“There is a reason for everything, and it is everyone’s duty to try to discover it. R. N. Elliott
Elliott Waves is a theory describing the interaction, development and change of people’s moods by recognizing special patterns. Back in the last century, Ralph Nelson Elliott revealed that price changes in the stock market occur according to certain patterns. These observations allowed Elliott to make outstanding market forecasts: he was able to predict large-scale stock market reversals in advance and accurately.
A little historical background
Ralph Elliott was engaged in the analysis of financial markets and at one point he discovered that there were certain regularities in the development of market quotes. He managed to systematize these patterns, presenting them in the form of 13 models (later they became known as waves).
The models appeared in the price data of stock markets each time, which allowed the author not only to identify them, but also to illustrate them. Each of the waves was clearly shown, as well as the relationship between them. In addition, Elliott discovered that market movements are essentially fractals. According to this hypothesis, any price movement can be represented as a set of wave patterns regardless of the asset in question and the timeframe used. At the same time, small models form larger patterns.
At present we can often encounter various interpretations of the Wave Principle by various modern experts that often do not have a solid evidence base. However, it is safe to say that the ideas proposed by the author have been fully tested by time and proved their effectiveness.
The financier Robert Prekter has played a great role in the development and popularization of the Wave Principle. He contributed greatly to the standardization of wave analysis, clarified many of the rules, and explained the mechanism of wave formation. Robert Prekter called the Wave Analysis one of the most effective tools of market analysis and forecasting.
What is the Wave Principle
In total, Elliott singled out 13 patterns that recur in historical data of market prices. Later he gave names to all these models, demonstrated them with illustrations, and formulated a list of rules that must be observed in each model.
Later, Elliott showed how waves form larger analogs; these analogs form the same models, but larger in size. This is how a structured progression is formed, which he later called the “Wave Principle”.
The Wave Principle gives the analyst a treasure trove of information about the current position of the market in the behavioral continuum and allows to get an idea about its probable behavior in the future. Thus, the main value of the Wave Theory is that it provides a context for subsequent analysis, which forms the basis for a perspective view.
Five wave model
Elliott identified one pattern: any price movement takes the form of five waves of a certain structure. Three waves – 1, 3, 5 (see Figure 1.1) – act as the reason for the directional movement. This movement is opposed by waves 2 and 4; they are directed in the opposite direction from the main trend. Two interruptions are necessary for the formation of a general directional movement.
The author also drew attention to three permanent properties of waves:
- (2) does not cross the origin of (1);
- (3) is not the shortest;
- (4) does not end on the price territory (1).
It is important to emphasize that Elliott did not state that there is only one 5-wave model. But after a long period of time, one can say that this is indeed the case. Any random segment of the stock market can be defined as being in one of 5 waves of any higher degree.
What types of waves exist
According to the methodology of Wave Analysis, there are driving waves and corrective waves.
A moving wave significantly pushes the stock market up or down. The distinguishing feature of moving waves is the 5-wave structure.
Correctional wave applies to counter-trend interruptions. It got its name for its ability to appear as a response to a moving wave with the recovery of only part of the available progress. Correctional waves have a 3-wave structure or one of its variations.
That is, the difference between the driving and corrective waves is very significant. They differ both in structure and in their role.
The complete cycle
The complete cycle consists of eight waves and includes two stages. The first stage is a five-wave moving stage. In communication, this stage is very often referred to as the “5” stage. The second stage is a corrective stage consisting of three waves. In communication, this stage is often referred to as a “three”.
The first stage is indicated by numbers on the chart, and the second stage by letters.
Figure 1.2 shows an 8-wave cycle. We can observe that after the end of one cycle the next one is formed, i.e. another 5-wave movement begins to develop. This development leads to the emergence of a new 5-wave pattern, which will have a higher degree than the waves of which it is composed.
The result of this movement is illustrated in Fig.1.3. This 5-wave pattern, marked on the chart by (1), (2), (3), (4) and (5) is further corrected by a 3-wave pattern of the same degree (it is marked by letters (A), (B) and (C)).
Examining Figure 1.3, it becomes clear that each unidirectional sub-wave (1,3,5) of the driving wave is nothing but a reduced copy of the driving wave. We can also see that waves 1+2 or 3+4 of the completed cycle act as a reduced copy of this cycle.
It is important to understand one more fundamental point.
Fig. 1.3 is not just a scaled-down copy of Fig. 1.2. Fig. 1.3 is more detailed compared to Fig. 1.2.
In Fig. 1.2, the sub-waves 1, 3 and 5 are the driving waves, which, when viewed in more detail, are “five waves”. Each corrective wave (waves 2 and 4) in a more detailed examination are three waves.
Thus, Fig. 1.3 perfectly illustrates the principle of fractality. It shows 2 waves, 8 or 34 waves, depending on the degree that we consider.
The essence of design
The basic essence of the construction lies in one obvious fact – moving waves are not always directed upwards, and corrective waves are not always directed downwards. The type of wave should be determined not by absolute, but by relative motion. If the waves are directed in an identical direction to the waves of a greater degree, they belong to the moving type. Correctional waves develop in the opposite direction from the wave per unit of greater degree.
The main tendency of the Elliott theory is the development of one big trend consisting of five waves in one direction and the subsequent corrective reaction to the growth consisting of three waves. This peculiarity is peculiar to all degrees of a trend. From Fig. 1.3 it is clear that wave (A), like wave (C), is a moving wave and is directed downward, while wave (B) becomes a corrective wave that resists the directional movement that develops within wave (A). The relationship between the form and directional movement is shown in Fig. 1.4, which is a logical continuation of Fig. 1.3.
It follows from this figure that in the market cycle waves are divided according to a known principle:
The construction of waves with a higher degree will occur until the end of the movement. Also, the reverse process of division into smaller degrees can continue indefinitely.
Elliott did not have to speculate on why any market movement consists of 5 driving waves and 3 corrective waves. He simply emphasized the real fact that he managed to discover. But does the form have to have exactly five waves of progress and three of regression? With a little thought, it is easy to conclude that this is one of the minimum requirements. Nevertheless, it is the most obvious and effective way of making progress in linear motion. One wave by itself is not a wobble, which means a minimum of three waves is required to create a wobble. Without a dimensional setting, three waves in both directions cannot produce progress. Progress in one direction requires a movement consisting of at least five waves. This is an important condition, without which it will not be possible to go more distance than the next three corrective waves. There may be more waves in theory, but it is the 5-3 model that is the most effective model of discontinuous development, and nature is known to follow the most rational path.
Sources: by J. Frost and R. Prekter: “Eliot’s Wave Principle. The Key to Market Behavior” 2005