Elliott Wave theory was established in the 1920s and 1930s by stock market analyst, Ralph Nelson Elliott, who believed that there was a more common structure to markets than the chaotic form seen by most other analysts at that time. His work on cycles and waves remains one of the most popular methods with which technical analysts can view financial markets, despite there being a range of views over the efficacy of his techniques.
Cycles and waves
The psychological element of trading can often provide waves rather than simple straight lines, and these waves form one of the biggest features of Elliott’s theory. To a large extent this is a reflection of Elliott’s studies of Charles Dow’s work, with Dow Theory stating that stock prices typically move in waves. He also relies on cycles, which accounts for the restitutive nature of the patterns. The theory refers mainly to waves as the key form seen throughout markets, with the fractal nature of his waves proving that the same patterns can be seen in both short-term and longer-term charts. Given that Elliott observed the same patterns over and over again, he suggested this to be a potential tool to predict future price movements.
Elliott saw that there is typically an impulsive wave which moves with the trend, followed by a corrective wave which is counter-trend. He saw that there is typically five waves that make up one larger impulsive wave, before a three-wave corrective phase. The ability to see the first five waves as one impulsive move highlights the fractal nature, given that you are expected to see the same patterns on a smaller and larger timeframe.
Elliott believed that every action is followed by a reaction. Thus, for every impulsive move, there will be a corrective one.
The first five waves form the impulsive move, moving in the direction of the main trend. The subsequent three waves provide the corrective waves. In total we will have seen one five-wave impulse move, followed by a three-wave corrective move (a 5-3 move). We label the waves within the impulsive wave as 1-5, while the three corrective waves are titled A, B and C.
Once the 5-3 move is complete, we have completed a single cycle.
However, those two moves (5 and 3) can then be taken to form the part of a wider 5-3 wave.