Elliot Wave theory was initiated in the 1930s by Ralph Nelson Elliot. His basic theory was that crowd behavior, the basis for market activity, tends to operate in recognizable phases, and as such, price movements can be anticipated to some degree.
During his early studies, using stock market data for his analysis, Elliot isolated thirteen examples of patterns – or waves – that are repetitive in their form only, and that the time and amplitude of the waves need not necessarily be repetitive. To demonstrate what he learned, Elliot named, defined and illustrated each pattern, showing how several small patterns could be brought together to create one larger example of the same form, which would in turn merge into another, larger version of the "wave".
Elliot Wave theory is a collection of these patterns, and a set of guidelines regarding as to where and when the patterns may occur in the financial markets. These patterns allow the Elliot Wave trader to understand market action, and possibly predict future trends. These patterns are now known throughout the industry as "The Elliot Wave principle".
There are two distinct parts to each wave: the numbered phase, and the lettered phase.
In the numbered phase, Waves 1, 3 and 5 are called "impulse" waves - minor upwards moves in an otherwise bullish trend. Waves 2 and 4 are the smaller, less powerful "corrective" waves. Greater volume on impulses than corrections helps confirm the pattern.
In the lettered phase, waves A and C are the stronger impulse waves down, with Wave B – the bull wave – being the weaker move.