BASIC TENETS OF THE
ELLIOTT WAVE PRINCIPLE
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. 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. Elliott, in
fact, categorized nine different degrees of trend (or
magnitude) ranging from a Grand Super cylce 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. 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 are subdivided further to the next smaller
degree, 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, 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,
waves (1), (3), and (5) subdivide into five waves
because the next larger wave of which they are partwave
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 Principle
