The Elliott Wave Principle began as a classification of rules for defining and interpreting a relatively small number of patterns in the major stock indexes. The Elliott analyst’s basic objective is to ultimately (and correctly) count a complete market cycle of five waves up, followed by three waves down. In the 1930s, Ralph Nelson Elliott put forth the proposition that this “five waves up, followed by three waves down” was a form or pattern that occurred in the market, regardless of time. In other words, the basic pattern occurs over different scales of time. Thus, a five-wave rally, followed by a three-wave decline, would be classified as the first and second waves of a pattern of one larger wave degree. In that simple observation, Elliott argued that the market could be analyzed in terms of wave form and wave degree. The form was constant, regardless of whether the analyst was monitoring the movements of the market on an hourly, daily, weekly, monthly, or quarterly time scale (or even larger). Thus, Elliott suggested that the market expands and contracts according to a definable or set pattern.

Elliott went so far as to give names to the different wave degrees. In order of increasing scale or degree, they are: subminuette, minuette, minute, minor, intermediate, primary, cycle, super cycle, and grand super cycle.

He also gave a name to both the five-wave rally and the three-wave decline. A five-wave structure is called an “impulse” wave – a trend move. The three-wave structure is called (not surprisingly) a “corrective” wave – it goes against the trend.

Impulse Waves: The ability to count from one to five does not make one an Elliott analyst. There are two inviolate rules that help the analyst to determine when a “five” really is a legitimate impulse wave.

1. In an impulse wave, the fourth wave cannot overlap the first wave. In other words, the end of the wave 4 correction cannot penetrate the terminus of wave 1.

2. Wave 3 can never be shorter than both waves 1 and 5. Wave 3 can be shorter than either wave 1 or wave 5, but not both. Indeed, wave 3 is often the longest and strongest impulse wave within the sequence.

There is a third element that is referred to as “The Rule of Alternation”, although we tend to view it as a strong guideline. In a five-wave sequence, the analyst should expect waves two and four to alternate in their complexity. For example, if wave 2 is fairly straightforward, wave 4 is likely to be more complex or frustrating. The opposite is also true.

Thus, if a rule is broken, the analyst will have to take what superficially looks like a five-wave pattern and safely assume that a different wave count is unfolding.

Impulse waves are labeled with numerals.

Corrective Waves: These are the waves that, by definition, go against the trend. They connect the impulse waves. Unfortunately, there are four different types of corrective wave. Corrective waves are labeled with letters.

1. The most simple or straightforward corrective pattern is the zig-zag. The pattern is a simple A-B-C pattern and tends to do more damage to the preceding trend than other corrective waves. Waves “A” and “C” are the trend moves and, therefore, are five-wave structures, while wave “B” is a three-wave pattern that retraces only part of the “A” wave. Thus, the A-B-C is an internal 5-3-5.
   
    

2. The flat is an A-B-C pattern that trends mostly in a sideways fashion (therefore, doing less damage to the underlying trend). The “A” and “B” waves are three wave structures, while the “C” wave is an impulsive pattern. Thus, the A-B-C is an internal 3-3-5. Unlike the zig-zag, the “B” wave often ends at or beyond the start of the “A” wave.
   
    

3. Nominally, there are four different kinds of triangle (symmetrical, expanding, ascending, and descending). Nonetheless, they all occur in the penultimate position prior to the final movement of the larger trend. Thus, triangles typically occur as a fourth wave or as a “B” wave. Structurally, the pattern is labeled “A-B-C-D-E” and each of those legs is made up of three waves. Thus, the A-B-C-D-E is an internal 3-3-3-3-3. The contracting triangle is shown below.
   
    

4. A zig-zag and a flat (and even a triangle) can be referred to as a “single three”. However, there are less common and more complex patterns known as double or triple threes. They are a combination of single threes that are joined by a connecting “X” wave. Double threes are made up of seven waves (A-B-C-X-A-B-C), while triple threes have 11 waves (A-B-C-X-A-B-C-X-A-B-C). A double-three is shown here:
   
    

By now, it is probably fairly obvious that, especially when compared to the straightforward five-wave impulse wave, corrective waves can be extremely confusing and can confound even the most experienced analyst. As a result, the analyst is advised not to use Elliott in isolation.

Fibonacci Analysis: One of the – if not the – most important tools the Elliott analyst can utilize in “counting” waves is Fibonacci analysis. This is another topic about which whole books have been written. Leonardo Fibonacci developed the sequence that bears his name many centuries ago. We will not get into how the sequence was created (hint: it has to do with rabbits). The result is a series of numbers – 1, 2, 3, 5, 8, 13, 21, etc on to infinity – where any member of the sequence is derived by adding the two numbers immediately preceding it.

The numbers themselves are useful. The numbers 5 and 3 (as in five waves up and three waves down) are Fibonacci numbers. Moreover, it is not uncommon for a rally or decline to approximate a Fibonacci number of points or take place over a Fibonacci number of days, weeks, months, or years. However, the greater value of Fibonacci has to do with the ratios between the numbers in the sequence. After the first few numbers, the ratio of any two consecutive numbers approximates 1.618 or its inverse, 0.618. Similarly, between alternate numbers, the ratio is 2.618 or its inverse, 0.382. The 1.618 and 0.618 ratios have importance in the worlds of science, architecture, and art through such tools as the logarithmic spiral, the golden section, and the golden triangle. In other words, it is a phenomenon that occurs in nature.

In the stock market, corrections often retrace a preceding rally by a Fibonacci ratio. Similarly, impulse waves are often related to each other by 0.618, 1.00, or 1.618. As a result, an Elliott analyst will often make “forecasts” or confirm his analysis through the use of these “wave relationships”. (Similar ratio analysis is often applied to time.)

There is much more to Fibonacci than can be highlighted here (just as there is much more to Elliott). The bottom line is that it is a critical tool in the overall analysis. Where Elliott provided the form, Fibonacci provided the symmetry.

References: For those interested in a more detailed explanation of the Elliott Wave, two books on the subject include R. N. Elliott’s Masterworks, edited by Robert R. Prechter, Jr. and The Elliott Wave Principle, by A. J. Frost and Robert R. Prechter, Jr.

Dow Jones Industrial Average 1929 through November 2003