The Wave Principle was Ralph Nelson Elliottâs discovery of how social or crowd behaviour trends and reverses in recognizable patterns. It is a detailed description of how financial markets behave. The description reveals that there is a PSYCHE OF THE CROWD inherent in all representative financial market series. The crowd is not a physical crowd but a psychological crowd. It constantly moves from pessimism to optimism, from fear to greed and from euphoria to panic and back in a natural psychological sequence, creating specific patterns in price movements.
This concept of recursive patterns across finer and finer scales in the financial markets (their fractal nature), was proposed by Elliott in the 1930s, which antedates todayâs formal study of non-linear dynamics and chaos. The main point emerging from the Elliott Wave concept is that markets have a form (pattern). It is here that the investor finds determinism in a seemingly random process.
Elliott discovered what the main initiator of the chaos theory, Benoit Mandelbrot, confirmed 50 years later in collaboration with Henry Houthakker, an economics professor at Harvard: that patterns made by taking very short-term "snapshots" of stock prices, for example, every day are similar to patterns formed by snapshots taken once a week, or once a month, or even once a year. Elliott isolated thirteen patterns. He cataloged them and explained that they link together, and where they are likely to occur in the overall path of the market development.
2.2 Details of Wave
The basic pattern shows that markets move forward in a series of 5 waves of psychological development (from pessimism to optimism). When these 5 forward waves are complete, a reaction sets in, taking place in 3 waves (from optimism to pessimism).
In the charts below- Numbers are used in the diagram are used to designate "5-wave" patterns, and letters to designate "3-wave" patterns. These 8 waves then complete a cycle from which a new series of 5 waves commences, to be followed by another set of 5 waves. And finally, after two sets of 5 waves (1) and (3) and two sets of three wave patterns (2) and (4), a final set of 5 waves materializes and completes the whole pattern.
At this point, after wave (5) is complete, there is now a set of 3 waves (a), (b) and (c) of greater magnitude than the two previous corrections. This set would correct the whole of the 5 upward waves, which themselves had each broken into 5 and 3 smaller waves along the way.