Basic tenets of the Elliott Wave Principle

Basic tenets of the Elliott Wave Principle

"The Wave Principle is Ralph Nelson Elliott discovery that social, or crowd, behavior trends and returns to recognizable patterns. Using market data for the Dow Jones Industrial Average (DJIA) as his main research tool, Elliott found that changing the way the market prices reveals a structural design that in turn reflects a basic harmony found in nature. From this discovery, he developed a rational system of market analysis.

Under the Wave Principle, every market decision is both produced significant information and produce meaningful information. Each transaction, while a sudden effect, enters the market structure, and communication with transactional data to investors, joins the chain of causes for the behavior of others. This feedback loop is driven by the social nature of man, and why he has such a nature, the process generates forms. As the forms are repetitive, they have predictive value.

Elliott isolated thirteen "waves" or patterns of Directional movement are repeated in the markets and are repetitive in form but not necessarily repetitive in time or amplitude. He named, defined and illustrated the patterns. He then described how these structures link together to form larger versions of the same models as those in turn are the building blocks for models of the next larger size, and so forth. His descriptions constitute a set of empirically derived rules and guidelines for interpreting market action. The patterns that naturally occur under the Wave Principle are described below.

Five Wave Pattern

In markets, progress ultimately takes the form of five waves of a specific structure. Three of these waves, which are labeled as 1, 3 and 5, in fact, the effect of targeted movement. They are separated by two countertrend interruptions that are labeled as 2 and 4, as shown in Figure 1. The two interruptions are apparently necessary for the overall direction of movement to occur.

At any time, the market can be identified as somewhere in the basic five wave pattern in the largest degree of trend. Because the five wave pattern is the main form of market progress, all other patterns are subsumed by it.

Wave Mode

There are two modes of wave development: impulsive and corrective. Impulsive waves have a five wave structure, while corrective waves have a three wave structure or a variation thereof. Impulsive mode is employed by the two five-wave model in Figure 1 and the same direction components, ie, wave 1, 3 and 5. Their structures are called "impulsive" because they powerfully impel the market. Corrective mode is employed by all countertrend cuts, which include waves 2 and 4 in Figure 1. Their structures are called "corrective" because they can be achieved only partial retracement, or "correction" of the progress achieved by any preceding impulsive wave. Thus, two fundamentally different ways, both in their roles and in their construction, as will be outlined in an upcoming section.

Full Cycle

A five-wave impulse (whose subwaves are denoted by numbers) is followed by a three-wave correction (whose subwaves are denoted by letters) to form a complete cycle of eight waves. The concept of five waves up followed by three waves down is shown in Figure 2. The eight-wave cycle

shown in Figure 2 is part of a cycle of one degree higher, as shown in Figure 3. As Figure 3 illustrates, each same-direction component of the impulsive wave, and each full cycle component (ie, waves 1 + 2 3 + waves or 4) a cycle, is a smaller version of itself.

It is crucial to understand the essential point: Figure 3 not only illustrates a larger version of Figure 2, it also illustrates Figure 2 itself, in greater detail. In 2 figure, each subwave 1, 3 and 5 is an impulsive wave that will divide into "five", and each subwave 2 and 4 is a corrective wave that will split in one A, B, C waves (1) and (2) Figure 3, if examined under a "microscope" will take the same form as waves. Thus, waves of any degree in any series always dividing and dividing again into waves of lesser degree and simultaneously are components of waves of higher degree. We can use Figure 3 to illustrate two waves, waves or eight thirty-four waves, depending on the degree to which we refer.

The Essential Design

Now note that within the corrective wave pattern as illustrated in Figure 3, waves (a) and (c), which point downward, are composed of five waves: 1, 2, 3, 4 and 5. Similarly, the wave (b), which shows up, is composed of three waves: a, b and c. This structure reveals a key point: that the impulsive waves do not always point upward, and corrective waves do not always point downward. The way a wave is largely determined not by the absolute direction, but by its relative direction. Aside from four specific exceptions, which will be discussed later in this booklet, in an impulsive wave gap mode (five waves) when trending in the same direction as the wave of a larger degree to which it is part, and in corrective mode (three waves or a variation) when trending in the opposite direction. Waves (a) and (c) impulsive, trending in the same direction as wave. Wave (b) is corrective because it corrects wave (a) and countertrend to wave. In summary, the essential underlying tendency of the Wave Principle is that action in the same direction as one larger trend develops in five waves, while reaction against a larger trend develops in three waves, in all degrees of trend.

Neither Figure 3 implies finality. As before, the termination of another eight wave movement (five and three bottom) completes a cycle that automatically becomes two subdivisions of the wave of the next higher level. As long as progress continues, the process of building a greater degree continues. The reverse process of separation to a lesser extent, apparently continues indefinitely as well. As far as we can determine, then, all waves both have and are an integral part waves.

Variations on the basic theme

Principle of wave will be simple to apply if the basic theme described above were complete description of market behavior. But in the real world, fortunately or unfortunately, is not so simple. The rest of this chapter filled with the description of the market behaves in reality.

Wave studies

All waves can be categorized in terms of size or extent. Elliott discerned nine degrees of waves, from the smallest wiggle on the hourly chart of the largest wave he could assume existed from the data then available. He chose the names listed below to label these degrees, from largest to smallest:

Grand Supercycle
Supercycle
Cycle
Primary
Secondary
Minor
Minute
Minuette
Subminuette

Cycle wave division primary division waves in Secondary waves, which in turn divide into small and sub-Minor waves. It is important to understand that these labels refer to specifically identifiable degrees of waves. Using this nomenclature, the analyst can identify precisely the position of a wave in the overall progression of the market, as far as length and width are used to identify the geographic location. To say, "The Dow Jones Industrial Average is in Minute wave V of Minor wave 1 of Intermediate wave (3) of the primary wave of Cycle wave I of Supercycle wave (V) of the current Grand Supercycle" is to identify specific point in the progression of market history.

When the numbers and letters waves, some scheme like the one shown below are recommended to differentiate degrees of waves in the stock market's progression:
Wave studies 5s 3s against the trend Trend
Supercycle (I) (II) (III) (IV) (V) (a) (b) (C)
Cycle I II III IV V A B C
Primary
Secondary (1) (2) (3) (4) (5) (a) (b) (c)
Low 1 2 3 4 5 A B C
The minute I II III IV V A B C
Minuette 1 2 3 4 5 A B C