The Elliott wave principle is a form of technical analysis that investors use to forecast trends in the financial markets and other collective activities. Ralph Nelson Elliott (1871–1948), a professional accountant, developed the concept in the 1930s: he proposed that market prices unfold in specific patterns, which practitioners today call Elliott waves, or simply waves. Elliott published his views of market behavior in the book The Wave Principle (1938), in a series of articles in Financial World magazine in 1939, and most fully in his final major work, Nature’s Laws – The Secret of the Universe (1946). Elliott said that “because man is subject to rhythmical procedure, calculations having to do with his activities can be projected far into the future with a justification and certainty heretofore unattainable.”

The wave principle posits that collective investor psychology (or crowd psychology) moves from optimism to pessimism and back again. These swings create patterns, as evidenced in the price movements of a market at every degree of trend.
From R.N. Elliott’s essay, “The Basis of the Wave Principle,” October 1940.Elliott’s model says that market prices alternate between five waves and three waves at all degrees of trend, as the illustration shows. As these waves develop, the larger price patterns unfold in a self-similar fractal geometry. Within the dominant trend, waves 1, 3, and 5 are “motive” waves, and each motive wave itself subdivides in five waves. Waves 2 and 4 are “corrective” waves, and subdivide in three waves. In a bear market the dominant trend is downward, so the pattern is reversed—five waves down and three up. Motive waves always move with the trend, while corrective waves move against it.

The patterns link to form five and three-wave structures of increasing size or “degree.” Note the lowest of the three idealized cycles. In the first small five-wave sequence, waves 1, 3 and 5 are motive, while waves 2 and 4 are corrective. This signals that the movement of one larger degree is upward. It also signals the start of the first small three-wave corrective sequence. After the initial five waves up and three waves down, the sequence begins again and the self-similar fractal geometry begins to unfold. The completed motive pattern includes 89 waves, followed by a completed corrective pattern of 55 waves.

Each degree of the pattern in a financial market has a name. Practitioners use symbols for each wave to indicate both function and degree—numbers for motive waves, letters for corrective waves (shown in the highest of the three idealized cycles). Degrees are relative; they are defined by form, not by absolute size or duration. Waves of the same degree may be of very different size and/or duration.[2]

The classification of a wave at any particular degree can vary, though practitioners generally agree on the standard order of degrees (approximate durations given):

Grand supercycle: multi-decade to multi-century
Supercycle: a few years to a few decades
Cycle: one year to a few years
Primary: a few months to a couple of years
Intermediate: weeks to months
Minor: weeks
Minute: days
Minuette: hours
Subminuette: minutes

Elliott Wave analysts (or “Elliotticians”) may not need to look at a price chart to judge where a market is in its wave pattern. Each wave has its own “signature” which often reflects the psychology of the moment. Understanding how and why the waves develop is the key to applying the Wave Principle; that understanding includes recognizing the characteristics described below.[2]

These wave characteristics assume a bull market in equities. The characteristics apply in reverse in bear markets.

Five wave pattern (dominant trend)

Wave 1: Wave one is rarely obvious at its inception. When the first wave of a new bull market begins, the fundamental news is almost universally negative. The previous trend is considered still strongly in force. Fundamental analysts continue to revise their earnings estimates lower; the economy probably does not look strong. Sentiment surveys are decidedly bearish, put options are in vogue, and implied volatility in the options market is high. Volume might increase a bit as prices rise, but not by enough to alert many technical analysts.

Wave 2: Wave two corrects wave one, but can never extend beyond the starting point of wave one. Typically, the news is still bad. As prices retest the prior low, bearish sentiment quickly builds, and “the crowd” haughtily reminds all that the bear market is still deeply ensconced. Still, some positive signs appear for those who are looking: volume should be lower during wave two than during wave one, prices usually do not retrace more than 61.8% (see Fibonacci section below) of the wave one gains, and prices should fall in a three wave pattern.

Wave 3: Wave three is usually the largest and most powerful wave in a trend (although some research suggests that in commodity markets, wave five is the largest). The news is now positive and fundamental analysts start to raise earnings estimates. Prices rise quickly, corrections are short-lived and shallow. Anyone looking to “get in on a pullback” will likely miss the boat. As wave three starts, the news is probably still bearish, and most market players remain negative; but by wave three’s midpoint, “the crowd” will often join the new bullish trend. Wave three often extends wave one by a ratio of 1.618:1.

Wave 4: Wave four is typically clearly corrective. Prices may meander sideways for an extended period, and wave four typically retraces less than 38.2% of wave three. Volume is well below than that of wave three. This is a good place to buy a pull back if you understand the potential ahead for wave 5. Still, the most distinguishing feature of fourth waves is that they often prove very difficult to count.

Wave 5: Wave five is the final leg in the direction of the dominant trend. The news is almost universally positive and everyone is bullish. Unfortunately, this is when many average investors finally buy in, right before the top. Volume is lower in wave five than in wave three, and many momentum indicators start to show divergences (prices reach a new high, the indicator does not reach a new peak). At the end of a major bull market, bears may very well be ridiculed (recall how forecasts for a top in the stock market during 2000 were received).

Three wave pattern (corrective trend)

Wave A: Corrections are typically harder to identify than impulse moves. In wave A of a bear market, the fundamental news is usually still positive. Most analysts see the drop as a correction in a still-active bull market. Some technical indicators that accompany wave A include increased volume, rising implied volatility in the options markets and possibly a turn higher in open interest in related futures markets.

Wave B: Prices reverse higher, which many see as a resumption of the now long-gone bull market. Those familiar with classical technical analysis may see the peak as the right shoulder of a head and shoulders reversal pattern. The volume during wave B should be lower than in wave A. By this point, fundamentals are probably no longer improving, but they most likely have not yet turned negative.

Wave C: Prices move impulsively lower in five waves. Volume picks up, and by the third leg of wave C, almost everyone realizes that a bear market is firmly entrenched. Wave C is typically at least as large as wave A and often extends to 1.618 times wave A or beyond.

Elliott’s market model relies heavily on looking at price charts. Practitioners study developing price moves to distinguish the waves and wave structures, and discern what prices may do next; thus the application of the wave principle is a form of pattern recognition.

The structures Elliott described also meet the common definition of a fractal (self-similar patterns appearing at every degree of trend). Elliott wave practitioners say that just as naturally-occurring fractals often expand and grow more complex over time, the model shows that collective human psychology develops in natural patterns, via buying and selling decisions reflected in market prices: “It’s as though we are somehow programmed by mathematics. Seashell, galaxy, snowflake or human: we’re all bound by the same order.”