Five Wave pattern

Though the 5-wave pattern in Elliot's Theory was used for stocks we will show you how it can be used in the forex industry.

Wave 1
The currency pair makes its initial uptrend move. Though barely noticeable at times, this marks the beginning of the bull market when a small group of people feel the currency is underpriced.

  • Fundamental analysts tend to revise their estimates, since the market sentiment is still quite strongly negative.
  • Volumes may rise a little, but not enough to get the Technical analyst's attention.

Wave 2
At this point many of the early entrants (who entered the trade with a small target in mind) exit. They also believe the currency could be overvalued. The 2nd wave is corrective. The currency pair usually finds support before previous lows.

Wave 3
This is usually the longest and most powerful wave. At this point the currency pair has got attention of the masses. Prices move quickly as more and more people enter the trend. At the beginning of the 3rd wave the overall sentiment could be still negative from the previous drop. This wave typically goes higher that the high created at the end of wave 1.

Some studies show that wave 3 often extends wave 1 by a ratio of 1.618:1 (you could use this as your target).

Wave 4
This is a clear corrective wave. Traders are exiting their positions booking profits. This movement is not sharp since many traders still believe in a bull run and are buying during the small fall backs. It could be good to buy on the pull back if you have an indication on the wave 5 upside.

Wave 5
Last of the rising waves, this represents a phase where the majority of the market is bullish on the currency pair. This is likely where most beginners and inexperienced traders enter, hoping to cash in on some quick pips. The sad part is that the institutions guys and big boys are leaving, bring with them the bear hug.

Note: Though we have used a bull market to illustrate the example, a 5 wave pattern can appear in a bear market too, where the prices are going south!

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