Nelson Elliot, an accountant, discovered that the stock market moved in repetitive cycles. This was in the 1920s and 1930s. The repetitive patterns were due to the psychology of the traders during that time.
Elliott named this theory: The Elliott Wave Theory also known as “Elliot Waves” and published a book about it. This pattern can be observed in both bullish and bearish markets.
The 5-3 Wave Pattern
The Elliott wave theory states that the market moves in a 5-wave and 3-wave pattern identified as impulse waves and corrective waves respectively.
In the 5-wave pattern, 3 waves (1, 3, and 5) move in the direction of the trend while 2 waves (2 and 4) move in the opposite direction.
In this wave, the price rises due to the increased number of people who have bought the asset. The price of the asset at this time is considered cheap thus influencing people to buy.
The price at this wave falls because the earlier entrants of wave 1 have collected their gains which they earned in the first wave.
In wave 2, the price movement does not reach its former lows. If it does then the formation of the pattern is disqualified.
Wave 3 is characterized by high trading volume due to the numerous traders entering the market. The traders’ psychology is optimistic and there is increased awareness of the asset. This causes the price to rise extensively resulting in wave 3 being the longest wave.
The price of the asset at this wave drops as traders take their profits. The price fall, however, is shallow as more people are waiting to buy the asset at the trough. The bullish market is expected to continue.
This wave is the one with the most traders entering the market seeking to profit like the other market participants before them. Price rises as a result. However, there are traders at this time who take their profits. The asset during this wave is overvalued and the volume has decreased. The actions in this wave influence the formation of the 3-wave pattern.
This is the 3-wave pattern that is the trend reversal to the impulse waves (5-wave pattern). The waves in this pattern are identified by letters and not numbers.
In this wave, traders believe that the retracement is a short-term movement before the price continues to move in the general direction of the trend. It is characterized by low trading volume.
Wave b is where traders take the opportunity to enter the market at a reduced price. However, the rise in price is shallow.
Wave c shows a change in the general direction of the trend either from an uptrend to a downtrend or vice versa. It indicates the crowd psychology as no longer optimistic.
Elliott Wave Theory Rules
- Wave 2 cannot move past the beginning of Wave 1.
- Among the impulse waves, Wave 3 cannot be shorter than the rest.
- Wave 4 never enters a similar price area as Wave 1.
Elliott Wave Cycles (Bullish and Bearish)
The Elliott Wave Theory can be used in the foreign exchange market and is not limited to the stock market. It is important to understand this theory and know how to identify the patterns Forex charts.