The Elliott Waves Theory is one of the most popular and effective trading theories that was invented by Ralph N. Elliott, hence its name.
Elliott studied the market and observed that it moves in so called “patterns” on and on, patterns that are repeating on different cycles, but the overall moves are the same and they can be interpreted in order to forecast future price levels.
And so the Waves Theory took place and Elliott divided the moves the market is forming into two categories: impulsive and corrective waves. An impulsive wave is always having a five wave structure while a corrective wave is always having a three wave structure, and this represents the basis of the Elliott Waves Theory: fives wave up corrected with three waves down, in a bullish trend, or five waves down corrected with three waves up in a bearish trend.
The key to correctly interpret markets with Elliott Waves Theory comes from the different cycles and degrees the waves are unfolding. According to Elliott, the cycles should start from the biggest time frame possible and then dividing them down into cycles of a lower degree until a trade can be taken.
Therefore, if an impulsive wave has a five wave structure to the upside, out of those five waves, waves 1, 3 and 5 are impulsive as well, while waves 2 and 4 are corrected.
Impulsive waves are always being labeled with numbers, while corrective waves with letters. If a corrective wave is labeled with numbers, like it was the example above with the 2nd and 4th wave, it means those waves are part of an impulsive wave of a bigger degree, so the whole 1,2,3,4,5 structure is actually only wave 1 of a bigger degree.
As mentioned above, any five wave structure is corrected with a three wave one, or a corrective wave, and any corrective wave is labeled with letters.
Corrections can be simple or complex, and if they are complex they should have at least one intervening wave, or a connecting one, named an x wave.
Simple corrections are formed out of three waves and can be either a flat, zigzag or triangle. In reality, a triangle has five different legs, labeled a-b-c-d-e but because all of them are corrective, it is being said that the whole pattern is a three wave structure.
An impulsive wave should always have a wave that is longer than the other ones and that wave is called the extended wave. Only waves 1, 3 and 5 can extend, so look for one of them to be the longest. Most of the times the extension is to be found on the 3rd wave and this is why a lot of traders are trying to pick the end of the second wave in order to trade the explosion higher (in a bullish impulsive wave) or dip lower (in a bearish impulsive wave) that should follow in the 3rd wave.
As a rule of thumb, no parts of wave 2 can exceed the beginning of wave and this brings some clarity regarding where the stop loss should be. The target on any third wave that is extended is to be found by applying the 161.8% extension when compared with the length of wave 1. This means to actually go and take the Fibonacci extension tool, measure the length of wave 1 and the outcome should be projected from the end of the 2nd wave. That will give a target for the 3rd wave and therefore both a stop loss and a take profit can be set.
It should be noted here though that exactly this simplicity of the Elliott Waves Theory makes it so difficult to understand and master. Markets spend most of the time in consolidation so a full understanding of corrective waves and how they are forming is key to trading successfully.
Moreover, there is a different interpretation of the theory based on the financial product that is traded, as FX and stock markets, for example, are different.
The original theory has been developed on the stock market, but the FX market is different. However, it is not impossible to apply if all the rules of both impulsive and corrective waves are respected. For that, one need to effectively study what are the things to watch in an impulsive wave and in a corrective wave, and on the premise that those rules are respected, future price action can be projected.
More details regarding impulsive and corrective waves are to be found here on ForexGator.com with our future articles as Elliott Waves Theory deserves more than one article.