Elliott Wave Principle: Basics

THE BASICS

“The Wave Principle” is Ralph Nelson Elliott’s discov­ery that social, or crowd, behavior trends and reverses in recognizable patterns. Using stock market data for the Dow Jones Industrial Average (DJIA) as his main research tool, Elliott discovered that the ever-changing path of stock 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 by meaningful information and produces meaningful information. Each transaction, while at once an effect, enters the fabric of the market and, by communi­cating transactional data to investors, joins the chain of causes of others’ behavior. This feedback loop is governed by man’s social nature, and since 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, that recur in markets and are repetitive in form, but are 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 patterns, how those in turn are the building blocks for patterns of the next larger size, and so on. 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.

The Five-Wave Pattern

In markets, progress ultimately takes the form of five waves of a specific structure.

Three of these waves, which are labeled 1, 3 and 5, actually effect the directional move­ment. They are separated by two countertrend interrup­tions, which are labeled 2 and 4, as shown in Figure 1. The two interruptions are apparently a requisite for overall directional movement to occur.

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

Wave Mode

There are two modes of wave development: motive and corrective. Motive waves have a five-wave structure, while corrective waves have a three-wave structure or a varia­tion thereof. Motive mode is employed by both the five-wave pattern of Figure 1 and its same-directional components, i.e., waves 1, 3 and 5. Their structures are called “motive” because they powerfully impel the market. Corrective mode is employed by all countertrend interruptions, which in­clude waves 2 and 4 in Figure 1. Their structures are called “corrective” because they can accomplish only a partial retracement, or “correction,” of the progress achieved by any preceding motive wave. Thus, the two modes are fun­damentally different, both in their roles and in their construction, as will be detailed in an upcoming section.

The five-wave motive phase has subwaves denoted by numbers, and the three-wave corrective phase has sub­waves are denoted by letters. Every motive wave is followed by a corrective wave. Just as wave 2 corrects wave 1 in Figure 1, the sequence A, B, C corrects the sequence 1, 2, 3, 4, 5 in Figure 2.

The Essential Design

Figure 3 not only illustrates a larger version of Figure 2, it also illustrates Figure 2 itself, in greater detail. Waves (1) and (2) in Figure 3, if examined under a “microscope,” would take the same form as waves 1 and 2. Regardless of degree, the form is constant. We can use Figure 3 to illustrate two waves, eight waves or thirty-four waves, de­pending upon the degree to which we are referring.

Now observe that within the corrective pattern illus­trated as wave 2 in Figure 3, waves (A) and (C), which point downward, are each composed of five waves: 1, 2, 3, 4 and 5. Similarly, wave (B), which points upward, is com­posed of three waves: A, B and C. This construction discloses a crucial point: Motive waves do not always point upward, and corrective waves do not always point down­ward. The mode of a wave is determined not by its absolute direction but primarily by its relative direction. Aside from four specific exceptions, which will be discussed later in this chapter, waves divide in motive mode (five waves) when trending in the same direction as the wave of one larger degree of which it is a part, and in corrective mode (three waves or a variation) when trending in the opposite direction. Waves (A) and (C) are motive, trending in the same direction as wave 2. Wave (B) is corrective because it cor­rects wave (A) and is countertrend to wave 2. In summary, the essential underlying tendency of the Wave Principle is that action in the same direction as the one larger trend develops in five waves, while reaction against the one larger trend develops in three waves, at all degrees of trend.

Nor does Figure 3 imply finality. As before, this larger cycle automatically becomes two subdivisions of the wave of next higher degree. As long as progress continues, the process of building to greater degrees continues. The re­verse process of subdividing into lesser degrees apparently continues indefinitely as well. As far as we can determine, then, all waves both have and are component waves.

Variations on the Basic Theme

The Wave Principle would be simple to apply if the basic theme described above were the complete descrip­tion of market behavior. However, the real world, fortunately or unfortunately, is not so simple. The rest of this section fills out the description of how the market be­haves in reality.

Wave Degree

All waves may be categorized by relative size, or de­gree. Elliott discerned nine degrees of waves, from the smallest wiggle on an hourly chart to 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

Intermediate

Minor

Minute

Minuette

Subminuette

Cycle waves subdivide into Primary waves that sub­divide into Intermediate waves that in turn subdivide into Minor and sub-Minor waves. It is important to understand that these labels refer to specifically identifiable degrees of waves. By using this nomenclature, the analyst can iden­tify precisely the position of a wave in the overall progression of the market, much as longitude and latitude are used to identify a geographical location. To say, “the Dow Jones Industrial Average is in Minute wave 0 of Minor wave 1 of Intermediate wave (3) of Primary wave 5 of Cycle wave I of Supercycle wave (V) of the current Grand Supercycle” is to identify a specific point along the progression of market history.

When numbering and lettering waves, some scheme such as the one shown at right is recommended to differen­tiate the degrees of waves in the stock market’s progression. We have standardized the labels as follows: