As discussed earlier, the Impulse pattern consists of 5 waves.
- These waves are labelled as 1, 3, & 5.
- Waves 1,3, and 5 moves in the same direction as the trend of the next larger degree
- Waves 2 and 4 moves in the opposite direction
Waves are not of uniform length or duration
The Five - Wave Pattern
The image below shows the impulse pattern formation in Nifty 50 weekly time frame:
Let us understand the individual waves of an impulse pattern
Wave 1 is rarely obvious when it starts. When the first wave of a new bull market begins, the fundamental news is almost universally negative. The previous trend is considered still strongly in force.
Fundamental analysts continue to revise their earnings estimates lower; the economy probably does not look strong. Sentiment surveys are decidedly bearish, put options are in vogue. Volume might increase a bit as prices rise, but not by enough to alert many technical analysts.
Wave 2 corrects wave 1 but can never extend beyond the starting point of wave one. Typically, the news is still bad. As prices retest the prior low, bearish sentiment quickly builds, and "the crowd" haughtily reminds all that the bear market is still deeply ensconced.
Some positive signs appear for those who are tracking closely. Volume should be lower during wave 2 than during wave 1, prices usually do not retrace more than 61.8% of the wave one gains, and prices should fall in a three-wave pattern.
Wave 3 is usually the largest and most powerful wave in an impulse pattern. The news is now positive and fundamental analysts start to raise earnings estimates. Prices rise quickly, corrections are short-lived and shallow.
Anyone looking to "get in on a pullback" will likely miss the boat. As wave three starts, the news is probably still bearish, and most market players remain negative; but by wave three's midpoint, "the crowd" will often join the new bullish trend.
Wave 4 corrects Wave 3. Prices may meander sideways for an extended period, and wave four typically retraces less than 38.2% of wave 3.
Volume is well below that of wave 3. This is a good place to buy a pullback if you understand the potential ahead for wave 5. Still, fourth waves are often frustrating because of their lack of progress in the larger trend.
Wave 5 is the final leg in the direction of the dominant trend. The news is almost universally positive, and everyone is bullish. Unfortunately, this is when many average investors finally buy-in, right before the top.
Volume is often lower in wave 5 than in wave 3, and many momentum indicators start to show divergences (prices reach a new high, but the indicators do not reach a new peak). At the end of a major bull market, bears may very well be ridiculed (recall how forecasts for a top in the stock market during 2000 were received).
The image below shows the impulse pattern formation in Bajaj Finance weekly time frame: