What is the Elliot Wave Theory - Clif Droke

Chapter 2

The term "Elliot Wave Theory" is being used more and more and more in the vocabulary of traders and investors around the world today. The theory itself has been around for many decades and popularized in the 1970s by Robert Prechter and A.J. Frost, through their book, Elliot Wave Principle. It has been learned by countless thousands of traders over the years and is increasingly incorporated in computer trading programs.

Despite all of this, however, there seems to be a very low comprehension of its tenets among traders and almost no consensus among practitioners of Elliot Wave Theory as to how the theory should be applied in order to best maximize profits. The aim of this book is to instruct the reader in the proper use of the theory for maximum profitability in almost any market. We will show you how to avoid the most common pitfalls that Elliot adherents encounter and how you can avoid the mistakes that most of the leading exponents of the theory make.

Before we do, however, we must lay the foundation for understanding Elliot Wave. It is essential that the analyst have a firm grasp of the basics of the theory and its application to financial markets.

In attempting to formally define the Elliot Wave Theory, we quote from Frost & Prechter in their seminal work, Elliot Wave Principle.

The 'Elliot Wave Principle' is Ralph Nelson Elliot's discovery that social, or crowd, behavior trends and reverses in recognizable patterns. Using Stock market data for the Dow Jones Industrial Average (DJIA) as his main research tool, Elliot discovered that the ever-changing path of stock market prices reveals a structural design that in turn reflects a basic harmony found in nature. From this discovery, he developed a rational system of market analysis. Elliot isolated thirteen pattern, or "waves," that recur in markets and are repetitive in form, but are not necessarily repetitive in time or amplitude. He named, defined and illustrated the patterns. He then described how these structures link together to form larger versions of the same patterns, how those in turn are the building blocks for patterns of the next larger size, and so on. His descriptions constitute a set of empirically derived rules and guidelines for interpreting market action. Elliot claimed predictive value for the Wave Principle, which now bears the name, "The Elliot Wave Principle."

Broadly speaking, the Elliot Wave Theory (which we will henceforth abbreviate with EWT) can be summarized in the following statement, also by Frost & Prechter:

In markets, progress ultimately takes form of five waves of a specific structure. Three of these waves, which are labeled 1, 3 and 5, actually effect the directional movement. They are separated by two counter trend interruptions, which are labeled 2 and 4... R.N. Elliot did not specifically state that there is only one over-riding form, the "five wave" pattern, but that is undeniably the case. At the time, the market may be identified as being somewhere in the basic five wave pattern at the largest degree trend. Because the five wave pattern is the overriding form of market progress, all other patterns are subsumed by it.

Before we can begin to discuss the nuances of the theory, it will be helpful to define a couple of terms that relate to EWT. There are two basic types of "waves" in any given market-impulsive and corrective. Impulsive waves are those price movements that are ascending in tandem with a rising trend or falling in a falling trend, while corrective waves are those waves that are falling counter to a rising trend, or rising in a falling trend. To provide for a better understanding of this, the following illustration should help: A completed Elliot Wave Cycle consists of five impulsive waves and three corrective waves:

As you can see, the three wave "correction" is labeled "A-B-C," which is standard Elliot Wave taxonomy. So then, the primary assumption of the Elliot Wave Theory is that each movement, or wave, of a price trend consists of five components - waves one through five. These five waves are followed by three corrective waves.

The term "wave" itself has its origin from Dow Theory, as Charles Dow first made the analogy of stock market movements as compared to the waves of the ocean. In his book, Elliot Wave Explained, Robert Beckman observed that "the waves are subordinate to the tide, the ripples in the water subordinate to the waves, each rising and falling with rhythmic regularity, self-generated and forming cross currents, but the whole governed by seemingly moon-driven tidal forces." Beckman further note that this comparison illustrates the various trends of share price, "sometimes acting concurrently, sometimes running contradictorily, but always subject to an overriding force." Beckman summarizes the most important rules governing Elliot Wave Theory as follows:

For every action there is a reaction. Stock market movements in the direction of the main trend are impulsive moves. Stock market movements counter to the main trend are corrective moves. An impulse move is always followed by a corrective move. Generally, all impulsive moves must have subordinate waves while all corrective moves have three waves.

  1. For every action there is a reaction. Stock market movements in the direction of the main trend are impulsive moves. Stock market movements counter to the main trend are corrective moves. An impulse move is always followed by a corrective move.
  2. Generally, all impulsive moves have subordinate waves while all corrective moves have three waves.

    When the main trend is upward, waves 1, 3, and 5 are impulsive moves and waves 2 and 4 are corrective moves. When the main trend is downward, the first and third waves become impulsive moves, while the second wave becomes a corrective move.

    The action of the main trend can be taking place over a time frame of anything from a few hours to many years. When the main trend has completed a series of five waves, it reverses and a counter move of three waves is expected.

    When completed, a move comprising five waves followed by a counter move consisting of three waves is the first cycle movement. This complete cycle movement will represent the first and second waves of a cycle in the time frame of the next higher degree.

    The Elliot Wave Theory is multifractal in nature, which is defined as a geometric shape that can be separated into parts, each of which is a reduced-scale version of the whole. The multifractal nature of the Elliot Wave Principle is illustrated below:

    In a nutshell, the Elliot Wave cycles can be numbered as 5-3-5-3-5-5-3-5. Elliot Wave Theory postulates that, regardless of size, a complete stock market cycle comprises eight movements. Those eight movements comprise the first five impulsive waves and the first three corrective waves of a market cycle.

    At this point, the theory gets a little more complex (and fascinating). Since Elliot Waves are multifractal, each individual wave subdivides into a further series of waves identical in form and number to the overall larger pattern of 5-3-5-3-5. For instance, wave 1 of a given impulsive Elliot Wave pattern subdivides into 5 additional waves. Of these five subdivided waves, a further subdivision is found which corresponds to the larger pattern in Pandora's Box fashion. Wave 2 subdivides into three "A-B-C" waves, and so on.

    These subdivided waves are classified according to cycle degree. In formulating this theory, Elliot labeled each of these cycles, from the very smallest to largest. The standard Elliot Wave classification - from greatest to least - is as follows:

    Grand Supercycle

    Supercycle

    Cycle

    Primary

    Intermediate

    Minor

    Minute

    Minuette

    The largest of these wave cycles, Grand Supercycle, can typically be said to encompass 100 years or more. Each subsequent cycle classification encompasses a progressively smaller timetable up until the Minuette cycle, which can last from a few hours to a few days. Elliot even went one step further and christened a class of waves in the "subminuette" category, which typically last for only a few minutes or less. For all intents and purposes most traders may disregard this class of waves as it is normally too inconsequential to merit tracking.

    In fact, as we will explain later in the book, traders will do well to ignore every wave cycle classification except for the minor, intermediate, and to a much more limited degree, the primary cycles.

    A numerical system for labeling wave progress was created by Elliot and further refined and modified years later by Robert Prechter, editor and publisher of the Elliot Wave Theorist. For academic purposes we include the wave labeling system here, but we will largely ignore it for the remainder of the book; thus, it is not necessary for the reader to memorize this system.

    Before closing this chapter it is necessary to delineate the basic rules of the overall Elliot Wave structure. They are as follows:

    1. A cycle may not be said to be complete until a 5-3 pattern is traced out.
    1. Waves are measured by distance covered on the chart (in terms of share price), not by time. (Time is relatively unimportant in our study of Elliot Wave Theory)
    1. Concerning the requisites for wave lengths it is sufficient to note that wave 3 in an impulsive 5-wave move is usually the longest wave of the 5 waves, and never the shortest.
    Of the three impulsive waves in a 5-wave sequence (the other two being corrective) two of the three waves tend toward equality, usually, but not always, waves one and five.
  1. In like manner, waves two and four tend toward equality (in terms of distance covered).
In a clear rising or falling trend, the bottom of wave four must never penetrate the bottom of wave two; otherwise your wave count is incorrect.
  1. In many unfolding waves, the 4th wave reaction (also known as "corrective") is equal to the 1st wave impulse. Similarly, the 5th wave impulse is often equivalent to the 2nd wave reaction.
  1. In corrective moves, waves A and C of the A-B-C correction tend toward equality in most instances.
  1. Wave B of the A-B-C correction must never penetrate below the bottom of wave A.
  1. A-B-C corrections, regardless of where they occur in a wave sequence, typically retrace one-third of the previous 5-wave sequence. A-B-C corrections tend to stop at the bottom of wave 4 in upward trends and at the top of wave 4 in downward trends.
  1. Fourth wave frequently take the form of a consolidation and often take the form of triangles or pennants on the chart.
While by no means providing a comprehensive explanation of all the nuances of EWT, this chapter lays out the basic tenets that will enable the beginning student to grasp the theory and apply it with at least some success. It will also help the intermediate-to-advanced Elliot students brush up on the basics and perhaps even gain new insight. In the chapters that follow we will delve into greater detail.