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THE BASICS

OF THE

ELLIOTT WAVE PRINCIPLE

by Robert R. Prechter, Jr.

Published by NEW CLASSICS LIBRARY a division of

Post Office Box 1618, Gainesville, GA 30503 USA 800-336-1618 or 770-536-0309 or fax 770-536-

7 The Basics 7 The Five Wave Pattern 8 Wave Mode 10 The Essential Design 11 Variations on the Basic Theme 12 Wave Degree

14 Motive Waves 14 Impulse 16 Extension 17 Truncation 18 Diagonal Triangles (Wedges)

19 Corrective Waves 19 Zigzags (5-3-5) 21 Flats (3-3-5) 22 Horizontal Triangles (Triangles) 24 Combinations (Double and Triple Threes)

26 Guidelines of Wave Formation 26 Alternation 26 Depth of Corrective Waves 27 Channeling Technique 28 Volume 29 Learning the Basics

32 The Fibonacci Sequence and its Application 35 Ratio Analysis 35 Retracements 36 Motive Wave Multiples 37 Corrective Wave Multiples

40 Perspective

41 Glossary

CONTENTS

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FOREWORD

By understanding the Wave Principle, you can antici- pate large and small shifts in the psychology driving any investment market and help yourself minimize the emo- tions that drive your own investment decisions. Where did this valuable tool come from? Ralph Nelson Elliott, a corporate accountant by pro- fession, studied price movements in the financial markets and observed that certain patterns repeat themselves. He offered proof of his discovery by making astonishingly ac- curate stock market forecasts. What appears random and unrelated, Elliott said, will actually trace out a recogniz- able pattern once you learn what to look for. Elliott called his discovery “the Wave Principle,” and its implications were huge. He had identified the common link that drives the trends in human affairs, from financial markets to fash- ion, from politics to popular culture. Robert Prechter resurrected the Wave Principle from near obscurity in 1976. Bob was working as an analyst for Merrill Lynch when he discovered the complete body of R.N. Elliott’s work in the New York Public Library. Mr. Prechter and A.J. Frost published Elliott Wave Principle in 1978. The book received enthusiastic reviews and became a Wall Street bestseller. Their forecast called for a roaring bull market in the 1980s, to be followed by a record bear market. Mr. Prechter left Merrill Lynch in 1979 to start the monthly publication, The Elliott Wave Theo- rist , and a new focus for Wall Street and investors worldwide was born. Knowledge of the Wave Principle among private and professional investors grew dramatically in the 1980s. The stunning accuracy of the forecasts in The Elliott Wave Theorist earned numerous awards, and received a level of recognition that no other such publication has ever achieved.

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ABOUT THE AUTHOR

Founder and president of Elliott Wave International, Robert Prechter has been publishing market commentary since 1976. He began his career with the Merrill Lynch Market Analysis Department in New York. In 1984, Bob set a record in the options division of the U.S. Trading Championship with a real-money trading account. In De- cember 1989, Financial News Network (now CNBC) named him “Guru of the Decade.” Bob served for nine years on the Board of the Market Technicians Association and in 1990-1991 served as its president. During the 1990s, he expanded his firm to provide analysis for institutions on every major financial market in the world. Bob has writ- ten 13 books on finance, most notably the two-volume set, Socionomics – The Science of History and Social Predic- tion. His recent title, Conquer the Crash — You Can Survive and Prosper in a Deflationary Crash and Depression , was a New York Times and Wall Street Journal business best- seller. In 1999, Bob received the CSTA’s first annual A.J. Frost Memorial Award for Outstanding Contribution to the Development of Technical Analysis. In 2003, Traders Library granted him its Hall of Fame award.

THE BASICS

“The Wave Principle” is Ralph Nelson Elliott’s discov- ery 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 mar- ket 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 communi- cating 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 direc- tional movement, that recur in markets and are repetitive in form, but are not necessarily repetitive in time or ampli- tude. 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 ac- tion. 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

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pattern of Figure 1 and its same-directional components, i.e., waves 1, 3 and 5. Their structures are called “motive” because they powerfully impel the market. Corrective mode is employed by all countertrend interruptions, which in- clude waves 2 and 4 in Figure 1. Their structures are called “corrective” because they can accomplish only a partial retracement, or “correction,” of the progress achieved by any preceding motive wave. Thus, the two modes are fun- damentally different, both in their roles and in their construction, as will be detailed in an upcoming section. The five-wave motive phase has subwaves denoted by numbers, and the three-wave corrective phase has sub- waves are denoted by letters. Every motive wave is followed by a corrective wave. Just as wave 2 corrects wave 1 in Figure 1, the sequence A, B, C corrects the sequence 1, 2, 3, 4, 5 in Figure 2.

Figure 2

10 The Basics of the Wave Principle

The Essential Design

Figure 3 not only illustrates a larger version of Figure 2, it also illustrates Figure 2 itself , in greater detail. Waves (1) and (2) in Figure 3, if examined under a “microscope,” would take the same form as waves 1 and 2. Regardless of degree, the form is constant. We can use Figure 3 to illustrate two waves, eight waves or thirty-four waves, de- pending upon the degree to which we are referring. Now observe that within the corrective pattern illus- trated as wave 2 in Figure 3, waves (A) and (C), which point downward, are each composed of five waves: 1, 2, 3, 4 and 5. Similarly, wave (B), which points upward, is com- posed of three waves: A, B and C. This construction

Figure 3

12 The Basics of the Wave Principle

Wave Degree

All waves may be categorized by relative size, or de- gree. Elliott discerned nine degrees of waves, from the smallest wiggle on an hourly chart to the largest wave he could assume existed from the data then available. He chose the names listed below to label these degrees, from largest to smallest:

Grand Supercycle Supercycle Cycle Primary Intermediate Minor Minute Minuette Subminuette

Cycle waves subdivide into Primary waves that sub- divide into Intermediate waves that in turn subdivide into Minor and sub-Minor waves. It is important to understand that these labels refer to specifically identifiable degrees of waves. By using this nomenclature, the analyst can iden- tify precisely the position of a wave in the overall progression of the market, much as longitude and latitude are used to identify a geographical location. To say, “the Dow Jones Industrial Average is in Minute wave 0 of Minor wave 1 of Intermediate wave (3) of Primary wave 5 of Cycle wave I of Supercycle wave (V) of the current Grand Supercycle” is to identify a specific point along the progression of market history. When numbering and lettering waves, some scheme such as the one shown at right is recommended to differen- tiate the degrees of waves in the stock market’s progression. We have standardized the labels as follows:

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Wave Degree 5s With the Trend 3s Against the Trend (↑ next is Arabic symbols) (↑ next is caps) Grand Supercycle I & * ( ) a b c Supercycle (I) (II) (III) (IV) (V) (a) (b) (c) Cycle I II III IV V a b c Primary 1 2 3 4 5 A B C Intermediate (^) (1) (2) (3) (4) (5) (A) (B) (C) Minor 1 2 3 4 5 A B C Minute 6 7 8 9 0 a b c Minuette (i) (ii) (iii) (iv) (v) (a) (b) (c) Subminuette i ii iii iv v a b c (↓ next is Arabic symbols) (↓ next is caps)

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equality, channeling, personality and ratio relationships are discussed below. A rule should never be disregarded. In many years of practice with countless patterns, we have found but one instance above Subminuette degree when all other rules and guidelines combined to suggest that a

Figure 4

16 The Basics of the Wave Principle

rule was broken. Analysts who routinely break any of the rules detailed in this section are practicing some form of analysis other than that guided by the Wave Principle. These rules have great practical utility in correct count- ing, which we will explore further in discussing extensions.

Extension

Most impulses contain what Elliott called an exten- sion. Extensions are elongated impulses with exaggerated subdivisions. The vast majority of impulse waves do con- tain an extension in one and only one of their three motive subwaves (1, 3 or 5). The diagrams in Figure 4, illustrat- ing extensions, will clarify this point. Often the third wave of an extended third wave is an extension, producing a profile such as shown in Figure 5.

Figure 5

18 The Basics of the Wave Principle

DIAGONAL TRIANGLES (WEDGES)

A diagonal triangle is a special type of wave that oc- curs primarily in the fifth wave position at times when the preceding move has gone “too far too fast,” as Elliott put it. A diagonal triangle is a motive pattern, yet not an impulse, as it has one or two corrective characteristics. Diagonal tri- angles substitute for impulses at specific locations in the wave structure. They are the only five-wave structures in the di- rection of the main trend within which wave four almost always moves into the price ter- ritory of (i.e., overlaps) wave one. (See Figure 8.) Figure 8

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CORRECTIVE WAVES

Markets move against the trend of one greater degree only with a seeming struggle. Resistance from the larger trend appears to prevent a correction from developing a full motive structure. The struggle between the two oppo- sitely trending degrees generally makes corrective waves less clearly identifiable than motive waves, which always flow with comparative ease in the direction of the one larger trend. As another result of the conflict between trends, cor- rective waves are quite a bit more varied than motive waves. Corrective patterns fall into four main categories: Zigzag (5-3-5; includes three types: single, double, and triple); Flat (3-3-5; includes three types: regular, expanded, and running); Triangle (3-3-3-3-3; four types: three of the contract- ing variety (ascending, descending, and symmetrical) and one of the expanding variety (reverse symmetrical); Combination ( two types: double three and triple three).

ZIGZAGS (5-3-5)

A single zigzag in a bull market is a simple three-wave declining pattern labeled A-B-C and subdividing 5-3-5. The top of wave B is noticeably lower than the start of wave A, as illustrated in Figures 9 and 10. Occasionally zigzags will occur twice, or at most, three times in succession, particularly when the first zigzag falls short of a normal target. In these cases, each zigzag is sepa- rated by an intervening “three” (labeled X), producing what is called a double zigzag (see Figure 11) or triple zigzag. The zigzags are labeled W and Y (and Z, if a triple).