5 Keys to Using Elliott Wave in Forex

04/25/2012 6:00 am EST

Focus: FOREX

Vadim Pokhlebkin of ElliottWave.com interviews expert analyst Jim Martens, who explains why Elliott Wave works well in the currency markets and gives five items to consider before every trade.

Vadim Pokhlebkin (VP): Jim, our readers often tell us that they want to make money trading the markets. There are lots of options for would-be speculators out there. Your area is forex, a market which has grown by leaps and bounds lately. Can you explain why I’d want to look at forex and not, say, more "traditional" stock trading?

Jim Martens (JM): First, currency markets are much larger than equity markets. By most estimates, the daily volume in forex is as much as ten times larger than the combined volume of all of the world’s stock markets. That makes it a very liquid market.

Plus, we’re also talking about a market that trades 24 hours a day. That means that if you are a short-term trader and the price spikes after hours, you can adjust your existing position or enter a new one without having to wait until the market reopens the next morning.

Sometimes you can do that with stocks, too, but typically, the spreads (the bid/ask) in stocks after hours widen out, so you may have to pay extra to buy a stock that, for example, announced great earnings after the close of the stock exchange at 4 pm ET.

That’s not the case with forex. Liquidity stays plenty deep for most investors around the clock. Yes, there are moments when currencies are less liquid, but for most participants, liquidity is fine even then.

Spreads stay tight, too. For example, for the euro-dollar exchange rate, or the EUR/USD, they are typically two pips (points) or less, and they may go to three pips when liquidity is not as high. But rarely do we ever see a major widening in spreads.

Secondly, I think the ease of choosing a currency to trade is a big advantage. How many stocks now trade around the world? Between the US, European, and Asian stock markets, there are at least 40 industries, each with a number of sub-industries, and each one of those with 100+ stocks. So we’re talking about tens of thousands of stocks, and you have to choose the right one!

Even in bull markets, while "the rising tide lifts all boats," as the saying goes, it may not lift your particular "boat." In fact, your stock may even decline if it’s not the best stock in its peer group, or if you’re in the wrong sector. Often, you see your sector or stock fall even as the general market rises, so you have to be very good—or lucky—with your stock picks.

The currency market has far fewer choices, and it’s a good thing, because that makes your job much easier. Most forex traders stick to the major pairs; in fact, the bulk of trading is between the US dollar and euro. By some estimates, it’s up to 70% of the total daily volume.

But besides EUR/USD, we have five or six other major pairs, and by watching those, you are basically watching the entire world.

I track and forecast six of the most popular forex pairs, plus the US dollar index:

  • EUR/USD
  • GBP/USD
  • AUD/USD
  • USD/CHF
  • USD/JPY
  • USD/CAD

Of course, we can expand forex trading into more cross rates—those are non-US-dollar currency pairs, like EUR/GBP, for example—but even then, we’re still talking about maybe two dozen markets versus tens of thousands of stocks.

Here are the crosses I follow:

  • EUR/CHF
  • EUR/JPY
  • EUR/GBP
  • EUR/CAD
  • AUD/JPY
  • GBP/JPY

So currencies are just easier to follow in that regard.

Thirdly, when you trade individual stocks, financial news plays a much bigger role; sector news, individual stock news like earnings, etc. With currencies, we focus on "the big story" instead.

There are big economic data releases coming out of each country every week, but we watch economic data calendars to know when they are coming out, and are rarely surprised by them. Instead, we spend more time watching forex market technical indicators.

Lastly, forex offers flexibility to go long and short with ease, something that stocks just don’t offer. When the broad stock market declines, most people are uncomfortable selling short; that is, selling a stock they don’t own in hopes of buying it back later, returning it at a lower price, and capturing the spread. Most investors just don’t do that, even with some new avenues for doing so that became open in recent years, like mutual funds, ETFs, etc.

In forex, it’s a whole different story. Whenever we quote a currency market—take EUR/USD, again—we are comparing one currency against the other. In this case, we are tracking the value of the euro against the value of the dollar. So even when we are selling one market, we are always buying another!

We are always buying the base currency, which is the first one in name of the pair. In EUR/USD, the base currency is the euro. On the other hand, in dollar-Swiss franc (or USD/CHF), we track the value of the dollar relative to franc, so the dollar is the base.

Forex markets have lots of volatility, too, which is good for aggressive traders. And if you’re a macro trader, currencies are well-known for staying with the trend for a long time. Volatile at times, yes, but steadily trending.

So, there are several reasons why one might look at forex versus stocks.

Vadim Pokhlebkin: I’ve seen online ads that say, "trading forex is easy." Do you think it’s easy?

Interview Continues on Page 2…

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Jim Martens: Well, I’d go back to the first question you asked me. Easy? No. Easier than equities? Yes.

In forex, there are fewer markets, so you have fewer choices and less news to be concerned with, so, fewer surprises.

Our main goal is to find the one currency that looks the strongest against others, and one that looks the weakest. When you find them, now pair them together. Sounds easy, but in practice, keep in mind that when trading any vehicle, we are trying to predict the future, and that’s a hard task.

It’s especially hard with individual equities, because you need a real system of how to approach first the broad market, then the sectors, then your stocks. That’s why Wall Street investment houses have hundreds of equity analysts and maybe five technicians, the analysis who, like us at Elliott Wave International, focus on the markets’ technical picture. That’s also why a lot more forex traders use technicals than equity traders. But winning is hard in both markets.

As la technical trader, you can only control one thing when it comes to the future: How many viable chart pattern possibilities there are. Elliott Wave analysis allows us to limit those down to a handful, and rank them in terms of theirprobability. That’s a great advantage, but at the end of the day, trading is trading, so the five requirements are the same:

  • Know your risks: What percentage of your capital are you betting with? What’s your "pain threshold" (i.e., stop-loss)? What’s your profit goal?
  • Know at what price you are wrong before you get in the trade. (Elliott Wave analysis is great at helping you determine that.)
  • Know your risk appetite and don’t risk beyond what you can stomach. If you’re only comfortable trading at, say, five times the leverage while risking 2% of your capital per trade, then don’t push yourself beyond that limit. (It’s different for everyone.)
  • Stick to your convictions. If your analysis strongly suggests the market will move in one particular direction, trust your analysis, not the "noise" like news, analyst opinions, etc.
  • Manage money for your own needs. This ties in with point #1: What are your goals? Are they realistic? How do you get there? Break it down to the smallest parts.

VP: In your research reports, you and your teammates forecast forex using Elliott Wave analysis. Why Elliott Wave? Why not just watch the news and trade forex around the major economic report releases?

JM: Yes, you should pay attention to the news, but relying solely on the news will get you into trouble. For example, let’s say the Federal Reserve raises interest rates. Will the dollar soar or fall? Using fundamental analysis, you can argue for both scenarios: 1) higher interest rates are bullish for the US dollar because it means the Fed thinks the US economy is getting stronger; or 2) higher interest rates are bearish for the US dollar because they make borrowing more expensive, and that slows the economy.

See? Same news, opposite interpretations, yet each one is perfectly logical!

With Elliott Wave analysis, you don’t have that. You know what the larger Elliott Wave pattern is, so regardless of the news-driven volatility, you know the larger trend. That means you can remain objective and not confuse yourself with the hour-by-hour news and the "fundamentals."

In my work, I do follow the news, I just use it differently. As technicians, we already know based on chart patterns where the market should go. We look at its reaction to the news and see how it fits into the Elliott Wave pattern.

Many traders shy away from taking risks around big news events, and I don’t blame them, because volatility can be tremendous. But we’ve had some good success over the years at forecasting the markets before a big news report…because we already know the larger trend! If wave patterns show a clear bullish or bearish set-up in front of the news, we’ve often been able to use the subsequent volatility to our advantage.

Besides that, why do I use Elliott Wave analysis, in general? It just fits my personality.

More from Jim: Merits of Elliott Wave Analysis

VP: How did you learn Elliott? How long was it before you were able to make confident forecasts? Where should one start with applying Elliott Wave analysis to forex?

JM: About 30 years ago, in the mid-80s, I first saw Robert Prechter, Elliott Wave International’s president, on TV. He had quite a following and was on almost every week. I watched his forecasts come true, for the most part, and that certainly gets your attention. As many people did, I ordered his book, Elliott Wave Principle—Key to Market Behavior, read it, and that was it.

The first two chapters tell you everything you need to know. It’s not an easy read; you do have to stop and think. There is really not a wasted word in those 70-some pages. It took me several readings, and even now I go back and re-read them every once in a while.

I started, like most people, by applying Elliott Wave analysis to equities, but after joining EWI in 1993, I’ve applied it to virtually every market we cover (about 60 of them, give or take), and in all time frames. So I’ve seen it work in every situation.

How long did it take to learn it? Well, I never stopped! Just the other day, I again watched one of Prechter’s old videos on applying Elliott Wave in practice.

Learning the basics with a few good books will help you tremendously. So, if you’re a forex trader interested in Elliott, start with Bob Prechter’s book, watch my videos, and then you progress to label your own charts.

Over the years, I’ve seen that the most successful forex traders are not those who blindly follow my forecasts. It’s those traders who do their homework, and who do their own analysis, Elliott Wave or something else.

They think for themselves, and when they put on a trade, it’s because they have their own conclusions. Once they’ve done that, then they look to see what my research is suggesting. If we agree on the trend, they have greater confidence. If we disagree, then the real work begins: Why do we disagree? What price levels need to break to make their wave interpretations work and mine fail, and vice versa?

That brings up another important point. Some say it’s confusing that you may sometimes have a couple of different Elliott Wave interpretations of the same price move. But the real question is, do they point in the same direction? If so, that’s not confusing, it’s a confirmation!

Those subscribers who do their own Elliott Wave, as long as their wave counts and mine give at least a common price target and stop-loss level, they can go ahead and act anyway. The market will eventually decide which Elliott Wave count is right, but if the trend is clear, go with it.

That’s how I use Elliott Wave analysis.

Interview by Vadim Pokhlebkin of ElliottWave.com

Jim Martens is an Elliott Wave instructor for ElliottWave.com. Watch his free introductory videos here.

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