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THE BASICS
OF THE
ELLIOTT WAVE PRINCIPLE
by Robert R. Prechter, Jr.
Published by
NEW CLASSICS LIBRARY
a division of
Post Office Box 1618, Gainesville, GA 30503 USA800-336-1618 or 770-536-0309 or fax 770-536-2514
THE BASICSOF THE
ELLIOTT WAVE PRINCIPLE
Copyright 1995-2004by Robert R. Prechter, Jr.
Printed in the United States of America
First Edition: August 1995Second Edition: February 1996
Third Edition: April 2000Fourth Edition: June 2004
August 2007
For information, address the publishers:New Classics Library
a division ofElliott Wave International
Post Office Box 1618Gainesville, Georgia 30503 USA
All rights reserved. The material in this volume may not bereprinted or reproduced in any manner whatsoever.
Violators will be prosecuted to the fullest extent of the law.
Cover design: Marc BenejanProduction: Pamela Greenwood
ISBN: 0-932750-63-X
7 The Basics7 The Five Wave Pattern8 Wave Mode
10 The Essential Design11 Variations on the Basic Theme12 Wave Degree
14 Motive Waves14 Impulse16 Extension17 Truncation18 Diagonal Triangles (Wedges)
19 Corrective Waves19 Zigzags (5-3-5)21 Flats (3-3-5)22 Horizontal Triangles (Triangles)24 Combinations (Double and Triple Threes)
26 Guidelines of Wave Formation26 Alternation26 Depth of Corrective Waves27 Channeling Technique28 Volume29 Learning the Basics
32 The Fibonacci Sequence and its Application35 Ratio Analysis35 Retracements36 Motive Wave Multiples37 Corrective Wave Multiples
40 Perspective
41 Glossary
CONTENTS
-iv -
FOREWORD
By understanding the Wave Principle, you can antici-pate large and small shifts in the psychology driving anyinvestment market and help yourself minimize the emo-tions that drive your own investment decisions. Where didthis valuable tool come from?
Ralph Nelson Elliott, a corporate accountant by pro-fession, studied price movements in the financial marketsand observed that certain patterns repeat themselves. Heoffered proof of his discovery by making astonishingly ac-curate stock market forecasts. What appears random andunrelated, Elliott said, will actually trace out a recogniz-able pattern once you learn what to look for. Elliott calledhis discovery the Wave Principle, and its implicationswere huge. He had identified the common link that drivesthe trends in human affairs, from financial markets to fash-ion, from politics to popular culture.
Robert Prechter resurrected the Wave Principle fromnear obscurity in 1976. Bob was working as an analyst forMerrill Lynch when he discovered the complete body ofR.N. Elliotts work in the New York Public Library.
Mr. Prechter and A.J. Frost published Elliott WavePrinciple in 1978. The book received enthusiastic reviewsand became a Wall Street bestseller. Their forecast calledfor a roaring bull market in the 1980s, to be followed by arecord bear market. Mr. Prechter left Merrill Lynch in 1979to start the monthly publication, The Elliott Wave Theo-rist, and a new focus for Wall Street and investorsworldwide was born.
Knowledge of the Wave Principle among private andprofessional investors grew dramatically in the 1980s. Thestunning accuracy of the forecasts in The Elliott WaveTheorist earned numerous awards, and received a level ofrecognition that no other such publication has everachieved.
-v -
It is no coincidence that the global acceptance of theElliott Wave Principle has paralleled the growth of ElliottWave International (EWI), the market analysis and pub-lishing corporation founded by Robert R. Prechter, Jr. Inthe two decades since then, EWI has earned the reputa-tion as the worlds premier publisher of Elliott waveanalysis and investment commentary. Tens of thousandsof investors use the Wave Principle to guide their finan-cial decisions. Tens of thousands more have boughtproducts indirectly, through distributors and representa-tives. Prechter and Frosts book has now been translatedinto French, German, Dutch, Spanish, Swedish, Polish,Japanese, Chinese, and Russian.
Elliott Wave International is one of the worlds larg-est providers of technical analysis. The revolution ininstant data transmission has given us a perfect vehiclefor around-the-clock coverage of global financial markets.
We now provide institutional and private investorswith 24-hour market commentary via electronic delivery.We also provide monthly publications, hotlines andeducational services that include periodic conferences,intensive workshops and tutorials, video tapes, specialreports and books.
-vi -
ABOUT THE AUTHOR
Founder and president of Elliott Wave International,Robert Prechter has been publishing market commentarysince 1976. He began his career with the Merrill LynchMarket Analysis Department in New York. In 1984, Bobset a record in the options division of the U.S. TradingChampionship with a real-money trading account. In De-cember 1989, Financial News Network (now CNBC) namedhim Guru of the Decade. Bob served for nine years onthe Board of the Market Technicians Association and in1990-1991 served as its president. During the 1990s, heexpanded his firm to provide analysis for institutions onevery major financial market in the world. Bob has writ-ten 13 books on finance, most notably the two-volume set,Socionomics The Science of History and Social Predic-tion. His recent title, Conquer the Crash You Can Surviveand Prosper in a Deflationary Crash and Depression, wasa New York Times and Wall Street Journal business best-seller. In 1999, Bob received the CSTAs first annual A.J.Frost Memorial Award for Outstanding Contribution tothe Development of Technical Analysis. In 2003, TradersLibrary granted him its Hall of Fame award.
THE BASICS
The Wave Principle is Ralph Nelson Elliotts discov-ery that social, or crowd, behavior trends and reverses inrecognizable patterns. Using stock market data for the DowJones Industrial Average (DJIA) as his main research tool,Elliott discovered that the ever-changing path of stock mar-ket prices reveals a structural design that in turn reflectsa basic harmony found in nature. From this discovery, hedeveloped a rational system of market analysis.
Under the Wave Principle, every market decision isboth produced by meaningful information and producesmeaningful information. Each transaction, while at oncean effect, enters the fabric of the market and, by communi-cating transactional data to investors, joins the chain ofcauses of others behavior. This feedback loop is governedby mans social nature, and since he has such a nature,the process generates forms. As the forms are repetitive,they have predictive value.
Elliott isolated thirteen waves, or patterns of direc-tional movement, that recur in markets and are repetitivein form, but are not necessarily repetitive in time or ampli-tude. He named, defined and illustrated the patterns. Hethen described how these structures link together to formlarger versions of the same patterns, how those in turnare the building blocks for patterns of the next larger size,and so on. His descriptions constitute a set of empiricallyderived rules and guidelines for interpreting market ac-tion. The patterns that naturally occur under the WavePrinciple are described below.
The Five-Wave Pattern
In markets, progress ultimately takes the form of fivewaves of a specific structure. Three of these waves, which
The Basics of the Wave Principle8
are labeled 1, 3 and 5, actually effect the directional move-ment. They are separated by two countertrend interrup-tions, which are labeled 2 and 4, as shown in Figure 1. Thetwo interruptions are apparently a requisite for overalldirectional movement to occur.
At any time, the market may be identified as beingsomewhere in the basic five-wave pattern at the largestdegree of trend. Because the five-wave pattern is the over-riding form of market progress, all other patterns aresubsumed by it.
Wave Mode
There are two modes of wave development: motive andcorrective. Motive waves have a five-wave structure, whilecorrective waves have a three-wave structure or a varia-tion thereof. Motive mode is employed by both the five-wave
Figure 1
Robert R. Prechter, Jr. 9
pattern of Figure 1 and its same-directional components,i.e., waves 1, 3 and 5. Their structures are called motivebecause they powerfully impel the market. Corrective modeis employed by all countertrend interruptions, which in-clude waves 2 and 4 in Figure 1. Their structures are calledcorrective because they can accomplish only a partialretracement, or correction, of the progress achieved byany preceding motive wave. Thus, the two modes are fun-damentally different, both in their roles and in theirconstruction, as will be detailed in an upcoming section.
The five-wave motive phase has subwaves denoted bynumbers, and the three-wave corrective phase has sub-waves are denoted by letters. Every motive wave is followedby a corrective wave. Just as wave 2 corrects wave 1 inFigure 1, the sequence A, B, C corrects the sequence 1, 2,3, 4, 5 in Figure 2.
Figure 2
The Basics of the Wave Principle10
The Essential Design
Figure 3 not only illustrates a larger version of Figure2, it also illustrates Figure 2 itself, in greater detail. Waves(1) and (2) in Figure 3, if examined under a microscope,would take the same form as waves 1 and 2. Regardlessof degree, the form is constant. We can use Figure 3 toillustrate two waves, eight waves or thirty-four waves, de-pending upon the degree to which we are referring.
Now observe that within the corrective pattern illus-trated as wave 2 in Figure 3, waves (A) and (C), whichpoint downward, are each composed of five waves: 1, 2, 3,4 and 5. Similarly, wave (B), which points upward, is com-posed of three waves: A, B and C. This construction
Figure 3
Robert R. Prechter, Jr. 11
discloses a crucial point: Motive waves do not always pointupward, and corrective waves do not always point down-ward. The mode of a wave is determined not by its absolutedirection but primarily by its relative direction. Aside fromfour specific exceptions, which will be discussed later inthis chapter, waves divide in motive mode (five waves) whentrending in the same direction as the wave of one largerdegree of which it is a part, and in corrective mode (threewaves or a variation) when trending in the opposite direc-tion. Waves (A) and (C) are motive, trending in the samedirection as wave 2. Wave (B) is corrective because it cor-rects wave (A) and is countertrend to wave 2. In summary,the essential underlying tendency of the Wave Principle isthat action in the same direction as the one larger trenddevelops in five waves, while reaction against the one largertrend develops in three waves, at all degrees of trend.
Nor does Figure 3 imply finality. As before, this largercycle automatically becomes two subdivisions of the waveof next higher degree. As long as progress continues, theprocess of building to greater degrees continues. The re-verse process of subdividing into lesser degrees apparentlycontinues indefinitely as well. As far as we can determine,then, all waves both have and are component waves.
Variations on the Basic Theme
The Wave Principle would be simple to apply if thebasic theme described above were the complete descrip-tion of market behavior. However, the real world,fortunately or unfortunately, is not so simple. The rest ofthis section fills out the description of how the market be-haves in reality.
The Basics of the Wave Principle12
Wave Degree
All waves may be categorized by relative size, or de-gree. Elliott discerned nine degrees of waves, from thesmallest wiggle on an hourly chart to the largest wave hecould assume existed from the data then available. Hechose the names listed below to label these degrees, fromlargest to smallest:
Grand SupercycleSupercycle
CyclePrimary
IntermediateMinor
MinuteMinuette
Subminuette
Cycle waves subdivide into Primary waves that sub-divide into Intermediate waves that in turn subdivide intoMinor and sub-Minor waves. It is important to understandthat these labels refer to specifically identifiable degreesof waves. By using this nomenclature, the analyst can iden-tify precisely the position of a wave in the overallprogression of the market, much as longitude and latitudeare used to identify a geographical location. To say, theDow Jones Industrial Average is in Minute wave 0 ofMinor wave 1 of Intermediate wave (3) of Primary wave5 of Cycle wave I of Supercycle wave (V) of the currentGrand Supercycle is to identify a specific point along theprogression of market history.
When numbering and lettering waves, some schemesuch as the one shown at right is recommended to differen-tiate the degrees of waves in the stock markets progression.We have standardized the labels as follows:
Robert R. Prechter, Jr. 13
Wave Degree 5s With the Trend 3s Against theTrend
( next is Arabic symbols) ( next is caps)Grand Supercycle I & * ( ) a b cSupercycle (I) (II) (III) (IV) (V) (a) (b) (c)Cycle I II III IV V a b cPrimary 1 2 3 4 5 A B CIntermediate (1) (2) (3) (4) (5) (A) (B) (C)Minor 1 2 3 4 5 A B CMinute 6 7 8 9 0 a b cMinuette (i) (ii) (iii) (iv) (v) (a) (b) (c)Subminuette i ii iii iv v a b c
( next is Arabic symbols) ( next is caps)
The Basics of the Wave Principle14
MOTIVE WAVES
Motive waves subdivide into five waves and always movein the same direction as the trend of one larger degree.They are straightforward and relatively easy to recognizeand interpret.
Within motive waves, wave 2 always retraces less than100% of wave 1, and wave 4 always retraces less than 100%of wave 3. Wave 3, moreover, always travels beyond theend of wave 1. The goal of a motive wave is to makeprogress, and these rules of formation assure that it will.
Elliott further discovered that in price terms, wave 3is often the longest and never the shortest among the threeactionary waves (1, 3 and 5) of a motive wave. As long aswave 3 undergoes a greater percentage movement thaneither wave 1 or 5, this rule is satisfied. It almost alwaysholds on an arithmetic basis as well. There are two typesof motive waves: impulse and diagonal triangle.
IMPULSE
The most common motive wave is an impulse. In animpulse, wave 4 does not enter the territory of (i.e., over-lap) wave 1. This rule holds for all non-leveraged cashmarkets. Futures markets, with their extreme leverage,can induce short term price extremes that would not occurin cash markets. Even so, overlapping is usually confinedto daily and intraday price fluctuations and even then israre. In addition, the actionary subwaves (1, 3 and 5) of animpulse are themselves motive, and subwave 3 is specifi-cally an impulse. Figures 2, 3 and 4 depict impulses in the1, 3, 5, A and C wave positions.
As detailed in the preceding three paragraphs, thereare only a few simple rules for interpreting impulses prop-erly. A rule is so called because it governs all waves towhich it applies. Typical, yet not inevitable, characteris-tics of waves are called guidelines. Guidelines of impulseformation, including extension, truncation, alternation,
Robert R. Prechter, Jr. 15
equality, channeling, personality and ratio relationshipsare discussed below. A rule should never be disregarded.In many years of practice with countless patterns, we havefound but one instance above Subminuette degree whenall other rules and guidelines combined to suggest that a
Figure 4
The Basics of the Wave Principle16
rule was broken. Analysts who routinely break any of therules detailed in this section are practicing some form ofanalysis other than that guided by the Wave Principle.These rules have great practical utility in correct count-ing, which we will explore further in discussing extensions.
Extension
Most impulses contain what Elliott called an exten-sion. Extensions are elongated impulses with exaggeratedsubdivisions. The vast majority of impulse waves do con-tain an extension in one and only one of their three motivesubwaves (1, 3 or 5). The diagrams in Figure 4, illustrat-ing extensions, will clarify this point.
Often the third wave of an extended third wave is anextension, producing a profile such as shown in Figure 5.
Figure 5
Robert R. Prechter, Jr. 17
Truncation
Elliott used the word failure to describe a situationin which the fifth wave does not move beyond the end ofthe third. We prefer the less connotative term, trunca-tion, or truncated fifth. A truncation can usually beverified by noting that the presumed fifth wave containsthe necessary five subwaves, as illustrated in Figures 6and 7. Truncation often occurs following a particularlystrong third wave.
Truncation gives warning of underlying weakness orstrength in the market. In application, a truncated fifthwave will often cut short an expected target. This annoy-ance is counterbalanced by its clear implications forpersistence in the new direction of trend.
Figure 7
Figure 6
The Basics of the Wave Principle18
DIAGONAL TRIANGLES (WEDGES)
A diagonal triangle is a special type of wave that oc-curs primarily in the fifth wave position at times when thepreceding move has gone toofar too fast, as Elliott put it. Adiagonal triangle is a motivepattern, yet not an impulse, asit has one or two correctivecharacteristics. Diagonal tri-angles substitute for impulsesat specific locations in the wavestructure. They are the onlyfive-wave structures in the di-rection of the main trendwithin which wave four almostalways moves into the price ter-ritory of (i.e., overlaps) waveone. (See Figure 8.)
Figure 8
Robert R. Prechter, Jr. 19
CORRECTIVE WAVES
Markets move against the trend of one greater degreeonly with a seeming struggle. Resistance from the largertrend appears to prevent a correction from developing afull motive structure. The struggle between the two oppo-sitely trending degrees generally makes corrective wavesless clearly identifiable than motive waves, which alwaysflow with comparative ease in the direction of the one largertrend. As another result of the conflict between trends, cor-rective waves are quite a bit more varied than motive waves.
Corrective patterns fall into four main categories:Zigzag (5-3-5; includes three types: single, double, and
triple);Flat (3-3-5; includes three types: regular, expanded,
and running);Triangle (3-3-3-3-3; four types: three of the contract-
ing variety (ascending, descending, and symmetrical) andone of the expanding variety (reverse symmetrical);
Combination (two types: double three and triple three).
ZIGZAGS (5-3-5)
A single zigzag in a bull market is a simple three-wavedeclining pattern labeled A-B-C and subdividing 5-3-5. Thetop of wave B is noticeably lower than the start of wave A,as illustrated in Figures 9 and 10.
Occasionally zigzags will occur twice, or at most, threetimes in succession, particularly when the first zigzag fallsshort of a normal target. In these cases, each zigzag is sepa-rated by an intervening three (labeled X), producing whatis called a double zigzag (see Figure 11) or triple zigzag.The zigzags are labeled W and Y (and Z, if a triple).
The Basics of the Wave Principle20
Figure 9 Figure 10
Figure 11
Robert R. Prechter, Jr. 21
Figure 15Figure 14
Figure 13Figure 12
FLATS (3-3-5)
A flat correction differs from a zigzag in that the sub-wave sequence is 3-3-5, as shown in Figures 12 and 13.Since wave A lacks sufficient downward force to unfoldinto a full five waves as it does in a zigzag, the B wavereaction seems to inherit this lack of countertrend pres-sure and terminates near the start of wave A. Wave C, inturn, generally terminates just slightly beyond the end ofwave A rather than significantly beyond as in zigzags.
Flat corrections usually retrace less of preceding im-pulse waves than do zigzags. They participate in periodsinvolving a strong larger trend and thus virtually always
The Basics of the Wave Principle22
precede or follow extensions. The more powerful the un-derlying trend, the briefer the flat tends to be. Withinimpulses, fourth waves frequently sport flats, while secondwaves rarely do.
Three types of 3-3-5 corrections have been identifiedby differences in their overall shape. In a regular flatcorrection, wave B terminates about at the level of thebeginning of wave A, and wave C terminates a slight bitpast the end of wave A, as we have shown in Figures 12and 13. Far more common, however, is the variety calledan expanded flat, which contains a price extreme beyondthat of the preceding impulse wave. In expanded flats, waveB of the 3-3-5 pattern terminates beyond the starting levelof wave A, and wave C ends more substantially beyondthe ending level of wave A, as shown in Figures 14 and 15.
In a rare variation on the 3-3-5 pattern, which we calla running flat, wave B terminates well beyond the begin-ning of wave A as in an expanded flat, but wave C fails totravel its full distance, falling short of the level at whichwave A ended. There are hardly any examples of this typeof correction in the price record.
HORIZONTAL TRIANGLES (TRIANGLES)
Triangles are overlapping five wave affairs that sub-divide 3-3-3-3-3. They appear to reflect a balance of forces,causing a sideways movement that is usually associatedwith decreasing volume and volatility. Triangles fall intofour main categories as illustrated in Figure 16. These il-lustrations depict the first three types as taking placewithin the area of preceding price action, in what may betermed regular triangles. However, it is quite common,particularly in contracting triangles, for wave b to exceedthe start of wave a in what may be termed a running tri-angle, as shown in Figure 17.
Robert R. Prechter, Jr. 23
Figure 16
The Basics of the Wave Principle24
Although upon extremely rare occasions a second wavein an impulse appears to take the form of a triangle, tri-angles nearly always occur in positions prior to the finalactionary wave in the pattern of one larger degree, i.e., aswave four in an impulse, wave B in an A-B-C, or the finalwave X in a double or triple zigzag or combination (seenext section).
COMBINATIONS (DOUBLE AND TRIPLE THREES)
Elliott called sideways combinations of corrective pat-terns double threes and triple threes. While a singlethree is any zigzag or flat, a triangle is an allowable finalcomponent of such combinations and in this context iscalled a three. A double or triple three, then, is a combi-nation of simpler types of corrections, including the varioustypes of zigzags, flats and triangles. Their occurrence ap-pears to be the flat corrections way of extending sidewaysaction. As with double and triple zigzags, each simple cor-rective pattern is labeled W, Y and Z. The reactionarywaves, labeled X, can take the shape of any corrective pat-tern but are most commonly zigzags. Figures 18 and 19show two examples of double threes.
For the most part, double threes and triple threes arehorizontal in character. One reason for this trait is that
Figure 17
Robert R. Prechter, Jr. 25
Figure 19
Figure 18
there is never more than one zigzag in a combination. Nei-ther is there more than one triangle. Recall that trianglesoccurring alone precede the final movement of a largertrend. Combinations appear to recognize this character andsport triangles only as the final wave in a double or triplethree.
All the patterns illustrated in this booklet take thesame form whether within a larger rising or falling trend.In a falling trend, they are simply inverted.
The Basics of the Wave Principle26
GUIDELINES OF WAVE FORMATION
ALTERNATION
The guideline of alternation states that if wave two ofan impulse is a sharp retracement, expect wave four to bea sideways correction, and vice versa. Figure 20 shows themost characteristic breakdowns of impulse waves, both upand down. Sharp corrections never include a new price ex-treme, i.e., one that lies beyond the orthodox end of thepreceding impulse wave. They are almost always zigzags(single, double or triple); occasionally they are double threesthat begin with a zigzag. Sideways corrections include flats,triangles, and double and triple corrections. They usuallyinclude a new price extreme, i.e., one that lies beyond theorthodox end of the preceding impulse wave.
DEPTH OF CORRECTIVE WAVES
No market approach other than the Wave Principlegives as satisfactory an answer to the question, How fardown can a bear market be expected to go? The primaryguideline is that corrections, especially when they them-
Figure 20
Robert R. Prechter, Jr. 27
Figure 21
selves are fourth waves, tend to register their maximumretracement within the span of travel of the previous fourthwave of one lesser degree, most commonly near the level ofits terminus. Note in Figure 21, for instance, how wave 2ends at the level of wave four of 1, and how wave 4 ends atthe level of wave four of 3.
CHANNELING TECHNIQUE
Elliott noted that parallel trend channels typicallymark the upper and lower boundaries of impulse waves,often with dramatic precision. Analysts should draw themin advance to assist in determining wave targets and toprovide clues to the future development of trends.
The Basics of the Wave Principle28
To draw a proper channel, first connect the ends ofwaves two and four. If waves one and three are normal,the upper parallel most accurately forecasts the end of wave5 when drawn touching the peak of wave three, as in Fig-ure 21. If wave three is abnormally strong, almost vertical,then a parallel drawn from its top may be too high. Expe-rience has shown that a parallel to the baseline thattouches the top of wave one is then more useful.
The question of whether to expect a parallel channelon arithmetic or semilog (percentage) scale is still unre-solved as far as developing a definite tenet on the subject.If the price development at any point does not fall neatlywithin two parallel lines on the scale (either arithmetic orsemilog) you are using, switch to the other scale in orderto observe the channel in correct perspective. To stay ontop of all developments, the analyst should always use both.
Within parallel channels and the converging lines ofdiagonal triangles, if a fifth wave approaches its uppertrendline on declining volume, it is an indication that theend of the wave will meet or fall short of it. If volume isheavy as the fifth wave approaches its upper trendline, itindicates a possible penetration of the upper line, whichElliott called throw-over. Throw-overs also occur, withthe same characteristics, in declining markets.
VOLUME
In normal fifth waves below Primary degree, volumetends to be less than in third waves. If volume in an ad-vancing fifth wave of less than Primary degree is equal toor greater than that in the third wave, an extension of thefifth is in force. While this outcome is often to be expectedanyway if the first and third waves are about equal inlength, it is an excellent warning of those rare times whenboth a third and a fifth wave are extended.
Robert R. Prechter, Jr. 29
At Primary degree and greater, volume tends to behigher in an advancing fifth wave merely because of thenatural long term growth in the number of participants inbull markets.
LEARNING THE BASICS
The Wave Principle is unparalleled in providing anoverall perspective on the position of the market most ofthe time. While this perspective is extremely comfortingand useful, the more practical goal of any analytical methodis to identify market lows suitable for entering positionson the long side and market highs offering the opportu-nity to take profits or enter the short side. The Elliott WavePrinciple is especially well suited to these functions. Nev-ertheless, the Wave Principle does not provide certaintyabout any one market outcome. One must understand andaccept that any approach that can identify high odds for afairly specific outcome will produce a losing bet some ofthe time.
What the Wave Principle provides is an objectivemeans of assessing the relative probabilities of possiblefuture paths for the market. Whats more, competent ana-lysts applying the rules and guidelines of the Wave Principleobjectively should usually agree on the order of those prob-abilities. At any time, two or more valid waveinterpretations are usually acceptable by the rules of theWave Principle. The rules are highly specific and keep thenumber of valid alternatives to a minimum. Among thevalid alternatives, the analyst will generally regard as pre-ferred the interpretation that satisfies the largest numberof guidelines and will accord top alternate status to theinterpretation satisfying the next largest number of guide-lines, and so on.
The Basics of the Wave Principle30
Alternate interpretations are extremely important.Your second-best count is an essential aspect of tradingwith the Wave Principle, because in the event that themarket fails to follow the preferred scenario, your top al-ternate count becomes your backup plan.
The best approach is deductive reasoning. Knowingwhat Elliott rules will not allow, one can deduce that what-ever remains must be the most likely course for the market.By applying all the rules of extensions, alternation, over-lapping, channeling, volume and the rest, the analyst hasa much more formidable arsenal than one might imagineat first glance.
Most other approaches to market analysis, whetherfundamental, technical or cyclical, disallow other than ar-bitrarily chosen stop points, thus keeping either risk orfrequency of stop-outs high. The Wave Principle, in con-trast, provides a built-in objective method for placing aloss-limiting stop. Since Elliott wave analysis is based uponprice patterns, a pattern identified as having been com-pleted is either over or it isnt. If the market changesdirection, the analyst has caught the turn. If the marketmoves beyond what the apparently completed pattern al-lows, the conclusion is wrong, and any funds at risk can bereclaimed immediately.
Of course, there are often times when, despite a rigor-ous analysis, the question may arise as to how a developingmove is to be counted or perhaps classified as to degree.When there is no clearly preferred interpretation, the ana-lyst must wait until the count resolves itself, in other words,to sweep it under the rug until the air clears, as HamiltonBolton suggested. Almost always, subsequent moves willclarify the status of previous waves by revealing their po-sition in the pattern of the next higher degree. Whensubsequent waves clarify the picture, the probability thata turning point is at hand can suddenly and excitingly riseto nearly 100%.
Robert R. Prechter, Jr. 31
The ability to identify junctures is remarkable enough,but the Wave Principle is the only method of analysis whichalso provides guidelines for forecasting. Many of theseguidelines are specific and can occasionally yield resultsof stunning precision. If indeed markets are patterned, andif those patterns have a recognizable geometry, then re-gardless of the variations allowed, certain price and timerelationships are likely to recur. In fact, real world experi-ence shows that they do. The next section addresses someadditional guidelines that are helpful in the forecastingexercise.
The Basics of the Wave Principle32
THE FIBONACCI SEQUENCEAND ITS APPLICATION
Known for centuries by scientists, naturalists andmathematicians, the sequence of numbers 1, 1, 2, 3, 5, 8,13, 21, 34, 55, 89, 144, and so on to infinity is known todayas the Fibonacci sequence. The sum of any two adjacentnumbers in this sequence forms the next higher numberin the sequence, viz., 1 plus 1 equals 2, 1 plus 2 equals 3, 2plus 3 equals 5, 3 plus 5 equals 8, and so on to infinity. Theratio of any two consecutive numbers in the sequence ap-proximates 1.618, or its inverse, .618, after the first severalnumbers. Refer to Figure 22 for a complete ratio table in-terlocking all Fibonacci numbers from 1 to 144.
1.618 (or .618) is known as the Golden Ratio or GoldenMean. Nature uses the Golden Ratio in its most intimatebuilding blocks and in its most advanced patterns, in formsas minuscule as atomic structure and DNA molecules tothose as large as planetary orbits and galaxies. It isinvolved in such diverse phenomena as quasi crystalarrangements, planetary distances and periods, reflectionsof light beams on glass, the brain and nervous system,musical arrangement, and the structures of plants andanimals. Science is rapidly discovering that there is indeeda basic proportional principle of nature. The stock markethas the very same mathematical base as do these naturalphenomena.
At every degree of stock market activity, a bull mar-ket subdivides into five waves and a bear marketsubdivides into three waves, giving us the 5-3 relation-ship that is the mathematical basis of the Elliott WavePrinciple. We can generate the complete Fibonacci se-quence by using Elliotts concept of the progression of themarket. If we start with the simplest expression of the con-cept of a bear swing, we get one straight line decline. Abull swing, in its simplest form, is one straight line advance.
Robert R. Prechter, Jr. 33
Figu
re 2
2
The Basics of the Wave Principle34
A complete cycle is two lines. In the next degree of com-plexity, the corresponding numbers are 3, 5 and 8. Asillustrated in Figure 23, this sequence can be taken to in-finity.
In its broadest sense, then, the Elliott Wave Principleproposes that the same law that shapes living creaturesand galaxies is inherent in the spirit and attitudes of menen masse. The Elliott Wave Principle shows up clearly in
Figure 23
Robert R. Prechter, Jr. 35
the market because the stock market is the finest reflectorof mass psychology in the world. It is a nearly perfect re-cording of mans social psychological states and trends,reflecting the fluctuating valuation of his own productiveenterprise, and making manifest its very real patterns ofprogress and regress. Whether our readers accept or rejectthis proposition makes no great difference, as the empiricalevidence is available for study and observation. Order inlife? Yes. Order in the stock market? Apparently.
RATIO ANALYSIS
Ratio analysis has revealed a number of precise pricerelationships that occur often among waves. There are twocategories of relationships: retracements and multiples.
Retracements
Fairly often, a correction retraces a Fibonacci percent-age of the preceding wave. As illustrated in Figure 24, sharpcorrections tend more often to retrace 61.8% or 50% of theprevious wave, particularly when they occur as wave 2 ofan impulse wave, wave B of a larger zigzag, or wave X in amultiple zigzag. Sideways corrections tend more often toretrace 38.2% of the previous impulse wave, particularlywhen they occur as wave 4, as shown in Figure 25.
Figure 24 Figure 25
The Basics of the Wave Principle36
Retracements are where most analysts place their fo-cus. Far more reliable, however, are relationships betweenalternate waves, or lengths unfolding in the same direc-tion, as explained in the next section.
Motive Wave Multiples
When wave 3 is extended, waves 1 and 5 tend towardsequality or a .618 relationship, as illustrated in Figure 26.Actually, all three motive waves tend to be related by Fi-bonacci mathematics, whether by equality, 1.618 or 2.618(whose inverses are .618 and .382). These impulse waverelationships usually occur in percentage terms. For in-stance, wave I in the Dow Jones Industrials from 1932 to1937 gained 371.6%, while wave III from 1942 to 1966gained 971.7%, or 2.618 times as much.
Figure 26 Figure 28Figure 27
Robert R. Prechter, Jr. 37
Wave 5s length is sometimes related by the Fibonacciratio to the length of wave 1 through wave 3, as illustratedin Figure 27. In those rare cases when wave 1 is extended,it is wave 2 that often subdivides the entire impulse waveinto the Golden Section, as shown in Figure 28.
In a related observation, unless wave 1 is extended,wave 4 often divides the price range of an impulse waveinto the Golden Section. In such cases, the latter portion is.382 of the total distance when wave 5 is not extended, asshown in Figure 29, and .618 when it is, as shown inFigure 30. This guideline explains why a retracement fol-lowing a fifth wave often has double resistance at the samelevel: the end of the preceding fourth wave and the .382retracement point.
Corrective Wave Multiples
In a zigzag, the length of wave C is usually equal tothat of wave A, as shown in Figure 31, although it is notuncommonly 1.618 or .618 times the length of wave A.This same relationship applies to a second zigzag relativeto the first in a double zigzag pattern, as shown in Figure32.
Figure 30Figure 29
The Basics of the Wave Principle38
In a regular flat correction, waves A, B and C are, ofcourse, approximately equal. In an expanded flat correc-tion, wave C is usually 1.618 times the length of wave A.Often wave C will terminate beyond the end of wave A by.618 times the length of wave A. Each of these tendencies
Figure 31 Figure 32
Figure 33
Robert R. Prechter, Jr. 39
are illustrated in Figure 33. In rare cases, wave C is 2.618times the length of wave A. Wave B in an expanded flat issometimes 1.236 or 1.382 times the length of wave A.
In a triangle, we have found that at least two of thealternate waves are typically related to each other by .618.I.e., in a contracting, ascending or descending triangle,wave e = .618c, wave c = .618a, or wave d = .618b. In anexpanding triangle, the multiple is 1.618.
In double and triple corrections, the net travel of onesimple pattern is sometimes related to another by equal-ity or, particularly if one of the threes is a triangle, by.618.
Finally, wave 4 quite commonly spans a gross or netprice range that has an equality or Fibonacci relationshipto its corresponding wave 2. As with impulse waves, theserelationships usually occur in percentage terms.
These guidelines increase dramatically in utility whenused together, as several are simultaneously applicable inalmost every situation at the various degrees of trend.
The Basics of the Wave Principle40
PERSPECTIVE
What the Wave Principle says is that mankindsprogress (of which the stock market is a popularly deter-mined valuation) does not occur in a straight line, doesnot occur randomly, and does not occur cyclically. Rather,progress takes place in a three steps forward, two stepsback fashion, a form that nature prefers. As a corollary,the Wave Principle reveals that periods of setback in factare a requisite for social (and perhaps even individual)progress.
Until a few years ago, the idea that market movementsare patterned was highly controversial, but recent scien-tific discoveries have established that pattern formationis a fundamental characteristic of complex systems, whichinclude financial markets. Some such systems undergopunctuated growth, that is, periods of growth alternat-ing with phases of non-growth or decline, building fractallyinto similar patterns of increasing size. This is preciselythe type of pattern identified in market movements by R.N.Elliott some sixty years ago.
Most important to individuals, portfolio managers andinvestment corporations is that the Wave Principle oftenindicates in advance the relative magnitude of the nextperiod of market progress or regress. Living in harmonywith those trends can make the difference between suc-cess and failure in financial affairs.
To obtain a full understanding of the Wave Principle,including the terms and patterns, please read Elliott WavePrinciple by A.J. Frost and Robert Prechter. We wish youevery success.
Robert R. Prechter, Jr. 41
GLOSSARY
Alternation (guideline of) - If wave two is a sharp cor-rection, wave four will usually be a sideways correction,and vice versa.Apex - Intersection of the two boundary lines of a con-tracting triangle.Corrective Wave - A three-wave pattern, or combina-tion of three-wave patterns, that moves in the oppositedirection of the trend of one larger degree.Diagonal Triangle (Ending) - A wedge-shaped patterncontaining overlap that occurs only in fifth or C waves.Subdivides 3-3-3-3-3.Diagonal Triangle (Leading) - A wedge-shaped pat-tern containing overlap that occurs only in first or A waves.Subdivides 5-3-5-3-5.Double Three - Combination of two simple sideways cor-rective patterns, labeled W and Y, separated by a correctivewave labeled X.Double Zigzag - Combination of two zigzags, labeled Wand Y, separated by a corrective wave labeled X.Equality (guideline of) - In a five-wave sequence, whenwave three is the longest, waves five and one tend to beequal in price length.Expanded Flat - Flat correction in which wave B entersnew price territory relative to the preceding impulse wave.Failure - See Truncated Fifth.Flat - Sideways correction labeled A-B-C. Subdivides 3-3-5.Impulse Wave - A five-wave pattern that subdivides 5-3-5-3-5 and contains no overlap.Motive Wave - A five-wave pattern that makes progress,i.e., any impulse or diagonal triangle.Irregular Flat - See Expanded Flat.
The Basics of the Wave Principle42
One-two, one-two - The initial development in a five-wave pattern, just prior to acceleration at the center ofwave three.Overlap - The entrance by wave four into the price ter-ritory of wave one. Not permitted in impulse waves.Previous Fourth Wave - The fourth wave within thepreceding impulse wave of the same degree. Correctivepatterns typically terminate in this area.Sharp Correction - Any corrective pattern that doesnot contain a price extreme meeting or exceeding that ofthe ending level of the prior impulse wave; alternateswith sideways correction.Sideways Correction - Any corrective pattern that con-tains a price extreme meeting or exceeding that of theprior impulse wave; alternates with sharp correction.Third of a Third - Powerful middle section within animpulse wave.Thrust - Motive wave following completion of a triangle.Triangle (contracting, ascending or descending) -Corrective pattern, subdividing 3-3-3-3-3 and labeled A-B-C-D-E. Occurs as a fourth, B, X or Y wave. Trendlinesconverge as pattern progresses.Triangle (expanding) - Same as other triangles buttrendlines diverge as pattern progresses.Triple Three - Combination of three simple sidewayscorrective patterns labeled W, Y and Z, each separated bya corrective wave labeled X.Triple Zigzag - Combination of three zigzags, labeledW, Y and Z, each separated by a corrective wave labeledX.Truncated Fifth - The fifth wave in an motive patternthat fails to exceed the price extreme of the third wave.Zigzag - Sharp correction, labeled A-B-C. Subdivides 5-3-5.
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