Elliott Wave Principle : Chapter 1.1

Chapter 1

Introduction

1.1 The Broad Concept

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.

In the 1930s, Ralph Nelson Elliott discovered that stock market prices trend and reverse in recognizable patterns. The patterns he discerned are repetitive in form but not necessarily in time or amplitude. Elliott isolated five such patterns, or "waves," that recur in market price data. He named, defined and illustrated these patterns and their variations. He then described how they link together to form larger versions of themselves, how they in turn link to form the same patterns of the next larger size, and so on, producing a structured progression. He called this phenomenon The Wave Principle.

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 display the Wave Principle, but it is most popularly used in the stock market. Truly, however, the stock market is far more significant to the human condition than it appears to casual observers and even to those who make their living by it. 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 reflected all market action known to him up to the mid-1940s. At that time, with the Dow near 100, 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, exceptional 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 Chapter 3. Until then, suffice it to say that the patterns described in Chapters 1 and 2 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 book. Welcome to the world of Elliott.

1.2 Basic Tenets

The Wave Principle is governed by man’s social nature, and since he has such a nature, its expression 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 external causality to which one becomes accustomed in the everyday experiences of life. The path of prices is not a product of news. Nor is the market the cyclically rhythmic machine that some declare it to be. Its movement reflects a repetition of forms that is independent both of presumed causal events and of periodicity.

The market’s progression unfolds in waves. Waves are patterns of directional movement. More specifically, a wave is any one of the patterns that naturally occur, as described in the rest of this chapter.

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.

Elliott noted three consistent aspects of the five-wave form. They are: Wave 2 never moves beyond the start of wave 1; wave 3 is never the shortest wave; wave 4 never enters the price territory of wave 1.

R.N. Elliott did not specifically say 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.

1.3 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 each one appears as a response to the preceding motive wave yet accomplishes only a partial retracement, or “correction,” of the progress it achieved. Thus, the two modes are fundamentally different, both in their roles and in their construction, as will be detailed throughout this chapter.

Figure 1-1

The Complete Cycle

One complete cycle consisting of eight waves, then, is made up of two distinct phases, the five-wave motive phase (also called a “five”), whose sub waves are denoted by numbers, and the three wave corrective phase (also called a “three”), whose sub waves are denoted by letters. Just as wave 2 corrects wave 1 in Figure 1-1, the sequence A, B, C corrects the sequence 1, 2, 3, 4, 5 in Figure 1-2.

Figure 1-2

Compound Construction

When an initial eight-wave cycle such as shown in Figure 1-2 ends, a similar cycle ensues, which is then followed by another five-wave movement. This entire development produces a five wave pattern of one degree (i.e., relative size) larger than the waves of which it is composed. The result is shown in Figure 1-3 up to the peak labeled (5). This five-wave pattern of larger degree is then corrected by a three-wave pattern of the same degree, completing a larger full cycle, depicted as Figure 1-3.

As Figure 1-3 illustrates, each same-direction component of a motive wave (i.e., wave 1, 3 and 5), 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 necessary to understand a crucial 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 sub waves 1, 3 and 5 is a motive wave that must subdivide into a "five," and each sub wave 2 and 4 is a corrective wave that must subdivide into a "three." Waves (1) and (2) in Figure 1-3, 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 1-3 to illustrate two waves, eight waves or thirty-four waves, depending upon the degree to which we are referring.

Figure 1-3

1.4 Essential Design

Now observe that within the corrective pattern illustrated as wave ② in Figure 1-3, 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 five 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.

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 table below.

Number of Waves at Each Degree

Figure 1-4

As with Figures 1-2 and 1-3, this larger cycle in Figure 1-4 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.

Why 5-3?

Elliott himself never speculated on why the market’s essential form is 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 (of unqualified size) in both directions would not allow progress. To progress in one direction despite periods of regress, movements in that direction must be at least five waves, simply to cover more ground than the intervening three waves. 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.

Wave Degree: Notation and Nomenclature

All waves may be categorized by relative size, or degree. The degree of a wave is determined by its size and position relative to component, adjacent and encompassing waves. Elliott named nine degrees of waves, from the smallest discernible on an hourly chart to the largest wave he could assume existed from the data then available. He chose the following terms for these degrees, from largest to smallest: Grand Super cycle, Super cycle, Cycle, Primary, Intermediate, Minor, Minute, Minuette, Subminuette. Cycle waves subdivide into Primary waves that subdivide into Intermediate waves that in turn subdivide into Minor waves, and so on. The specific terminology is not critical to the identification of degrees, although out of habit, today’s practitioners have become comfortable with Elliott’s nomenclature.

When labeling waves on a graph, some scheme is necessary to differentiate the degrees of waves in the market’s progression. We have standardized a sequence of labels involving numbers and letters, as shown in the table below, which has several virtues heretofore lacking. The progression is infinite in both directions. It is based upon an easily memorized repetition. Motive waves are labeled with alternating sets of three Roman numerals followed by three Arabic numerals. The corrective-wave labels similarly alternate between three upper-case letters and three lower-case letters. Roman numerals always go with lower case letters, and Arabic numbers always go with upper case letters. Finally, all Roman numerals are lower case below Minor degree and upper case above Primary degree, so that a quick glance at a chart reveals some perspective on its time scale. (Several charts in this book deviate from this standard, as they were constructed prior to its adoption.)

We may also refer to waves by their degree number. A wave of Cycle degree is a wave of degree six. The largest degree in progress, dating from the Stone Age, is degree zero (Epochal degree), so these numbers should serve all analytical endeavors. The most desirable form for scientific work would be 1₁, 1₂, 1₃, 1₄, 1₅, etc., with subscripts denoting degree, but it is difficult to read a large number of such notations on a graph. The above standard provides for rapid visual orientation.

It is important to understand that these names and labels refer to specifically identifiable degrees of waves. By using a nomenclature, an analyst can identify precisely the position of a wave in the overall progression of the stock market, much as longitude and latitude are used to identify a geographical location. To say, "The Dow Jones Industrial Average is in Minute wave ⓥ 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.

All waves are of a specific degree. Yet it may be impossible to identify precisely the degree of developing waves, particularly sub waves at the start of a new wave. Degree is not based upon specific price or time lengths but upon form, which is a function of both price and time. Fortunately, the precise degree is usually irrelevant to successful forecasting since it is relative degree that matters most. To know a major advance is due being more important than its precise name. Later events always clarify degree.

1.5 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 (for example, 1, 3, 5, a and c in Figure 1-2). Reactionary waves are labeled with even numbers and letters (for example, 2, 4 and b in Figure 1-2).

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 in order to understand the distinction between actionary function and motive mode, which in the underlying model of Figures 1-1 through 1-4 are indistinct. A thorough understanding of the forms detailed later in this chapter will clarify why we have introduced these terms to the Elliott wave lexicon.

Variations on the Basic Theme

The Wave Principle would be simple to apply if the essential design described above were the complete description of market behavior. The real world, fortunately or unfortunately, is not so simple. While an idea such as cyclicality in markets or human experience implies precise repetition, the concept of waves allows for immense variability, which is in fact abundantly in evidence. The rest of this chapter fills out the description of how the market actually behaves. That is what Elliott set out to describe, and he succeeded in doing so.

There are a number of specific variations on the underlying theme, which Elliott meticulously described and illustrated. He also noted the important fact that each pattern has identifiable requirements as well as tendencies. From these observations, he was able to formulate numerous rules and guidelines for proper wave identification. A thorough knowledge of such details is necessary to understand what the market can do, and at least as important, what it does not do.

Chapters 2 and 4 present a number of guidelines to proper wave interpretation. If you do not wish to become a market analyst or are concerned that you will become bogged down in technical detail, skim the next paragraph and then skip to Chapter 3. A brief perusal of the highly condensed summary below should ensure that you will at least recognize the concepts and terms referenced in later chapters as necessary aspects of the Wave Principle.

Summary of Additional Technical Aspects

Additional technical aspects of waves, which are discussed in detail from here through Chapter 2, are herewith stated as briefly as possible: Most motive waves take the form of an impulse, i.e., a five-wave pattern like those shown in Figures 1-1 through 1-4, in which sub wave 4 does not overlap sub wave 1, and sub wave 3 is not the shortest sub wave. Impulses are typically bound by parallel lines. One motive wave in an impulse, i.e., 1, 3 or 5, is typically extended, i.e., much longer than the other two. There is a rare motive variation called a diagonal, which is a wedge-shaped pattern that appears at the start (wave 1 or A) or the end (wave 5 or C) of a larger wave. Corrective waves have numerous variations. The main ones are named zigzag (which is the one shown in Figures 1-2, 1-3 and 1-4), flat and triangle (whose labels include D and E). These three simple corrective patterns can string together to form more complex corrections (the components of which are labeled W, X, Y and Z). In impulses, waves 2 and 4 nearly always alternate in form, where one correction is typically of the zigzag family and the other is not. Each wave exhibits characteristic volume behavior and a "personality" in terms of attendant momentum and investor sentiment.

General readers may now skip to Chapter 3. For those who want to learn the details, we will turn our attention to the specifics of wave form.

1.6 Detailed Analytics

Motive Waves

Motive waves subdivide into five waves and always move in the same direction as the trend of one larger degree. They are straightforward and relatively easy to recognize and interpret.

Within motive waves, wave 2 always retraces less than 100% of wave 1, and wave 4 always retraces less than 100% of wave 3. Wave 3, moreover, always travels beyond the end of wave 1. The goal of a motive wave is to make progress, and these rules of formation assure that it will.

Elliott further discovered that in price terms, wave 3 is often the longest and never the shortest among the three actionary waves (1, 3 and 5) of a motive wave. As long as wave 3 undergoes a greater percentage movement than either wave 1 or 5, this rule is satisfied. It almost always holds on an arithmetic basis as well. There are two types of motive waves: impulse and diagonal.

Impulse

The most common motive wave is an impulse, per Figure 1-1. In an impulse, wave 4 does not enter the price territory of (i.e., "overlap") wave 1. This rule holds for all non-leveraged "cash" markets. Futures markets, with their extreme leverage, can induce short term price extremes that would not occur in cash markets. Even so, overlapping is usually confined to daily and intraday price fluctuations and even then is rare. In addition, the actionary sub waves (1, 3 and 5) of an impulse are themselves motive, and sub wave 3 is always an impulse. Figures 1-2, 1-3 and 1-4 all depict impulses in the 1, 3, 5, A and C wave positions.

As detailed in the preceding three paragraphs, there are only a few simple rules for interpreting impulses properly. A rule is so called because it governs all waves to which it applies. Typical, yet not inevitable, characteristics of waves are called guidelines. Guidelines of impulse formation, including extension, truncation, alternation, equality, channeling, personality and ratio relationships are discussed below and throughout Chapters 2 and 4. A rule should never be disregarded. In many years of practice with countless patterns, the authors have found but one or two instances above Subminuette degree when all other rules and guidelines combined to suggest that a rule was broken. Analysts who routinely break any of the rules detailed in this section are practicing some form of analysis other than that guided by the Wave Principle. These rules have great practical utility in correct counting, which we will explore further in discussing extensions.

Extension

Most impulses contain what Elliott called an extension. An extension is an elongated impulse with exaggerated subdivisions. The vast majority of impulses contain an extension in one and only one of their three actionary sub waves. The rest either contain no extension or an extension in both sub waves three and five. At times, the subdivisions of an extended wave are nearly the same amplitude and duration as the other four waves of the larger impulse, giving a total count of nine waves of similar size rather than the normal count of "five" for the sequence. In a nine-wave sequence, it is occasionally difficult to say which wave extended. However, it is usually irrelevant anyway, since under the Elliott system, a count of nine and a count of five have the same technical significance. The diagrams in Figure 1-5, illustrating extensions, will clarify this point.

The fact that an extension typically occurs in only one actionary sub wave provides a useful guide to the expected lengths of upcoming waves. For instance, if the first and third waves are of about equal length, the fifth wave will likely be a protracted surge. Conversely, if wave three extends, the fifth should be simply constructed and resemble wave one.

In the stock market, the most commonly extended wave is wave 3. This fact is of particular importance to real-time wave interpretation when considered in conjunction with two of the rules of impulse waves: Wave 3 is never the shortest actionary wave, and wave 4 may not overlap wave 1. To clarify, let us assume two situations involving an improper middle wave, as illustrated in Figures 1-6 and 1-7.

Figure 1-5

In Figure 1-6, wave 4 overlaps the top of wave 1. In Figure 1-7, wave 3 is shorter than wave 1 and shorter than wave 5. According to the rules, neither is an acceptable labeling. Once the apparent wave 3 is proved unacceptable, it must be relabeled in some way that is acceptable. In fact, it is almost always to be labeled as shown in Figure 1-8, implying an extended wave (3) in the making. Do not hesitate to get into the habit of labeling the early stages of a third wave extension. The exercise will prove highly rewarding, as you will understand from the discussion under Wave Personality (see Chapter 2). Figure 1-8 is perhaps the single most useful guide to real time impulse wave counting in this book.

Extensions may also occur within extensions. In the stock market, the third wave of an extended third wave is typically an extension as well, producing a profile such as shown in Figure 1-9. A real-life example is shown in Figure 5-5. Figure 1-10 illustrates a fifth wave extension of a fifth wave extension. Extended fifths are quite common in major bull markets in commodities (see Chapter 6).

Truncation

Elliott used the word "failure" to describe a situation in which the fifth wave does not move beyond the end of the third. We prefer the less connotative term, "truncation," or "truncated fifth." A truncation can usually be verified by noting that the presumed fifth wave contains the necessary five subwaves, as illustrated in Figures 1-11 and 1-12. A truncation often occurs following a particularly strong third wave.

Figure 1-11

Figure 1-12

The U.S. stock market provides two examples of major degree truncated fifths since 1932. The first occurred in October 1962 at the time of the Cuban crisis (see Figure 1-13). It followed the crash that occurred as wave 3. The second occurred at yearend in 1976 (see Figure 1-14). It followed the soaring and broad wave (3) that took place from October 1975 to March 1976.

Figure 1-13

Figure 1-14

Diagonal

A diagonal is a motive pattern yet not an impulse, as it has two corrective characteristics. As with an impulse, no reactionary sub wave fully retraces the preceding actionary sub wave, and the third sub wave is never the shortest. However, a diagonal is the only five-wave structure in the direction of the main trend within which wave four almost always moves into the price territory of (i.e., overlaps) wave one and within which all the waves are "threes," producing an overall count of 3-3-3-3-3. On rare occasions, a diagonal may end in a truncation, although in our experience such truncations occur only by the slimmest of margins. This pattern substitutes for an impulse at two specific locations in the wave structure.

Ending Diagonal

An ending diagonal occurs primarily in the fifth wave position at times when the preceding move has gone "too far too fast," as Elliott put it. A very small percentage of diagonals appear in the C-wave position of A-B-C formations. In double or triple threes (see next section), they appear only as the final C wave. In all cases, they are found at the termination points of larger patterns, indicating exhaustion of the larger movement.

A contracting diagonal takes a wedge shape within two converging lines. This most common form for an ending diagonal is illustrated in Figures 1-15 and 1-16 and shown in its typical position within a larger impulse wave.

We have found one case in which an ending diagonal’s boundary lines diverged, creating an expanding diagonal rather than a contracting one. However, it is unsatisfying analytically in that its third wave was the shortest actionary wave.

Ending diagonals have occurred recently in Minor degree as in early 1978, in Minute degree as in February-March 1976, and in Subminuette degree as in June 1976. Figures 1-17 and 1-18 show two of these periods, illustrating one upward and one downward "real life" formation. Figure 1-19 shows our real-life possible expanding diagonal. Notice that in each case, an important change of direction followed.

Although not so illustrated in Figures 1-15 and 1-16, the fifth wave of an ending diagonal often ends in a "throw-over," i.e., a brief break of the trend line connecting the end points of waves one and three. The real-life examples in Figures 1-17 and 1-19 show throw-overs. While volume tends to diminish as a diagonal of small degree progresses, the pattern always ends with a spike of relatively high volume when a throw-over occurs. On rare occasions, the fifth sub wave falls short of its resistance trend line.

A rising ending diagonal is usually followed by a sharp decline retracing at least back to the level where it began and typically much further. A falling ending diagonal by the same token usually gives rise to an upward thrust.

Figure 1-17

Figure 1-18

Figure 1-19

Fifth wave extensions, truncated fifths and ending diagonals all imply the same thing: dramatic reversal ahead. At some turning points, two of these phenomena have occurred together at different degrees, compounding the violence of the next move in the opposite direction.

Leading Diagonal

It has recently come to light that a diagonal occasionally appears in the wave 1 position of impulses and in the wave A position of zigzags. In the few examples we have, the subdivisions appear to be the same: 3-3-3-3-3, although in two cases, they can be labeled 5-3-5-3-5, so the jury is out on a strict definition. Analysts must be aware of this pattern to avoid mistaking it for a far more common development, a series of first and second waves, as illustrated in Figure 1-8. A leading diagonal in the wave one position is typically followed by a deep retracement (see Chapter 4).

Figure 1-20 shows a real-life leading diagonal. We have recently observed that a leading diagonal can also take an expanding shape. This form appears to occur primarily at the start of declines in the stock market (see Figure 1-21). These patterns were not originally discovered by R.N. Elliott but have appeared enough times and over a long enough period that the authors are convinced of their validity.