At the end of the 1800s Charles Dow’s market theory had already included some hints about the three phases of market trends. Deliberately I use the word “hint,” because his principles are formulated much too vaguely to build an active trading strategy with.
According to Dow, the first phase is a slow up leg governed by the shift from the overly-pessimistic assessment, but pessimism and disbelief still rule. The middle phase is all about the recognition of the improving fundamentals, as now, for the first time, the new trend becomes apparent. Finally, in the third phase, participants overrate the potential during the euphoric swing, and they make the stock market similar to a casino. Or, as Robert Prechter says, the crowd likes to buy fantasies.
It is very likely that Elliott knew and used Dow’s theory, although he excelled beyond that in accuracy and detail, and he was also able to identify the causes behind it.
First of all he discovered that the phenomenon described above is independent of the market being observed (i.e. we can apply the principles to stocks, commodities, currencies or bonds the overall picture always stays the same).
Elliott observed the two corrective sections that bind the trending phases and thereby pieced together the set of five waves – what we call an “impulse” or just simply a “five.” He revealed the three-wave structure of corrections running against the five-wave impulsive moves. Also, he identified the three-step forward, two-step back price cycles and their variety of components – in other words the Elliott patterns. In addition, he described the way these structures link to one another, and he phrased the related rules and guidelines. Thus, Elliott laid out the framework to describe financial market action. This Elliott framework is valid on every degree of trend from the one-minute timeframe all the way out to the monthly chart and even beyond.
This fractal structure can be observed in many different forms in nature. Clouds shape in fractals, plants grow in them which is the reason why one branch of a tree looks like the whole tree. Or, take a broccoli floret where each branch looks like a miniature edition of the whole floret. Let it be your first homework to pick a broccoli or a cauliflower and observe the typical structure at all levels of the geometric order. Returning to the world of financial markets, R. N. Elliott would say that broccoli and markets are similar in that they both have many different layers of trend.
Again and again these five-waves of an impulse and three-waves of correction follow one another in a harmonic and unending manner. A fractal forms in each of the three trending sections; as you see on this chart below: waves 1, 3 and 5 subdivide into five smaller degree waves labeled roman [i] through [v]. At the same time every degree of a five is followed by a three-wave interruption of the trend. So, if we catch an impulse somewhere, we can assume that it is part of an even larger degree trend. In other words, when we start a count from a significant low, and we can label a later high as the top wave (small) five, then the whole impulse is also the large wave one of the larger degree trend. Impulses are the constant form of growth and prosperity of ever-changing degrees. Therefore, you might often have the déjà vu feeling that a breakout or pullback had already been seen.
Although in theory it is incredibly simple to comprehend the logic of an up-down-up-down-up impulsive move, in real life charts it is much harder to classify the price action. What we have above is a schematic illustration, which in reality looks like this in the progressing phase of 1-2-3-4-5:
Ralph Nelson Elliott’s original profession was accounting, not what one would call a “super-exciting” activity. But, he was able to observe and organize market action into a discovery that we can easily verify by using his rules and guidelines. Elliott went further and put the question that no one before him had: Why do financial markets experience this kind of fluctuation?
Why do financial markets experience this kind of fluctuation?
He found that from time-to-time everyone goes through certain psychological phases from deep pessimism to extreme optimism and back again. This is simply human nature, and to a certain extent we are all driven by emotions that are hard to control. This is the natural order that gives structure to mass psychology which draws the charts and provides us with technical clues. To a large extent individual financial decisions are determined by the atmosphere and the way people – traders, investors and media personalities – communicate with each other. In other words human interaction generates fear and greed which causes many people to act in a certain way. These waves of exaggerated emotions, or moods, create trends and events in all areas of life.
Let’s conclude with the most tangible parts of the Elliott Wave Theory. These are the three fundamental rules of impulse waves that are always true, regardless of the instrument, size or timeframe. Later we are going to introduce many guidelines, but those just give aid in determining the more probable scenario, and they are not written in stone like the following three rules. Since the stock exchange has existed, there has never been any exception; all impulsive moves have obeyed the cardinal rules:
1) Wave two never goes beyond the staring point of wave one, therefore any second wave correction can’t retrace over 100% of the first wave.
2) Wave four never ends in the price territory of wave one.
3) The third wave can never be the shortest among wave one, three and five in either price nor in percentage terms. This does not mean that the third wave has to be the longest.
You might have already figured out that the impulse pattern is only one of the six basic Elliott patterns. Among the building blocks, we will also discover the other type of trending formation that is labeled with numbers called diagonals, and also those labelled with letters such as zigzags, flats, and triangles, or the combination thereof. At this point just remember that the form of growth is the impulse, and it eventually consists of, or is interrupted by, five other types of patterns: diagonals, zigzags, flats, triangles and combinations.
The time zone we reference on our charts is Pacific Standard Time. Therefore, the U.S. cash market opens at 6:30 AM PST and closes at 1:00 PM PST.