In the 1930s, Ralph
Nelson Elliott, a corporate accountant by profession, studied price
movements in the financial markets and observed that certain patterns
repeat themselves. He offered evidence of his discovery by making a
number of accurate stock market forecasts. What appears random and
unrelated, Elliott said, is actually tracing out a recognizable pattern
once you learn what to look for. Elliott called his discovery "The Wave
Principle," and its implications were huge. He had identified the common
link that drives the trends in human affairs, from financial markets to
fashion, from politics to popular culture.
Robert Prechter, Jr., president of Elliott
Wave International, resurrected the Wave Principle from near
obscurity in 1976 when he located copies of R.N. Elliott's books in the
New York Public Library. Robert Prechter, Jr. and A.J. Frost published Elliott
Wave Principle in
1978. The book
received enthusiastic reviews and became a Wall Street bestseller. In
the late 1970s, gloom was pervasive, but in Elliott
Wave Principle, Prechter
and Frost called for a roaring bull market akin to that of the 1920s, to
be followed by a record bear market. As the stock market rose, knowledge
of the Wave Principle among private and professional investors grew
When investors and traders first discover the Elliott Wave Principle,
there are several reactions:
Disbelief that markets are patterned and largely predictable
Joy at having found a “crystal ball” to foretell the future
And finally the correct,
and useful response –
“Wow, here is a valuable model I should learn to use.”
Just like any system in nature, the closer you look at wave patterns,
the more structured complexity you see. It is structured,
because nature’s patterns build on themselves, creating similar forms
at progressively larger sizes. You can see these fractal patterns in
botany, geography, physiology and the things humans create, such as
roads, residential subdivisions… and – as recent discoveries have
confirmed – in market prices.
The first step in Elliott wave analysis is to identify patterns in
market prices. At their core, wave patterns are simple; there are only
two types: “impulse waves,” and “corrective waves.”
Impulse waves are composed of five
subwaves (labeled as 1, 2, 3, 4, 5) and move in the same direction
as the trend of the next larger size. Impulse waves are so named because
they powerfully impel the market.
A corrective wave
follows, composed of three
subwaves (labeled as a,
b, c), and it moves against the trend of the next larger size.
Corrective waves accomplish only a partial retracement, or "correction,"
of the progress achieved by any preceding impulse wave.
As the figure above shows, one complete Elliott wave consists of eight
waves and two phases: five-wave impulse phase, whose subwaves are
denoted by numbers, and the three-wave corrective phase, whose subwaves
are denoted by letters.
R.N. Elliott was not an ivory tower theorist. He set out to observe and
then describe how the market actually behaves. Later he realized that
his model had an important theme of self-similarity and a relationship
to nature. There are a number of specific variations on the underlying
pattern, which Elliott meticulously described and illustrated. He also
noted the important fact that each pattern has identifiable certainties 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 helpful in understanding what a market can do, and at least
as important, what it will not do.
You have just begun to learn the power and complexity of the Elliott
Wave Principle. So, don't let your Elliott wave education end here. Join
Elliott Wave International's free Club EWI and access the Basic
Tutorial: 10 lessons on The Elliott Wave Principle
learn how to use this valuable tool in your own trading and investing.
Using Elliott Waves: As Simple As A-B-C
Two resources from Elliott Wave International can help you get started
By Elliott Wave International
When Ralph Nelson Elliott discovered the Wave Principle nearly 70 years ago, he explained how social (or crowd) behavior trends and reverses in recognizable patterns. You can learn to identify these patterns as they unfold in the financial markets, and use them to help anticipate where prices will go next. Elliott Wave International has developed a free comprehensive online course -- The Elliott Wave Tutorial: 10 Lessons on the Wave Principle -- which describes these patterns and explains how they relate to one another.
To use the Wave Principle as you analyze the markets, you need a basic understanding of the Elliott method -- the rules and guidelines, the literal shape of individual waves, even when the larger trend may turn.
To get you started, we've included an excerpt from the free Elliott Wave Tutorial, adapted from Elliott Wave Principle by Frost and Prechter, and a short video clip from the live presentation, Tips from a Pro.
Here is your quick lesson excerpted from The Elliott Wave Tutorial:
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.
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).
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.
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.
Learn about the Elliott Wave Principle and how applying it to your market analysis can improve your investing and trading. Take the entire online course -- The Elliott Wave Tutorial: 10 Lessons on the Wave Principle -- FREE!
Get free, instant access the 10 Lessons now.
This article was syndicated by Elliott Wave International and was originally published under the headline Using Elliott Waves: As Simple As A-B-C. EWI is the world's largest market forecasting firm. Its staff of full-time analysts led by Chartered Market Technician Robert Prechter provides 24-hour-a-day market analysis to institutional and private investors around the world.