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 dramatically.
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 and learn how to use this valuable tool in your own trading and investing.