InvestorQ : What are the various waves that combine to actually form the Elliott Wave theory and how can they be deciphered?
Mahima Roy made post

What are the various waves that combine to actually form the Elliott Wave theory and how can they be deciphered?

Aditi Sharma answered.
2 years ago

In Elliott Wave Theory, the first wave consists of the initial move upwards in case of an uptrend (or downwards in a downtrend). This wave is normally sparked by a sudden influx of buyers in case of an uptrend (or an influx of sellers in case of a downtrend). This wave spurs investors and traders to take long (or short) positions and causing the price to make a big rally (or selloff) as the case may be.

The second wave in Elliott Theory occurs in the opposite direction of the first one as traders book profits off a key inflection point or start to believe that the asset or currency pair is already overvalued (or undervalued). This is quite normal as scepticism is a natural tendency in humans once they see the price moving in the direction of their view. The general approach is that if something is too good to be true then it is probably not true. This leads to a move lower (or higher) but not beyond the initial price before the first wave started. This is a necessary condition for the wave to sustain over a longer period of time.

The third wave is perhaps the most interesting and shows a lot more seriousness. It takes place when more buyers (or sellers) pay attention to the asset class and see that it is moving in a strong trend. This is common to most stocks and also to broader asset classes. This pullback allows them to get in the trend at a relatively good price so they set their long (or short) orders and push the price up (or down). This wavy pattern is what we normally call the building of conviction or doubt as the case may be; depend on whether you are looking at the wave on the long side or the short side.

The fourth wave of the Elliott Theory happens because traders once again think that the asset is becoming overvalued and that it may be time to book profits once again. However, this intent to book profits has a lot less conviction compared to the second wave and the trade intent here is more a reaction rather than a proactive action. Even the intensity of the fourth wave is less intense.

The fifth and last wave of the Elliott Theory occurs to extend the price rally to a point where it becomes extremely overvalued (or undervalued), before the trend starts to reverse. This is the stage where the froth or extreme pessimism gets built into the stock or the market as a whole. This wave is of extreme interest to fundamental analysts too as they need to take a call on when to exit the stock or when is the time ripe to enter the stock at low valuations on the down side.