This theory was developed by Ralph Nelson Elliot and bares his name. It is a collection of theories on how a market acts and reacts. Elliott wave theory is an idea that market behavior is based on waves rather than random timing. Elliott believed that market prices rose and fell in a series of waves based on the same Golden ratio or Golden mean that Fibonacci proved. This ratio is present in many aspects of nature and science, and Elliott felt that it had great significance on the financial markets as well.
The basic idea of this theory is that a market rises in a series of 5 “waves”, as he called them. Also, the theory states that the market declines in a series of 3 declines. Elliott’s theory is that on the first wave a market rises, on wave two it declines, beginning again to rise on wave three, has a period of decline again on wave four, and finally completes the rise on wave five. The period of correction is referred to as a three- wave correction, where the market declines for wave A, begins to rise for wave B, and falls again for wave C.

It is by this theory that Elliott believed that all market behavior corresponded with either a 5 wave advance or a three wave decline. Elliot went on further to explain that major chart advances and declines could be shown as a series of 5 and 3 wave cycles. He believed that a complete market cycle consisted of a 144 wave cycle, broken down into an 89 wave bull cycle, and a 55 wave bear cycle.

The Elliott Wave Principle is a detailed description of how groups of people behave. It reveals that mass psychology swings from pessimism to optimism, are creating specific and always measurable patterns. The idea is that if you can identify repeating patterns in prices, and figure out where in those repeating patterns you are today, then you can predict where you will be going in the future.  The wave is a movement in the market, either up or down. The size of the wave depends upon the period of time that is being analyzed. Basically, market cycles are composed of two major types of waves:

A. The Impulse Wave:

It is a wave that moves in the direction of the main trend of the market. Every impulse wave can be sub-divided into a 5 - wave structure (1-2-3-4-5).

B. The Corrective Wave:

It is a wave that moves counter to the direction of the main trend of the market. Every corrective wave can be sub-divided into a 3 - wave structure (a-b-c).
An important feature of the principle is that it is "Fractal" in nature. "Fractal" means market structure is built from similar patterns on a larger or smaller scales. Therefore, we can count the wave on a long-term yearly market chart as well as short-term hourly market chart. We like day charts.

The following wave description applies to a market moving upwards. In a down market, there are generally the same types of behavior in reverse:

Wave 1: The market makes its initial move upwards. This is usually caused by a relatively small number of people that all of the sudden feel that the previous price of the stock was cheap and therefore worth buying, causing the price to go up.

Wave 2: The market is considered overvalued. At this point enough people who were in the original wave consider the market overvalued and start taking profits. This causes the stock to go down.

Wave 3: This is usually the longest and strongest wave. More people have found out about the market, more people want the market and they buy it for a higher and higher price. This wave usually exceeds the tops created at the end of wave 1.

Wave 4: At this point people again take profits because the market is again considered expensive.

Wave 5: This is the point that most people get on the stock, and is most driven by hysteria. People will come up with lots of reasons to buy the market, and won't listen to reasons not to. At this point is where the market becomes the most overpriced. At this point the market will move into one of two patterns, either towards a correction (a-b-c) or it will start over again with wave 1.

1. Wave 2 does not fall below the starting price of Wave 1.
2. Wave 3 is not the shortest wave by price movement when compared to Wave 1 and Wave 5.
3. Wave 4 does not overlap the range of Wave 2.

A correction (a-b-c) is when the market will either go down or up in preparing for another 5 way cycle. During this time volatility is usually much less than the previous 5 wave cycle, and what is generally happening in the market is taking a pause while fundamentals catch up.

Elliott Wave Step-By-Step Illustration

WAVE THREE

WAVE  FOUR

WAVE  FIVE

EXAMPLE
Elliott Wave are considered difficult to interpret by the average investor. Well, we couldn't agree more! However, if you can learn even their basic function, it can help with your analysis of where a currency is going to move in the future. All so-called Elliott Wave software forces wave counts in all situations when no useful wave count exists from a practical trading perspective. This misleads traders and is cause for a lot of bad trades.
Elliott Wave is very simple once you ignore all of the so-called complex correction wave patterns which are useless to traders. Since there is a useful Elliott pattern only about 50% of the time in any actively traded market, we need to confirm patterns with other softwares. For you "engineers" like me who like to analize so- called complex wave patterns,here is a useful example.