In its purest form, the five-wave pattern is the bull market rhythm and the three-wave pattern is the bear market rhythm. The five-wave pattern entails three upward thrusts (waves 1, 3 and 5) and two recoils (waves 2 and 4). The three-wave pattern entails two downward thrusts and one corrective recoil in the opposite direction… a rally in a bear market.
The basic five-wave phenomena is best seen in Figure 4.
Figure 4
Rarely is the stock market as symmetrical as appears in the diagram, therefore treat the illustration as a guide only. We have a bull trend consisting of five waves, three in the direction of the main trend and two smaller waves which move counter to the main trend. As explained, the three waves in the direction of the main trend are “impulse waves” and the two smaller waves which run counter to the main trend are “corrective waves”. Wave 1 is “corrected” by Wave 2. Wave 3 is “corrected” by Wave 4.
Ground Rules
Now we can begin to establish a few characteristic rules which will help when using the Wave Principle as a forecasting tool. But first observe that the impulse waves are parallel to each other, and the corrective waves are parallel to each other also. These characteristics will later prove to be very valuable when applying the Wave Principle in the context of “channelling”, the subject of a subsequent chapter.
Probably more important at this stage are the bottom levels of Wave 2 and Wave 4. It should be observed that in most stock market cycles Wave 2 will not retrace all of the ground gained by Wave 1 but only a proportion of it. When dealing with the subject of cycle amplitude we will be able to establish approximately what proportion.
Likewise Wave 4 will not retrace the total ground covered by Waves 1, 2 and 3, nor is it likely to retrace the ground covered by 3. In fact, we will find the depth of Wave 4 is usually related to the depth of Wave 2.
We can now establish the general rule: during an upward progression of five normal waves, Wave 2 of the formation will have an amplitude less than Wave 1 and Wave 2 will have an amplitude less than Wave 3, such is the nature of the corrective process. Furthermore, Wave 4 will usually terminate above the bottom of Wave 2.
For the sake of clarification, referring to the diagram, on the assumption that Wave 1 is say, 10 points in amplitude, when the downwave comes we act on the assumption that such a downwave will be less than 10 points. Likewise, if Wave 3 is 15 points we act on the assumption that Wave 4 will be less than 15 points. Generally, our Wave 4 will be closer to whatever the amplitude of Wave 2 happens to be. With these few simple concepts we are able to establish probable and maximum extents of the “corrective waves”. It doesn’t really take a genius to understand, does it? Let’s continue by studying Figure 5.
Figure 5
The five-wave pattern which has been illustrated in Figure 4 represents one complete upward phase of a cycle. To complete the cycle, what is expected to follow would be a correction of the entire move which began at the inception of Wave 1. A further rule we can establish is that when five waves are completed, the next corrective wave will be larger than any of the previous corrective waves, since the correction following a “Wave 5” acts to correct a cycle of greater magnitude. In Figure 4, Wave 2 corrects Wave 1 and Wave 4 corrects Wave 3. The correction that follows Wave 5 acts in correction of the sum total of Waves 1, 3 and 5 rather than just Wave 5.
In Figure 5 the corrective wave of the entire up move has been added, labelled ABC. As previously mentioned, the cyclical bear wave consists of three movements, two downward thrusts and one upward thrust. The upward thrust (Wave B) acts in correction of the first downward thrust (Wave A). The second downward thrust (Wave C) acts to complete the entire previously established five wave upward cycle. As the termination of Wave C, we then begin all over again with a new upward cycle, starting with Wave 1 and progressing through four subsequent waves of the next higher cycle. Before we introduce any further ground rules, I will demonstrate how to apply the principles outlined thus far.
Application to Investment Strategy
Getting back to our previous example in Figure 4, we started with the suggestion that Wave 1 in that illustration encompassed say, a 20-point move in the D.J.30. When Wave 2 started, our assumption would be that it would comprise less than a 20-point down move. So should Wave 1 have begun at the D.J.30 level of 800, terminating at 820, we would “forecast” that the move downward from 820 would terminate above 800 on the principle that Wave 2 will not retrace the entire Wave 1 movement.
Also, for the purpose of illustrating the rule that Wave 4 would not retrace all of Wave 3 but related in amplitude to Wave 2, we suggested that Wave 3 be 30 points. Assuming a classic pattern, with Wave 2 consisting of a 6 point amplitude, we would then establish that the downwave that begins after Wave 3, when completed will be (a) less than 30 points, (b) more likely to be in the region of 8 points.
Now we can begin to fill in a few hypothetical numbers on our imaginary D.J.30 chart in Figure 4. Wave 1 begins at 800 and terminates at 820. We then have a 6-point down move which is Wave 2 taking us down to 814. Then comes the up move of 30 points to 844 for Wave 3 and this is followed by corrective Wave 4 of 8 points pulling us back to D.J.I.A. 836. Before demonstrating how we can make profitable use of the phenomenon we’ll now add a further supposition, viz. that Wave 5 is of the same amplitude as Wave 1, lifting the index 20 points upward to 856. We’re now ready for the “crash”. What do we do as investors? How do we incorporate the overall scheme into an investment strategy?
In the first instance, under no circumstances would the investor have considered buying any shares on the move up from D.J.30 836 to 856 for this is a Wave 5 formation. He would have been quite happy to buy in the area of 814, realising his downside risk was no more than 12 points since Wave 2 would not retrace all of Wave 1. He would then be quite happy to buy following completion of Wave 2. He would also be quite happy to buy following completion of Wave 4 when the D.J.30 dipped to 836, realising that his downside risk was less than 30 points, and more likely 6 to 8 points, since Wave 4 would not retrace all of Wave 3 but would probably approximate the amplitude of Wave 2. In addition, the cycle was incomplete. Wave 5 was still to come.
The investor would naturally wish to begin disposing of some issues near the top of Wave 5 and would not consider making any repurchases until the D.J.30 had fallen a minimum of ten points. The rule which has been established is that the correction which follows the fifth wave, not only acts in correction of that fifth wave but also acts to correct the entire movement. Consequently, the downward wave following the fifth wave will be greater in amplitude than any of the preceding corrective waves. The largest corrective wave was Wave 3 involving a downward move of 8 points, thus the minimum expectation of the corrective wave following Wave