ELLIOTT WAVE PRINCIPLE
1.1 Introduction: The Broad Concept
In
The Elliott Wave Principle — A Critical Appraisal, Hamilton Bolton made this
opening statement:
As we have advanced through some of the most unpredictable economic climate
imaginable, covering depression, major war, and postwar reconstruction and
boom, I have noted how well Elliott's Wave Principle has fitted into the facts
of life as they have developed, and have accordingly gained more confidence
that this Principle has a good quotient of basic value.
"The Wave Principle" is Ralph Nelson Elliott's
discovery that social, or crowd, behavior trends and reverses in recognizable
patterns. Using stock market data 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. Elliott
isolated thirteen patterns of movement, or "waves," that recur in market price
data 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 those same
patterns, how they in turn link to form identical patterns of the next larger
size, and so on. In a nutshell, then, the Wave Principle is a catalog of price
patterns and an explanation of where these forms are likely to occur in the
overall path of market development. Elliott's descriptions constitute a set of
empirically derived rules and guidelines for interpreting market action.
Elliott claimed predictive value for The Wave Principle, which now bears the
name, "The Elliott Wave Principle."
1.2 Short History:-
Although it is the best forecasting tool in
existence, the Wave Principle is not primarily a forecasting tool; it is a
detailed description of how markets behave. Nevertheless, that description
does impart an immense amount of knowledge about the market's position within
the behavioral continuum and therefore about its probable ensuing path. The
primary value of the Wave Principle is that it provides a context for market
analysis. This context provides both a basis for disciplined thinking and a
perspective on the market's general position and outlook. At times, its
accuracy in identifying, and even anticipating, changes in direction is almost
unbelievable. Many areas of mass human activity follow the Wave Principle, but
the stock market is where it is most popularly applied. Indeed, the stock
market considered alone is far more important than it seems to casual
observers. The level of aggregate stock prices is a direct and immediate
measure of the popular valuation of man's total productive capability. That
this valuation has form is a fact of profound implications that will
ultimately revolutionize the social sciences. That, however, is a discussion
for another time.
R.N. Elliott's genius consisted of a wonderfully disciplined mental process,
suited to studying charts of the Dow Jones Industrial Average and its
predecessors with such thoroughness and precision that he could construct a
network of principles that covered all market action known to him up to the
mid-1940s. At that time, with the Dow in the 100s, Elliott predicted a great
bull market for the next several decades that would exceed all expectations at
a time when most investors felt it impossible that the Dow could even better
its 1929 peak. As we shall see, phenomenal stock market forecasts, some of
pinpoint accuracy years in advance, have accompanied the history of the
application of the Elliott Wave approach.
Elliott had theories regarding the origin and meaning of the patterns he
discovered, which we will present and expand upon in Lessons 16-19. Until
then, suffice it to say that the patterns described in Lessons 1-15 have stood
the test of time.
Often one will hear several different interpretations of the market's Elliott
Wave status, especially when cursory, off-the-cuff studies of the averages are
made by latter day experts.
However, most uncertainties can be avoided by
keeping charts on both arithmetic and semi-logarithmic
scale and by taking care to follow the rules and guidelines as laid down in
this course. Welcome to the world of Elliott.
1.3 Basic Tenets:
-
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.
Sometimes the market appears to reflect outside conditions and events, but at
other times it is entirely detached from what most people assume are causal
conditions. The reason is that the market has a law of its own. It is not
propelled by the linear causality to which one becomes accustomed in the
everyday experiences of life. Nor is the market the cyclically rhythmic
machine that some declare it to be. Nevertheless, its movement reflects a
structured formal progression.
That progression unfolds in waves. Waves are patterns of directional movement.
More specifically, a wave is any one of the patterns that naturally occur
under the Wave Principle, as described in Lessons 1-9 of this course.
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 1-1. The two
interruptions are apparently a requisite for overall directional movement to
occur.
Figure 1-1
R.N. Elliott did not specifically state that there
is only one overriding form, the "five wave" pattern, but that is undeniably
the case. 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.
1.4 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 1-1 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 1-1. 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 throughout this course.
In his 1938 book, The Wave Principle, and again in a series of articles
published in 1939 by Financial World magazine, R.N. Elliott pointed out
that the stock market unfolds according to a basic rhythm or pattern of five
waves up and three waves down to form a complete cycle of eight waves. The
pattern of five waves up followed by three waves down is depicted in Figure
1-2.
Figure 1-2
One complete cycle consisting of eight waves, then, is made up of two distinct
phases, the motive phase (also called a "five"), whose
subwaves are denoted by numbers, and the corrective phase (also called
a "three"), whose subwaves are denoted by letters.
The sequence a, b, c corrects the sequence 1, 2, 3, 4, 5 in Figure 1-2.
At the terminus of the eight-wave cycle shown in Figure 1-2 begins a second
similar cycle of five upward waves followed by three downward waves. A third
advance then develops, also consisting of five waves up. This third advance
completes a five wave movement of one degree larger than the waves of which it
is composed. The result is as shown in Figure 1-3 up to the peak labeled (5).
Figure 1-3
At the peak of wave (5) begins a down movement of correspondingly larger
degree, composed once again of three waves. These three larger waves down
"correct" the entire movement of five larger waves up. The result is another
complete, yet larger, cycle, as shown in Figure 1-3. As Figure 1-3
illustrates, then, each same-direction component of a motive wave, and each
full-cycle component (i.e., waves 1 + 2, or waves 3 + 4) of a cycle, is
a smaller version of itself.
It is crucial to understand an essential point: Figure 1-3 not only
illustrates a larger version of Figure 1-2, it also illustrates
Figure 1-2 itself, in greater detail. In Figure 1-2, each
subwave 1, 3 and 5 is a motive wave that will
subdivide into a "five," and each subwave 2 and 4
is a corrective wave that will subdivide into an a, b, c. Waves (1) and (2) in
Figure 1-3, if examined under a "microscope," would take the same form as
waves [1]* and [2]. All these figures illustrate the phenomenon of constant
form within ever-changing degree.
1.5 Essential Design:
-
The market's compound construction is such that two waves of a particular
degree subdivide into eight waves of the next lower degree, and those
eight waves subdivide in exactly the same manner into thirty-four waves of the
next lower degree. The Wave Principle, then, reflects the fact that waves of
any degree in any series always subdivide and re-subdivide into waves of
lesser degree and simultaneously are components of waves of higher degree.
Thus, we can use Figure 1-3 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 1-3, waves (a) and (c), which point downward, are 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: that
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 course, 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.
*Note: For this course, all Primary
degree numbers and letters normally denoted by circles are shown with
brackets.
Essential Concepts
Figure 1-4
The
phenomena of form, degree and relative direction are
carried one step further in Figure 1-4. This illustration reflects the general
principle that in any market cycle, waves will subdivide as shown in the
following table.
1.6 Wave
Numbers: -
Number of Waves at Each Degree
Impulse + Correction = Cycle
Largest waves 1+1=2
Largest subdivisions
5+3=8
Next subdivisions
21+13=34
Next subdivisions
89+55=144
As with Figures 1-2 and 1-3 in Lesson 2, neither does Figure 1-4 imply
finality. As before, the termination of yet another eight wave movement (five
up and three down) completes a cycle that 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.
Elliott himself never speculated on why the market's essential form was five
waves to progress and three waves to regress. He simply noted that that was
what was happening. Does the essential form have to be five waves and three
waves? Think about it and you will realize that this is the minimum
requirement for, and therefore the most efficient method of, achieving both
fluctuation and progress in linear movement. One wave does
not allow fluctuation. The fewest subdivisions to create fluctuation
is three waves. Three waves in both directions
does not allow progress. To progress in one
direction despite periods of regress, movements in the main trend must be at
least five waves, simply to cover more ground than the three waves and still
contain fluctuation. While there could be more waves than that, the most
efficient form of punctuated progress is 5-3, and nature typically follows the
most efficient path.
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. From here through Lesson 15,
we will fill out the description of how the market behaves in reality. That's
what Elliott set out to describe, and he succeeded in doing so.
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 Super cycle
Super cycle
Cycle
Primary
Intermediate
Minor
Minute
Minuette
Subminuette
It is important to understand that these labels refer to specifically
identifiable degrees of waves. For instance, when we refer to the U.S. stock
market's rise from 1932, we speak of it as a Super cycle with subdivisions as
follows:
1932-1937 the first wave of Cycle degree
1937-1942 the second wave of Cycle degree
1942-1966 the third wave of Cycle degree
1966-1974 the fourth wave of Cycle degree
1974-19??
the fifth wave of Cycle degree
Cycle waves subdivide into Primary waves that subdivide into Intermediate
waves that in turn subdivide into Minor and sub-Minor 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 v of Minor wave 1 of Intermediate wave (3) of Primary wave [5]
of Cycle wave I of Super cycle wave (V) of the
current Grand Super cycle" is to identify a
specific point along the progression of market history
1.7
Degrees: -
When numbering and lettering waves, the scheme shown
below is recommended to differentiate the degrees of waves in the stock
market's progression:
The most desirable form for a scientist is usually something like 11,
12, 13, 14, 15, etc., with
subscripts denoting degree, but it's a nightmare to read such notations on a
chart. The above table provides for rapid visual orientation. Charts may also
use color as an effective device for differentiating degree.
In Elliott's suggested terminology, the term "Cycle" is used as a name
denoting a specific degree of wave and is not intended to imply a cycle in the
typical sense. The same is true of the term "Primary," which in the past has
been used loosely by Dow Theorists in phrases such as "primary swing" or
"primary bull market." The specific terminology is not critical to the
identification of relative degrees, and the authors have no argument with
amending the terms, although out of habit we have become comfortable with
Elliott's nomenclature.
The precise identification of wave degree in "current time" application is
occasionally one of the difficult aspects of the Wave Principle. Particularly
at the start of a new wave, it can be difficult to decide what degree the
initial smaller subdivisions are. The main reason for the difficulty is that
wave degree is not based upon specific price or time lengths. Waves are
dependent upon form, which is a function of both price and time.
The degree of a form is determined by its size and position relative to
component, adjacent and encompassing waves.
This relativity is one of the aspects of the Wave Principle that make real
time interpretation an intellectual challenge. Fortunately, the precise degree
is usually irrelevant to successful forecasting since it is relative
degree that matters most. Another challenging aspect of the Wave Principle is
the variability of forms, as described through Lesson 9 of this course.
1.8
Wave Function: -
Every wave serves one of two functions: action or reaction.
Specifically, a wave may either advance the cause of the wave of one larger
degree or interrupt it. The function of a wave is determined by its
relative direction. An actionary
or trend wave is any wave that trends in the same direction as
the wave of one larger degree of which it is a part. A reactionary or
countertrend wave is any wave that trends in the direction opposite
to that of the wave of one larger degree of which it is part.
Actionary waves are labeled with odd
numbers and letters. Reactionary waves are labeled with even numbers and
letters.
All reactionary waves develop in corrective mode. If all
actionary waves developed in motive mode, then there would be no need
for different terms. Indeed, most actionary waves
do subdivide into five waves. However, as the following sections reveal, a few
actionary waves develop in corrective mode, i.e.,
they subdivide into three waves or a variation thereof. A detailed
knowledge of pattern construction is required before one can draw the
distinction between actionary
function and motive mode, which in the underlying model introduced so
far are indistinct. A thorough understanding of the forms detailed in the next
five lessons will clarify why we have introduced these terms to the Elliott
Wave lexicon.
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