Understanding the Psychology of Stock Traders

Countless ways to explain market action have been introduced over the years. One of those is the Elliott Wave Principle, which at its core can help traders make sense of human behavior in the financial markets.

The basic tenets of the Wave Principle include the following:

  • Movement of the market unfolds in waves. This movement generally takes the form of five waves – three waves forming the main directional trend of the market, labeled as waves 1, 3, and 5, punctuated by two countertrend movements, labeled as waves 2 and 4. This describes what’s known as an impulsive wave structure.
  • There are two types of wave structures – impulsive and corrective. Impulsive waves have a 5-wave sequence as just described, whereas corrective waves then play out in a 3-wave sequence. Putting these together you get a complete cycle that actually consists of eight waves. In other words, there is ideally a directional impulsive movement followed by a countertrend corrective movement.
  • Each wave tends toward its own specific personality. For example, a third wave is generally the strongest wave within the sequence, and a fifth and final wave in the run is generally accompanied by one-sided investor sentiment.
  • All waves are classified by size or degree. In other words, waves can vary from what are called Grand Supercycle Waves – which, as the name implies, are very long-term in nature – to the smallest minor waves that might be discernable in day-to-day market movements.

History of Elliott Wave

Although the concept has been around since the 1930s, introduced by R.N. Elliott, it wasn’t until 1978 that the first definitive textbook made its appearance – “Elliott Wave Principle” by Robert Prechter and A.J. Frost.

Elliott discovered that the stock market appeared to move in recognizable and repetitive patterns. Moreover, Prechter and Frost noted that the Wave Principle is not primarily a forecasting tool, but rather a detailed description of how markets behave.

Using the Elliott Wave

A full understanding of the Elliott Wave Principle, with all its subtle nuances, involves a long learning curve, which may make it difficult for novice traders to use.

But for practical purposes, simply recognizing something like a 5-wave impulsive structure playing out on a chart is of value if you want to stay in step with the major trend of the market. Recognizing that the 5-wave sequence provides a guideline for when you might expect a potential turning point, leading to a 3- way corrective sequence that can also provide its own clues, along with trading opportunities.

Although at first glance Elliott Wave analysis seems to be very subjective, there is a set of well-defined guidelines and rules that must be followed to accurately assess the position of the market at a given point in time. At a more advanced level, it involves recognizing a number of possibilities for anticipated market action.

“The Elliott Wave is just one of the many tools in the trader’s arsenal to help accomplish financial goals,” said Brian Bachelier, vice president of active trader strategy at Scottrade. “Traders should consider a wide array of financial analysis to help plot the trading strategy that will bring the greatest likelihood of financial success.”

What technical or fundamental trading and investing techniques do you use?

Read Next: Candlesticks: Putting Emotion on Your Side

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