Elliott Waves Theory was been by Ralph Elliott in the early 1900s and the whole concept is based on the way the stock market moved in those days. Elliott found out that the market moves in repetitive cycles that, if understood properly, can lead to successful trading.
These cycles were then grouped in waves of different degrees; repetitive cycles become patterns and from that moment on, specific rules for each type of wave emerged. The whole Elliott Waves concept is based on market psychology or crowd psychology and, at that time, Elliott had tremendous success predicting market behavior.
Long story short, the Elliott Waves Theory calls for five waves to be corrected with a three wave sequence. This means that if the market moves to the upside, it will move in five waves, and this move will be corrected by three waves in the opposite direction. The same thing is valid with a bearish move; five waves to the downside should be corrected by three waves in the opposite direction.
The five wave structure or sequence is actually forming an impulsive wave of a bigger degree, and it is labeled with numbers. Therefore, all the waves that make the five wave sequence are labeled as 1-2-3-4-5, and this makes the five wave structure. Elliott refers to this as an impulsive, or motive, wave. This 1-2-3-4-5 is followed by a three wave correction, labeled with letters, a-b-c. To sum up, the overall Elliott Waves Theory calls for a 1-2-3-4-5 move to be corrected with a-b-c.
As it can be interpreted from the above statement, impulsive waves are being labeled with numbers, while corrective waves are being labeled with letters. A rule of thumb says that forex markets, despite the general belief, are spending most of the time in consolidation, therefore, one should not be surprised to see more letters than numbers on any given Elliott Waves count that refer to this market.
From this moment on, the theory gets complicated. Elliott found that impulsive and corrective waves are subject to totally different rules and any analysis of a move market makes should start by answering the following question; is this move an impulsive or a corrective move?
If one is able to answer this question, then the analysis further develops only into that direction. For example, if it is an impulsive wave, the next question will be what kind of impulsive wave, and so on, or, if the market forms a corrective wave, the next thing to answer is if that move is a simple or complex correction.
In an impulsive wave, or a five-wave structure, Elliott found that there are three impulsive waves of a lower degree and two waves that are corrective in nature. Primarily out of a 1-2-3-4-5 labeling, waves 1,2 and 3 are impulsive on their own, while the 2nd and the 4th waves are corrective.
As mentioned at the start of this article, all impulsive waves, these ones included, are subject to impulsive wave rules, and all corrective waves, these ones included, are subject to corrective wave rules. These rules are extremely strict and cannot be changed.
One of the greatest discoveries Elliott made is referring to the alternation between different waves of an impulsive structure. The principle is quite simple and refers to the fact that in an impulsive wave, the two corrective waves (the 2nd and the 4th one) should be different.
Different means that they should alternate to such an extent that the two corrections are not similar. One should look at the distance price travels, the time taken for the two corrective waves to form, as well as the complexity or the subdivisions of the two moves. If any one of these is found to be true, there are enough reasons for the principle of alternation to be considered respected.
Moreover, alternation refers to the un-extended waves in an impulsive move, but this will be covered in the future in our learning center at ForexGator.com.
By now, you have a clue why the Elliott Waves Theory is considered to be so simple and in reality is one of the most complex theories that has ever been created. Its complexity is only normal if one considers trading complexity and it is suiting perfectly to the Forex market as this is the most complex market in the world.