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 he Wave Principle is Ralph Nelson Elliott’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, Elliott 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.
Under the Wave Principle, every market decision
is both produced by meaningful information and produces meaningful
information. Each transaction, while at once an effect, enters the fabric
of the market and, by communicating transactional data to investors, joins the
chain of causes of others’ behavior. This feedback loop is governed by
man’s social nature, and since he has such a nature, the process
generates forms. As the forms are repetitive, they have predictive value.
Elliott isolated thirteen “waves,” or patterns of
directional movement, 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. The patterns that naturally occur under the Wave Principle are
described below.
The Five Wave Pattern
In markets, progress ultimately takes the 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
countertrend interruptions, which are labeled 2 and 4, as shown in Figure 1. The
two interruptions are apparently a requisite for overall directional movement to
occur.
Figure 1
At any time, the market may be identified as
being somewhere in the basic five wave pattern at the largest degree of trend.
Because the five wave pattern is the overriding form of market progress, all
other patterns are subsumed by it.
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