Pattern Cycles: Declines
As uptrends 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 smart money quietly exits, the uptrend 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 features appear through most price declines. Several false bottoms print and fail. Volume repeatedly surges as losers unload positions and price carries well past downside target after target. Then just as hope collapses, the stock makes a final, multiple bottom.
Pattern Cycles offer 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.
|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 the trendline can violate in any way it wants. The first bounce after the (Drop) may come close to that trendline but will rarely violate it.|
5WDs consist of three downward impulses and two corrections. The first impulse (Top) corrects the uptrend 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 selling pressure, bouncing the stock. Rapid upward motion ignites the first impulse of a significant countertrend. 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 uptrend.
The skilled eye can see 5WDs in all time frames, from 5-min to monthly bars. And the unconscious crowd behavior represented by this fascinating pattern goes well beyond declining markets. These volatile movements fit perfectly into the larger structure of herd mentality that drives Pattern Cycles through their orderly and predictable process.