Elliott Wave Theory

In the 1920s and '30s, analyst Ralph Nelson Elliott observed that markets, often assumed to move chaotically, actually move in repetitive cycles reflecting the collective psychology of investors reacting to outside events. He called the recurring patterns "waves," and the resulting framework became known as Elliott Wave Theory. Although he studied stocks, the same structure is commonly applied to currencies and other markets.

The 5-3 pattern. A trending market, in Elliott's framework, moves through five "impulse" waves followed by three "corrective" waves.

The five impulse waves (illustrated with a rising market, though the same structure applies in reverse during a downtrend):

Wave 1, an initial move as a small group of early buyers decides the price looks cheap.

Wave 2, profit-taking by that early group pulls price back down, though not all the way to the prior low.

Wave 3, usually the longest, strongest wave, as broader attention and participation drive price well past the Wave 1 high.

Wave 4, a weaker pullback as some profit-taking occurs, tempered by traders still bullish and buying dips.

Wave 5, the final push, often driven by late, hype-fueled participation, marking the point of maximum overvaluation before contrarians start selling.

The 5-wave move is then followed by a 3-wave corrective sequence (labeled A-B-C rather than numbered), which can also occur in a bearish market as a mirror image.

Waves within waves. Each wave is itself composed of smaller waves following the same 5-3 structure, Wave 1, for instance, typically contains its own smaller 5-wave impulse sequence, and Wave 2 its own smaller 3-wave correction. Real charts rarely form as cleanly as textbook diagrams, and labeling waves accurately takes practice.

The core takeaway: markets tend to move in repetitive wave structures, and recognizing them, even loosely, adds another lens to your analysis.