Elliott Waves and Trend Trading
The term waves is most often associated with Elliott waves. Ralph Nelson Elliott developed the Elliott wave theory. Elliott wave theory can be very detailed in its rules and complicated in its application.
The alternation of optimism and pessimism among the masses of traders creates the waves in the market.
Traditional Elliott wave theory declares that every trend has five waves: three impulse moves and two corrective moves. Each impulse move has unique characteristics with regard to the actions of market participants:
The first impulse move is difficult to spot until after it’s over. Prior to this impulse move, the market had been trending in the opposite direction, and for that reason, sentiment is still generally bearish (assuming the market is starting a new wave of an uptrend).
The second impulse move is normally the longest of the three impulse moves. As it begins to gain steam, sentiment begins to change, and eventually the masses begin to get onboard (normally after the market breaks the high of the previous impulse move).
The third and final impulse move is characterized by very positive sentiment among traders. It’s during this third leg up that many retail traders buy in because now the uptrend is very clear. However, like many things in trading, by the time everything is obvious for all to see, you are late to the party. This move is typically shorter in duration and price range than the second impulse move.
Elliott waves take the general information about the mass psychology of waves and apply more strict and specific rules. Here are three hard-and-fast rules that determine which impulse and corrective waves are Waves 1, 2, 3, 4, and 5:
Wave 2 can’t go beyond the beginning of Wave 1.
Wave 3 can’t be the shortest of the three impulse moves.
Wave 4 can’t go beyond the end of Wave 1.Credit: Figure by Barry Burns