The Basics of Elliott wave principle

Any market is driven by the psychology of the people,

by knowing this principle you can forecast large and small shifts in the price action. 

In final result it will minimize emotions and your doubtfulness before getting into trade. Furthermore this analysis will maximize your profits and success of prognosis by placing the stop losses/take profits, trade setups the right way. These patterns were noticed by Ralph Nelson Elliot who watched and identified these by watching the market for about 10 years. He called this discovery "the Wave Principle" and these days it belongs to one of the fundamental technical analysis in trading. The book was published in 1978 by Mr. Prechter, who has found the Elliott's work in the New Your Public library and published a book "Elliott wave principle, which has spread like a fire throughout the world. The new focus for Wall Street and investors worldwide was designated. Nowadays tens of thousands of people use Elliott wave principle because of its astonishing accuracy to identify market behavior and to guide their financial decisions.

The Fundamentals 

The Elliott has discovered that social behavior creates recognizable patterns, which repeat themselves and have a structural design. Every decision in the market is a meaningful information and produces meaningful operation, which then joins the chain of causes of other behaviors. This observance has roots in basic harmony found in nature and man's social nature. The Elliott has invented 13 patterns, which have directional movement and repeat themselves in form. He described how these patterns behave, link together and how they create then bigger patterns, which create even bigger patterns (chain principle).

The Five-Wave Pattern

The Elliott said that the progress of market takes form of five waves of specific structure. Three of these waves are motive (are moving in the direction of the progress) and 2 of these waves are corrective (are moving in the opposite direction of progress).  The market may be identified as being somewhere in the basic five-wave pattern at the larger degree. So the smaller 5 wave can be linked to a bigger 5 wave pattern of bigger degree of level of trend. The five-wave pattern is the most important of the patterns and all other patterns are subsumed by it.

2 Wave Modes 

There are 2 wave modes among all Elliott wave patterns. The first one is motive and the second one is corrective. Motive waves have 5 wave structure and corrective waves have 3 wave structure. The 1st, 3rd and 5th are known as motive waves because they move in direction of the whole wave but on the other hand the corrective waves are waves, which go against the direction of the whole wave. They are called corrective because they can achieve just partial retracement of the motive wave. The motive waves are denoted by numbers(1,2,3,4,5) and corrective waves are denoted by letters (A,B,C).

In the picture the A,B,C wave corrects the bigger 1,2,3,4,5 wave, just as wave 2 corrects wave 1, so regardless of scale, the trend is always constant.

Notice that wave (A) is composed of 5 wave pattern and (B) wave is composed of simple a,b,c corrective pattern, it means that (B) corrects the (A) wave, so it makes partial retracement as Elliott has described. It means, that even in the corrective wave can be motive wave (wave B in this example).

Conclusion: 

motive  waves don't always point upwards, but can move also downward, so the direction of the wave has got no absolute direction, but is determined relatively. In summary the action develops in five waves as the one larger trend(1,2,3,4,5) and the reaction against larger trend develops in three waves(A,B,C).

Wave degree

The chart seen above can be a subdivision of a wave of a bigger degree. As long as progress continues, the process of building waves of greater degree continues. As far as we can define, all waves have or are built by waves of smaller waves and are components of bigger waves.

Elliott discerned 9 wave degrees, ranging from small wave on 1 hour chart to as much as Grand Supercycle, which is still in development since inception of humanity. This is how he labeled them:

Grand Supercycle
Supercycle
Cycle
Primary
Intermediate
Minor
Minute
Minuette
Subminuette

So for example Cycle wave subdivides to Primary waves and Primary wave subdivides to Intermediate waves etc. Each type of these waves has its own labeling which is commonly used by wave traders.

Motive waves  

The most common motive wave is impulse wave. The impulse should have a very sharp and big movement in the comparison with corrective wave. So the Five-wave pattern has 3 motive waves (1., 3., 5. wave), where also the impulses take place and the 3. wave should be specifically an impulse(should be stronger and sharper than 1st wave and 5th wave impulse). There are few particular rules, which help us determining the impulses and motive waves. A rule is so called because it governs all waves to which it applies.

A rule should never be disregarded!

• An impulse always subdivides into five waves
• Wave 1 always subdivides into an impulse or (rarely) diagonal
• Wave 3 always subdivides into an impulse
• Wave 5 always subdivides into an impulse or diagonal
• Wave 2 and 4 always subdivide into corrective waves (zigzag, flat, traingle or combination)
• Wave 2 never moves beyond the start of wave 1
• Wave 3 is never the shortest wave
• Wave 4 never moves beyond the end o wave 1

The guidelines determine the characteristic behaviors of waves, which are also crucial for designating  accurately the impulses and motive waves. I will note just the most important ones to know:

• Wave 4 will almost always be a different corrective pattern than wave 2 
• There can be almost always one extension in the wave 
• The 3rd wave has almost always the steepest slope of all motive waves ( has the biggest impulse) 
• Wave 1,3 or 5 are usually extended (one at a time)
• Wave 1 is the least commonly extended wave 
• If the 3. wave is extended, the 1. and 5. wave have usually gains related by equality 

Extension

Most impulses have as Elliott called it extensions. The vast majority of motive waves(1,3 and 5) has just one extension. Most of the time the 3rd wave is an extension, because it has bigger impulse and tends to be longer than the other motive waves. This is how it should look like: 

Truncation

This action was described by Elliott as "failure", in which the 5th wave didn't move beyond the top of the 3rd wave. This action can be proven on the chart if the 5th wave contains necessary 5 subwaves as depicted on the picture:

Diagonal Triangles (Wedges) 

The so called wedge occurs mostly on the end of the 5th wave when the proceeding move has gone too far, too fast. It is a motive pattern but not an impulse because it has also got a corrective characteristics. After the pattern the bigger corrective wave of whole motive wave of bigger degree should follow up (A,B,C).

In the next article I will cover all corrective waves, stay tuned!