In the late 1920s, an accountant named Ralph Nelson Elliott theorized that rather than being chaotic, the stock market tends to trade in a certain up and down pattern that is primarily affected by mass psychology. He referred to this pattern as “wavesâ€, and published his findings in the book “The Wave Principle†in 1938, and also in a series of articles in the magazine “Financial Worldâ€.Â
The basis for the theory is the idea that group psychology moves back and forth between optimism and pessimism, and prices tend to reflect this by moving according to society’s current mood. Elliott proposed that the pattern alternates between five waves and three waves, where in the first five, waves 1, 3, and 5 move in one direction and are called “motive†waves while the second and fourth waves move in the opposite direction, acting to correct each of the previous waves. Hence they are called “corrective†waves. In a bull market, when prices are generally rising, the general direction of the first group of waves is upward, and the trend is downward in a bear market. At the sixth wave, the trend reverses itself, and heads down in a bull market, and up in a bear market. There are only three waves in this grouping, however, with the first and third traveling in one direction and the second wave correcting the first by traveling in the opposite direction. Each wave is driven by certain predictable actions in the marketplace such as short covering from the previous leg down, profit taking from the preceding rally, and traders “piling on†when a major rally is occurring. Traders who can develop a good understanding of these events will hold the key to the theory.
