During an illness in the mid 1930s, Ralph Nelson Elliott discovered the correlation between human emotion and trend patterns contained within stock price charts. Elliott discovered different patterns that repeated themselves in form but not necessarily in size or length of time; these patterns could always be subdivided into smaller waves within the framework of certain rules. He called this phenomenon the “wave principle.” There are two basic waves in Elliott wave theory: a five wave impulse pattern in the direction of the main trend and a three wave correction pattern against the main trend. In a later stage, Elliott used Fibonacci numbers together with the waves to predict target prices.
With this article we continue investigating Elliott waves, looking at the application and rules for impulse waves. These are the 5 waves of the impulse wave:
In wave 1 there are a limited number of people believing that the underestimated value of stocks is worth buying; a long term belief in survival. In about half of the cases, wave 1 is still part of the bottoming pattern of the previous downtrend. As a result, wave 2 will redraw most of wave 1. A lot of investors look at wave 1 as a correction in the downtrend in order to profit from getting a higher price to close positions. They believe the trend will continue farther down. In the other half of the cases, there is a strong belief that the trend will turn up again, in which case wave 2 will usually only make a small correction.
Wave 2 is a test of the low point of wave 1. There are not yet any visible fundamental changes. With the start of correction wave 2, believers in an additional downtrend will get confirmation. As a result, and often out of pure panic, call options will drop fast in price. Selling pressure drops with lower volume and lower volatility. Wave 2 never goes below the start of wave 1.
Wave 3 is strong up move based on good economical prospects; real improvement in living conditions and never the shortest wave. On its way up, wave 3 will find the resistance of the wave 1 top. This may take some time, but once it is broken, more investors will step in, believing that the trend is really up again. Wave 3 is usually strong because it is supported by big masses. The trend is clear, and there is positive news. Wave 3 makes the biggest move and has intermediate extensions. Almost all stocks take part in this move.
In wave 4 there is the question; is this already the end of the growth cycle? No, just some temporary profit taking! Wave 4 never reaches the territory of wave 1. Correction wave 4 is generally predictable in size and pattern. Wave 4 mostly is a limited correction and rather flat. Wave 4 can be used to synchronize the wave.
During wave 5 there are more positive developments; usually not as strong as in wave 3; there is psychological overestimation. Those who missed wave 3 believe in a further uptrend. Usually, wave 5 makes a higher top than wave 3 with lower volume from a smaller group of investors. The price acceleration is usually slower than in wave 3. If, however, wave 5 proves to be another extension of wave 3, the acceleration will be stronger.
Recognizing wave patterns is the most important occupation within Elliot wave analysis. An impulse wave is always composed of 5 waves, numbered 1 to 5. Waves 1, 3, and 5 are, again, impulse patterns. Waves 2 and 4 are correction patterns.
•Wave 1 is an impulse wave or a starting wedge impulse wave (we will look at later on)
•Wave 2 cannot move beyond the start of wave 1.
•Wave 3 is an impulse wave.
•Wave 3 is never the smallest wave.
•Wave 4 can be any type of correction pattern.
•Waves 2 and 4 are not overlapping.
•Wave 5 is an impulse wave or an ending wedge impulse wave.
A correct count is of course utmost important. Counts with wave 4 and 2 overlapping or where wave 3 is the smallest wave are wrong. Beware that of course not all impulse waves look perfect!
Waves 1, 3, and 5 can be extended and therefore take much more time than the other waves to complete. A wave extension is very common for all waves; in most cases, this happens with wave 3. Waves 1 and 5 than incline toward equality.
Many times, price targets are given by Fibonacci projections. You will note many times that a Fibonacci price projection based on the height of wave 1 is reaching targets at 161.8 , 261.8 and 423.6 to complete finally the impulse wave 5. We will talk about Fibonacci projections in a future article.
The starting wedge impulse wave can only appear in waves 1 or a correction wave A. There may be, at first, some confusion when wave 3, within the starting wedge impulse wave, is seen as an extension wave. You must recognize the starting wedge impulse wave at the start of wave 5 by drawing the wedge pattern between 1 and 3 and 2 and 4. You know now that the starting wedge impulse wave 5 is really just the top of a new wave 1 of a higher order. The wave that follows is not an extended impulse wave 3 up, but a correction wave 2 down.
•This pattern has 5 waves.
•The price is moving between 2 converging lines, a wedge pattern.
•Wave 1 is an impulse wave or a lower order starting wedge impulse wave.
•Wave 2 is a correction pattern smaller than wave 1.
•Wave 3 is an impulse pattern.
•Wave 3 is never the smallest wave.
•Wave 4 can be any correction pattern.
•Waves 4 and 2 may be overlapping.
•Wave 5 is an impulse pattern or an ending wedge impulse wave.
Ending wedge impulse waves are mostly found in higher order impulse waves. Because the ending wedge impulse wave is a wave 5 impulse wave or a wave C correction wave, there will be a bigger market reversal on wave completion. At first, there may be some confusion when waves 3 and 4, within the ending wedge impulse wave, are seen as the start of extension waves 1 and 2. It is important to recognize the ending wedge impulse wave at the start of wave 5 by drawing the wedge pattern. You know now that the ending wedge impulse wave 5 is really the end of wave 5 of a higher order wave. The wave that follows is not an extended impulse wave 3, but a bigger correction wave. The ending wedge impulse wave can be easily recognized by the internal 3 wave structure for all waves.
•The price is moving between two converging lines, a wedge pattern.
•Waves 1, 3, and 5 are 3 wave zigzag patterns.
•Wave 2 is a correction pattern.
•Wave 3 is always bigger than wave 2.
•Wave 3 is never the smallest wave.
•Wave 4 can be any correction pattern.
•Waves 4 and 2 may be partly overlapping.
In my next article we will have a look at Elliott correction waves.
Author Resource:
Want to learn everything about technical analysis? You can find free information at my website: http://stocata.org/ . Sylvain Vervoort is a trader and the author of a new book “Capturing Profit with Technical Analysis” and a regular contributor to Stocks & Commodities magazine.
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