Analyzing the validity of Wave Principle in Foreign Exchange Markets

17 Pages   |   4,113 Words
Contents
Abstract. 3
Introduction. 4
Elliott’s Wave Principle. 5
Stock and Forex Markets. 8
Stock Market. 8
Foreign exchange (Forex) Market. 9
Differences between Stock Market and Foreign Exchange Market. 9
Literature Review.. 10
Application of the Wave Principle in Forex Market. 12
Conclusion and Recommendation. 13
References. 15
Appendix 1. 17

Abstract

The effectiveness of technical analysis techniques to predict future stock prices has always been rigorously debated in the financial literature. Proponents of the view that markets are efficient believe that technical analysis cannot help in determining the future stock prices. The wave theory is quite wide spread in the technical analysis and is used mostly in the context of the stock markets. On the other hand, many analysts are reluctant in applying the wave principle to the forex markets. The purpose of this paper is to discuss the theoretical background of the wave principle and examine the validity of wave theory in financial markets with the special reference to the comparison between stock and forex markets. The result shows that if the government intervention is at a minimum, the wave principle can provide extremely useful information in relation to the future forex prices. Moreover, forex markets have some features that place them in a better position compared to the stock markets for the employment of the wave theory.
 

Introduction

World is becoming increasingly interdependent these days. World trade has ballooned quite significantly for last few years. More specifically, the world trade has almost tripled from 2000 to 2010 (WTO Statics Database, 2010). On the other hand, investors are also investing heavily in foreign markets. The total worldwide worth of FDI has increased from $0.2 trillion dollars in 1990 to about $1.4 trillion dollars in 2011 (World Bank, 2011). The net return on the foreign investments depends highly on the spot exchange rate. On the other hand, stock markets are also extremely volatile, and investment is seen to be quite risky. However, stock markets are often found in certain situations that are full of the prospects of the high rate of return. Therefore, investors are always looking to have some prophecy about the stock exchange market trends that can help them to decide about their respective positions on different type of financial instruments. Beside private investors, the mutual funds are also keen to know about the likely trends of different stocks so that they can fully diversify their portfolios in an attempt to maximize expected profits and minimize risks.
 

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Economic literature has presented several theories that try to predict the future behaviour of different financial markets. One of those that have always been given a lot of attention is known as the random walk theory. The theory states that the stock prices move with a ‘random walk’ i.e. without any specific pattern and trend, and hence, it is not possible to predict the future prices of stocks and bonds. Random walk hypothesis is quite consistent with the efficient market hypothesis according to which markets are information efficient. All the public information is eventually reflected in stock and bonds prices because all investors in the market are likely to regularly update their market behaviour as new information is revealed to them. Though quite appealing, the theory has been continuously under attack in the recent years by various economists especially after the global financial crisis of 2007 (Fox, 2011). It was increasingly believed that markets may not behave as efficiently as predicted by theory and thus, an alternative theory may provide a better answer in dealing with the overall behaviour of how stock market functions.
One of the theories that take an alternative perspective in dealing with the way the stock markets move is ‘Elliott’s wave theory or principle’ According to this theory, prices are likely to follow a trend based upon the Fibonacci Sequence. The human psychology is likely to alternate between optimistic and pessimistic approach and this very nature of the human psyche determine the trends in the stock markets. The prices alternate between the impulsive and corrective phases that can help to predict the trend of future prices. A cycle consists of 8 waves out of which five are impulsive, and three are corrective waves. The purpose of this paper is to extensively review the theory of wave principle, in addition to its reliability, in the context of both stock markets and exchange rate markets. Though stock and exchange markets have many similarities in common, they differ from each other by some conspicuous traits and it would be interesting to analyze whether the wave principle’s ability to explain the future trends of each of the market is similar or not.
The paper is organized as followed: The second section explains the theory of Elliott’s wave principle in detail. The third section defines the nature of stock and exchange markets with a stress on their respective distinguishing features. The fourth section deals with the validity of the wave principle in the context of detailed and in-depth literature review. In addition, the section will also highlight the relative concurrence of foreign exchange market in relation to wave principle. Last section concludes the study with some recommendations.

Elliott’s Wave Principle

When looked closely, it can be seen that Elliott’s wave principle in itself is not a forecasting tool. Rather, it provides with an outline with which the markets behave (Investopedia, 2009). Then, this picture of the overall market trend can be used to predict how the markets may behave in the future. The theory is driven by the notion that each decision in the market is shaped by some meaningful information extracted from within the market and once taken, each decision contributes in determining the decisions taken by other players in the market (Frost and Prechter, 2005, p. 20). This whole phenomenon of human behaviour is seen to be following some specific patterns and trends and Elliott’s wave principle claims to capture that relationship.
 The basic component in the theory is the 5-wave pattern as shown in figure 1.  The waves 1, 3 and 5 are known as impulsive waves as they are impelling the markets. Waves 2 and 4, moving in the opposite directions to wave 1, 3 and 5, are known as corrective waves as they are seen to partially correct the market in response to waves 1 and 3 respectively (Poser, 2003, p. 7). Some specific features can also be inferred from this five wave phenomenon. Firstly, wave 3 never starts beyond the point wave 1 starts. Wave 3 is never the shortest of the five 5 waves and lastly, wave 4 never enters the region of wave 1 (Frost and Prechter, 2005, p. 21).
 
 
 
 
                                                4                    5
               2               3
 
      1
Figure 1: Five wave structure
 
 

                                                                                             
A complete cycle is composed of eight waves that can be subdivided into two phases. (Figure 2) Motive phase is composed of five waves containing three motive waves and two corrective waves. On the other hand, the corrective phase consists of total three waves out of which two are corrective, and one is a motive wave. Conventionally, waves in the motive phase are denoted by numbers whereas the waves in the corrective phase are represented by alphabets. Just as waves 2 and 4 corrects for motive waves 1 and 3, three-wave corrective phase correct for five-wave motive phase.
Motive Phase                                    Corrective Phase
 
                                     4       5       A       B           C
             2            3
 
  1
Figure 2: A complete Cycle
 
                                                                                                                                                       
 
On the basis of these basic cycles, the cycles of greater degree can also be composed. However, the main concept remains the same whereby the cycle can be subdivided into various types of phases and waves. For example, a structure of a cycle that is one relative degree greater than cycle represented in figure 2 will compose of total thirty four waves that will contain three eight wave pattern as depicted in figure 2 and two five wave pattern as depicted in figure 1 (Figure 3). The motive phase will consist of two eight wave cycles and one five wave pattern (a total of 21 waves) whereas the corrective phase will now consist of one eight wave cycle and one five wave pattern (a total of 13 waves).  So, when the trend of numbers is observed in the theory starting from number 1 for each motive wave and 1 for each corrective wave and then, proceeding from five wave pattern and eight wave cycle to a higher degree cycles, the series 1, 1, 3, 5, 8, 13, 21,  34…. is similar to the pattern of Fibonacci series.
 
(Figure 3)
By the very nature of this principle, some general conclusions can be drawn. Motive waves do not always point upwards, and corrective waves do not always point downwards. In other words, it is not the absolute direction that determines the nature of the mode, but it is the overall relative direction. The nature of analysis reverses when bearish market instead of bullish market is considered.
Another important point in the case of wave theory is Fibonacci ratios. When impulse or motive waves are initiated, they are retraced by the corrective waves in fixed ratios as developed by Fibonacci. Some of the ratios are 23.6%, 38.2%, 50%, 61.8% and 100%.
The choice of ratio depends upon the nature of the under-consideration data. Firstly, the historical data on prices are needed to be analyzed closely. Then, the crucial point is to determine the starting point of the cycle followed by the nature, degree and duration of the cycle in addition to, the reference points for the motive and corrective waves. After that, it will be seen which ratio explains the nature of data in the best manner. Eventually, this all information can be used for the prediction of trends of future prices.

Stock and Forex Markets

Stock Market

Stock market is the public entity where various buyers invest to buy or sell stocks and derivatives of different companies. The investors in the stock markets can range from an individual investor to huge hedge funds or banks located anywhere in the world. The stock exchanges provide firms a platform by which they can not only do businesses with public, but can also gather huge capitals to expand their businesses through issuing additional company stocks. The market can be classified into two broader classes: primary market and secondary market. The primary market is one where new shares are offered whereas secondary market is the place where previously issued shares are traded (Gomez, 2008, p. 70).
The primary aim of investors is to earn profit by extracting the difference between selling and buying price. However, as the share holders are also considered to be the partial owners of the company, a company may also offer a part of company’s profit in the form of dividends on a regular basis. The price of the share is determined by the supply and demand side effects that may depend upon various firms specific, country specific or the some of the global factors. Another conspicuous aspect of a stock exchange is the liquidity as investors can buy or sell commodities quite readily compared to more illiquid investment options such as real estate or bonds with long maturity. Nature of the stock market makes it a good indicator of overall business performances and country’s economic activity. Countries with well functioning stock markets are considered to have a stable economic activity (Thomas, 2005, p. 12).

Foreign exchange (Forex) Market

Foreign exchange market is the exchange where major currencies are traded against each other. The foreign exchange markets also determine the relative rates of different currencies. The relative value of two currencies i.e. the exchange rate is based upon the principle of no arbitrage theory. It is believed that in the absence of transaction costs and no capital control, the rate of return of return on two similar kinds of assets from two different countries should be the same. In case, the rate of return is not the same investors will try to invest in the country that offers the high rate of return. This will result in an increase in demand for the currency of that country, and consequently, the currency will appreciate against the other currency. This phenomenon will continue until the rate of return is same for both of the assets (Krugman and Obstfeld, 2008, p. 383).
Foreign exchange markets act as intermediaries for international trade and investments. For instance, if a Japanese firm is planning to make an investment in American business, first, it has to exchange Japanese Yen for American dollars through foreign exchange markets and then, the converted money can be invested in American businesses. It is not only the private firms or investors that are active players in the foreign exchange markets, but governmental bodies such as central banks and commercial banks are also few of the major players in the market. More specifically, the central bank is a unique player that can manipulate or manage the currency’s relative value by using different monetary and fiscal policy tools. Similarly, the market is also extremely sensitive to other macroeconomic variables such as inflation and productivity.
 

Differences between Stock Market and Foreign Exchange Market

Several features of stock markets and foreign exchange markets are quite similar to each other.  For example, the direction of the equilibrium crucially depends on the relative demand and supply factors. Similarly, both markets are the composition of human’s psychological factors and various external and internal factors are likely to change the way the market behaves. However, there are certain distinguishing factors that may result in different behaviours and market paths on various fronts. Normally, stock markets of almost all countries follow strict timings ranging around 8 hours or so, whereas most foreign exchange markets operate round the clock. Some of the conspicuous distinguishing factors are as followed:
  • Trading volume: One of the most important distinctions of the foreign exchange or the Forex market is the high trading volume. Approximately three trillion dollar worth of trading is done in the foreign exchange market on the daily basis that is higher than the trading volume of any stock exchange market around the world (Bank for International Settlement, 2010). Moreover, compared to stock exchange markets, different financial institutions such as central banks, governments and banks are more proactively involved in the foreign exchange markets and hence, are highly likely to interfere in the market that may affect the way the market runs.
  • Complexity: The foreign exchange markets normally deals in major five or so currencies, whereas thousands of the stocks are traded in stock markets daily. Moreover, the minimum investment required to invest in foreign exchange market is also low compared to the stock market.
  • Liquidity: The foreign exchange markets are more liquid than the stock exchange markets as the former markets mostly deal in currency itself, or the securities that can be easily converted in the cash. Moreover, the nature of the foreign exchange market eases rapid trading. Unlike stock markets, the trading procedure is not as complex where the investor has to invest through the brokers and the middle men that may result in delay.
  • Location: Stock exchange markets are based in some country, and hence, their general spill over and effects are limited to only that country. On the other hand, foreign exchange markets are likely to have many global dynamics too. People can invest in foreign exchange markets through various currencies whereas to invest in the stock market, the investor has to buy the currency of the country the stock exchange is operating in.

Literature Review

The application of wave principle in predicting future stock prices has been a well-accepted methodology among several financial analysts. Wilkon (2006) discusses various advantages and disadvantages of using this technique. Wave theory is likely to filter out high and low chance trades in the market. The approach is to-the-point in the sense it provides exact entry and exit points. Triggers from other market can also be traced, and a more general global framework can be drawn. On the other hand, the technique is not without shortcomings. Exact configuration of start and end point is quite challenging especially when the reference timeframe is small.  Nevertheless, many theorists and financial analysts have tried to test the validity of the theory by working with real time data. Magazzino et al (2012) have presented with an extensive study in which it has been observed whether wave principle can be applied to the three year data of S&P index. Empirical findings of the study predicted that the first half of the year 2012 was likely to be even more volatile than the previous years. Moreover, the market was also likely to show some of the bullish trend. It was predicted that this phenomenon would lead to an adoption of the monetary policy with a further decrease in interest rates. The figure below shows the path followed by the S&P 500 index in last three years and possible trends in the year of 2012.
 
Figure 4: Magazzino et al (2012)
Another paper related to wave principle has been presented by Karthikeyen and Chendroyaperuma (2011). The approach is bit comprehensive as various sectors of the Indian economy have been selected to check the validity of the wave theory. Major companies and firms have been selected from each of the banking, energy, automobile, information technology and telecommunication sectors, and it was seen which sector’s stock prices are in the greatest compliance with the wave principle. The expected time period for the completion of 8-wave cycle for each of the firm has also been reported. Overall analysis showed the wave theory is quite applicable in the Indian context as about 22 out of 25 companies chosen for the analysis depicted trends that could be explained in terms of waves. More specifically, wave principle phenomenon was extremely conspicuous in the banking, energy and automobile sectors where majority of the firms exhibited this trend. On the other hand, it was inferred that the theory should be applied with extreme caution in the case of information technology sector where only 2 out of the 5 companies showed concurrence with the theory. Appendix 1 shows the wave theory results for various firms in different sectors of the Indian economy.

Application of the Wave Principle in Forex Market

There are several factors that make the wave principle work better for the purpose of future prediction. According to research by Swannell (2003), the following traits, if found in any security, market or the firm’s prices, are likely to improve the validity of wave principle:
  1. The greater volatility in the market
  2. The psychic factors of fear and greed are translated clearly in the trends exhibited by prices.
  3. When the security under consideration is a composite index such as S&P rather than an individual security
When compared with the stock market, it has been seen that a free forex market is likely to be more volatile than the stock exchange as discussed in the previous section. The daily turnover is also greater than the forex market and high volatility and speedy transactions result in immediate human response to any external news. So, it can be said that, under this scenario, the forex market is more likely to exhibit wave like trends in comparison to the stock exchange and hence, the prediction analysis can be more accurate. On the other hand, the analysis can be more fruitful if the instrument under consideration is a composite of various securities. For instance, the wave principle will be more reliable if applied to the instrument that is a composition of two or more stocks like S&P index rather than the individual stock.
The markets in which the human behaviour is not very clear, or those markets that are continuously being controlled by few participants or government, the phenomenon of wave principle is not likely to fit very closely. Though certain factor may make wave theory a better tool of technical analysis in the forex market, the preliminary analysis of the market must be performed to rule out the possibility of any anomalous case. For example, it is a proven fact that most of the currency markets are not completely free. Exchange rates are very crucial for various financial indicators of any economy like exports and foreign debt and hence, a central bank is likely to intervene continually to restrict the exchange rate within acceptable levels. Therefore, this act of managed floating may make the results by the wave principle imprecise, if not, completely invalid. On the other hand, there may also exist the case of fixed exchange rate in which the currency is either pegged to another currency or kept at a fixed level with respect to some other asset like gold etc. The application of wave principle is likely to be even more complex in these types of markets. Similarly, this analysis can also be extrapolated to those markets, either currency or stock market, in which the human attributes are kept into control and cannot affect the direction or path taken by prices.   

Conclusion and Recommendation

The usefulness of the technical analysis to predict future prices has always been questioned among financial analysts and theorists. Proponents of ‘efficient market hypothesis’ completely rejected the technique as prices are seen to exhibit the ‘random walk’ property. On the other hand, it has been established in several studies that technical analysis techniques such as Elliott’s wave theory are not completely redundant and may help in exploiting various profitable opportunities. Elliot’s wave principle believes that the human psyche is an important determinant of the way the financial markets behave and trends in the markets can be represented in the form of waves.
It has been seen that though quite similar in many aspects, several differences exist between stock and forex markets. Not only is the daily turnover for forex market greater than the stock market the forex markets are more volatile, and smoother in transactions. After the detailed analysis of both markets, it can be said that, under certain circumstances, the wave principle may explain the phenomenon of forex market in the better way compared to that of stock market. However, it is not always true. Governments are likely to intervene regularly in the currency markets to keep the exchange rates within the desirable range, and that is likely to affect the validity of wave principle. Similarly, in the regimes following highly managed, pegged or fixed exchange rate, the theory is of extremely limited relevance.
So, it is recommended to investors that they must analyze the forex market fully for any anomaly before employing the wave theory. If the prerequisites, as suggested by the wave principles, are met, the technique can help to predict the future price trends quite accurately. On the other hand, another crucial point for the meaningful result is the correct recognition of the starting point of the wave cycle. A good analyst is needed to decipher the impulsive and corrective phase correctly and hence, can utilize that knowledge to open up the chances of future profits.

References

Bank for International Settlement (2010) Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in 2010 - Final results. [online] Available at: http://www.bis.org/publ/rpfxf10t.htm [Accessed: 16 Feb 2013].
Fox, J. (2011) The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street. Harper Business.
Frost, A. and Prechter, R. (2005) Elliott Wave Principle: Key to Market Behaviour. 10th ed. Elliott Wave International.
Gomez, C. (2008) Financial Markets Institutions And Financial Services. New Dehi: Prentice-Hall.
Investopedia.com (2009) Elliott Wave Theory. [online] Available at: http://www.investopedia.com/articles/technical/111401.asp#axzz2L3PA4zjs [Accessed: 16 Feb 2013].
Karthikeyan, B. and Chendroyaperumal, C. (2011) Empirical Verification of Elliott Wave Theory in Indian Stock Market. Social Science Research Network.
Krugman, P. and Obstfeld, M. (2008) International Economics: Theory And Policy. 8th ed. Pearson Education India.
Magazzino, C. et al. (2012) The Elliott’s Wave Theory: Is It True during the Financial Crisis? Journal of Money, Investment and Banking, 1 (24), p.100-108.
Poser, S. (2003) Applying Elliot Wave Theory Profitably. John Wiley & Sons.
Swannell, R. (2003) Elite Trader’s Secrets: Market Forecasting with the New Refined Elliott Wave Principle. Elliott Wave Research.
Thomas, L. (2005) Money, Banking and Financial Markets. Cengage Learning.
Wilkin, R. (2006) "Riding the Waves: Applying Elliott Wave Theory to the Financial and Commodity Markets", paper presented at The Second LBMA Assaying and Refining Seminar, London, 26 November. The London Bulletin Market Association.
World Bank (2011) World Databank. [online] Available at: http://databank.worldbank.org/ddp/home.do?Step=2&id=4&DisplayAggregation=N&SdmxSupported=Y&CNO=2&SET_BRANDING=YES [Accessed: 25 Jan 2013].
WTO Statistics Database (2010) WSDBHome. [online] Available at: http://stat.wto.org/Home/WSDBHome.aspx?Language=E [Accessed: 25 Jan 2013]

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