT IN THE FOREX MARKET

Elliott moved to Guatemala City after the United States extricated itself

from Nicaragua to take on the position of general auditor of the Interna-

tional Railway of Central America. While in Central America in the late

1920s, Elliott contracted an “alimentary tract illness caused by the organ-

ism amoeba histolytica.”

2

At 58 years of age, the former accountant was very sick and confined

to his home. His mind always at work (he had written two books), Elliott

dedicated his time to studying the price behavior of the Dow Jones Aver-

ages. Elliott studied many time frames, from 30 minute to yearly. This must

have been quite an arduous task given that charts were plotted by hand on

graph paper then.

Elliott discovered that price action displayed on different time frames

formed the same basic patterns. In other words, there is a market form

at all degrees of trend. The basic pattern that Elliott discovered was that

a market cycle consists of eight waves, five waves with the trend and

three waves against the trend. Within the five waves, waves 1, 3, and 5

are in the direction of the trend while waves 2 and 4 are against the

trend, or corrections of the trend. Wave 2 corrects wave 1 and wave 4 cor-

rects wave 3. Following the completion of five waves in one direction, a

larger correction takes place in three waves. The basic 5–3 pattern forms

the foundation from which everything else is a part. Figure 7.1 shows

the basic pattern of five waves with the trend and three waves against

the trend.

Motive

(Numbered)

Phase

1

2

Wave 1

Wave 3

Wave 5

Wave B

Wave 2

Wave 4

Wave A

Wave C

(1)

5

3

4

A

B

C

(2)

Corrective

(Lettered)

Phase

FIGURE 7.1 Basic Five Wave Idealized Pattern

Source: Courtesy of Elliott Wave International, Inc.