Elliot waves are based on the premise that markets move in repetitive cycles reflecting the mass psychology of market traders. Ralph Nelson Elliott discovered this phenomenon back in the 1920s, and many, many traders use Elliot waves even today.
The basic premise of this theory is that market prices move in 5-step stages up and down. Here is a summary of each step or wave. In this example, we will suppose that the market is moving up.
Wave 1 - this is the initial move of the market. This move is caused by a relatively small group of people buying because they believe that the market is undervalued.
Wave 2- because the price has moved up, some investors believe that the price is over-inflated and they sell to take their profits. This of course will cause the market to fall. However, the price will not fall below the original point of step 1.
Wave 3 - this is usually the strongest move. It is at this point that the general market has seen the price move and wants to get in on some of the action. These investors buy and cause the price to rise further than the high of the 2nd step.
Wave 4 - now the price has moved quite high, and again, some investors get out and take profits. This will cause the market to fall slightly, but it won't stay down for long.
Wave 5 - this is the final move of the market. At this time, the smart people have already made their money, but there are still plenty of people willing to buy because of the recent movements. This buying will naturally push the market price quite high.
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