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TradingDay.com > Technical Analysis Tutorial

T e c h n i c a l   A n a l y s i s   T u t o r i a l
by Alan Farley

Five Wave Declines

As up trends end, the same crowd that lifts price provides fuel for the ensuing decline. Longs get lulled into a false sense of confidence as rally momentum fades and a topping pattern forms. As the smart money quietly exits, the up trend hits a critical trigger point: the bulls suddenly realize they're trapped. Seeking to protect profits, they start dumping the stock. Price fails and selling spirals downward through wave after wave.

Common pattern features appear in most price declines. Several false bottoms print and fail. Volume surges repeatedly, as losers unload their positions onto the waiting value crowd. Price carries well past downside target after target. Then just as hope collapses, the stock makes a final, multiple bottom.

Pattern analysis offers a superb way for the short-term trader to understand and capitalize upon this repeating market behavior. Look no further than R. N. Elliott's work in the 1930s and you'll find the Five Wave Decline. This structure for price correction is as powerful today as it was 60 years ago. And as a parable for crowd behavior, traders can use it without understanding the broader Elliott Wave Theory.

5WDs consist of three downward impulses and two corrections. The first impulse (Top) corrects the up trend that carries an issue to a new high. This Top begins the price failure that completes through the second impulse (1): the technical breakdown of the stock. As with rising markets, this impulse can be very dynamic. But in most declines, the worst is usually reserved for last. As this 2nd impulse completes, a false bottom paints a comforting picture that slows the selling and brings in weak longs. The selling then suddenly resumes and accelerates into a final 3rd impulse (2) that is so emotional that prices violate set targets and reasonable support zones.

The emotion of this last wave extinguishes the selling pressure, bouncing the stock. This rapid upward motion ignites the first impulse of a significant counter trend. This strong rally then fails suddenly. As the longs brace for more pain, the prior low unexpectedly holds. A new crowd then steps in and price returns to the 1-2 trendline as a double bottom forms. The balance of power shifts and the stock breaks through that line into a new up trend.

The skilled eye can see 5WDs in all time frames, from 5-min to monthly bars. These volatile movements fit perfectly into the larger structure of greed that drives the cycle of trend through an orderly and predictable process. And the unconscious crowd behavior represented by this pattern goes well beyond the financial markets.

5WD Trendline Rules: The 1st, 3rd and 5th wave impulses in EWT become Top-1-2 in the Decline's count. Connect the 3rd (1) and 5th (2) waves with a trendline. Ignore the 1st (Top) wave, which that trendline can violate in any way it wants. The first impulse after the (Drop) may come close to that trendline but will rarely violate it.
 


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