On occasion investors may observe that the stock markets and the stocks traded in them appear to follow repetitive patterns; and are identifiable in series of waves quite like a building up followed by a subsequent breaking down. The basic tenants of the Elliott wave theory are described below.
- Action is followed by a reaction.
- There are five waves in the direction of the underlying main trend, followed with three corrective waves. This would add up to a 5-3 wave sequence.
- The 5-3 wave sequence would complete one cycle. Then this 5-3 wave pattern becomes two subparts of the next higher 5-3 wave sequence.
- This 5-3 wave sequence remains constant; although the length and time span of each individual wave may vary.
Thus, the cycle is made up of eight waves (five up and three down) and are usually labeled 1, 2, 3, 4, 5, a, b and c on the price charts of stocks and indexes being studied and monitored by investors.
The waves 1, 3, and 5 are called impulse waves, while waves 2 and 4 are called corrective waves; and the waves a, b, and c correct the main trend made by waves 1 through 5. The main trend shown by waves 1 through 5 may be either up or down; and the corrective waves a, b and c would move in an opposite direction to this main trend formed by waves 1 through 5.
The impulse waves correspond with trending markets, while the corrective waves would correspond with trading markets. There would be only two types of waves; namely, the impulse waves and the corrective waves, and would strictly alternate from one to the other. Thus, an impulse wave would be followed by a corrective wave and a corrective wave would be followed by an impulse wave.
The Elliott Wave theory states that each wave within a wave count would contain a complete 5-3 wave sequence and count of a smaller cycle; and the longest wave count is called the Grand Super Cycle. By seniority, the Grand Super Cycle would comprise of Super Cycles and the Super Cycle would comprise of Cycles. Further, this process would define the primary, intermediate, minute and sub-minute waves.
Indeed the Elliott Wave theory finds its foundation in the Fibonacci numbers explained earlier. For instance, two primary waves (including impulse wave and corrective wave) would enclose eight intermediate waves (that is, the 5-3 wave sequence) which would further enclose 34 minute waves. Now, the numbers 2, 8 and 34 belong to the Fibonacci number sequence.
Thus, the discerning investor while viewing technical parameters would apply a combination of both the Elliott Wave and the Fibonacci numbers to elicit both time span and magnitude of future price moves for stocks he may have under study for onward investment from minutes and hours to days and weeks to months and years. Its validity would depend on the correctness and accuracy of the wave count; and be able to correctly assessing the points at which wave start and another wave ends. This would be open to subjective interpretation. So, it may be said that, the stock market has a continuous "impulse − correction − impulse − correction" pattern and progression. This progression may be either upward in the case of a bull market or downward in a bear market. Either ways the motivation of the investor would be a maximization of profits.
Elliott provided the investors with tools to analyze these individual waves and determine where the market was positioned with regard to the wave cycle. Some relevant rules are listed below for a bull market scenario:
- The corrective wave may be of two types; namely, zigzag and flat. For instance, if wave 2 is zigzag, then wave 4 would be flat.
- Wave 1 on occasion may be confused with the wave 'a' of the a-b-c correction; as wave 1 is positioned after the correction wave a-b-c.
- Wave 2 on occasion can correct all the start of wave 1. This may often be a zigzag a-b-c correction, as the flat correction wave is more easily identified.
- Wave 3 would be the longest in price magnitude (and amplitude) but not in time span when compared with waves 1 and 5. However, under certain market conditions wave 5 may exceed wave 3 in length (enclosing a series of impulse and corrective waves of lesser magnitude). This wave 3 would in any case be stronger and more volatile when compare with the other two impulse waves.
- Wave 4 would not descend below the end of wave 2; and would have a higher probability to end before the beginning of wave 2.
- Wave 5 would end much higher than the beginning of wave 1 on the back of lighter volumes when compared with impulse waves 1 and 3.
- The a-b-c correction would not end at a level lower than the end of wave 4; while wave a would be similar to wave c. However, this wave a can comprise of the a-b-c correction or a 1 through 5 wave sequence. Wave b is always made up of the a-b-c correction. And wave c is always made up of a 1 through 5 wave sequence. But if certain market conditions are met, then wave c would be similar to wave a.
It would be the investment objective of the investor which would determine the time frame he would decide to track. Of course, he would be faced with the difficulties listed below:
- Identifying the present position of the stock market with regard to the cycle; identifiable in part with a systemic breakdown of the price charts.
- Correctly identifying either a 1 through 5 wave sequence or the a-b-c correction wave.
- Attempting to fit smaller cycles within the larger cycles.
- 4. Be aware that the initial position of the wave count itself would be open to subsequent correction.
To conclude, the various Elliott waves described above would be useful in determining whether a stock price is approaching a reversal of the present trend. As trends do persist and repeat themselves into the future, these studies would have an important place as a stock price or even a market forecasting tool. On the flip side, there would be others who would opine that these are but windmills of the mind; while some wave sequences and correction waves may have worked in the past, they may not oblige in the future. This would be so, when the market and stock prices are in an uptrend or a downtrend based on fundamental factors both micro-economic as well as macro-economic.