Elliott Wave Principle

The Elliott Wave Principle is a form of technical analysis that investors use to forecast trends in the financial markets by identifying extremes in investor psychology, highs and lows in prices, 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 theory 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).^[1] 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.”

Elliott Wave Principle measures investor psychology, which is the real engine behind the stock markets. When people are optimistic about the future of a given issue, they bid the price up.

Two observations will help you grasp this: First, for hundreds of years, investors have noticed that events external to the stock markets seem to have no consistent effect on the their progress. The same news that today seems to drive the markets up are as likely to drive them down tomorrow. The only reasonable conclusion is that the markets simply do not react consistently to outside events. Second, when you study historical charts, you see that the markets continuously unfold in waves.

Using the Elliott Wave Principle is an exercise in probability. An Elliottician is someone who is able to identify the markets structure and anticipate the most likely next move based on our position within those structures. By knowing the wave patterns, you’ll know what the markets are likely to do next and (sometimes most importantly) what they will not do next. By using the Elliott Wave Principle, you identify the highest probable moves with the least risk.

Elliott Wave Theory

R. N. Elliott believed markets had well-defined waves that could be used to predict market direction. In 1939, Elliott detailed the Elliott Wave Theory, which states that stock prices are governed by cycles founded upon the Fibonacci series (1-2-3-5-8-13-21…).

According to the Elliott Wave Theory, stock prices tend to move in a predetermined number of waves consistent with the Fibonacci series. Specifically, Elliott believed the market moved in five distinct waves on the upside and three distinct on the downside. The basic shape of the wave is shown below.

Waves one, three and five represent the ‘impulse’, or minor up-waves in a major bull move. Waves two and four represent the ‘corrective,’ or minor down-waves in the major bull move. The waves lettered A and C represents the minor down-waves in a major bear move, while B represents the one up-wave in a minor bear wave.

Elliott proposed that the waves existed at many levels, meaning there could be waves within waves. To clarify, this means that the chart above not only represents the primary wave pattern, but it could also represent what occurs just between points 2 and 4. The diagram below shows how primary waves could be broken down into smaller waves.

Elliott Wave theory ascribes names to the waves in order of descending size:

1. Grand Supercycle
2. Supercycle
3. Cycle
4. Primary
5. Intermediate
6. Minor
7. Minute
8. Minuette
9. Sub-Minuette

The major waves determine the major trend of the market, and minor waves determine minor trends. This is similar to the way Dow Theory postulates primary and secondary trends. Elliott provided numerous variations on the main wave, and placed particular importance on the golden mean, 0.618, as a significant percentage for retracement.

Trading using Elliott Wave patterns is quite simple. The trader identifies the main wave or Supercycle, enters long, and then sells or shorts, as the reversal is determined. This continues in progressively shorter cycles until the cycle completes and the main wave resurfaces. The caution to this is that much of the wave identification is taken in hindsight and disagreements arise between Elliott Wave technicians as to which cycle the market is in.

Here is an example of an Elliott Wave cycle. Ideally, Wave Two would not retrace more than 66%, but you can get a real sense of the wave patterns in action from the chart, just as well.

ElliotWave and Fibonacci sequences

Elliot later discovered that “his numbers” were actually the identical numbers represented in the Fibonacci sequence. Fibonacci was a medieval Italian mathematician who introduced mathematic principals from the Arab and Hindu world to the west. One idea was a number sequence known as the Fibonacci sequence. Fibonacci sequence is based on a sequence of numbers which state 1, 1, 2, 3, 5, 8 or that state n is always preceded by (n-1) + (n-2).

What makes the connection between the Elliot Wave numbers and the Fibonacci sequence numbers interesting is that both theories focus on numbers that allegedly occur in nature. The Fibonacci sequence and the ratios derived from it can be seen again and again in the natural world from flower petals to tree rings. Some argue it is a numeric expression of optimum natural growth. This certainly fortified Elliot’s ideas and it appears there is some empirical basis to both.

Elliot’s rules

In counting waves Elliot had three rules that could never be broken for the analysis to work: Rule 1: Wave 2 cannot go below the low of wave 1. Rule 2: Of the three impulse waves-1,3 and 5-wave 3 can never be the shortest. Rule 3: Wave 4 can’t end in the area of wave 1, except in the rare case of a diagonal triangle. It was critical to understand which wave is which or the analysis will not work.

The Rediscovery of Elliot

Robert Prechter rediscovered Elliott’s works while working as technician at Merrill Lynch. He used Elliot’s work to establish himself as one of the dominant forecasters of the 1980s bull market. He has written over 25 books on the theory since first publishing a magazine about it in 1979.

Wave analysis is widely accepted among market technicians and is widely accepted as a component of their trade. Elliott Wave Theory is also among the methods included on the Chartered Market Technician Exam.

Books about at Amazon.com

Book Name:Elliott Wave Principle: Key to Market Behavior

Developed by Ralph Nelson Elliott in the 1930s and ’40s, the Elliott Wave Principle is a powerful analytical tool for forecasting stock market behavior. The basic concept behind the Wave Principle is that stock market prices rise and fall in discernible patterns and that those patterns can be linked together into waves.

In the years since it was first published, this classic guide to the Elliott Wave Principle has acquired a cult status among technical analysts, worldwide. And with each new edition, the authors have refined and enhanced the principle, while retaining all the predictions from past editions.

The 20th Anniversay Edition includes a special foreword and enhanced text. It’s the final revision of a classic.

“Elliott Wave Principle is simply the best description and validation of a concept which by all rights should be revolutionizing the scientific study of history and sociology.” –JWG, New York

“Elliott Wave Principle is such an important, fascinating, even mind-bending work, we are convinced that is should be read by any and every serious student of the market, be they fundamentalist or technician, dealing in stocks, bonds or commodities.” –Market Decision$

“Even allowing for minor stumbles, that 1978 prediction must go down as the most remarkable stock market prediction of all time.” –James W. Cowan, Monitor Money Review

“Elliott Wave Principle is the greatest work of any kind, anywhere. It has helped me abandon speculative stock tips and stockbroker newsletter recommendations for my own predictions based on the simple wave theory.” –J.V.

“I have just received my copy of Elliott Wave Principle and find it to be unquestionably the best book and explanation regarding the works of Elliott that I’ve ever seen.” –J.B.B.

“I have recently read and reread Elliott Wave Principle. I was impressed with the research and especially thrilled with the excitement of coming into contact with a truly original concept.” –M.F.