The Wave Principle, Condensed Version
By Elliott Wave International's Robert Prechter, Prechter's Market Perspective
Dec 9, 2005
A local theater company staged a play last year that promised to condense all of Shakespeare's plays into one night at the theater. It was a fast-paced romp, all right, fun for audience members who had seen many of the plays full-length and just as fun for those who hadn't.
Those who study the Wave Principle and use it for trading appreciate all it can do to provide a framework for making trading decisions – notwithstanding the fear and trepidation or other emotions that come out when trading. Learning how to use the Wave Principle in all its rich complexity can be so satisfying, but sometimes it's fun to read the condensed version. In this excerpt from Bob Prechter's question-and-answer book, Prechter's Perspective, he explains in short, easy-to-understand answers exactly what the Wave Principle is.
What is the Wave Principle?
Bob Prechter: The Wave Principle is, first and foremost, a detailed description of how markets behave. Now, there's probably more that is not in that sentence than is in that sentence. For instance, a detailed description of how markets behave does not refer to what outside events are occurring, such as in the fields of economics, politics, or social trends. It's strictly a study of how human beings behave collectively in the trading arena.
What specifically did R.N. Elliott discover in the 1930s?
Bob Prechter: Elliott's most important discovery is that the patterns that develop in the stock market occur at all degrees of trend. The larger patterns are made up of components that are themselves composed of smaller ones. The same patterns on a smaller scale combine to create any one of those patterns on a larger scale. The larger pattern will combine with several others of the same degree to create an even larger pattern, and so on. He described in detail exactly what those patterns look like. He identified 13 of them. Only recently has data been available for general stock prices back to the late 1700s, and the patterns are there as well.
How did he label the 'degrees' of trend?
Bob Prechter: Elliott began by naming a particular structure with an arbitrary label. Primary degree, a term borrowed from Dow Theory. The next larger degree he called Cycle, and the next larger Supercycle. The lower degrees he named Intermediate, Minor, and so on. We therefore have a way to refer to the degrees of trend that we are talking about.
You once referred to the Wave Principle as the 'purest form of technical analysis.' Why?
Bob Prechter: For a hundred years, investors have noticed that events external to the market often seem to have no effect on the market's progress. With the knowledge that the market continuously unfolds in waves that are related to each other through form and ratio, we can see why there is little connection. The market has a life of its own. It is mass psychology that is registering. Changes in feelings show up directly as price changes in the register known as the DJIA.
The Wave Principle is a catalog of the ways that the crowd goes from the extreme point of pessimism at the bottom to the extreme point of optimism at the top. It is a description of the steps human beings go through when they are part of the investment crowd, to change their psychological orientation from bullish to bearish and vice versa. That description fits the movement of any market, as long as human beings are involved, rather than Martians, who may have a differently operating unconscious mind. Since this aspect of people doesn't change, the path they follow in moving from extreme pessimism to extreme optimism and back again is essentially the same over and over and over, regardless of news and extraneous events.
What is the basic path?
Bob Prechter: Very simply, Elliott recognized that movement in the direction of the one larger trend subdivides into five waves. Movement against the trend subdivides into a three-wave pattern or some variation involving several three-wave patterns. In rising markets, true bull markets, the subdivisions occur in fie waves up, an up-down-up-down-up sequence. Bear markets tend to occur in three-wave sequences, down-up-down. Each one of those movements has a shape and a personality. As long as you can recognize the shapes that are occurring, you have a handle on what might happen next.
But the five-wave form does occur on the downside.
Bob Prechter: Yes, but only as a component of a larger three-wave pattern. The essence of the Wave Principle is that the moves in the direction of the one larger trend are five-wave structures, while moves against the one larger trend are three-wave structures. From that, you can tell what the underlying trend is and invest accordingly.
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