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, 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
section) 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.
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
Traders 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. Traders
and investors 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.
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 which is extended. As time went by,
this old school style of wave labeling has changed because more and more people
started labeling the third wave as the extended one.
Check out this forum thread for more Elliott Wave diagrams.
