Why Elliott Wave Works!
The Elliott Wave pattern can best be explained by considering the activity behind the waves themselves – who is causing them and why. The two major players are institutional investors and retail investors. Of course Institutional investors (e.g. mutual funds) have very large buying power and comprise the bulk of the activity in the market. The retail investor impacts the market less significantly than the institutional investor. How these two groups of investors interact in various parts of the five wave cycle is described below for a bullish market. This interaction works in bearish markets using reverse logic.
Wave 1 is generally considered to be the “short covering” wave. A bout of short covering (profit-taking for short sellers) turns a trending stock in the opposite direction. This influx of buying incites a bounce in the opposite direction.
Once the buying subsides, Wave 2 begins with a very strong round of selling (or buying for bearish pattern), however the selling is not enough to bring the stock to the beginning of Wave 1, forming a higher low.
Wave 3 begins with another round of buying. Wave 3 will often find resistance at the high of Wave 1, where stops will tend to accumulate. Gaps above Wave 3 are an indication that a large number of stops have been taken out and signal that a strong Wave 3 is underway. Wave 3 is often called the “Institutional Wave” and is driven by large investors. It is most often the longest and strongest wave in terms of price movement and time.
The retail investor is typically not aware of this rally until an orderly profit-taking rally takes place – Wave 4. As Wave 4 is formed, retail investors become aware of the stock and join in on the buying. Of course, retail investors make up only a small portion of the market and lack the influence of institutional investors.
Wave 5 begins when new highs are set, but on less momentum (pressure). The end of the trend is near.