A Psychological Analysis of an Elliott Wave By-line: by Julie Hawk : A description of the elliot wave personality as it pertains to the classic eight-wave Elliot series, what that represents in terms of market psychology and the importance of performing this analysis to an Elliott Wave theorist.

Wave Personality and the Classic Eight-Wave Sequence

Diagram 1: Schematic of a Classic Eight-Wave Elliott Wave Sequence


Elliott Wave Theory

Developing an understanding of the personality of each of the eight component waves of a classic Elliott Wave cycle, as illustrated in Diagram 1, provides a technical analyst with a useful barometer of the human psychological element working within the Elliott Wave Principle. In each wave of the classic five-wave upward and three-wave downward sequences that comprise the overall eight-wave movement, the collective psychology of human emotions becomes reflected on a grand scale in the price action observed. This phenomenon visually demonstrates the alternating cycles of optimism and pessimism operating in the mass psyche that impacts market price action and causes the observed wave patterns to occur.

Personalities of Each Wave in the Sequence

The following commonly-observed wave personality traits pertain to an Elliott Wave analysis of a market with an underlying bullish or upward trend where corrections generally move downwards, as is illustrated schematically in Diagram 1 above. Naturally, the traits would be applied in reverse for a downward-trending bearish market where reactionary corrective waves are generally upwards.

First Waves – In general, first waves fall either into being either part of the basing process, which accounts for about half of first waves, or they arise out of a large base formation resulting from a previous correction.

The first wave can often be recognized by the observation of an improvement in the technical indicators. For example, one might observe an expansion in volume and breadth on an upward first wave movement, despite it being subject to a substantial correction by wave two.

Furthermore, a large amount of short-selling tends to occur in wave one because some traders are stubbornly bearish and remain convinced that all rallies should be shorted. Because of the tendency of the trading crowd to “sell at the bottom,” first waves often retrace significantly, despite the dynamic and impulsive nature of their movement that is upward in direction.

Second Waves – The character of the second wave is primarily formed by the mass psychology of rampant bearishness that refuses to acknowledge that the tide has turned and are instead firmly convinced that the market can only continue to drop.

In fact, the correcting of the first wave in the second can be so extreme that the rise of the first wave can be completely eliminated by the time the second wave ends. When correctly identified, second waves usually present great buying opportunities to get in on the dramatic move higher of the upcoming third wave.

Look for low volatility and a lack of trading volume to signal the end of second wave selling pressures.

Third Waves -Third waves are strong, sweeping upward waves containing an internal five-wave sequence that confirm the overall bullish direction of the trend. They are usually unmistakable in the enthusiasm they are based on, as good news and favorable fundamentals add to the overall rise as the masses begin to buy as they regain confidence in the market.

The strong volume and breadth of the market, along with improving prices make this the most extensive wave in the sequence, and never the shortest. It therefore stands to reason that the third wave of a third wave, according to Elliott Wave theory, would be the most volatile point of strength or weakness in any wave sequence.

In fact, this third wave segment is commonly associated with major price breakouts, breadth and volume expansions, trend confirmations and other major market movements.

Fourth Waves – Fourth waves generally alternate in character with the other corrective second wave of the overall bullish move. As a result, while second waves are often sharply corrective, fourth waves frequently tend to demonstrate sideways price action that arises in order to build up momentum for a further move higher during the upcoming fifth wave.

Furthermore, according to Elliott Wave rules, the fourth wave correction cannot extend below the top of the first wave. Also, they tend to correct to within the region of the fourth wave of one lesser degree, which would be the fourth wave of the preceding third wave.

The newly-bearish psychology of this corrective downward move initiates the tone of pessimism that will culminate in the eventual reversal at the end of the coming fifth wave.

Fifth Waves – Fifth waves are generally less impressive than third waves, and are also usually shorter in total length and display a reduced volume. Generally, fifth waves extend beyond the highest price attained by the preceding third wave, otherwise they are characterized as “failed fifths” or a new wave count might even be necessitated.

In addition, the market’s overall optimism for higher prices is usually at a maximum during a fifth wave that represents the end of the bullish trend. This wave immediately precedes the eventual price reversal downward in the following A-B-C waves that form the bearish correction of the original trend.

A Wave – A waves are the first leg of the downward correction that begins at the top of the preceding fifth wave. Psychologically, most of the market might be convinced that this was just another pullback in the overall uptrend, and so would tend to look for levels to buy.

An A wave can have either five-wave or three-wave character that tends to indicate what sort of B wave will soon follow. Usually, a five-wave A argues for a sharper upcoming B-wave, while a three-wave A is a sign of a more consolidative following B-wave.

B Wave – B waves fake out and give false hopes to the over-optimistic market participants that still think the upward trend is not yet complete. These waves are also sometimes known as a “Bull Trap” where the temporarily-upward price action suckers relatively unsophisticated players into continuing to maintain long positions in the market.

C Wave – C waves are also third waves, and as a result, they demonstrate especially dynamic declining price action that often develops in a sharp move containing an internal five-wave sequence.

From a psychological perspective, they arise as frustrated market participants fearfully look to sell out long positions after the disappointing termination of the preceding B wave convinces them that the bull move is finally over.

Due to their sharpness, C wave price action has an alarming tendency to stop out most of the long positions in the market, thereby dashing any remaining illusory hopes of a continuing uptrend.

The Value of Assessing Wave Personality

With respect to the usefulness of this information, since each wave tends to manifests a certain personality that then results in a similar price pattern, these repetitive patterns can be very helpful in predicting what will happen in a subsequent wave.

These patterns can also be used to deduce the market’s present position in an ongoing wave progression.

Furthermore, knowing and recognizing a wave’s personality can be invaluable when the trader lacks clarity in their wave count or when different interpretations compete. This situation sometimes arises because several alternative wave counts frequently become simultaneously possible in the early development of a larger wave pattern under the rules involved in applying Elliott Wave Theory.

Basically, by accurately observing the general character of a wave, a trader can develop a considerably greater insight into the bigger picture currently unfolding in the marketplace, and hence they can derive greater predictive power from their Elliott Wave analysis.[/FONT]