This theory is a very popular tool used in the technical analysis that allows brokers to predict the evolution trend of the currency market, or any other market, such as for example the stock market. Elliott's wave theory is based on the specific form of the currency market developing in three main waveforms of the principal trend followed by three on the opposite trend, considering mass psychology.
As Ralph Elliott says, the prices of the traded currency pairs evolves in waves, five impulsive waves and three corrective waves. Impulsive waves give the main direction of the market expansion and the corrective waves are in the opposite direction.To fully understand the Elliott's wave theory, it is important to understand the psychological reasoning of each of these waves, because the zig-zag of the prices is the variation of investor optimism and pessimism.
Here's what happens on a growing market:
Wave 1 (impulsive) is an increasing small wave, a light pressure of demand (Bull Move). In Wave 1, prices rise because of a relatively small number of participants who buy traded currency pairs, for fundamental or technical reasons (speculation), pushing the prices up.
Wave 2 (corrective) is a decreasing wave, downward pressure in the supply (Bear Move). After a significant growth, investors may receive fundamental and technical signals that the currency was over purchased. In such a moment, wave 2 increases when people who initially bought decide to take advantage, while the newcomers initiate short positions. Price starts in the other direction, but generally does not pass over the minimum initial position which initially attracted buyers at a moment of the wave 1.
Wave 3 (impulsive) is an increasing small wave in a pressure of the demand (Bull Move). It is often the longest of the five waves, wave 3 is a sustained wave when a large number of investors were mobilized by wave 2 to buy. With a larger number of buyers, the safety margin increases, extending above the maximum price originally formed by the wave 1. At this point the threshold of resistance is one of support.
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Wave 4 (corrective) is a small wave in a supply pressure (Bear Move). At Wave 4, buyers start getting tired (they remain without money or optimism) and again use the over purchasing signals. Generally, there are still quite enough buyers on the market, so here the decrease is relatively small.
Wave 5 (impulsive) is an increasing small wave in a demand pressure (Bull Move). Wave 5 is the final movement of the observed sequence evolution. Right now buyers are all motivated by greed rather than fundamental or technical justification, to buy and bid higher prices elsewhere. Normal price reaches a maximum before starting to move in the opposite direction.