Ralph Nelson Elliott noticed in 1930s that the up-and-down movements in the stock market prices have identifiable patterns. Based upon this observations he deduced a wave structure that he named The Wave Principle and published a book in 1938 detailing it. Now it is known as Elliott Wave Principle. After Elliott’s death in 1948, many people worked on his principle and made it more popular and accepted by ordinary investors. At present, no one is more famous as its proponent than Robert R. Prechter Jr., who, along with A. J. Frost, published Elliott Wave Principle in 1978. The following is primarily based upon Prechter and Frost. Elliott (and Prechter) stated various rules and guidelines for wave analysis. A rule should never be disregarded whereas a guideline is a characteristic of wave that may be violated.
Market’s progression unfolds in waves, which are patterns of directional movement. There are two modes of wave development:
- Motive Waves (Impulse): This has a five-wave structure and they are the primary driver of the market direction. These are denoted by numbers 1, 2, 3, 4 and 5 or Roman numerals I,II, III, IV and V
- Corrective Waves (Zig-Zag): This is a three-wave structure and they retrace the motive waves. These are denoted by alphabets A, B and C
- One complete cycle consists of eight waves – a five-wave Motive phase and a three-wave corrective phase.
- Motive waves do not always point upwards and corrective waves do not always move down
- All waves are categorized by relative size or degree. A smaller duration motive wave would be contained within a larger duration motive wave
The Five-Wave Pattern
- Motive mode take the form of five waves
- Three waves, which are labeled 1, 3, and 5 effect the directional movement
- Waves 2 and 4 are countertrend interruptions
- Wave 2 never moves beyond the start of wave 1 – i.e. wave 2 never retraces more than 100% of wave 1
- Wave 4 never enters the price territory of wave 1 – i.e. these two waves never overlap
- Wave 3 is never the shortest – usually it is the largest one
Every wave serves one of two functions:
- Action: These are trend waves and are in the same direction as the wave of one larger degree of which it is a part
- Reaction: These are countertrend waves that moves in opposition to the trend of larger degree wave
Action waves are labeled with odd numbers and letter – 1, 3, 5, A and C whereas the reactionary waves are labeled with even number – 2, 4, and b. All reactionary waves develop in corrective mode. Most action waves occur in motive mode but some form in corrective phase too.
One of the guidelines of the Wave Principle is that two of the motives waves in a five-wave sequence are of same duration and magnitude.
(To be contd.)