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Technical Analysis - Elliott Wave, Gann and
2. Elliott Wave Introduction
Secrets of Price Bars
Fibonacci Number Sequence
Market Cycles and Fibonacci
Elliott Wave Principle
This is an explanation of Elliott Wave Principle by Robert Prechter. The
text is taken from one of EWI’s most popular titles, Prechter’s Perspective.
What is the Wave Principle?
The Wave Principle is, first and foremost, a detailed description of how
markets behave. Now, there’s probably more that is not in that sentence than
is in that sentence. For instance, a detailed description of how markets
behave does not refer to what outside events are occurring, such as in the
fields of economics, politics, or social trends. It’s strictly a study of
how human beings behave collectively in the trading arena.
What specifically did Elliott discover?
Elliott’s most important discovery was that the patterns that develop in
the stock market occur at all degrees of trend. The larger patterns are made
up of components that are themselves composed of smaller ones. The same
patterns on a smaller scale combine to create any one of those patterns on a
larger scale. The larger pattern will combine with several others of the
same degree to create an even larger pattern and so on. He described in
detail exactly what those patterns look like. He identified 13 of them. Only
recently has data been available for general stock prices back to the late
1700s, and the patterns are there as well.
How did he label the “degrees” of trend?
Elliott began by naming a particular structure with an arbitrary label,
Primary degree, a term borrowed from Dow Theory. The next larger degree he
called Cycle, and the next larger Supercycle. The lower degrees he named
Intermediate, Minor, and so on. We therefore have a way to refer to the
degrees of trend that we are talking about.
What was the biggest degree trend he talked about?
Grand Supercycle, which he guessed dated back to the founding of the
United States. Since then, more detailed stock market data has confirmed
that he was right. That’s not the biggest degree, though, as all waves are
components of larger ones.
You once referred to the Wave Principle as the “purest form of technical
For a hundred years, investors have noticed that events external to the
market often seem to have no effect on the market’s progress. With the
knowledge that the market continuously unfolds in waves that are related to
each other through form and ratio, we can see why there is little
connection. The market has a life of its own. It is mass psychology that is
registering. Changes in feelings show up directly as price changes in the
barometer known as the DJIA, or the S&P 500, or any other index. The Wave
Principle is a catalog of the ways that the crowd goes from the extreme
point of pessimism at the bottom to the extreme point of optimism at the
top. It is a description of the steps human beings go through when they are
part of the investment crowd, to change their psychological orientation from
bullish to bearish and back again. That description fits the movement of any
market, as long as human beings are involved, rather than Martians, who may
have a differently operating unconscious mind. Since people don’t change
much, the path they follow in moving from extreme pessimism to extreme
optimism and back again tends to be the same over and over and over,
regardless of news and extraneous events.
What is the basic path?
Very simply, Elliott recognized that movement in the direction of the one
larger trend subdivides into five waves. Movement against the trend
subdivides into a three-wave pattern or some variation involving several
three-wave patterns. In rising markets, true bull markets, the subdivisions
occur in five waves up, an up-down-up-down-up sequence. Bear markets tend to
occur in three wave sequences, down-up-down. Each one of those movements has
a shape and a personality. As long as you can recognize the shapes that are
occurring, you have a handle on what might happen next.
But the five-wave form does occur on the downside?
Yes, but only as a component of a larger three-wave pattern. The essence
of the Wave Principle is that the moves in the direction of the one larger
trend are five-wave structures, while moves against the one larger trend are
three-wave structures. From that, you can tell what the underlying trend is
and invest accordingly.
You just go on Elliott’s description alone. Does that mean you must act
without knowing what’s causing the pattern?
On the contrary, I know what is causing the patterns: human nature as it
relates to a person interacting with his fellows. When you ask what outside
force is “causing” the patterns, you are asking the wrong question, so you
are already on the wrong path. Elliott’s description of how markets behave
forces you to a conclusion about cause and effect in social events. All of
the causes most people assume to be operative are not, such as the latest
political speeches or the latest numbers on the economy. They are simply
results of the patterns of mass human psychology.
Is Elliott’s a mechanical system?
Not really. What we’re dealing with here is the behaviour of people. If
the tools you work with measure something other than the behaviour of people,
you’ll be removed from the reality of what’s going on. One of the biggest
failures, in terms of approaching the stock market, is to assume that the
market is mechanical in the sense that outside action causes market
reaction, such as the idea that the market “responds” to Fed policy or the
trade balance or political decisions. Others have tried to reduce it to a
sum of periodic sine waves, but always find that it cannot be done, because
the market is not a time-repetitive machine in its essence.
From the standpoint of theory, market behaviour is tied to a mathematical
law, but it is just not the same type of law found in the physical sciences.
From the standpoint of practical application, the Wave Principle is tracking
a living system, which is allowed variation in its forms, in fact, infinite
variation, but limited by an essential form. Whereas a rigid system with
numbers, strict mechanical numbers, never works.
Doesn’t infinite variation imply that anything goes?
Not at all. Trees vary infinitely, but they all look like trees, don’t
they? And you can tell them apart from clouds, which also vary infinitely,
and buildings as well. In fact, despite infinite variability, they are
amazingly similar. The same is true of market patterns.
Does knowing Elliott guarantee profits?
Only the most trained and experienced market participants can act
contrarily to their natural tendencies. I have yet to meet a man who
invested or traded with a completely rational program based on reasonable
probabilities without allowing his greed, his fear, his extraneous opinions
or his irrelevant judgments to interfere. It is man’s emotional side,
particularly his social dependency, that makes him think the way his fellows
do, and when he does that, he loses money in the markets. At least using
Elliott, you have a basis that makes winning possible.
Most people are more interested in how the Wave Principle works than why
it works. Is there any one thing people need to remember to make it work for
The key to Elliott Wave patterns is that the market goes three steps
forward for every two steps back. If you do not get scared by the two steps
back, and if you are not euphorically confident after the third step
forward, you’re light-years ahead of the pack. Even then, I would add that
it is one easy thing to recognize that the Wave Principle governs stock
prices, while it is quite another to predict the next wave, and still
another to profit from the exercise. There is no substitute for experience,
so that you can learn what you feel and when you feel it, with respect to
Jack Frost has described the Wave Principle as something that has to be
seen to be believed. What does he mean by that?
The principle is complicated to express in words. With the Wave
Principle, you are dealing with a phenomenon that reveals itself visually.
Try describing the concept and variations of “tree” in detail to someone
who’s never seen one and you’ll see that it can be a complex task. Saying,
“Look! There’s one,” is a lot easier. The human brain is very good at
recognizing a pattern visually. If a computer must be programmed to
recognize shapes in the sky, it would be difficult to teach it the
difference between a cloud and bird and an airplane. Once you have that
programmed, of course, a blimp floats by and the computer is in trouble. The
human brain works differently, however, and is extremely efficient at
pattern recognition. If you draw out the Principle, it is much more quickly
grasped. Then when you compare actual market pictures with the model, you
can accept the truth more readily. It is at the perceptual level that it is
best presented, then, not the conceptual.
Can you really teach it?
Sure. Video is an excellent approach, for instance. A lot of people have
learned how to apply it that way. Some have trouble at first, but then say
“Once I saw your video tape, I understood it all.”
What are the Wave Principle’s key strengths?
Frost liked to say, “Its most striking characteristics are its generality
and its accuracy.” Its generality gives market perspective most of the time,
and its accuracy in pointing out changes in direction is almost unbelievable
Why does the Wave Principle work so well?
Because it is 100% technical. No armchair theorizing from economics and
politics is required.
What are its biggest shortcomings?
There is one main weakness, and this accounts for just about all the
problems. There are eleven different patterns for corrections. When a
correction starts, it is impossible to tell in advance which pattern has
begun, so you do not know how it is going to unfold. Therefore, the best
that you can do is apply some of Elliott’s observations as guidelines in
making an intelligent guess as to what it is.
Another problem is that corrections can do what Elliott called “double”
or “triple” — that is, repeat several times. Triple corrections are the
largest formations possible, so at least there is a limit. These repetitions
can be frustrating because they can last decades. For example, we had a
16-year sideways correction in the Dow Jones Industrial Average from 1966 to
1982. A.J. Frost and I thought it was over in 1974, and the market was ready
for another bull wave. To be sure, most stocks rose from that point forward,
but the Dow went sideways for another eight years in a doubling of the time
element, which caused some frustrations before the next bull wave finally
began on August 12, 1982.
It sounds like a chess game. The number of possibilities, and therefore
the probabilities of success, vary at certain junctures.
Chess provides an excellent analogy. The market can do whatever it wants,
except that it will always do it in an Elliott Wave structure. Similarly,
your opponent can move chess pieces wherever he wants, except that he must
follow basic rules. On the other side of the board, you still have a lot of
hard thinking to do despite your absolute knowledge that pieces must move
according to those rules.
Are there situations where the Wave Principle does not hold true?
No, it always holds true. But of course, it is one thing to say the
markets will follow the Wave Principle and another thing entirely to
forecast the future based on that knowledge. It is always a question of
probabilities. Once you have hands-on experience with it, once you
understand all the rules and guidelines, it is a lot like becoming Sherlock
Holmes. There are many possible outcomes, but guidelines force you along
certain paths of thinking. You finally reach a point where the evidence
becomes overwhelming for a certain conclusion.
Have you ever had a case where you thought the probability of a certain
outcome was high, say 90%, but the market went otherwise from your
expectation? What did you do then?
Of course it happens. But you should never be wrong for long relative to
the degree that you are trying to assess. One of the terrific things about
the approach is that it’s price that tips you off. With other approaches,
price can go a long way before the reason behind your opinion changes, if it
ever does. No matter how difficult the pattern is to read sometimes, it
always resolves satisfactorily into a classic pattern.
Can you illustrate how knowledge of “wave structure” comes into play when
For instance, the bottom of the fourth wave, which is a pullback, cannot
overlap the peak of the first rally. If it does, then it’s not a fourth
wave. The fourth wave is still ahead of you, and the third wave is
subdividing. Knowing this tenet can keep you out of a lot of trouble that an
armchair wave counter would encounter. Another very basic tenet is that wave
three is never the shortest. It is usually the longest. Wave three is the
recognition stage when most people get aboard.
But if there is always a correct pattern, and it is only a matter of
seeing it, why aren’t accuracy levels higher than the 40%, 50%, 60% or even
the 80% ratios of hits to misses?
First, just because R.N. Elliott discerned that the market follows rules
as in a chess game doesn’t mean you can predict the market’s next move. All
you can give are probabilities. But the psychological difficulties are at
least an equal impediment. Hamilton Bolton once said that the hardest thing
he had to learn when using Elliott was to believe what he saw. Despite all I
know, I have fallen prey to that problem more than once. The fact that even
perfect analysis only results in the best probability provides the
uncertainty that feeds the psychological unease. As Frost is fond of saying,
“The market always leaves its options open.” So when you combine human
weakness with a game of probability, the result is many errors in judgment.
Nevertheless, I must stress that the ratio of success with Elliott is better
than that with other approaches, and that is the only rational basis for
judging its value. Besides, the inestimable value of the Wave Principle is
not so much that it provides a high percentage of correct “calls” on the
market, but that it always gives the investor a sense of perspective.
Is it possible that the system merely takes into account every possible
pattern and thus allows the practitioner to force things into a satisfactory
wave count retrospectively — but not prospectively?
No, for two reasons. First, if that were true, then there would be no
record of success such as the Wave Principle has over the decades. There are
numerological approaches to the market, ones based on fantasy that may as
well be dealing with a random walk, and they produce worthless results, as
they should. As Paul Montgomery likes to say, a good test of a theory is
whether it can predict. Second, there are many non-Elliott patterns that the
market could trace out if it were a random walk; but it has never done it. I
have never seen a market unfold in other than an Elliott Wave pattern.