This theory was originally developed in the 1920’s by Ralph Nelson Elliott and is based on market sentiment. This system clearly shows the mindset of the market participants as a whole. Elliott noticed that rhythms or cycles found in nature seemed to repeat as similar movements within the financial markets. Prior to this observation most people believed that the share market moved in a somewhat chaotic manner.

The theory suggests that the market moves upward in a succession of five waves, and downward in a succession of three waves, (otherwise known as ‘impulse waves’ and ‘corrective waves’), which are impulses of fear and greed. The key difference between the Elliott Wave Principle and other cyclical theories is that this theory suggests no absolute time requirements for a cycle to complete, so can be quite subjective. 

Elliott broke down the market movements into unique wave patterns that continually repeated themselves in 5 waves.  A common statement in the financial markets is; “for every action there is an equal and opposite reaction”.

These waves can be defined as impulse waves which are movements ‘into’ the trend, and corrective waves which are movements ‘against’ the trend. Waves 1, 3 and 5 are the ‘impulse waves’, whilst Waves 2 and 4 are ‘corrective waves’.

I personally try to avoid going long in markets that seem to be displaying characteristics of a Wave 5.  Wave 5 is typically when the novice investors are entering the market, and the prices are being pushed higher and higher through supply and demand; there is euphoria driving the prices rather than logic – in this scenario you will see higher bar after higher bar without many ‘pauses’ or pull backs in the market, best seen on a ‘monthly chart’.

Waves A, B & C are the corrective waves against the 5 waves on the way up where it is taking a much more significant pause while the fundamentals catch up.

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