Understanding Elliott Wave Patterns: Trader Psychology Behind Every Wave

The Elliott Wave Theory is an effective form of technical analysis for understanding market trends and price movements, based on the idea that “markets move in cycles of impulsive and corrective waves, forming a complete pattern of eight waves.”

The foundation of this theory lies in the assumption that “market waves reflect human psychology,” and each wave count is believed to be closely tied to collective investor sentiment.

By applying knowledge of the Elliott Wave Theory and considering the characteristics of each wave along with the corresponding market psychology,
you can make informed decisions such as:

In this article, we’ll explain the collective market psychology inferred from each wave count in the Elliott Wave Theory.

To make the explanation easier to follow, we’ll use a market example composed of an upward trend with impulsive waves 1 through 5, followed by a downward correction consisting of corrective waves A through C.

Wave 1: The Beginning of a Trend

In Elliott Wave Theory, Wave 1 marks the starting point of a new trend.

On the surface, it may still appear that the downtrend is continuing, but in reality, the market is beginning to shift into a new upward trend.

From a psychological standpoint, most market participants are likely thinking along the following lines.

At this stage, it is also common for the market fundamentals to appear weak.

However, unlike a simple price correction during a downtrend, the impulsive Wave 1 has several distinctive characteristics, such as the following:

Wave 1 can sometimes start suddenly and unexpectedly, making it difficult to enter trades at its early stage because contrarian trading is considered high risk.

Generally, it is only after Wave 2 has formed and completed that traders can often confirm that the previous upward movement was indeed Wave 1.

Wave 2: The Corrective Wave (Often a Price Adjustment)

In Elliott Wave Theory, Wave 2 is a wave where a significant price correction is likely to occur.

The price increase seen in Wave 1 is typically followed by a significant correction, driven by “selling on the rally” from participants who still expect the downtrend to continue.

At this stage, market participants are likely to experience doubts and concerns such as the following:

However, although the price correction in Wave 2 can be significant, this wave generally does not fall below the starting point of Wave 1.

Traders typically use Fibonacci retracement levels of Wave 1 to estimate where Wave 2 might end.

Wave 3: The Strongest Price Expansion Wave

In Elliott Wave Theory, Wave 3 is the most likely to produce the largest price increase.

Since Wave 2 did not fall below the starting point of Wave 1, a growing number of market participants begin to recognize that a trend reversal may have occurred.

In the case of an upward price movement, new buy orders start to flood in, while stop-loss orders from the sell side are triggered. This buying pressure drives the price sharply higher.

At this stage, market participants are likely to be filled with a mix of hopes and concerns such as the following:

Additionally, from both fundamental and technical perspectives, indicators often emerge that support the upward trend, along with bullish statements and buy signals.

The typical target price for Wave 3 corresponds to the 161.8% Fibonacci extension of the Wave 1 price increase.

If the wave pattern is an “impulse,” an “extension” may occur, causing the price to rise beyond 161.8%, with the next target level around the 261.8% Fibonacci extension.

Wave 4: The Time Correction Wave (Often a Pause)

In Elliott Wave Theory, Wave 4 is most likely to appear as a time-based correction, where prices move sideways rather than sharply up or down.

The movement in Wave 3 often experiences a temporary pause, where profit-taking sells and new buying pressure oppose each other, causing the price to move sideways. This typically forms what is known as a range-bound market.

Note: Of course, price corrections similar to those in Wave 2 can also occur.

From a psychological perspective, market participants are likely feeling the following:

When fundamentals are already priced in and no new factors emerge, it becomes difficult for new buyers or sellers to enter the market.

As a result, price movements often become complex, forming prolonged range-bound markets.

When a range-bound market occurs, the price often transitions into Wave 5 once new fundamental factors arise.

Wave 5: The Final Wave of the Trend

Wave 5 is the last wave of the trend and can show either a strong upward movement or a weak rally.

Whether the upward movement in Wave 5 is strong or weak depends on fundamental factors at the time and the positioning of stops.

For example, if there are favorable fundamentals supporting the trend or a large number of stop-loss orders in place, the price tends to rise strongly.

From a psychological standpoint, market participants are often a mix of bullish and bearish sentiments at this stage.

Because market sentiment is mixed at this stage, prices may not rise as strongly as expected.

In particular, when Wave 5 fails to surpass the high of Wave 3, it is called a “failure” (or “fifth wave failure”) and is often seen as a pattern that forms a double top.

It can be difficult to judge whether prices will continue to rise, and holding onto positions too aggressively in line with the trend may result in significant losses during the following corrective wave—Wave A.

Wave A: The Reversal Wave

In Elliott Wave Theory, the first wave of a three-wave correction is called Wave A.

This wave is often referred to as the “trend reversal wave” because it moves significantly in the opposite direction of the preceding trend formed by Waves 1 through 5.

Wave A marks the beginning of a trend reversal. If waves 1 through 5 formed an uptrend, then waves A through C typically form a downtrend.

Since wave A initiates a new impulsive move, it often results in a larger price decline compared to the corrective pullbacks seen in waves 2 or 4 during the previous uptrend.

The market sentiment among participants during wave A can be interpreted as follows:

While some new participants enter the market during Wave 5, expecting the trend to continue based on the price movement, others who had entered earlier begin to take profits during Wave 5.

At the same time, more counter-trend traders start to enter the market, increasing the pressure for a trend reversal.

As a result, the price often drops back near the starting point of Wave 5—or even below it—leading to what’s known as a “full retracement” or a “round trip” move.

Wave B: The Deceptive Wave

In Elliott Wave Theory, Wave B is often referred to as a “deceptive wave” that moves in the direction of the previous trend.

Wave B moves in the same direction as the previous uptrend formed by Waves 1 through 5, but it is actually just a corrective move against Wave A’s decline.

This makes it a misleading wave that often creates confusion among market participants.

During Wave B, optimism toward the previous trend tends to resurface, leading many traders to believe the original trend is resuming.

However, in most cases, Wave B fails to surpass the new high reached at Wave 5 and transitions into the next Wave C, which is a decline.

From both fundamental and technical perspectives, it is common to encounter situations where traders feel they “don’t understand why the price is rising” or “the analysis doesn’t seem to add up.”

If you entered a buy position during Wave A, failing to close it out during Wave B could result in significant losses in the upcoming Wave C.

Wave C: The Wave That Breaks the Previous 1–5 Trend

In Elliott Wave Theory, Wave C is called the “wave that breaks the previous trend.”

It is characterized by a strong price movement in the opposite direction of the trend formed by Waves 1 through 5.

If Wave B fails to surpass the high of Wave 5, or if the upward movement is weak, selling pressure increases as participants begin taking profits.

This, combined with new selling, triggers the start of Wave C’s decline.

In terms of market sentiment, participants tend to split into two groups:

Those who become convinced that the trend has ended.

And those who are forced to cut their losses.

The reason why Wave C often brings such a strong move—enough to make many believe a full trend reversal has occurred—can be explained as follows:

Especially on higher timeframes—such as the monthly or daily chart—Wave C tends to produce a significant decline.

On the other hand, on shorter timeframes like the 5-minute or 15-minute chart, Wave C often fails to break below the end of Wave A, resulting in what’s known as a “failure.”

This is likely because, from the perspective of the larger trend on higher timeframes, Wave C is merely a corrective move.

Summary

This overview introduced the likely market psychology of participants during the “5-wave impulse and 3-wave correction” structure in Elliott Wave Theory.

It covered the sentiment behind Waves 1 through 5, as well as Waves A through C, highlighting how traders typically think and behave at each stage.

That wraps up the summary of each wave count and its typical characteristics.

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