The theory was formulated by Ralph Nelson Elliott, initially to be used on the Capital Market, but is also fully applicable in FOREX.

Nelson wanted to prove that, beyond its seemingly chaotic evolution, the market is moving in certain graphic cycles. He believed that price developments are influenced by investors’ behaviour towards external factors, such as news on CNBC, BLOOMBERG, ESPN, or by the dominant psychology of the masses.
Projected on the charts, these psychological ‘moves’ appear as repetitive cycles/patterns. Elliott called them “waves” .

Correctly identified, these waves help us to foresee the price direction and potential trend-reversal points.


Impulse waves

There are 5 wave patterns, that can be ascending or descending.

As you can see in the picture above, waves 1, 3 and 5 respect the general trend. These are called impulse waves.
Waves 2 and 4 are contrary to the general trend and are called corrective waves.

The mechanism behind each wave

V1 - this is usually generated by the fact that a relatively small number of traders, for various reasons (real or imaginary), think that the price is low (high) enough to buy (sell). After the row of Buy orders, the price increases (decreases).

V2 - At this point, buyers (sellers) think that the price won’t continue to rise (fall) and liquidate their positions, which leads to a decrease (increase), but not to the initial Low (High).

V3 - as a rule, this is the longest and strongest wave, because public attention is drawn to the pair in question, which is now heavily traded. The price increases (decreases), reaching above (below) first wave’s Highest (Lowest) level.

V4 - traders begin to close their positions again, speculating that the current move is exhausted. This wave is generally the weakest, as many traders still have open positions.

V5 - marks an over-appreciation (under-appreciation) period, the price rising (dropping) excessively. There are also traders who are sceptical and liquidate their positions, which leads to an ABC corrective pattern (will be analysed later).

Extended impulse waves

There will be always one impulse wave longer than the other two. According to Elliott's theory, this wave is V5, but more and more traders think that this is V3, thinking that move the price accordingly.


Corrective waves

Trends on 5 waves are followed by a correction, reversing in a 3-wave patterns. The corrective waves are identified using letters.


Types of corrective waves

According to Elliott’s theory, there are 21 types of corrective waves, either simple or complex. These can be compressed in 3 basic types:

1. The Zig-Zags
2. The Flats
3. The Triangle formation

1. The Zig-Zags

This involves sharp moves, contrary to the general trend. Typically, wave b is shorter than the other two waves. Corrective waves can also be divided into smaller waves with the same configuration as the initial ones.

2. The Flats formation

This is a sideways corrective move. The waves’ length is approximately equal. The wave b reverses the direction of the wave a and the wave c reverses the direction of the wave b. Sometimes the wave b is longer than the wave a.

3. The Triangle formation

It involves convergent/divergent trend lines. The price moves sideways, contrary to the general trend. Triangles can be symmetrical, ascending, descending or expanding.


Fractals - Elliott Waves within Elliott Waves

Elliott waves are fractals.
Fractals are structures whose divisions have the same form or similar form to the whole. They can be found everywhere in nature – the shells, the snow flakes, the clouds, the lightning are fractals.

Therefore, the Elliott waves may be divided into smaller waves, which are similar to the main waves.


You can see how waves 1, 3 and 5 are structured in other 5 smaller waves with the same configuration as the initial pattern, while waves 2 and 4 are each formed of 3 smaller waves with the same configuration as the inital corrective pattern.
These are fractals and the division can continue in the same without ending.

To simplify the waves' overall picture, Elliott proposed their downward classification, as follows:
 

Each of these categories consists of the waves of its subcategory.
 

As you can see from the picture above, on the charts Elliott waves are not so clearly defined and directed. Thus, the speculative advantages associated with them depend on their correct identification.

How do we know if the price really moved in Elliott waves?
The answer to this question is given by the characteristics of the waves.