A cycle is a repeated sequence of events (OR BEHAVIOUR). Until that cycle is broken we can PROFIT FROM PEOPLES PREDICTABILITY. The prime levers to control them is ignorance, greed and fear.
Understanding how people behave and react easily allows us to profit from them. THIS IS CRITICAL TO SUCCESSFUL TRADING
Looking at basic waves there is a highly repetitive 5 waves up and down structure.
Using the bell curve we can use the 80:20 rule - we have 10% extremists one side, 80% who swing this way or the other and 10% extremists on the other side.
Other than bulls and bears these can be labelled as (in monetary terms and not number of participants);
WAVE 1 - Astute value for money investors or smart money - 10%. -Individual independent decision makers
These are the investors that by on fundamentals looking for under valued opportunities in down trends and over valued opportunities in uptrends.
WAVE 2 - They are not greedy and so take some profits off the table. This generally is a short sharp correction.
WAVE 3 - Follow the crowd institutional money - 80% when new a new high is made. Nearing the top Dumb money starts to get in because people are talking how wonderful the market is.
WAVE 4 - Institutional money takes some profits and some dumb money panics, causing a more complex correction.
WAVE 5 - Dumb money - 10% The general person on the street who does not understand about value but just sees everyone else making money so they jump up on the band wagon. Institutional money sells and the dumb money is left holding the shares.
Astute money hears the taxi driver and shop assistant talking about how wonderful the market is and how it will go up forever - they are fine they unloaded near pivot 3 and then the rest in wave 5!
Investors except the greedy ones are fine because they managed to unload most to dumb money in wave 5.
Time to short the market!
No new highs are made and supply overtakes demand causing prices to drop. Dumb money starts to panic and the whole cycle reverses and repeats!
From original work published 29 April 2012.
Rather than reinventing the wheel for a basic wave introduction I have used eSignal’s Advanced GET Elliot Wave description document (I am purely stating that in the hope that by giving them credit where it is due that I will not be sued for copyright and NOT as an advert for their system), and added in the MAP Waves explanations where appropriate in red.
1 – Impulse Patterns
The impulse pattern consists of five waves. The five waves can be in either direction, up or down. Some examples are shown here. The first wave is usually a weak rally with only a small percentage of the traders participating (later we will be looking at wave shapes where you will see that this is very often not the case!). Once Wave 1 is over, traders sell the market on Wave 2. The sell-off in Wave 2 is very vicious. Wave 2 will finally end without making new lows, and the market will start to turn around for another rally.
The initial stages of the Wave 3 rally are slow, and it finally makes it to the top of the previous rally (the top of Wave 1). At this time, there are a lot of stops above the top of Wave 1.
Traders are not convinced of the upward trend and are using this rally to add more shorts. For their analysis to be correct, the market should not take the top of the previous rally.
Therefore, many stops are placed above the top of Wave 1.
The Wave 3 rally picks up steam and takes the top of Wave 1. As soon as the Wave 1 high is exceeded, the stops are taken out. Depending on the number of stops, gaps are left open. Gaps are a good indication of a Wave 3 in progress. After taking the stops out, the Wave 3 rally has caught the attention of traders.
The next sequence of events is as follows: Traders who were initially long from the bottom finally have something to cheer about. They might even decide to add positions.
The traders who were stopped out (after being upset for a while) decide the trend is up, and they decide to buy into the rally. All this sudden interest fuels the Wave 3 rally. This is the time when the majority of the traders have decided that the trend is up (hence most likely place for extensions - or sub waves - or FRACTAL WAVES). Finally, all the buying frenzy dies down. Wave 3 comes to a halt. Now profit-taking begins to set in. Traders who were long from the lows decide to pull out. They have a good trade and start to protect profits. This causes a pullback in the prices that is called Wave 4.
Where Wave 2 was a vicious sell-off, Wave 4 is an orderly profit-taking decline.(and hence more often a complex correction) While profit taking is in progress, the majority of traders are still convinced the trend is up. They were either late in getting in on this rally, or they have been on the sidelines. They consider this profit-taking decline an excellent place to buy in and get even. On the end of Wave 4, more buying sets in and the prices start to rally again. The Wave 5 rally lacks the huge enthusiasm and strength found in the Wave 3 rally. The Wave 5 advance is caused by a small group of traders. While the prices make a new high above the top of Wave 3, the rate of power, or strength, inside the Wave 5 advance is very small when compared to the Wave 3 advance. Finally, when this lackluster buying interest dies out, the market tops out and enters a new phase.
Down impulse waves are exactly the opposite as described with the psychology reversed. They happen much quicker as fear is generated and panic often takes over! Also if we look from economics basic supply and demand theory – when demand is higher, price increases as there is fixed supply, and vice a versa, when supply is higher prices decrease as there is a fixed supply!