Thursday, May 17, 2012

Chapter 1 ~ The Basics

In the 1930’s R. N. Elliott discovered that the stock market moves in certain patterns. He isolated and described these different patterns and called the theory “the Wave Principle”.

Progress unfolds in five waves
He noticed that the market’s progression unfolds in waves. More precisely, progress ultimately takes the form of five waves. Three of them, waves 1, 3, and 5, ensure the direction of the movement. They are separated by waves 2 and 4 which point to the other direction.

Chart 1.1 - Five-Wave-Pattern

Two modes: motive and corrective
There are two modes of waves: motive and corrective. Motive waves point to the direction of the bigger trend and are five-wave patterns. Corrective waves are countertrend and consist of three waves.

While the components (subwaves) of motive waves are numbered, the subwaves of correctives are lettered.

A cycle consists of eight waves
A complete cycle consists of one motive and one corrective pattern. This results in eight waves in total.

Chart 1.2 - Cycle

Once one cycle is completed another will follow which is then followed by another five-wave pattern. This creates a five-wave structure of one degree larger than in chart 1.2. This five-wave pattern is then followed by a three-wave correction of the same degree. The result is a cycle of one larger degree:

Chart 1.3 - Cycle of one larger degree

This is the most important chart in this tutorial so it’s crucial that you understand it. Chart 1.3 is actually just a bigger copy of chart 1.2.

Each subwave of [1] (= circle 1) ((1), (2), (3), (4), (5)) consists of five waves (1, 2, 3, 4, 5) which themselves consist of five waves and so on... Imagine you could zoom in endlessly and always get the same picture.

Chart 1.4 - Chart 1.3 zoomed in = Chart 1.2

Additionally, if you have a look at wave (A) in chart 1.3. you can see that it consists of five waves and points downward and not upward as we’ve always seen it so far. What may look wrong at the first glance is actually correct:

Motive waves don’t always point upward and corrective waves downward. The absolute direction doesn’t define the mode, the relative direction does. Motive waves trend in the same direction as the wave of one larger degree and corrective waves trend in the opposite direction.
In above example wave [2] is the wave of one larger degree (relative to wave (A)) and points downward. Hence wave (A) is motive and consists of five waves because it points downward as well.

Chart 1.5 - Cycle of one larger degree relative to Chart 1.3

As you've probably already noticed, I used different ways to label a wave one. Once I used a simple 1, another time I added brackets, square brackets, and in the last chart I even used Roman numerals. This isn't by chance.

So that Elliott wave practitioners understand each other they agreed on the following notation:

Chart 1.6 - Notation (Circles are often replaced by square brackets for practical reasons)

I suggest you to use this notation as well. If you tell a friend that the Dow Jones completed wave 3 of 5 of B of 3 he most likely doesn't know what you're talking about. If you tell him that the Dow Jones completed Minor 3 of Intermediate (5) of Primary [B] of Cycle III though, then he probably still doesn't know what you're talking about but most likely because he doesn't know Elliott waves.

For reasons of simplification I won't use above notation in this tutorial so you can skip it until the end of the tutorial. To distinguish between the waves of different degrees I'm going to use different font sizes.

Key notes
  • Motives consist of 5 waves and point towards the direction of the wave of one larger degree
  • Correctives consist of 3 waves and trend in the opposite direction of the wave of one larger degree
  • The structure always repeats itself (Zoom in/out, chart 1.4)

In the next chapter you’ll learn the variations of motive waves.

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