According to physical law: "Every action creates an
equal and opposite reaction". The same goes for the financial
markets. A price movement up or down must be followed by a
contrary movement, as the saying goes: "What goes up
must come down"( and vice versa).
Price movements can be divided into trends on the one hand
and corrections or sideways movements on the other hand. Trends
show the main direction of prices, while corrections move
against the trend. In Elliott terminology these are called
Impulsive waves and Corrective waves.
The Impulse wave formation has five distinct price movements,
three in the direction of the trend (I, III, and V) and two
against the trend ( II and IV).
Obviously the three waves in the direction of the trend are
impulses and therefore these waves also have five waves. The
waves against the trend are corrections and are composed of
The corrective wave formation normally has three, in some
cases five or more distinct price movements, two in the direction
of the main correction ( A and C) and one against it (B).
Wave 2 and 4 in the above picture are corrections. These waves
have the following structure:
Note that these waves A and C go in the direction of the
shorter term trend, and therefore are impulsive and composed
of five waves, which is shown in the picture above.
An impulse wave formation followed by a corrective wave,
form an Elliott wave degree, consisting of trend and counter
trend. Although the patterns pictured above are bullish, the
same applies for bear markets, where the main trend is down.
The following example shows the difference between a trend
(impulse wave) and a correction (sideways price movement with
overlapping waves). It also shows that larger trends consists
of (a lot of ) smaller trends and corrections, but the result
is always the same.
Very important in understanding the Elliott Wave Principle
is the basic concept that wave structures of the largest degree
are composed of smaller sub waves, which are in turn composed
of even smaller sub waves, and so on, which all have more
or less the same structure ( impulsive or corrective) like
the larger wave they belong to.
Elliott distinguished nine wave degrees ranging from two centuries
to hourly. Below, these wave degrees are listed together with
the style ELWAVE used to distinguish them:
In theory the number of wave degrees are infinite, in practice
you can spot about four more wave degrees if you examine at
This indicates that you can trade the investment horizon,
which is most suited for you, from very aggressive intra day
trading to longer term investing. The same rules and patterns
apply over and over again. Now we will take a look at the
Next: 3. Patterns