Elliott Wave is a form of Technical Analysis. It has a well established following and came about in the 1930's when R.N. Elliott announced his observations of regularly repeating patterns in the Dow Jones Industrial Average. Since then the phenomenon has been observed in all markets.
As all tools used for technical analysis EW seeks to predict future price movements based on past price action. It has a history of both spectacularly accurate and timely forecasts as well as infamously inaccurate predictions. All in all it has a high success rate when used properly.
These repeating patterns are considered to reflect the ebb and flow of fear and greed in market participants. As their actions resulting from these emotional extremes show up in historical data in the market a pattern forms. This takes the overall form of a progression/regression which the broader school of analytics defines as expanding and contracting. The EW school specifically labels these respectively as motive and corrective and disassociates itself from any of the bullish or bearish connotations of those terms.
EW components build together to form larger components which in turn do the same in a fractal manner and are individually called waves. Moving from one size component to a larger or smaller one is known as a change of degree which is similar to changing Timeframe.
The fractal nature of wave construction is based on the naturally occurring number series known as Fibonacci Numbers. These are both related to the number Phi ( Ø ) 1.6180339887 which is known as the Golden Mean and has been known and used for millennia by artists, architects and mathmeticians.
The 4th and 5th numbers in the Fibonacci series, or 3 and 5 are the basis for the EW patterns of motive and corrective waves. A motive wave is constructed of 5 waves of the next smaller degree. A corrective wave is constructed of 3 waves in similar manner.
All that you need to be able to apply EW analysis is the ability to count to 5. Simple right? Yes it is simple. Easy? That is another matter. But here goes with some basics.
The first thing to know about EW is that it works identically in either bull or bear markets. Whatever the next larger degree trend happens to be the motive waves are moving in that direction and the corrective waves are moving against that trend.
The 5 wave motive series is built by 3 smaller motive waves and 2 smaller corrective waves. This becomes wave 1 in an even larger motive series. The motive (m) and corrective (c) waves always alternate on the degree being constructed. So the 5 wave sequence is 1m-2c-3m-4c-5m. These have a 1-2-3-4-5 labeling. At the end of the 5th wave a new trend will always begin.
The 3 wave corrective series is built by 2 smaller motive waves and 1 smaller corrective wave. This becomes wave 2 in an even larger motive series. These also alternate and so the 3 wave sequence is 1m-2c-3m. These have an A-B-C labeling. At the end of the C wave a new trend will always begin.
The corrective wave pattern will never completely retrace (on the same degree) the motive wave's beginning. This is how progression takes place.
So thus is constructed the basic building block of the next larger degree wave which will reflect the exact same characteristics when it is completed. This wave 1 and 2 set is known as a complete market cycle.
Individual waves have characteristics and there are rules which govern their formation. These rules give the structure necessary in order to use the wave formations and patterns as a foundation for trading decisions.
It should be noted that the rules of formation do differ for leveraged instruments such as forex, commodities and futures as opposed to non-leveraged such as stocks. Forex traders know this difference as a marked increase in volatility as compared to stocks. Volatility is the direct result of corrective waves.
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Articles in Forex Traders Glossary
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Elliott Wave
Linear Mode
