Mr. Elliott demonstrated that a trending market follows a 5-3 wave pattern. The first 5-wave pattern is referred to as impulse waves.
The final three-wave pattern is known as corrective waves.
Waves 1, 3, and 5 in this pattern are motive, meaning they follow the broader trend, whereas Waves 2 and 4 are corrective.
However, do not confuse Waves 2 and 4 with the ABC corrective pattern (covered in the following lesson)!
Let’s start with the 5-wave impulse pattern. It’s easier to understand if you think of it as a picture:
Here’s a quick rundown of what happens during each wave.
We’ll use stocks as an example because that’s what Mr. Elliott used, but it doesn’t really matter. Currency, bonds, gold, and oil are all possibilities.
The crucial thing to remember is that the Elliott Wave Theory may be applied to the foreign currency market as well.
Wave 1
Wave 1’s creation signifies that the old trend has finished and a new trend has formed.
If the prior trend was negative, it will now be positive. (If the preceding trend was bullish, it will now be bearish.)
This is frequently produced by a relatively small number of people who suddenly (for a variety of reasons, real or imagined) believe that the stock price is low and that now is a good moment to buy. As a result, the price rises.
It may be difficult to detect this wave at first since market sentiment will remain negative if the prior trend was bearish.
Wave 2
Wave 2 is the initial pullback from Wave 1 in the previous trend’s direction.
At this point, enough people who were part of the initial wave believe the stock is expensive and have taken profits.
This leads the stock to fall. However, the stock will not return to its former lows before it is considered a bargain once more.
Wave 2 can never retrace more than the full height of Wave 1.
Wave 3
Wave 3 is frequently the longest and most powerful. The asset has piqued the interest of the general population.
Most market participants will notice that the previous trend has ended and will now follow the new trend during Wave 3.
More individuals become aware of the stock and wish to purchase it. As a result, the price continues to rise. This wave frequently exceeds the high created by wave 1.
In a bullish market, the price rises significantly during Wave 3. In a bear market, the opposite happens.
Wave 4
Wave 4 is a corrective wave, indicating that the best portion of the trend move has passed.
Traders takes profit since the asset is now regarded pricey.
Wave 4 is difficult to count and may take a long time to develop, although it should not last any longer than Wave 3.
This wave is usually weak since more individuals are still bullish on the market and are waiting to “buy on the dips.”
Wave 5
Wave 5 is the final move in the trend’s direction.
This is the time at when the majority of people pay attention to the asset, and it is primarily driven by hysteria.
When you disagree with them, traders and investors start making up ludicrous reasons to buy the asset and try to choke you.
This is the final surge of purchase before a new trend begins.
After all, purchasers eventually exhaust themselves, and the price loses momentum.
This is the point at which the asset becomes the most overpriced. The ABC pattern is initiated by contrarians shorting the asset.
Extended Impulse Waves
Another important aspect of the Elliott Wave Theory is that one of the three impulse waves (1, 3, or 5) will always be “stretched.”
Simply put, regardless of degree, one wave will always be longer than the other two.
According to Elliott, the fifth wave is generally extended.
This old-school method of wave labeling evolved over time as more people began to refer to the third wave as the extended one.
Next Lesson: Corrective Waves
