Commander in Pips: So, it’s time get back to work, tighten your belt and get started. Today we will talk about major EW patterns, which are an impulse move and a corrective move. Both of these moves Mr. Elliot called “waves”, so we will follow to this definition.
Elliot’s work tells us that a trending market moves in 5-3 wave pattern. First a 5 wave pattern is called “impulsive”, while the last 3 wave pattern is called “Corrective”.
So let’s take a look at the picture first, since it will be easier to explain it:
In this pattern 1, 3 and 5 “green” waves are leading or so called “Motive”. They call like that because they go together with the major trend, while 2 and 4 “black” waves are corrective. But do not mess up 2 and 4 corrective waves with ABC corrective pattern that we will discuss in later parts of this chapter. While ABC is a corrective pattern that follows an Impulse move, the 2 and 4 waves are corrective moves inside the Impulse move itself.
Pipruit: Hm, I’m hardly understanding what you’re talking about. But I hope that it will become clear later on. But Commander, why did Mr. Elliot think that market trending, or “impulse” move develops precisely or as usual with such pattern?
Commander in Pips: Well, actually this kind of developing of overall market sentiment is very logical. And to make it clear for you also, let’s pass through market mechanic of each wave, as we did in previous chapters with other patterns:
This is initial move up. It happens just because number of investors/market participants thinks that some currency or asset (if you will apply it to other markets, say, commodities) is undervalued and should rise during the nearest time. The number of traders, who think like that relatively small, and their thoughts about reasons for such growth could be absolutely different – fundamental, technical or imagined. This leads some currency to slight growth, which is wave 1.
This type could takes place in a position of 1st wave, although you will not see it very often. That’s why it calls “leading”. It will be simpler if I just give you the picture:
After initial move up, when price has risen, some people start to think that maybe the currency is overvalued and decide to take profit. This leads to some pullback, which is wave 2. But price does not reach the low of wave 1, because the currency again becomes attractive for buyers somewhere around the low of wave 2. The major thought here is wave 2 is not an entry of a huge amount of sellers, but an exit of “fast traders”, who have bought during Wave 1 but for some reasons decided to take profit. So, other participants just absorb sells of those. Otherwise it should lead to a move below the low of wave 1.
Second Wave’s low/high could not be lower than first wave low/high on bull/bear trend!
This wave usually the strongest and longest among 1st, 3rd and 5th waves. Because initial swing up and shallow retracement tells that there is some upside power and energy in this currency, since price couldn’t return back to the low of wave 1. This moment attract the attention of the public and other large participants who have not entered on wave 1 and wait for retracement (read wave 2) to step in. Almost as we did – “buy deeps”, remember? Since the mass public and other participants are stepping and stepping in, this leads to strong and sustainable move up. As a rule wave 3 exceeds the highs of wave 1.
Third Wave could not be smallest trending sub-wave!
This is just a profit taking retracement. Some participants decide to exit and take profit, since the currency has shown solid growth and probably they have changed their assessment of the attractiveness of holding positions. Usually the 4th wave is weakest among all others. Because many trades wait to “buy at deep” again and step in with long positions. Many professionals decides to exit precisely at 4th wave, because public has tremendous enthusiasm to Buy, and they (public) provide excellent demand and liquidity at good prices to sell huge professional’s positions. It is not very important on FOREX, where liquidity is always high, but this is significant for the stock market.
Now a couple of words are about second and 4th waves. They have a tendency to take one of two different forms – “flat” or “sideways” retracement or “sharp” retracement. They are always alternate between these two ways of retracement. Here is how this it looks like:
Fourth Wave should not overlap with First wave! Other words – low of 4th wave should not be lower than the high of 1st wave in bull trend and high of 4th wave should not be higher, than low of 1st wave in bear trend
This is a period of sick fascination of currency growth. But here is easier to imagine the psychology of 5th wave on some stock. If you see, how your grandma has read in some magazine about this stock and put her money in, and the Executive of this company tells almost every day on CNBC about huge long term perspectives, or he/she has become a Person of the year with “People” magazine or some other, numerous brokers, traders and investors start to coming up with a lot of reasons (sometimes curious) why this currency or stock is undervalued and has to be bought – you should know – it’s time to get out. This is the time, when stock/currency is strongly overpriced. Also during the 5th waves contrarians start to initiate short positions. That’s why very often 5th wave could be flat or has unstable shape – the move up happens but very irregular. This initial shorting later leads to ABC retracement pattern.
Since 5th wave very often develops in Overbought (on bull trend) or Oversold (on bear trend), it falls in “Truncation”. This is a situation, when high of 5th wave can’t establish new high and remains lower than the high of third wave – look at the picture:
All this explanation is absolutely applicable to a bear trend as well.
Ending Diagonal appears during 5th wave. This occurs much oftener than leading diagonal, and as you can see consists of 5 3-wave corrective patterns. Here is you also could see another example of Fractal – 5th larger wave that marked as (5) consists of 5 smaller waves, although they have 3-wave structure.
Ok, the last note for today here is according to EW theory one of the three impulse waves usually extended, compared to the others. “Extended” means longer. Usually this is wave 5 or 3. Mr. Elliot told us that usually the 5th wave is extended, but this was in 20-30s of the 20th century. Markets have changed significantly since that time. And now many participants have come to conclusion that the 3rd wave is extended mostly. Sometimes happens that 1st wave will be extended. And the final possibility is the situation when extension of waves could not be identified. Definitely speaking, it is unclear what particular wave is extended. In this case common 5 waves pattern shifts to 9 waves. It is easier to understand with followed pictures:
Pipruit: Looks like EW theory has as much exceptions as general rules. Because it’s only a start point, but I already can’t capture it in my head.
Commander in Pips: Well, in general, you’re right. EW approach to the market analysis has a lot of nuances. But since you will follow it – much of them will put in mind fast. Don’t worry.