Back in the old school days during the 1920-30s, there was this mad genius named Ralph Nelson Elliott. Elliott discovered that stock markets, thought to behave in a somewhat chaotic manner, actually, did not.
They traded in repetitive cycles, which he pointed out were the emotions of investors and traders caused by outside influences (ahem, CNBC) or the predominant psychology of the masses at the time.
Elliott explained that the upward and downward swings of the mass psychology always showed up in the same repetitive patterns, which were then divided into patterns he called "waves". He needed to claim this observation and so he came up with a super original name: The Elliott Wave Theory.
The 5 – 3 Wave Patterns
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 and the last 3-wave pattern is called corrective waves.
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 magnefico! Me likes colors. It’s so pretty! I’ve color-coded each wave along with its wave count.
Here is a short description of what happens during each wave. I am going to use stocks for my example since stocks is 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.
Wave 1
The stock makes its initial move upwards. 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.Wave 2
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 stock will not make it to its previous lows before the stock is considered a bargain again.Wave 3
This is usually the longest and strongest wave. The stock has caught the attention of the mass public. More people find out about the stock and want to buy it. This causes the stock’s price to go higher and higher. This wave usually exceeds the high created at the end of wave 1.Wave 4
People take profits because the stock is considered expensive again. 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
This is the point that most people get on the stock, and is most driven by hysteria. You usually start seeing the CEO of the company on the front page of major magazines as the Person of the Year. People start coming up with ridiculous reasons to buy the stock and try to choke you when you disagree with them. This is when the stock becomes the most overpriced. Contrarians start shorting the stock which starts the ABC pattern.ABC Correction
The 5-wave trends are then corrected and reversed by 3-wave countertrends. Letters are used instead of numbers to track the correction. Check out this example of smokin’ hot 3-wave corrective wave pattern!
Just because I’ve been using a bull market as my primary example doesn’t mean the Elliott Wave theory doesn’t work on bear markets. The same 5 – 3 wave pattern can look like this:
Waves within a Wave
The other important thing you have to know about the Elliot Wave Theory is that a wave is made of sub-waves? Huh? Let me show you another picture. Pictures are great aren't they? Yee-haw!
Do you see how Wave 1 is made up of a smaller 5-wave impulse pattern and Wave 2 is made up of smaller 3-wave corrective pattern? Each wave is always comprised of smaller wave patterns.
Okay, let’s look at a real example.
As you can see, waves aren’t shaped perfectly in real life. You’ll also learn its sometimes difficult to label waves. But the more you stare at charts the better you’ll get.
Okay, that’s all you need to know about the Elliott Wave Theory. Remember the market moves in waves. Now when you hear somebody say “Wave 2 is complete.” You’ll know what the heck he is talking about.
If you wish to become an Elliott Wave Theory guru, you can learn more about it at www.elliottwave.com.
Summary
- According to the Elliott Wave Theory, the market moves in repetitive patterns called waves.
- A trending market moves in a 5-3 wave pattern. The first 5-wave pattern are called impulse waves. The second 3-wave pattern are called corrective waves.
- If you look hard enough at a chart, you'll see that the market really does move in waves.
