In our previous post, we talked about the laws that govern nature and how observation and experience allow making predictions. We also comment that human activities move in waves, which are repetitive in time. In this post, we will discuss waves in financial markets and how to identify them.
Nature, Markets, and Waves
As we mentioned, nature is governed by laws that, although, even when we do not know its causes, we can deduct a mathematical representation of the phenomenon which can be used to make predictions. At the same time, we have observed since the beginning of the scientific method the importance of vibrations and cycles in every aspect of the physical world. This, applied to the markets, is what we know as the Wave Principle.
A movement is composed of five waves. Why five and not another arbitrary number? For us, that is a mystery of the universe. However, we can give an account of its validity. For example, the human being has five senses: smell, sight, touch, hearing, and taste. It has five extremities: head, two arms, and two legs. An arm ends in five fingers, as well as in the legs. Socio-economic activities is not an exception. The life cycle of a product has five phases: product development, introduction, growth, maturity, and decline.
Financial markets, as well as social phenomena, are also subject to wave movement. Each movement is composed of five waves, out of which the first, third and fifth is moving in the direction of the primary trend. According to the principle of action and reaction, the second and fourth waves move opposite to the main direction. When a movement is complete, a wave of higher degree has finished, and a new cycle starts.
A movement has five waves, of which waves one, three and five moves are “impulses” in the direction of the main trend. Waves Two and four move in the opposite direction, which retrace or correct the impulsive movement. In the following chart, we observe a complete move and its five waves.
The main difference between motive and corrective waves is that the motive or impulsive waves is composed of five waves, and the corrective waves show three. If we apply this on the previous chart, we will see the movements as follows.
- Motive waves move in the main trend direction and show five internal waves.
- Corrective waves move against the main trend, showing three internal waves.
- Waves do not necessarily have the same length or time span.
- In general, we expect that Wave Three will move above Wave One, and Wave Five will climb above Wave Three.
- Wave Two never retrace under Wave One, and Wave Four never retrace below Wave Three completely.