Wave theory revolves around the idea that markets are cyclical and exhibit waves of pessimism and optimism. Some believe the markets are governed by powerful waves of nature which affect us in many unknown ways. Theorists view wave analysis as important in understanding the movement in the market. Wave theory is also a branch of cycle theory, which will be covered in the objective analysis.

R.N. Elliott believed markets had well-defined waves that could be used to predict market direction. The Elliot Wave theory is a unique way of viewing patterns in the market. Elliott believed the market moved in five distinct waves on the upside and three distinct waves on the downside. The basic shape of the wave is with waves one, three, and five representing the "im­pulse," or minor up waves in the major bull move.

Waves two and four represent the "corrective," or minor down waves in the major bull move. The waves lettered A and C represent the minor down waves In the major bear move. Wave B represents the one up wave in the major bear move. This pattern is the basic form and rhythm of the market according to Elliott Wave theory.

Elliott postulated that the waves existed at many distinct levels, which meant there were waves within waves. Each minor wave in the Elliott Wove was composed of another series of waves in the same form as Elliott Wave. He gave the waves names in descending size:

1. Grand Super-cycle

2. Super-cycle

3. Cycle

4. Primary

5. Intermediate

6. Minor

7. Minute

8. Minuette

9. Sub-Minuette

The major waves determined the major trend of the market. Minor waves within the major waves determined the minor trend of the market. The idea is somewhat similar to the Dow Theory of a primary and secondary trend. There is a major trend, and within this trend are smaller bull and bear trends. Elliott also had various extensions or variations on the main wave which appeared in the market.

Elliott attached great importance to the Fibonacci series and considered it a natural and universal mathematical series. He also believed the Elliott Wave pattern was a naturally occurring pattern in nature. The number of waves in a bull move was five and the number of waves in a down move was three-both numbers in the Fibonacci series. Elliott placed particular importance on the golden mean, or 0.618, as a significant percentage for retracements in the market.