Elliott Wave Theory
According to Elliott Wave Theory, the market traded in repetitive cycles, which he pointed out were the emotions of investors caused by outside influences (Truce, CNBC, Bloomberg, ESPN) or the predominant psychology of the masses at the time. Elliott shows that the upward and downward swings in price caused by the collective psychology always showed up in the same repetitive patterns. They are called upward and downward swings “waves.”
Fractals are structures that can be split into parts, each of which is a similar copy of the whole. Mathematicians like to call this property “self-similarity.” A sea shell is a fractal. A snowflake is a fractal. A cloud is a fractal. Heck, a lightning bolt is a fractal. So why are fractals important? One important quality of Elliott waves is that they are fractals. Elliott waves could be subdivided into smaller Elliot waves like sea shells and snowflakes.
Impulse Waves: 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, and 5 are motive, meaning they go along with the overall trend, while Waves 2 and 4 are corrective.
Wave 1: The stock makes its initial move upward. A relatively small number of people usually cause this that suddenly (for various reasons, real or imagined) feel that the stock price is low, so it’s a perfect time to buy. This causes the price to rise.
Wave 2: At this point, enough people in the original wave consider the stock overvalued and take profits. This causes the stock to go down. However, the stock will not reach its previous lows before it 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 more people are usually bullish on the stock and waiting to “buy on the dips.”
Wave 5: This is the point that most people get on the stock and are driven by hysteria.
Extended Impulse Waves
One thing 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 that is extended.
The 5-wave trends are then corrected and reversed by 3-wave countertrends. According to Elliott, 21 corrective ABC patterns range from simple to complex. But they are just made up of three very simple, easy-to-understand formations.
Zig-zag formations are very steep moves in price that go against the predominant trend. Wave B is typically the shortest length compared to Waves A and C. These zig-zag patterns can happen twice or thrice in a correction (2 to 3 zig-zag patterns linked together). Like all waves, each wave in zig-zag patterns could be broken into 5-wave patterns.
Flat formations are simple sideways corrective waves. The waves’ lengths in flats are generally equal, with wave B reversing wave A’s movement and wave C undoing wave B’s movement. We generally say that wave B can sometimes go beyond the beginning of wave A.
Triangle formations are corrective patterns bound by converging or diverging trend lines. Triangles are made up of 5-waves that move against the trend in a sideways fashion. These triangles can be symmetrical, descending, ascending, or expanding.