Elliott-Wave-Basics.pdf

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 USA 800-336-1618 or 770-536-0309 or fax 770-536-2514 THE BASICS OF THE ELLIOTT WAVE PRINCIPLE Copyright © 1995-2004 by Robert R. Prechter, Jr. Printed in the United States of America First Edition: August 1995 Second Edition: February 1996 Third Edition: April 2000 Fourth Edition: June 2004 August 2007 For information, address the publishers: New Classics Library a division of Elliott Wave International Post Office Box 1618 Gainesville, Georgia 30503 USA All rights reserved. The material in this volume may not be reprinted or reproduced in any manner whatsoever. Violators will be prosecuted to the fullest extent of the law. Cover design: Marc Benejan Production: Pamela Greenwood ISBN: 0-932750-63-X CONTENTS 7 The Basics 7 The Five Wave Pattern 8 Wave Mode 10 The Essential Design 11 Variations on the Basic Theme 12 Wave Degree 14 Motive Waves 14 Impulse 16 Extension 17 Truncation 18 Diagonal Triangles (Wedges) 19 Corrective Waves 19 Zigzags (5-3-5) 21 Flats (3-3-5) 22 Horizontal Triangles (Triangles) 24 Combinations (Double and Triple Threes) 26 Guidelines of Wave Formation 26 Alternation 26 Depth of Corrective Waves 27 Channeling Technique 28 Volume 29 Learning the Basics 32 The Fibonacci Sequence and its Application 35 Ratio Analysis 35 Retracements 36 Motive Wave Multiples 37 Corrective Wave Multiples 40 Perspective 41 Glossary N. Bob was working as an analyst for Merrill Lynch when he discovered the complete body of R. and received a level of recognition that no other such publication has ever achieved. studied price movements in the financial markets and observed that certain patterns repeat themselves. Mr. Prechter left Merrill Lynch in 1979 to start the monthly publication. and a new focus for Wall Street and investors worldwide was born. a corporate accountant by pro- fession. The stunning accuracy of the forecasts in The Elliott Wave Theorist earned numerous awards. Elliott called his discovery “the Wave Principle. Knowledge of the Wave Principle among private and professional investors grew dramatically in the 1980s. Elliott said. Mr. FOREWORD By understanding the Wave Principle. What appears random and unrelated. Elliott’s work in the New York Public Library.J. to be followed by a record bear market. you can antici- pate large and small shifts in the psychology driving any investment market and help yourself minimize the emo- tions that drive your own investment decisions. Frost published Elliott Wave Principle in 1978. Where did this valuable tool come from? Ralph Nelson Elliott. will actually trace out a recogniz- able pattern once you learn what to look for. Their forecast called for a roaring bull market in the 1980s. The book received enthusiastic reviews and became a Wall Street bestseller.” and its implications were huge. Robert Prechter resurrected the Wave Principle from near obscurity in 1976. from financial markets to fash- ion. The Elliott Wave Theo- rist. from politics to popular culture. He offered proof of his discovery by making astonishingly ac- curate stock market forecasts. -iv - . He had identified the common link that drives the trends in human affairs. Prechter and A. It is no coincidence that the global acceptance of the Elliott Wave Principle has paralleled the growth of Elliott Wave International (EWI). Chinese. and Russian. video tapes. Swedish. the market analysis and pub- lishing corporation founded by Robert R. -v - . special reports and books. Polish. Jr. German. The revolution in instant data transmission has given us a perfect vehicle for around-the-clock coverage of global financial markets. Spanish. Elliott Wave International is one of the world’s larg- est providers of technical analysis. EWI has earned the reputa- tion as the world’s premier publisher of Elliott wave analysis and investment commentary. hotlines and educational services that include periodic conferences. intensive workshops and tutorials. In the two decades since then. Tens of thousands of investors use the Wave Principle to guide their finan- cial decisions. through distributors and representa- tives. Dutch. We also provide monthly publications. Japanese. We now provide institutional and private investors with 24-hour market commentary via electronic delivery. Prechter. Prechter and Frost’s book has now been translated into French. Tens of thousands more have bought products indirectly. most notably the two-volume set. In De- cember 1989. Conquer the Crash — You Can Survive and Prosper in a Deflationary Crash and Depression.” Bob served for nine years on the Board of the Market Technicians Association and in 1990-1991 served as its president. Socionomics – The Science of History and Social Predic- tion. In 2003. In 1999. was a New York Times and Wall Street Journal business best- seller. Bob has writ- ten 13 books on finance. Robert Prechter has been publishing market commentary since 1976.S. He began his career with the Merrill Lynch Market Analysis Department in New York. he expanded his firm to provide analysis for institutions on every major financial market in the world. In 1984. Traders Library granted him its Hall of Fame award. Frost Memorial Award for Outstanding Contribution to the Development of Technical Analysis. -vi - . His recent title. Bob received the CSTA’s first annual A. Trading Championship with a real-money trading account. Bob set a record in the options division of the U.J. During the 1990s. ABOUT THE AUTHOR Founder and president of Elliott Wave International. Financial News Network (now CNBC) named him “Guru of the Decade. This feedback loop is governed by man’s social nature. From this discovery. His descriptions constitute a set of empirically derived rules and guidelines for interpreting market ac- tion. the process generates forms. every market decision is both produced by meaningful information and produces meaningful information. by communi- cating transactional data to investors. He named. while at once an effect. defined and illustrated the patterns. how those in turn are the building blocks for patterns of the next larger size. THE BASICS “The Wave Principle” is Ralph Nelson Elliott’s discov- ery that social. and so on. Under the Wave Principle. but are not necessarily repetitive in time or ampli- tude. behavior trends and reverses in recognizable patterns. which . joins the chain of causes of others’ behavior.” or patterns of direc- tional movement. he developed a rational system of market analysis. or crowd. they have predictive value. and since he has such a nature. progress ultimately takes the form of five waves of a specific structure. As the forms are repetitive. enters the fabric of the market and. Elliott isolated thirteen “waves. Three of these waves. The patterns that naturally occur under the Wave Principle are described below. that recur in markets and are repetitive in form. Using stock market data for the Dow Jones Industrial Average (DJIA) as his main research tool. The Five-Wave Pattern In markets. Elliott discovered that the ever-changing path of stock mar- ket prices reveals a structural design that in turn reflects a basic harmony found in nature. Each transaction. He then described how these structures link together to form larger versions of the same patterns. all other patterns are subsumed by it. Because the five-wave pattern is the over- riding form of market progress. while corrective waves have a three-wave structure or a varia- tion thereof. as shown in Figure 1. actually effect the directional move- ment. 3 and 5. They are separated by two countertrend interrup- tions. Motive mode is employed by both the five-wave . Motive waves have a five-wave structure. The two interruptions are apparently a requisite for overall directional movement to occur. the market may be identified as being somewhere in the basic five-wave pattern at the largest degree of trend. Wave Mode There are two modes of wave development: motive and corrective. At any time.8 The Basics of the Wave Principle Figure 1 are labeled 1. which are labeled 2 and 4. ” of the progress achieved by any preceding motive wave. waves 1. 3 and 5. 4. Just as wave 2 corrects wave 1 in Figure 1. or “correction. the sequence A. 9 pattern of Figure 1 and its same-directional components. as will be detailed in an upcoming section.e. which in- clude waves 2 and 4 in Figure 1. 5 in Figure 2.Robert R. Figure 2 . Their structures are called “motive” because they powerfully impel the market. and the three-wave corrective phase has sub- waves are denoted by letters. Jr. B. Prechter. Corrective mode is employed by all countertrend interruptions. C corrects the sequence 1. both in their roles and in their construction. Every motive wave is followed by a corrective wave. Thus. The five-wave motive phase has subwaves denoted by numbers. Their structures are called “corrective” because they can accomplish only a partial retracement. 2. the two modes are fun- damentally different. 3.. i. 10 The Basics of the Wave Principle Figure 3 The Essential Design Figure 3 not only illustrates a larger version of Figure 2. it also illustrates Figure 2 itself. which point downward. wave (B). 2. Similarly. B and C. the form is constant. Waves (1) and (2) in Figure 3. in greater detail. which points upward.” would take the same form as waves 1 and 2. Now observe that within the corrective pattern illus- trated as wave 2 in Figure 3. This construction . de- pending upon the degree to which we are referring. 4 and 5. Regardless of degree. eight waves or thirty-four waves. are each composed of five waves: 1. We can use Figure 3 to illustrate two waves. if examined under a “microscope. 3. is com- posed of three waves: A. waves (A) and (C). As long as progress continues. all waves both have and are component waves. is not so simple. this larger cycle automatically becomes two subdivisions of the wave of next higher degree. The mode of a wave is determined not by its absolute direction but primarily by its relative direction. Jr. trending in the same direction as wave 2. Variations on the Basic Theme The Wave Principle would be simple to apply if the basic theme described above were the complete descrip- tion of market behavior. The rest of this section fills out the description of how the market be- haves in reality. 11 discloses a crucial point: Motive waves do not always point upward. the real world. the essential underlying tendency of the Wave Principle is that action in the same direction as the one larger trend develops in five waves. Nor does Figure 3 imply finality. fortunately or unfortunately.Robert R. The re- verse process of subdividing into lesser degrees apparently continues indefinitely as well. As far as we can determine. the process of building to greater degrees continues. However. and in corrective mode (three waves or a variation) when trending in the opposite direc- tion. which will be discussed later in this chapter. at all degrees of trend. Waves (A) and (C) are motive. As before. In summary. and corrective waves do not always point down- ward. then. while reaction against the one larger trend develops in three waves. . Aside from four specific exceptions. waves divide in motive mode (five waves) when trending in the same direction as the wave of one larger degree of which it is a part. Wave (B) is corrective because it cor- rects wave (A) and is countertrend to wave 2. Prechter. from largest to smallest: Grand Supercycle Supercycle Cycle Primary Intermediate Minor Minute Minuette Subminuette Cycle waves subdivide into Primary waves that sub- divide into Intermediate waves that in turn subdivide into Minor and sub-Minor waves. Elliott discerned nine degrees of waves. He chose the names listed below to label these degrees. from the smallest wiggle on an hourly chart to the largest wave he could assume existed from the data then available. the analyst can iden- tify precisely the position of a wave in the overall progression of the market. much as longitude and latitude are used to identify a geographical location. It is important to understand that these labels refer to specifically identifiable degrees of waves.12 The Basics of the Wave Principle Wave Degree All waves may be categorized by relative size. To say. “the Dow Jones Industrial Average is in Minute wave 0 of Minor wave 1 of Intermediate wave (3) of Primary wave 5 of Cycle wave I of Supercycle wave (V) of the current Grand Supercycle” is to identify a specific point along the progression of market history. some scheme such as the one shown at right is recommended to differen- tiate the degrees of waves in the stock market’s progression. We have standardized the labels as follows: . By using this nomenclature. or de- gree. When numbering and lettering waves. Prechter. Jr. Robert R. 13 Wave Degree 5s With the Trend 3s Against the Trend (↑ next is Arabic symbols) (↑ next is caps) Grand Supercycle I & * ( ) a b c Supercycle (I) (II) (III) (IV) (V) (a) (b) (c) Cycle I II III IV V a b c Primary 1 2 3 4 5 A B C Intermediate (1) (2) (3) (4) (5) (A) (B) (C) Minor 1 2 3 4 5 A B C Minute 6 7 8 9 0 a b c Minuette (i) (ii) (iii) (iv) (v) (a) (b) (c) Subminuette i ii iii iv v a b c (↓ next is Arabic symbols) (↓ next is caps) . 3 and 5) of an impulse are themselves motive. As detailed in the preceding three paragraphs. The goal of a motive wave is to make progress. moreover. Typical. 3 and 4 depict impulses in the 1. Elliott further discovered that in price terms. the actionary subwaves (1. IMPULSE The most common motive wave is an impulse. 5. there are only a few simple rules for interpreting impulses prop- erly. truncation. wave 3 is often the longest and never the shortest among the three actionary waves (1. There are two types of motive waves: impulse and diagonal triangle. Within motive waves. always travels beyond the end of wave 1. and wave 4 always retraces less than 100% of wave 3. In addition. A and C wave positions. wave 4 does not enter the territory of (i. In an impulse.14 The Basics of the Wave Principle MOTIVE WAVES Motive waves subdivide into five waves and always move in the same direction as the trend of one larger degree. As long as wave 3 undergoes a greater percentage movement than either wave 1 or 5. including extension. wave 2 always retraces less than 100% of wave 1. 3. It almost always holds on an arithmetic basis as well. overlapping is usually confined to daily and intraday price fluctuations and even then is rare. . Guidelines of impulse formation. Even so.e. and subwave 3 is specifi- cally an impulse.. This rule holds for all non-leveraged “cash” markets. this rule is satisfied. Wave 3. can induce short term price extremes that would not occur in cash markets. A rule is so called because it governs all waves to which it applies. with their extreme leverage. Futures markets. “over- lap”) wave 1. alternation. yet not inevitable. 3 and 5) of a motive wave. characteris- tics of waves are called guidelines. and these rules of formation assure that it will. They are straightforward and relatively easy to recognize and interpret. Figures 2. 15 Figure 4 equality. we have found but one instance above Subminuette degree when all other rules and guidelines combined to suggest that a . channeling.Robert R. In many years of practice with countless patterns. A rule should never be disregarded. Jr. Prechter. personality and ratio relationships are discussed below. will clarify this point.16 The Basics of the Wave Principle rule was broken. Analysts who routinely break any of the rules detailed in this section are practicing some form of analysis other than that guided by the Wave Principle. The vast majority of impulse waves do con- tain an extension in one and only one of their three motive subwaves (1. producing a profile such as shown in Figure 5. 3 or 5). Often the third wave of an extended third wave is an extension. The diagrams in Figure 4. Extensions are elongated impulses with exaggerated subdivisions. Extension Most impulses contain what Elliott called an exten- sion. illustrat- ing extensions. Figure 5 . which we will explore further in discussing extensions. These rules have great practical utility in correct count- ing. Jr. Figure 6 Figure 7 .” or “truncated fifth. In application. a truncated fifth wave will often cut short an expected target. Truncation gives warning of underlying weakness or strength in the market.Robert R. This annoy- ance is counterbalanced by its clear implications for persistence in the new direction of trend. as illustrated in Figures 6 and 7. We prefer the less connotative term.” A truncation can usually be verified by noting that the presumed fifth wave contains the necessary five subwaves. Prechter. Truncation often occurs following a particularly strong third wave. “trunca- tion. 17 Truncation Elliott used the word “failure” to describe a situation in which the fifth wave does not move beyond the end of the third. overlaps) wave one. as it has one or two corrective characteristics. A diagonal triangle is a motive pattern. (See Figure 8.18 The Basics of the Wave Principle DIAGONAL TRIANGLES (WEDGES) A diagonal triangle is a special type of wave that oc- curs primarily in the fifth wave position at times when the preceding move has gone “too far too fast. yet not an impulse. They are the only five-wave structures in the di- rection of the main trend within which wave four almost always moves into the price ter- ritory of (i..) Figure 8 .” as Elliott put it.e. Diagonal tri- angles substitute for impulses at specific locations in the wave structure. Jr. 19 CORRECTIVE WAVES Markets move against the trend of one greater degree only with a seeming struggle. Triangle (3-3-3-3-3.Robert R. and triple). Resistance from the larger trend appears to prevent a correction from developing a full motive structure. 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. particularly when the first zigzag falls short of a normal target. As another result of the conflict between trends. includes three types: regular. ZIGZAGS (5-3-5) A single zigzag in a bull market is a simple three-wave declining pattern labeled A-B-C and subdividing 5-3-5. four types: three of the contract- ing variety (ascending. which always flow with comparative ease in the direction of the one larger trend. double. and running). The struggle between the two oppo- sitely trending degrees generally makes corrective waves less clearly identifiable than motive waves. three times in succession. Flat (3-3-5. descending. The top of wave B is noticeably lower than the start of wave A. each zigzag is sepa- rated by an intervening “three” (labeled X). producing what is called a double zigzag (see Figure 11) or triple zigzag. or at most. Occasionally zigzags will occur twice. and symmetrical) and one of the expanding variety (reverse symmetrical). Combination (two types: double three and triple three). expanded. In these cases. if a triple). The zigzags are labeled W and Y (and Z. Prechter. as illustrated in Figures 9 and 10. . 20 The Basics of the Wave Principle Figure 9 Figure 10 Figure 11 . Since wave A lacks sufficient downward force to unfold into a full five waves as it does in a zigzag. as shown in Figures 12 and 13. in turn. 21 Figure 12 Figure 13 FLATS (3-3-5) A flat correction differs from a zigzag in that the sub- wave sequence is 3-3-5. Flat corrections usually retrace less of preceding im- pulse waves than do zigzags.Robert R. generally terminates just slightly beyond the end of wave A rather than significantly beyond as in zigzags. They participate in periods involving a strong larger trend and thus virtually always Figure 14 Figure 15 . Wave C. Prechter. Jr. the B wave reaction seems to inherit this lack of countertrend pres- sure and terminates near the start of wave A. particularly in contracting triangles. however. and wave C ends more substantially beyond the ending level of wave A. They appear to reflect a balance of forces. The more powerful the un- derlying trend. However. causing a sideways movement that is usually associated with decreasing volume and volatility. wave B terminates about at the level of the beginning of wave A. and wave C terminates a slight bit past the end of wave A. for wave b to exceed the start of wave a in what may be termed a running tri- angle. which we call a running flat. HORIZONTAL TRIANGLES (TRIANGLES) Triangles are overlapping five wave affairs that sub- divide 3-3-3-3-3. in what may be termed regular triangles. In a regular flat correction. which contains a price extreme beyond that of the preceding impulse wave. . These il- lustrations depict the first three types as taking place within the area of preceding price action. fourth waves frequently sport flats. as shown in Figures 14 and 15. it is quite common. Far more common. There are hardly any examples of this type of correction in the price record. wave B of the 3-3-5 pattern terminates beyond the starting level of wave A. falling short of the level at which wave A ended. while second waves rarely do. Three types of 3-3-5 corrections have been identified by differences in their overall shape. Triangles fall into four main categories as illustrated in Figure 16. but wave C fails to travel its full distance. the briefer the flat tends to be.22 The Basics of the Wave Principle precede or follow extensions. as shown in Figure 17. Within impulses. as we have shown in Figures 12 and 13. is the variety called an expanded flat. In a rare variation on the 3-3-5 pattern. In expanded flats. wave B terminates well beyond the begin- ning of wave A as in an expanded flat. 23 Figure 16 .Robert R. Jr. Prechter. flats and triangles. or the final wave X in a double or triple zigzag or combination (see next section). As with double and triple zigzags. as wave four in an impulse. double threes and triple threes are horizontal in character. Figures 18 and 19 show two examples of double threes. The reactionary waves. Y and Z. can take the shape of any corrective pat- tern but are most commonly zigzags. Their occurrence ap- pears to be the flat correction’s way of extending sideways action. a triangle is an allowable final component of such combinations and in this context is called a “three. including the various types of zigzags.” While a single three is any zigzag or flat.e. each simple cor- rective pattern is labeled W.. i. labeled X.” A double or triple three. then. tri- angles nearly always occur in positions prior to the final actionary wave in the pattern of one larger degree. For the most part. One reason for this trait is that . wave B in an A-B-C. is a combi- nation of simpler types of corrections. COMBINATIONS (DOUBLE AND TRIPLE THREES) Elliott called sideways combinations of corrective pat- terns “double threes” and “triple threes.24 The Basics of the Wave Principle Figure 17 Although upon extremely rare occasions a second wave in an impulse appears to take the form of a triangle. Jr.Robert R. . they are simply inverted. Recall that triangles occurring alone precede the final movement of a larger trend. Nei- ther is there more than one triangle. 25 Figure 18 Figure 19 there is never more than one zigzag in a combination. All the patterns illustrated in this booklet take the same form whether within a larger rising or falling trend. Prechter. In a falling trend. Combinations appear to recognize this character and sport triangles only as the final wave in a double or triple three. Figure 20 DEPTH OF CORRECTIVE WAVES No market approach other than the Wave Principle gives as satisfactory an answer to the question. triangles. Sideways corrections include flats. and vice versa.26 The Basics of the Wave Principle GUIDELINES OF WAVE FORMATION ALTERNATION The guideline of alternation states that if wave two of an impulse is a sharp retracement. one that lies beyond the orthodox end of the preceding impulse wave. Sharp corrections never include a new price ex- treme. i. i. especially when they them- . both up and down.. double or triple).e. “How far down can a bear market be expected to go?” The primary guideline is that corrections. occasionally they are double threes that begin with a zigzag. expect wave four to be a sideways correction.. one that lies beyond the orthodox end of the preceding impulse wave. Figure 20 shows the most characteristic breakdowns of impulse waves. They are almost always zigzags (single. They usually include a new price extreme. and double and triple corrections.e. often with dramatic precision. Prechter. Jr. Note in Figure 21. tend to register their maximum retracement within the span of travel of the previous fourth wave of one lesser degree. for instance. 27 selves are fourth waves. . how wave 2 ends at the level of wave four of 1. and how wave 4 ends at the level of wave four of 3. Figure 21 CHANNELING TECHNIQUE Elliott noted that parallel trend channels typically mark the upper and lower boundaries of impulse waves. most commonly near the level of its terminus. Analysts should draw them in advance to assist in determining wave targets and to provide clues to the future development of trends.Robert R. almost vertical. If waves one and three are normal. if a fifth wave approaches its upper trendline on declining volume. The question of whether to expect a parallel channel on arithmetic or semilog (percentage) scale is still unre- solved as far as developing a definite tenet on the subject. first connect the ends of waves two and four. an extension of the fifth is in force. then a parallel drawn from its top may be too high. it indicates a possible penetration of the upper line. Expe- rience has shown that a parallel to the baseline that touches the top of wave one is then more useful. If wave three is abnormally strong. the analyst should always use both.28 The Basics of the Wave Principle To draw a proper channel. Within parallel channels and the converging lines of diagonal triangles. If volume in an ad- vancing fifth wave of less than Primary degree is equal to or greater than that in the third wave. volume tends to be less than in third waves. . To stay on top of all developments. While this outcome is often to be expected anyway if the first and third waves are about equal in length. as in Fig- ure 21. If volume is heavy as the fifth wave approaches its upper trendline.” Throw-overs also occur. in declining markets. it is an indication that the end of the wave will meet or fall short of it. which Elliott called “throw-over. with the same characteristics. it is an excellent warning of those rare times when both a third and a fifth wave are extended. If the price development at any point does not fall neatly within two parallel lines on the scale (either arithmetic or semilog) you are using. the upper parallel most accurately forecasts the end of wave 5 when drawn touching the peak of wave three. switch to the other scale in order to observe the channel in correct perspective. VOLUME In normal fifth waves below Primary degree. the more practical goal of any analytical method is to identify market lows suitable for entering positions on the long side and market highs offering the opportu- nity to take profits or enter the short side. While this perspective is extremely comforting and useful. the analyst will generally regard as pre- ferred the interpretation that satisfies the largest number of guidelines and will accord top alternate status to the interpretation satisfying the next largest number of guide- lines.” At any time. Prechter. volume tends to be higher in an advancing fifth wave merely because of the natural long term growth in the number of participants in bull markets. The rules are highly specific and keep the number of valid alternatives to a minimum. One must understand and accept that any approach that can identify high odds for a fairly specific outcome will produce a losing bet some of the time. What the Wave Principle provides is an objective means of assessing the relative probabilities of possible future paths for the market. competent ana- lysts applying the rules and guidelines of the Wave Principle objectively should usually agree on the order “of those prob- abilities. What’s more. . two or more valid wave interpretations are usually acceptable by the rules of the Wave Principle. the Wave Principle does not provide certainty about any one market outcome. Jr. Nev- ertheless. The Elliott Wave Principle is especially well suited to these functions.Robert R. and so on. Among the valid alternatives. 29 At Primary degree and greater. LEARNING THE BASICS The Wave Principle is unparalleled in providing an overall perspective on the position of the market most of the time. Most other approaches to market analysis. despite a rigor- ous analysis.” as Hamilton Bolton suggested. to “sweep it under the rug until the air clears. By applying all the rules of extensions. one can deduce that what- ever remains must be the most likely course for the market. the question may arise as to how a developing move is to be counted or perhaps classified as to degree. If the market changes direction. The Wave Principle. When there is no clearly preferred interpretation. and any funds at risk can be reclaimed immediately. the probability that a turning point is at hand can suddenly and excitingly rise to nearly 100%. When subsequent waves clarify the picture. the analyst has caught the turn. subsequent moves will clarify the status of previous waves by revealing their po- sition in the pattern of the next higher degree. a pattern identified as having been com- pleted is either over or it isn’t. in con- trast. because in the event that the market fails to follow the preferred scenario. the ana- lyst must wait until the count resolves itself. over- lapping. there are often times when. disallow other than ar- bitrarily chosen stop points. Your second-best “count” is an essential aspect of trading with the Wave Principle. If the market moves beyond what the apparently completed pattern al- lows. alternation. The best approach is deductive reasoning. . volume and the rest. Knowing what Elliott rules will not allow. the analyst has a much more formidable arsenal than one might imagine at first glance. provides a built-in objective method for placing a loss-limiting stop. Since Elliott wave analysis is based upon price patterns. Almost always.30 The Basics of the Wave Principle Alternate interpretations are extremely important. the conclusion is wrong. channeling. thus keeping either risk or frequency of stop-outs high. in other words. whether fundamental. your top al- ternate count becomes your backup plan. Of course. technical or cyclical. Jr. real world experi- ence shows that they do. . certain price and time relationships are likely to recur. Many of these guidelines are specific and can occasionally yield results of stunning precision. In fact. If indeed markets are patterned.Robert R. but the Wave Principle is the only method of analysis which also provides guidelines for forecasting. The next section addresses some additional guidelines that are helpful in the forecasting exercise. Prechter. then re- gardless of the variations allowed. 31 The ability to identify junctures is remarkable enough. and if those patterns have a recognizable geometry. a bull mar- ket subdivides into five waves and a bear market subdivides into three waves. 1 plus 1 equals 2.32 The Basics of the Wave Principle THE FIBONACCI SEQUENCE AND ITS APPLICATION Known for centuries by scientists. 34. 21. We can generate the complete Fibonacci se- quence by using Elliott’s concept of the progression of the market. 55. 2. or its inverse.618. giving us the 5-3 relation- ship that is the mathematical basis of the Elliott Wave Principle. 3. If we start with the simplest expression of the con- cept of a bear swing. Refer to Figure 22 for a complete ratio table in- terlocking all Fibonacci numbers from 1 to 144. in forms as minuscule as atomic structure and DNA molecules to those as large as planetary orbits and galaxies. 144. The sum of any two adjacent numbers in this sequence forms the next higher number in the sequence. The ratio of any two consecutive numbers in the sequence ap- proximates 1. is one straight line advance. the sequence of numbers 1. 1. musical arrangement. reflections of light beams on glass.618) is known as the Golden Ratio or Golden Mean. viz.. At every degree of stock market activity. 5. 1. 2 plus 3 equals 5. . 8. Science is rapidly discovering that there is indeed a basic proportional principle of nature.618. 89. The stock market has the very same mathematical base as do these natural phenomena.618 (or . 3 plus 5 equals 8. A bull swing. and so on to infinity is known today as the Fibonacci sequence. after the first several numbers. Nature uses the Golden Ratio in its most intimate building blocks and in its most advanced patterns. . planetary distances and periods. It is involved in such diverse phenomena as quasi crystal arrangements. the brain and nervous system. and the structures of plants and animals. and so on to infinity. 1 plus 2 equals 3. in its simplest form. we get one straight line decline. 13. naturalists and mathematicians. Prechter. 33 Figure 22 .Robert R. Jr. As illustrated in Figure 23. In its broadest sense. 5 and 8. In the next degree of com- plexity. this sequence can be taken to in- finity.34 The Basics of the Wave Principle Figure 23 A complete cycle is two lines. then. the Elliott Wave Principle proposes that the same law that shapes living creatures and galaxies is inherent in the spirit and attitudes of men en masse. The Elliott Wave Principle shows up clearly in . the corresponding numbers are 3. Robert R. particularly when they occur as wave 4. As illustrated in Figure 24. as shown in Figure 25. Whether our readers accept or reject this proposition makes no great difference. wave B of a larger zigzag. Order in the stock market? Apparently. as the empirical evidence is available for study and observation. and making manifest its very real patterns of progress and regress. Prechter. It is a nearly perfect re- cording of man’s social psychological states and trends.8% or 50% of the previous wave. particularly when they occur as wave 2 of an impulse wave. Sideways corrections tend more often to retrace 38.2% of the previous impulse wave. There are two categories of relationships: retracements and multiples. Jr. Order in life? Yes. RATIO ANALYSIS Ratio analysis has revealed a number of precise price relationships that occur often among waves. Retracements Fairly often. Figure 24 Figure 25 . sharp corrections tend more often to retrace 61. reflecting the fluctuating valuation of his own productive enterprise. 35 the market because the stock market is the finest reflector of mass psychology in the world. a correction retraces a Fibonacci percent- age of the preceding wave. or wave X in a multiple zigzag. 36 The Basics of the Wave Principle Retracements are where most analysts place their fo- cus.618 or 2.618 and .618 relationship. whether by equality. however.618 times as much. or 2. Figure 26 Figure 27 Figure 28 . as illustrated in Figure 26.618 (whose inverses are . Motive Wave Multiples When wave 3 is extended.6%. Actually. 1. or lengths unfolding in the same direc- tion. as explained in the next section. while wave III from 1942 to 1966 gained 971.382). Far more reliable. wave I in the Dow Jones Industrials from 1932 to 1937 gained 371. waves 1 and 5 tend towards equality or a . For in- stance. all three motive waves tend to be related by Fi- bonacci mathematics. are relationships between alternate waves.7%. These impulse wave relationships usually occur in percentage terms. In a related observation. the length of wave C is usually equal to that of wave A. as shown in Figure 29. as shown in Figure 30.618 when it is. unless wave 1 is extended. although it is not uncommonly 1. as shown in Figure 28. This guideline explains why a retracement fol- lowing a fifth wave often has double resistance at the same level: the end of the preceding fourth wave and the . wave 4 often divides the price range of an impulse wave into the Golden Section. 37 Wave 5’s length is sometimes related by the Fibonacci ratio to the length of wave 1 through wave 3. Prechter. . as illustrated in Figure 27. as shown in Figure 32. and .618 times the length of wave A. the latter portion is . as shown in Figure 31. Jr. Figure 29 Figure 30 Corrective Wave Multiples In a zigzag.382 retracement point. This same relationship applies to a second zigzag relative to the first in a double zigzag pattern.382 of the total distance when wave 5 is not extended. In those rare cases when wave 1 is extended. it is wave 2 that often subdivides the entire impulse wave into the Golden Section.618 or .Robert R. In such cases. In an expanded flat correc- tion. wave C is usually 1. Each of these tendencies Figure 33 . approximately equal.618 times the length of wave A. B and C are.618 times the length of wave A.38 The Basics of the Wave Principle Figure 31 Figure 32 In a regular flat correction. of course. waves A. Often wave C will terminate beyond the end of wave A by . ascending or descending triangle. the multiple is 1. as several are simultaneously applicable in almost every situation at the various degrees of trend.Robert R. by .618c. 39 are illustrated in Figure 33. Prechter. the net travel of one simple pattern is sometimes related to another by equal- ity or. I. Jr. or wave d = . In a triangle. wave e = . wave C is 2. these relationships usually occur in percentage terms. particularly if one of the threes is a triangle.e. In rare cases.618b.236 or 1. In double and triple corrections. These guidelines increase dramatically in utility when used together. wave 4 quite commonly spans a gross or net price range that has an equality or Fibonacci relationship to its corresponding wave 2. in a contracting. Finally. As with impulse waves.618. . Wave B in an expanded flat is sometimes 1. wave c = . we have found that at least two of the alternate waves are typically related to each other by ..618 times the length of wave A.618a.618. In an expanding triangle.382 times the length of wave A.618. periods of growth alternat- ing with phases of non-growth or decline. please read Elliott Wave Principle by A. does not occur randomly. the Wave Principle reveals that periods of setback in fact are a requisite for social (and perhaps even individual) progress. the idea that market movements are patterned was highly controversial. and does not occur cyclically. We wish you every success. Frost and Robert Prechter. Elliott some sixty years ago. To obtain a full understanding of the Wave Principle. which include financial markets. a form that nature prefers. Living in harmony with those trends can make the difference between suc- cess and failure in financial affairs. Until a few years ago. two steps back” fashion. portfolio managers and investment corporations is that the Wave Principle often indicates in advance the relative magnitude of the next period of market progress or regress. This is precisely the type of pattern identified in market movements by R. Some such systems undergo “punctuated growth. As a corollary. . but recent scien- tific discoveries have established that pattern formation is a fundamental characteristic of complex systems. Rather.” that is.N.40 The Basics of the Wave Principle PERSPECTIVE What the Wave Principle says is that mankind’s progress (of which the stock market is a popularly deter- mined valuation) does not occur in a straight line.J. building fractally into similar patterns of increasing size. Most important to individuals. progress takes place in a “three steps forward. including the terms and patterns. Intersection of the two boundary lines of a con- tracting triangle.See Expanded Flat. Subdivides 3- 3-5.. waves five and one tend to be equal in price length. Impulse Wave . .If wave two is a sharp cor- rection. Failure . Subdivides 5-3-5-3-5. and vice versa.Combination of two zigzags.A three-wave pattern. Double Three .A five-wave pattern that makes progress.In a five-wave sequence. Double Zigzag . Apex . Expanded Flat . separated by a corrective wave labeled X. Prechter.A five-wave pattern that subdivides 5- 3-5-3-5 and contains no overlap.A wedge-shaped pat- tern containing overlap that occurs only in first or A waves.e. that moves in the opposite direction of the trend of one larger degree. 41 GLOSSARY Alternation (guideline of) . Irregular Flat .A wedge-shaped pattern containing overlap that occurs only in fifth or C waves. Corrective Wave .Combination of two simple sideways cor- rective patterns. Diagonal Triangle (Ending) . Subdivides 3-3-3-3-3. Motive Wave .Flat correction in which wave B enters new price territory relative to the preceding impulse wave. any impulse or diagonal triangle. when wave three is the longest.Robert R.Sideways correction labeled A-B-C. labeled W and Y. separated by a corrective wave labeled X. Diagonal Triangle (Leading) . labeled W and Y. wave four will usually be a sideways correction. or combina- tion of three-wave patterns. Jr. i. Flat . Equality (guideline of) .See Truncated Fifth. alternates with sideways correction.The entrance by wave four into the price ter- ritory of wave one. B.42 The Basics of the Wave Principle One-two.Combination of three zigzags. Y and Z.Sharp correction. each separated by a corrective wave labeled X. Trendlines converge as pattern progresses. Corrective patterns typically terminate in this area. Triangle (contracting. Previous Fourth Wave .Motive wave following completion of a triangle.Any corrective pattern that does not contain a price extreme meeting or exceeding that of the ending level of the prior impulse wave. Triangle (expanding) . Occurs as a fourth. Y and Z. Not permitted in impulse waves. Thrust . ascending or descending) - Corrective pattern.The fourth wave within the preceding impulse wave of the same degree.Powerful middle section within an impulse wave. alternates with sharp correction. Sideways Correction .Combination of three simple sideways corrective patterns labeled W. labeled A-B-C.The fifth wave in an motive pattern that fails to exceed the price extreme of the third wave. Third of a Third .The initial development in a five- wave pattern. Subdivides 5- 3-5.Same as other triangles but trendlines diverge as pattern progresses. Sharp Correction . Truncated Fifth . . labeled W. one-two . Triple Three . subdividing 3-3-3-3-3 and labeled A- B-C-D-E. Triple Zigzag .Any corrective pattern that con- tains a price extreme meeting or exceeding that of the prior impulse wave. just prior to acceleration at the center of wave three. each separated by a corrective wave labeled X. Zigzag . Overlap . X or Y wave. recorded over 15 years ago. 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