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Explanation of
Elliott Wave and
n this chapter, I will cover the basic rules, of which there are just a few,
of wave formation and introduce setups for timing your trade. “A rule is
so called because it governs all waves to which it applies. Characteris-
tics of waves are called guidelines.”
Many guidelines of impulse formation
and many details pertaining to corrective patterns are not covered here.
Also covered briefly in this chapter is Fibonacci analysis. Many traders are
familiar with Fibonacci retracements but do not realize that Fibonacci was
first introduced as a method of technical analysis by R. N. Elliott. In fact,
Fibonacci is the mathematical basis for the wave principle.
If you long for a fuller understanding of Elliott (which includes
Fibonacci), then I urge you to read the books listed in the Notes section
at the back of the book. An experienced Elliottician has at his or her dis-
posal what I believe to be one of the most powerful market timing tools in
Ralph Nelson Elliott was a successful accountant early in the twentieth
century and “held executive positions primarily with railroad companies
in Mexico and Central America.” His success in turning around troubled
rail companies attracted the attention of the U.S. State Department, and
in 1924 the department “chose him to become the Chief Accountant for
Nicaragua, which was under the control of the U.S. marines at the time.”
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Elliott moved to Guatemala City after the United States extricated itself
from Nicaragua to take on the position of general auditor of the Interna-
tional Railway of Central America. While in Central America in the late
1920s, Elliott contracted an “alimentary tract illness caused by the organ-
ism amoeba histolytica.”
At 58 years of age, the former accountant was very sick and confined
to his home. His mind always at work (he had written two books), Elliott
dedicated his time to studying the price behavior of the Dow Jones Aver-
ages. Elliott studied many time frames, from 30 minute to yearly. This must
have been quite an arduous task given that charts were plotted by hand on
graph paper then.
Elliott discovered that price action displayed on different time frames
formed the same basic patterns. In other words, there is a market form
at all degrees of trend. The basic pattern that Elliott discovered was that
a market cycle consists of eight waves, five waves with the trend and
three waves against the trend. Within the five waves, waves 1, 3, and 5
are in the direction of the trend while waves 2 and 4 are against the
trend, or corrections of the trend. Wave 2 corrects wave 1 and wave 4 cor-
rects wave 3. Following the completion of five waves in one direction, a
larger correction takes place in three waves. The basic 5–3 pattern forms
the foundation from which everything else is a part. Figure 7.1 shows
the basic pattern of five waves with the trend and three waves against
the trend.
Wave 1
Wave 3
Wave 5
Wave B
Wave 2
Wave 4
Wave A
Wave C
FIGURE 7.1 Basic Five Wave Idealized Pattern
Source: Courtesy of Elliott Wave International, Inc.

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