Mr. Elliott showed that a trending market moves in what he calls a 5-3 wave pattern.
The first 5-wave pattern is called impulse waves.
The last 3-wave pattern is called corrective waves.
In this pattern, Waves 1, 3, and 5 are motive, meaning they go along with the overall trend, while Waves 2 and 4 are corrective.Do not confuse Waves 2 and 4 with the ABC corrective pattern (discussed in the next lesson) though!
Let’s first take a look at the 5-wave impulse pattern. It’s easier if you see it as a picture:
That still looks kind of confusing. Let’s splash some color on this bad boy.
Ah, magnifico! It’s so pretty! We like colors, so we’ve color-coded each wave along with its wave count.Here is a short description of what happens during each wave.
We’re going to use stocks for our example since stocks are what Mr. Elliott used but it really doesn’t matter what it is. It can easily be currencies, bonds, gold, oil, or Tickle Me Elmo dolls.
The important thing is the Elliott Wave Theory can also be applied to the foreign exchange market.
The formation of Wave 1 indicates that the previous trend has ended and a new trend has emerged.
If the previous trend was bearish, then it will now point upward. (And if the previous trend was bullish, then it will now point downward.)
This is usually caused by a relatively small number of people that all of the sudden (for a variety of reasons, real or imagined) feel that the price of the stock is cheap so it’s a perfect time to buy. This causes the price to rise.
Initially, it can be hard to identify this wave because if the previous trend was bearish, market sentiment will still be negative.
Wave 2 is the first pullback from Wave 1 in the direction of the previous trend.
At this point, enough people who were in the original wave consider the stock overvalued and take profits.
This causes the stock to go down. However, the price will not make it to its previous lows before the stock is considered a bargain again.
As a rule, Wave 2 can never retrace more than the entire height of Wave 1.
Wave 3 is usually the longest and strongest wave. The asset has caught the attention of the mass public.
During Wave 3 is when most market participants will realize that the previous trend is over and will now follow the new trend.
More people find out about the stock and want to buy it. This causes the price to go higher and higher. This wave usually exceeds the high created at the end of wave 1.
In a bullish market, the price during Wave 3 rises rapidly. In a bearish market, the opposite occurs.
Wave 4 is corrective in nature and signals that the best part of the trend move is over.
Traders take profits because the asset is considered expensive again.
Wave 4 is difficult to count and may take a long time to develop, but generally, should not be longer than the previous Wave 3.
This wave tends to be weak because there are usually more people that are still bullish on the stock and are waiting to “buy on the dips“.
Wave 5 is the last move in the direction of the trend.
This is the point that most people pay attention to the asset and is mostly driven by hysteria.
Traders and investors start coming up with ridiculous reasons to buy the asset and try to choke you when you disagree with them.This wave marks the last burst of buying before a new trend starts.
Eventually, after all, buyers are exhausted, and the price loses momentum.
This is when the asset becomes the most overpriced. Contrarians start shorting the asset which starts the ABC pattern.
Extended Impulse Waves
One thing that you also need to know about the Elliott Wave Theory is that one of the three impulse waves (1, 3, or 5) will always be “extended.”
Simply put, there will always be one wave that is longer than the other two, regardless of degree.
According to Elliott, it is usually the fifth wave that is extended.
As time went by, this old-school style of wave labeling changed because more and more people started labeling the third wave as the extended one.