The start of a new trading year can be a very good time to learn new things as well as revisit some of the old in our study of the markets. With an 85th birthday this year, let’s take a look at The Wave Principle.
The Wave Principle was first discovered by Ralph Nelson Elliott in the mid 1930’s. It was reintroduced in the 1970’s and is collectively known as Elliott Waves these days. It is also referred to as an Elliott Wave principle, theory or model, but as Shakespeare wrote, “ a rose by any other name would still smell as sweet.”
As Ralph Elliott wrote in his blue-binder, hand typed copies of The Wave Principle in 1932, “ The Wave Principle makes no errors, only the interpretation of The Wave Principle, by the interpreter, can be at error.” Or something thereabouts. He also stated clearly that no interpretation of The Wave Principle is considered valid unless made by him or by a student directly licensed by him, of which there was only one.
So with no valid interpretation of The Wave Principle possible without clearance, and none readily available, the possibilities for faulty interpretations were boundless. We’ll use Ralph Elliott “ Discoverer” as a labeling model and use the old notations that were included in his pioneering work, The Wave Principle.
The 3 Rules of The Wave Principle
It is hard to imagine hand drawing charts based on prices received through the ticker that Ralph Elliott was able to see what he thought to be a pattern in the price data of the Dow Jones Industrial Averages every 60 minutes. What he found was that the market moved in what he thought to be “Waves” and that a movement of 5 of them at least would usually coincide with the trend of the market at the time. Moves in 3 “Waves” would usually stop short of becoming a Five Wave pattern and would then in fact give way to a Five Wave advance. So 5 wave advances were followed by 3 waves against them, then another 5 Wave advance would follow. A 5-3-5 pattern emerged.
This would later form the basis for what he labeled as Cardinal Waves, 5 wave moves with the trend, and Corrective Waves, 3 wave moves against the
trend.
With more study, rules and guidelines were formed for his newly discovered principle. The term principle is an interesting choice, as it is a constant. Later works included Natures Law where he tied the correlation between the Fibonacci ratio and his wave mechanics together to form a template for spiral type growth in the markets. Many traders today use the Fibonacci retracement tools handily. Fibonacci speed lines, arc fans, grids and the like are canned studies that can overlay on trading charts to measure waves, though often wantonly.
After a further careful study, Ralph Elliott declared these three fundamental rules of his newly formed Principle, never to be broken.
Rule #1 : Wave 2 of a Five Wave advance labeled 1,2,3,4,5 can not go below
the start of Wave 1.
Rule #2 : Wave 3 of a Five Wave advance labeled 1,2,3,4,5 can not be the
shortest wave, of Waves 1, 3 and 5.
Rule # 3 : Wave 4 of a Five Wave advance labeled 1,2,3,4,5 can not go below
the end of Wave 1.
If you broke one of these three rules, I would imagine he could not endorse your pledge to be considered a student directly licensed by him to interpret his Wave Principle.
It would be the same as if you are wanting to become a Spanish language interpreter and someone said casa, and you stated that they were saying the word for water, you would not likely gain your interpreters license, because casa means house, not water, in that particular language.
The Wave Principle Today in Charts
In a recent chart going into the last week’s of 2016 in the E-mini S&P we can see a wave interpretation on the chart. In reviewing the rules we see:
Rule #1 : Wave 2 of a Five Wave advance labeled 1,2,3,4,5 can not go below
the start of Wave 1.
Rule #2 : Wave 3 of a Five Wave advance labeled 1,2,3,4,5 can not be the
shortest wave, of Waves 1, 3 and 5.
Rule # 3 : Wave 4 of a Five Wave advance labeled 1,2,3,4,5 can not go below
the end of Wave 1.
In this interpretation, a definite Five Wave advance can be seen, in which Wave 2 does not go below the start of Wave 1 for Rule #1.
Wave 3 appears to be not the shortest of Waves 1,3 or 5 for Rule #2.
And Wave 4 does not go below the end of Wave 1 for Rule #3.
Everything seems fit to label and interpret a Cardinal Five Wave advance, marked 1,2,3,4,5 ending at the top of the chart with the label 5. There is no way to confirm this is the correct interpretation, but it meets the rules of the particular language of The Wave Principle.
Once a Five Wave advance is counted as having completed, Ralph Elliott goes further to define the following Three Wave correction that follows a Cardinal Five Wave advance as an A,B,C Corrective Wave sequence.
After 1,2,3,4,5 then A,B the Wave C would still be incomplete in the chart example and would remain unlabeled until it ended.
His pattern was complete. 1,2,3,4,5,A,B,C formed one full complete cycle, or degree, of trend. Like a musical octave, this 8 wave cycle of progression became the foundation of Elliott’s Wave Principle.
The Wave Principle Coined the term “Channel” as a Guideline
As part of Ralph Elliott’s observations on the market, that was within the Wave Principle, certain wave characteristics would appear to form. Apart from his observations on Cardinal Waves and that Corrective Waves would occur thereafter, he separated them into a few types, such as a Zigzag, a Flat or a Triangle, each with their own characteristics. These patterns could appear as Waves 2 or 4 in the Cardinal Wave series.
Later, these patterns were also found in Wave B of the Corrective Wave series as well. Waves A and C were found to be Five Wave structures in Zigzag corrections and contain them in Flats and Triangles, but they were not Cardinal Waves, as they were not with the Cardinal trend, where prices advanced within what he termed a “Channel.”
He stated that if you drew a line connecting Waves 2 and 4, it would slope upward in a Cardinal Wave. Once Waves 3 and Wave 4 were done of the 1,2,3,4,5 series, he found that by drawing another line, parallel to the Wave 2, 4 line, and placed on top of Wave 3, it could project where Wave 5 would
eventually likely travel.
A Channel was now constructed, like a track or trough, with two sides containing what was within, in this case, a Cardinal Wave advance in the DJIA. When the market moved below the Channel bottom, the higher degree A,B,C Corrective Wave would begin.
While inside the channel, the Five Wave advance series would be viewed as progress until we were at or near enough to the top of the channel. Many times he witnessed a “Throwover” which would imply striking through the upper part of the Channel in a final Wave 5 frenzy. Other times we could see an “Extension”, whereby Wave 5 would go on inside the Channel for some time higher, and then to well above the top of the initial Channel top.
And whenever and wherever the bottom of the Channel eventually did give way, the Cardinal Wave advance was labeled complete with the Wave 5 label and the A,B,C Corrective Wave would be thought to have begun.
A Bullish wave interpretation while above S&P 2,000
The monthly chart of the E-mini S&P and the 60 minute chart example both display similar characteristics of a Five Wave advance. Wave 2 does not go below the start of Wave 1. Wave 3 is not the shortest of Waves 1, 3 or 5. And finally Wave 4 does not move below the end of Wave 1. All the conditions are met for a valid Cardinal Wave interpretation in progress.
In the 60 minute chart example, Wave 5 ended near the top of the channel. For this same incidence to occur on a monthly scale, it would look like the same top of the Channel is up around 2,400 to 2,500, going higher as more time goes by.
An A,B.C higher degree correction would follow based on The Wave Principle. With Wave 3 already longer than Wave 1, Wave 5 may travel freely higher. This has been called an “Extension” and would also eventually relate in size by ratio to the distance traveled in Waves 1 through 3, as for the size of Wave 5 one could expect.
Also it can been seen on the 6o minute example that the A,B,C correction did not begin until the market went through the bottom of the Channel. The similar level is near S&P 2,000. This would be support for a bullish wave interpretation for the E mini S&P, with the risk of an A,B,C correction if and when the market moves out of the Channel, as 2,000 S&P will move ever higher as support with time.
With many possibilities and no right or wrong interpretation within the rules, it is either valid or not valid; The Wave Principle still would allow for many interpretations.
So the next time you grab those parallel trendlines from your charting tools or are sliding your ruler up, putting pad to pen, we can thank Ralph Elliott and The Wave Principle for his solo take on market behavior. Many people still use trendlines today in the field of technical chart analysis of market prices.
There is a substantial risk of loss in futures trading. past past performance is not indicative of future results.
