Avoid Being Misled by Forex News

12/26/2011 6:00 am EST

Focus: FOREX

Vadim Pokhlebkin of ElliottWave.com explains how the news can lead traders down the wrong path and why using an objective chart measure like Elliott Wave is a safer, more reliable route.

On December 21, EUR/USD shot up to 1.3200. Forex news headlines were quick to comment: "Euro rises on stronger US, European data." But after EUR/USD hit that high, it promptly reversed and crashed down to the 1.3000 level, where it stuck for the next three days.

You may ask: What happened to that "euro boost" from the "stronger US and European data?"

Good question, and here’s the answer: That explanation came after the EUR/USD rally, not before. It’s easy to fit the news to market action after the fact: Just grab the news story that best "explains" market action. But retrospective explanations don’t keep you ahead of the trend.

See related: Trade the News with Less Risk

To make consistent profits in forex, you need to be focused on your forward-looking analysis, before the market moves.

As EUR/USD was moving towards it December 21 high, Elliott Wave traders were watching the charts:

chart
Click to Enlarge

I wrote this at the time for the Elliott Wave service:

EUR/USD (Intraday)
Last Price: 1.3112 [Nearing a top]

“The euro has struggled against a target cluster consisting of where wave (Y) equals wave (W) and the upper channel line. The final leg higher (from 1.3060) is in five waves. The stage is set for a reversal, though the lack of an impulsive decline keeps us from turning bearish.”

The next day, as EUR/USD pushed higher into that expected top, and in an intraday update I wrote:

“Prices have reached 1.3199, just below resistance at 1.3210. Five-waves up from 1.2982 are visible, so a setback is due and should it move lower, back through trendline support.”

Here was the chart from that time:

chart
Click to Enlarge

Note that neither of my two forecast updates mentioned the news. And for good reason: The December 21 euro-bullish news would have had you buying EUR/USD all the way into the top.

Instead of news, Elliott Wave traders focus on objective Elliott wave chart patterns and work to forecast the markets before they move. 

See related: Elliott Wave Called the Euro Collapse

Continued…

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We don’t always succeed. But using an objective measure like Elliott Wave can keep you out of trouble when the news is telling a different story.

In the 1930’s, Ralph Nelson Elliott, a corporate accountant by profession, studied price movements in the financial markets and observed that certain patterns repeat themselves. He offered evidence of his discovery by making a number of accurate stock market forecasts.

What appears random and unrelated, Elliott said, is actually tracing out a recognizable pattern once you learn what to look for. Elliott called his discovery "The Wave Principle," and its implications were huge. He had identified the common link that drives the trends in human affairs, from financial markets to fashion, from politics to popular culture.

Robert Prechter, Jr., president of Elliott Wave International, resurrected the Wave Principle from near obscurity in 1976 when he located copies of R.N. Elliott’s books in the New York Public Library. Robert Prechter, Jr. and A.J. Frost published Elliott Wave Principle in 1978. The book received enthusiastic reviews and became a Wall Street bestseller.

In the late 1970’s, gloom was pervasive, but in Elliott Wave principle, Prechter and Frost called for a roaring bull market akin to that of the 1920’s to be followed by a record bear market.

As the stock market rose, knowledge of the Wave Principle among private and professional investors grew dramatically. When investors and traders first discover the Elliott Wave Principle, there are several reactions: Disbelief that markets are patterned and largely predictable, and joy at having found a “crystal ball” to foretell the future, and, finally the correct, and useful response: “Wow, here is a valuable model I should learn to use.”

Just like any system in nature, the closer you look at wave patterns, the more structured complexity you see. It is structured, because nature’s patterns build on themselves, creating similar forms at progressively larger sizes. You can see these fractal patterns in botany, geography, physiology, and the things humans create, such as roads, residential subdivisions, and as recent discoveries have confirmed, in market prices. 

The first step in Elliott wave analysis is to identify patterns in market prices. At their core, wave patterns are simple; there are only two types: “impulse waves,” and “corrective waves.”

Chart3

Impulse waves are composed of five sub-waves (labeled as 1, 2, 3, 4, 5) and move in the same direction as the trend of the next larger size. Impulse waves are so named because they powerfully impel the market.

A corrective wave follows, composed of three sub-waves (labeled as a, b, c), and it moves against the trend of the next larger size. Corrective waves accomplish only a partial retracement, or "correction," of the progress achieved by any preceding impulse wave.

As the figure above shows, one complete Elliott wave consists of eight waves and two phases: five-wave impulse phase, whose sub-waves are denoted by numbers; and the three-wave corrective phase, whose sub-waves are denoted by letters.

R.N. Elliott was not an ivory tower theorist. He set out to observe and then describe how the market actually behaves. Later, he realized that his model had an important theme of self-similarity and a relationship to nature. There are a number of specific variations on the underlying pattern, which Elliott meticulously described and illustrated. He also noted the important fact that each pattern has identifiable certainties as well as tendencies.

From these observations, he was able to formulate numerous rules and guidelines for proper wave identification. A thorough knowledge of such details is helpful in understanding what a market can do, and at least as important, what it will not do.

By Vadim Pokhlebkin of ElliottWave.com

Vadim Pokhlebkin is a trader who uses Elliott Wave to make profitable trading decisions. Access the Basic Tutorial: 10 Lessons on The Elliott Wave Principle and learn how to use this valuable tool in your own trading and investing.

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