Basic Tenets of the Elliott Wave Principle: "Understanding Market Waves and Learning the Rules of Construction

by Harry Schlanger, EW Patterns.
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Before the Elliott Wave Principle can be used for trading the markets, the Elliott technician must learn well its basic tenets and governing rules of construction.

This article explains the basic tenets of the Elliott Wave Principle, including a few associated construction rules. These need to be followed by the Elliott technician for successful wave counting in preparation for forecasting and trading the next big market move Knowledge about the Wave Principle can be applied to trading any market such as the stock market, commodities markets (pork bellies, precious metals, forex, etc), or financials.

Markets Reduce to Tides of Waves

Charles Henry Dow was first to adopt the abstraction comparing market trends with tides: the waves are subordinate to the tide and the ripples in the water are subordinate to the waves.

However, Elliott’s work presented a greater precision in the classification of the various price movements of a complete market cycle, than that of Charles Dow's trend theory.

A fascination of the Wave Principle is Elliott’s basic pattern repeating itself again and again. Waves begin with the sub-minuette cycle, on to the minor cycle, still up to the intermediate cycle, continuing on to the grand super cycle of one hundred years or more, which span major changes in our civilization.

The Five Basic Tenets of Elliott Waves

Elliott’s basic pattern is quite simple to comprehend. The Wave Principle can be summarized in five important statements:

1. Financial market movements in the direction of the main trend are impulse moves. Movements counter to the main trend are corrective moves (see figure 1).
2. All impulse moves have five subordinate waves, while all corrective moves have three waves.
3. When the main trend is upward, waves 1, 3, and 5 are impulse moves and waves 2 and 4 are corrective moves. When the main trend is downward, the first wave, A, and third wave, C, become corrective moves, while the second intervening wave, B, becomes a corrective move.
4. The action of the main trend can be taking place over a time frame from a few hours to many years. When the main trend has completed a series of five waves, it reverses and a counter move of three waves is expected.
5. When completed, a move comprising of five waves followed by a counter wave, is the first cycle movement. This will represent the first (1) and second (2) waves of a cycle in the time frame of the next higher degree.

Important Associated Rules

A few associated rules should be known before the Wave Principle can be properly utilized for trading in the markets.

1. Wave 3 cannot be the shortest of the impulsive waves
2. Waves 1 and 4 should not overlap
3. Wave 2 and 4 should alternate. That is, if one wave is a correction of complex shape, then the other wave will probably be of a simple pattern.

Elliott Waves often relate with Fibonacci ratios. Corrective waves often retrace either 38.2% or 61.8% of the impulsive waves. In addition, waves 2 and 4 often relate according to these two ratios.

Application of the Wave Principle in Markets

This article presents the rudiments of the Wave Principle, but learning to count waves is only the first step. It is suggested that the potential Elliott Wave practitioner obtain a good book to study further details of the subject, such as the array of triangles and the plethora of corrective patterns; and how to use the Wave Principle for trading - timing entries and exits.

Elliott Wave software is a useful tool for facilitating the complex counting task. The software also provides swing ratios. Familiar ratios at completed swings can indicate increased probabilities for the market to turn.

References:

1. "Powertiming – Using the Elliott Wave Principle to Anticipate and Time Market Turns". Robert C. Beckman. Probus Publishing Co. Chicago, 1992.
2. "Elliott Wave Simplified - Making Stock Market profits with RN Elliott's Simple Theory", Clif Droke. MarketPlace Books, 2000.

Introducing the Elliott Wave Principle: How the Market Cycle Theory Emerged

Ralph Elliott

by Harry Schlanger
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Ralph Elliott was not very well in retirement but spent his convalescence attempting to discover pattern and predictability in the US share market - as a Wave Principle.

Ralph Nelson Elliott (1871 – 1948) was an American born in Marysville, Kansas. In his youth, he was employed, amongst other things, as a telegraph operator, train dispatcher and station hand. In 1896 he chose to enter the accounting profession and worked in New York City for six years. He became quite familiar with the Wall Street area, preparing reports in the financial district.

Elliott then travelled extensively for the next twenty-five years and also worked for railroad companies in Mexico and Guatemala, until forced by illness to retire back to his native California. During three convalescent years, on his front porch, he studied the roaring bull market’s stock market charts of the past eight years.

A Wave Pattern of Markets Emerges

Elliott’s theory of markets was formulated entirely from empirical evidence. He discovered a pattern of previous share behavior that seemed to account for the many times the known patterns failed. He saw a wave rising, falling back, and rising again repeatedly and on many time scales (Fig 1).

Figure 1. Wave Structure Model of the Markets

  

Elliott In Action

By 1934, Elliott’s theory was sufficiently developed that he decided to present them to at least one member of the financial community, Charles J. Collins. Collins was intrigued but not convinced. However, he would be happy to monitor Elliott’s “calls” of the market.

In March 1935 the Dow Jones Rail Average was in decline. Elliott was forecasting that that the Rails would break their 1934 low but the Industrials would not. Elliott cabled Collins on the day that saw the Dow Jones touch an important low; insisting that the market correction was over and that another leg of the bull market had begun. These were forecasts that later struck Collins as uncannily accurate.

System of Labelling Wave Patterns

Elliott used his Wave Principle to map fluctuations in the stock market, which are fragments of a great rhythmic system of waves and cycles in ascending and descending orders of magnitude.

Early economists had already put forward cyclical theories, but Elliott was the first person to apply them to stock market behavior. This rhythm he argued, is repeated in the various forms of nature in the universe.

 


Figure 2. Number of Waves in Market Cycles



 

In Figure 2, Elliott gave us an upward movement of five waves, three up (1, 3, 5) and two down (2, 4), with the former longer than the latter. After the fifth wave, the momentum is downward in three corrective waves (A, B, C), with two down (A, C) and one up between the two (B), but shorter than its predecessor.

Labelling Market Wave Scales

 
A market impulse begins with one major long-term market force, which Elliott subdivided into lesser short-term forces. To explain the different scales (Fig 2), he coined his own terminology:


The Grand Super Cycle
The Super Cycle (54 years)
The Cycle (15-20 years)
The Primary Wave (4 years)

From here, he continued down the scale with an intermediate, minor, minute, minuette, and finally a sub-minuette cycle.
 

Elliott's Published Works

 Elliott published his findings in two articles. “The Wave Principle” was published in The Financial World in 1939. Seven years later, he published in "Nature's Law -- The Secret of the Universe" his deepened and updated thesis. Elliott died two years later in 1948.

Elliott's legacy has been the basis for trading stocks, commodities, forex, etc., according to the tenets of the Wave Principle. Today, traders map out the markets by labelling waves on stock chart paper, or using stock trading software.

The reader may be interested in the basic tenets of the Wave Principle, which are rules governing the construction of market waves.

References:

1. "Powertiming – Using the Elliott Wave Principle to Anticipate and Time Market Turns". Robert C. Beckman. Probus Publishing Co. Chicago, 1992.
2.  "The Major Works of R.N. Elliott". Ed. Robert R. Prechter, Jr. New Classics Library. NY, 1990.