Elliott Wave

Learn to trade Elliot Wave

The 5 – 3 Wave Patterns
A theory named after Ralph Nelson Elliott, who contended that the stock market tends to move in discernible and predictable patterns reflecting the basic harmony of nature and extended by other technical analysts to futures markets; (2) in technical analysis, a charting method based on the belief that all prices act as waves, rising and falling rhythmically.

Let’s first take a look at the 5-wave impulse pattern. It’s easier if you see it as a picture:

Let us break it up for you.

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’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 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 with ridiculous reasons to buy the stock and try to choke you if 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 counter trends. 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:

Okay, let’s look at a real example.