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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 (1, 3, and 5) and two against the trend ( 2 and 4).
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 three waves.
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 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 to 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 consist of (a lot of ) smaller trends and corrections, but the result is always the same.
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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 we use to distinguish them:
In theory, the number of wave degrees is infinite, in practice, you can spot about four more wave degrees if you examine tick charts.
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 patterns…