Swayam Academy - Elliot Wave Theory Page 1 of 3

TheElliottWavePrincipleisaformoftechnicalanalysisthatsometradersusetoanalyze
financial market cycles and forecast market trend's by identifying extremes in investor
psychology, highs and lows in prices, and other collective factors. Ralph Nelson Elliott
( 1871 - 1948 ) , a professional accountant, discovered the underlying social principles
anddevelopedtheanalyticaltoolsinthe1930s.Heproposedthatmarketpricesunfoldin
specificpatterns,whichpractitionerstodaycallElliottwaves,orsimplywaves.

TheElliotWavePrinciplepositsthatcollectiveinvestorpsychology,orcrowdpsychology,
movesbetweenoptimismandpessimisminnaturalsequences.Thesemoodswings
createpatternsevidencedinthepricemovementsofmarketsateverydegreeoftrendor
timescale.

InElliott'smodel,marketpricesalternatebetweenanimpulsive,ormotivephase,anda
correctivephaseonalltimescalesoftrend,astheillustrationshows.Impulsesare
alwayssubdividedintoasetof5lower-degreewaves,alternatingagainbetweenmotive
andcorrectivecharacter,sothatwaves1,3,and5areimpulses,andwaves2and4are
smallerretracesofwaves1and3.Correctivewavessubdivideinto3smaller-degree
wavesstartingwithafive-wavecounter-trendimpulse,aretrace,andanotherimpulse.
Inabearmarketthedominanttrendisdownward,sothepatternisreversedfive
wavesdownandthreeup.Motivewavesalwaysmovewiththetrend,whilecorrective
wavesmoveagainstit.

ElliottWavePersonalityandCharacteristics
Elliottwaveanalysts(orElliotticians)holdthateachindividualwavehasits
ownsignatureorcharacteristic,whichtypicallyreflectsthepsychologyofthe
moment.UnderstandingthosepersonalitiesiskeytotheapplicationoftheWave
Principle;theyaredefinedbelow.(Definitionsassumeabullmarketinequities;the
characteristicsapplyinreverseinbearmarkets.)

FiveWavePattern(DominantTrend)

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Wave1: Waveoneisrarelyobviousatitsinception.Whenthefirstwaveofanewbull
marketbegins,thefundamentalnewsisalmostuniversallynegative.Theprevioustrend
isconsideredstillstronglyinforce.Fundamentalanalystscontinuetorevisetheir
earningsestimateslower;theeconomyprobablydoesnotlookstrong.Sentiment
surveysaredecidedlybearish,putoptionsareinvogue,andimpliedvolatilityinthe
optionsmarketishigh.Volumemightincreaseabitaspricesrise,butnotbyenoughto
alertmanytechnicalanalysts.

Wave2: Wavetwocorrectswaveone,butcanneverextendbeyondthestartingpointof
waveone.Typically,thenewsisstillbad.Aspricesretestthepriorlow,bearish
sentimentquicklybuilds,and"thecrowd"haughtilyremindsallthatthebearmarketis
stilldeeplyensconced.Still,somepositivesignsappearforthosewhoarelooking:
volumeshouldbelowerduringwavetwothanduringwaveone,pricesusuallydonot
retracemorethan61.8%(seeFibonaccisectionbelow)ofthewaveonegains,and
pricesshouldfallinathreewavepattern.

Wave3: Wavethreeisusuallythelargestandmostpowerfulwaveinatrend(although
someresearchsuggeststhatincommoditymarkets,wavefiveisthelargest).Thenews
isnowpositiveandfundamentalanalystsstarttoraiseearningsestimates.Pricesrise
quickly,correctionsareshort-livedandshallow.Anyonelookingto"getinonapullback"
willlikelymisstheboat.Aswavethreestarts,thenewsisprobablystillbearish,and
mostmarketplayersremainnegative;butbywavethree'smidpoint,"thecrowd"will
oftenjointhenewbullishtrend.Wavethreeoftenextendswaveonebyaratio
of1.618:1.

Wave4: Wavefouristypicallyclearlycorrective.Pricesmaymeandersidewaysforan
extendedperiod,andwavefourtypicallyretraceslessthan38.2%ofwavethree(see
Fibonaccirelationshipsbelow). Volumeiswellbelowthanthatofwavethree.Thisisa
goodplacetobuyapullbackifyouunderstandthepotentialaheadforwave5.Still,
fourthwavesareoftenfrustratingbecauseoftheirlackofprogressinthelargertrend.

Wave5:Wavefiveisthefinalleginthedirectionofthedominanttrend.Thenewsis
almostuniversallypositiveandeveryoneisbullish.Unfortunately,thisiswhenmany
averageinvestorsfinallybuyin,rightbeforethetop.Volumeisoftenlowerinwavefive
thaninwavethree,andmanymomentumindicatorsstarttoshowdivergences(prices
reachanewhighbuttheindicatorsdonotreachanewpeak).Attheendofamajorbull
market,bearsmayverywellberidiculed(recallhowforecastsforatopinthestock
marketduring2000werereceived).

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ThreeWavePattern(CorrectiveTrend)

WaveA: Correctionsaretypicallyhardertoidentifythanimpulsemoves.InwaveAofa
bearmarket,thefundamentalnewsisusuallystillpositive.Mostanalystsseethedropas
acorrectioninastill-activebullmarket.Sometechnicalindicatorsthataccompanywave
Aincludeincreasedvolume,risingimpliedvolatilityintheoptionsmarketsandpossibly
aturnhigherinopeninterestinrelatedfuturesmarkets.

WaveB:Pricesreversehigher,whichmanyseeasaresumptionofthenowlong-gone
bullmarket.Thosefamiliarwithclassicaltechnicalanalysismayseethepeakasthe
rightshoulderofaheadandshouldersreversalpattern.ThevolumeduringwaveB
shouldbelowerthaninwaveA.Bythispoint,fundamentalsareprobablynolonger
improving,buttheymostlikelyhavenotyetturnednegative.

WaveC:Pricesmoveimpulsivelylowerinfivewaves.Volumepicksup,andbythethird
legofwaveC,almosteveryonerealizesthatabearmarketisfirmlyentrenched.WaveC
istypicallyatleastaslargeaswaveAandoftenextendsto1.618timeswaveAor
beyond.

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