The Basic Tenets of the Elliott Wave Principle
posted under
Philosophy of Technical Analysis
by ceecabolos
There are three important aspects of wave theory—pattern, ratio, and time—in that order of importance. Pattern refers to the wave patterns or formations that comprise the most important element of the theory. Ratio analysis is useful in determining retracement points and price objectives by measuring the relationships between the different waves. Finally, time relationships also exist and can be used to confirm the wave patterns and ratios, but are considered by some Elliotticians to be less reliable in market forecasting.
Elliott Wave Theory was originally applied to the major stock market averages, particularly the Dow Jones Industrial Average. In its most basic form, the theory says that the stock market follows a repetitive rhythm of a five wave advance followed by a three wave decline. Figure 13.1 shows one complete cycle. If you count the waves, you will find that one complete cycle has eight waves—five up and three down. In the advancing portion of the cycle, notice that each of the five waves are numbered. Waves 1, 3, and 5—called impulse waves—are rising waves, while waves 2 and 4 move against the uptrend. Waves 2 and 4 are called corrective waves because they correct waves 1 and 3. After the five wave numbered advance has been completed, a three wave correction begins. The three corrective waves are identified by the letters a, b, c.
Along with the constant form of the various waves, there is the important consideration of degree. There are many different degrees of trend. Elliott, in fact, categorized nine different degrees of trend (or magnitude) ranging from a Grand Supercycle spanning two hundred years to a subminuette degree covering only a few hours. The point to remember is that the basic eight wave cycle remains constant no matter what degree of trend is being studied.
Each wave subdivides into waves of one lesser degree that, in turn, can also be subdivided into waves of even lesser degree. It also follows then that each wave is itself part of the wave of the next higher degree. Figure 13.2 demonstrates these relationships. The largest two waves-1 and 2—can be subdivided into eight lesser waves that, in turn, can be subdivided into 34 even lesser waves. The two largest waves-1 and 2—are only the first two waves in an even larger five wave advance. Wave 3 of that next higher degree is about to begin. The 34 waves in Figure 13.2 are subdivided further to the next smaller degree in Figure 13.3, resulting in 144 waves.The numbers shown so far 1,2,3,5,8,13,21,34,55,89,144—are not just random numbers. They are part of the Fibonacci number sequence, which forms the mathematical basis for the Elliott Wave Theory. We'll come back to them a little later. For now, look at Figures 13.1-13.3 and notice a very significant characteristic of the waves. Whether a given wave divides into five waves or three waves is determined by the direction of the next larger wave. For example, in Figure 13.2, waves (1), (3), and (5) subdivide into five waves because the next larger wave of which they are part—wave 1—is an advancing wave. Because waves (2) and (4) are moving against the trend, they subdivide into only three waves. Look more closely at corrective waves (a), (b), and (c), which comprise the larger corrective wave 2. Notice that the two declining waves—(a) and (c)—each break down into five waves. This is because they are moving in the same direction as the next larger wave 2. Wave (b) by contrast only has three waves, because it is moving against the next larger wave 2.Being able to determine between threes and fives is obviously of tremendous importance in the application of this approach. That information tells the analyst what to expect next. A completed five wave move, for example, usually means that only part of a larger wave has been completed and that there's more to come (unless it's a fifth of a fifth). One of the most important rules to remember is that a correction can never take place in five waves. In a bull market, for example, if a five wave decline is seen, this means that it is probably only the first wave of a three wave (a-b-c) decline and that there's more to come on the downside. In a bear market, a three wave advance should be followed by resumption of the downtrend. A five wave rally would warn of a more substantial move to the upside and might possibly even be the first wave of a new bull trend
Elliott Wave Theory was originally applied to the major stock market averages, particularly the Dow Jones Industrial Average. In its most basic form, the theory says that the stock market follows a repetitive rhythm of a five wave advance followed by a three wave decline. Figure 13.1 shows one complete cycle. If you count the waves, you will find that one complete cycle has eight waves—five up and three down. In the advancing portion of the cycle, notice that each of the five waves are numbered. Waves 1, 3, and 5—called impulse waves—are rising waves, while waves 2 and 4 move against the uptrend. Waves 2 and 4 are called corrective waves because they correct waves 1 and 3. After the five wave numbered advance has been completed, a three wave correction begins. The three corrective waves are identified by the letters a, b, c.
Along with the constant form of the various waves, there is the important consideration of degree. There are many different degrees of trend. Elliott, in fact, categorized nine different degrees of trend (or magnitude) ranging from a Grand Supercycle spanning two hundred years to a subminuette degree covering only a few hours. The point to remember is that the basic eight wave cycle remains constant no matter what degree of trend is being studied.
Each wave subdivides into waves of one lesser degree that, in turn, can also be subdivided into waves of even lesser degree. It also follows then that each wave is itself part of the wave of the next higher degree. Figure 13.2 demonstrates these relationships. The largest two waves-1 and 2—can be subdivided into eight lesser waves that, in turn, can be subdivided into 34 even lesser waves. The two largest waves-1 and 2—are only the first two waves in an even larger five wave advance. Wave 3 of that next higher degree is about to begin. The 34 waves in Figure 13.2 are subdivided further to the next smaller degree in Figure 13.3, resulting in 144 waves.The numbers shown so far 1,2,3,5,8,13,21,34,55,89,144—are not just random numbers. They are part of the Fibonacci number sequence, which forms the mathematical basis for the Elliott Wave Theory. We'll come back to them a little later. For now, look at Figures 13.1-13.3 and notice a very significant characteristic of the waves. Whether a given wave divides into five waves or three waves is determined by the direction of the next larger wave. For example, in Figure 13.2, waves (1), (3), and (5) subdivide into five waves because the next larger wave of which they are part—wave 1—is an advancing wave. Because waves (2) and (4) are moving against the trend, they subdivide into only three waves. Look more closely at corrective waves (a), (b), and (c), which comprise the larger corrective wave 2. Notice that the two declining waves—(a) and (c)—each break down into five waves. This is because they are moving in the same direction as the next larger wave 2. Wave (b) by contrast only has three waves, because it is moving against the next larger wave 2.Being able to determine between threes and fives is obviously of tremendous importance in the application of this approach. That information tells the analyst what to expect next. A completed five wave move, for example, usually means that only part of a larger wave has been completed and that there's more to come (unless it's a fifth of a fifth). One of the most important rules to remember is that a correction can never take place in five waves. In a bull market, for example, if a five wave decline is seen, this means that it is probably only the first wave of a three wave (a-b-c) decline and that there's more to come on the downside. In a bear market, a three wave advance should be followed by resumption of the downtrend. A five wave rally would warn of a more substantial move to the upside and might possibly even be the first wave of a new bull trend
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