What Is Elliot Wave Theory

The Elliot Wave Theory suggests that market movements can be described with waves. Inside a large up or downtrend are several smaller trends that make up the whole of the market movement.

Ralph Elliot spent the better part of his whole life on the planet to prove his own theory that the markets moved in cycles. He proposed that movements in the market are not random, and that traders and investors are naturally emotionally driven. He also said that successful traders could use the whims of investors to their advantage in riding the waves that these emotion-driven investors made in the market.

Elliot is Right

Elliot was, and is, completely correct; markets do move in cycles, and there is plenty of money to be made in riding each market wave. He proposed a very basic 5 and 3 wave pattern. This wave pattern is described below.

Trading the 5 – 3 Wave

A trending market, Elliot suggested, should move in a 5-3 wave pattern. At first, the market should make 5 waves that are labeled as “impulse waves.” Following the five waves would be 3 other waves which he named “corrective waves.”

The following diagram shows how Elliot Wave Theory sees the markets:

As you can see, the market makes 5 major waves, and three corrective waves in between. He described in his book each wave:

• Wave 1 – An initial surge in investment interest pushes up the price on the market. Investors are bullish, and are ready to ride an emerging trend, for whatever reason that may compel them to do so.
• Wave 2 – After the brief move upward, traders who were in on the first wave are ready to exit the market. They’re confident of a future increase in price, but they don’t want to leave profits on the table. As such, the early entrants sell, and the price declines.
• Wave 3 – Now that the market has been alerted to this excellent opportunity for profit-making, traders pile in for the third wave. The currency pair should rise as those who were waiting idle for an entry point find a good price to get in—at the bottom, the price of the currency pair is only slightly higher than before the first wave.
• Wave 4 – The selloff happens again as buyers lock in short-term profits. However, this dip is often the weakest, as the first and third waves have everyone’s attention. Those who are in it for the long haul snap up the currency pair at every opportunity they can at a lower price, thus making this one of the weakest retracements. Traders are still bullish.
• Wave 5 – The final wave in the price of a currency pair, any trader who wanted to go in as a bull is doing so, or has already done so. The price can move big here. However, those who have ridden the waves for the length of the movement are staring at major profits, and start to sell. Additionally, those who want to call a market top pile on the short positions, reading the currency pair for a corrective cycle.

The corrective cycle

All markets eventually correct, and Elliot’s theory has an explanation for this, as well. The market correction is described as an ABC pattern that follows the 5-3 pattern. Take a look at the following diagram:

The ABCs are fairly self-explanatory. They’re the minute waves that follow a general up or downtrend.