What is Wave
A pattern of behavior marked by noticeable increases and decreases. Waves can be identified in stock price movements and in consumer behavior. Investors trying to profit from a market trend could be described as "riding a wave." A large, strong movement by homeowners to replace their existing mortgages with new ones that have better terms is called a refinancing wave.
BREAKING DOWN Wave
Some technical analysts try to profit from wave patterns in the stock market using the Elliott Wave Theory. This hypothesis says that stock price movements can be predicted because they move in repeating up-and-down patterns called waves that are created by investor psychology. The theory identifies several different types of waves, including motive waves, impulse waves and corrective waves. It is subjective, and not all traders interpret the theory the same way, or agree that it is a successful trading strategy. The whole idea of wave analysis itself does not equate to a regular blueprint formation, where you simply follow the instructions, unlike most other price formations. Wave analysis offers insights into trend dynamics and helps you understand price movements in a much deeper way.
Types of Elliot Wave Patterns
The motive wave represents the first half of the idealized Elliott Wave pattern. It always advances in the direction of the trend of one larger degree, and it is subdivided into five smaller waves. These waves are labeled as 1, 2, 3, 4, and 5. Within the motive wave, there are two types of smaller, sub-waves: the impulse wave and the diagonal wave.
- Impulse wave: This pattern is the most common motive wave and the easiest to spot in a market. Like all motive waves, it consists of five sub-waves; three of them are also motive waves, and two are corrective waves. This is labeled as a 5-3-5-3-5 structure, which was shown above. However, it has three rules that define its formation. These rules are unbreakable. If one of these rules is violated, then the structure is not an impulse wave and one would need to re-label the suspected impulse wave. The three rules are: wave two cannot retrace more than 100 percent of wave one; wave three can never be the shortest of waves one, three and five.
- Diagonal wave: A diagonal wave is the second type of motive wave. Like all motive waves, its goal is to move the market in the direction of the trend. Also, like all motive waves, it consists of five sub-waves. The difference is that the diagonal looks like either an expanding or contracting wedge. Also, the sub-waves of the diagonal may not have a count of five, depending on what type of diagonal is being observed. As with the motive wave, each sub-wave of the diagonal never fully retraces the previous sub-wave, and sub-wave three of the diagonal may not be the shortest wave.