Elliott Wave Theory was originally developed by Ralph N. Elliott to analyze the stock market which he believed moved in repetitive cycles rather than randomly.
Elliott postulated that these cycles arose from the complex operation of mass market psychology and that they created patterns which could be discerned and used to predict future market price action.
Figure 1: This schematic diagram depicts a classic Elliott Wave sequence with price on the vertical axis and time on the horizontal. The diagram shows an initial five wave upward trend with individual waves labeled 1, 2, 3 4 and 5, followed by a three wave downward correction with component waves labeled A, B and C.
Specifically, Elliott noted that trending markets moved in a directional or trending five wave pattern, which was usually then followed by a corrective three wave pattern in the opposite direction. The psychology of each wave in the initial five wave trending sequence is described further below:
First Wave of Elliott Wave Theory
A currency pair will make the first wave in an initial trending move, spurred on by any of a number of fundamental reasons.
Many of the traders who benefited from that initial move will take their profits when the market’s momentum on the first wave wanes.
Second Wave of Elliott Wave Theory
This profit taking will cause the exchange rate to retrace in a second wave that corrects some or even occasionally all of the territory initially covered by the first wave.
Yet the rate does not exceed the start of the first wave since traders now think the rate may well move that way again. As a result, they will reenter the market to take the rate back in the direction of the original first wave move.
Third Wave of Elliott Wave Theory
The resulting third wave is usually the strongest and longest wave as more traders recognize and seek to participate in the move. The extra volume pushes the rate considerably and often sharply beyond the extreme reached in the first wave.
Eventually, the exchange rate will come to an exhaustion point where continuation no longer seems attractive. Traders will then take profits as the movement’s momentum dissipates.
Fourth Wave of Elliott Wave Theory
This profit taking after the impressive third wave leads to the next corrective fourth wave.
This move tends to retrace less territory than the second wave since more traders have been convinced of the trend by the strength of the preceding third wave. As a result, they will be looking for pullbacks to enter the market in that direction.
Fifth Wave of Elliott Wave Theory
This renewed interest leads to the fifth and final wave where many traders now want to get in on what seems to be the hot trend. This forces the market into extreme territory where contrarians trade against and eventually end the move.
This starts the subsequent overall corrective period that usually unfolds in three waves.