Introduction to Elliott Wave Theory

Ralph Nelson Elliott developed the Elliott Wave Theory in the 1930s.1 Elliott believed that stock markets, generally thought to behave in a somewhat random and chaotic manner, in fact, traded in repetitive patterns. In this article, we'll take a look at the history behind Elliott Wave Theory and how it is applied to trading. 

Waves

Elliott proposed that financial price trends result from investors' predominant psychology.  He found that swings in mass psychology always showed up in the same recurring fractal patterns, or "waves," in financial markets.

Elliott's theory somewhat resembles the Dow theory in that both recognize that stock prices move in waves. Because Elliott additionally recognized the "fractal" nature of markets, however, he was able to break down and analyze them in much greater detail. Fractals are mathematical structures, which on an ever-smaller scale infinitely repeat themselves. Elliott discovered stock index price patterns were structured in the same way. He then began to look at how these repeating patterns could be used as predictive indicators of future market moves.

Market Predictions Based on Wave Patterns

Elliott made detailed stock market predictions based on reliable characteristics he discovered in the wave patterns. An impulse wave, which net travels in the same direction as the larger trend, always shows five waves in its pattern. A corrective wave, on the other hand, net travels in the opposite direction of the main trend. On a smaller scale, within each of the impulsive waves, five waves can again be found.

This next pattern repeats itself ad infinitum at ever-smaller scales. Elliott uncovered this fractal structure in financial markets in the 1930s, but only decades later would scientists recognize fractals and demonstrate them mathematically.

In the financial markets, we know that "what goes up, must come down," as a price movement up or down is always followed by a contrary movement. Price action is divided into trends and corrections. Trends show the main direction of prices, while corrections move against the trend.

Elliott Wave Theory Interpretation

The Elliott Wave Theory is interpreted as follows:

• Five waves move in the direction of the main trend, followed by three waves in a correction (totaling a 5-3 move). This 5-3 move then becomes two subdivisions of the next higher wave move.
• The underlying 5-3 pattern remains constant, though the time span of each wave may vary.

Let's have a look at the following chart made up of eight waves (five net up and three net down) labeled 1, 2, 3, 4, 5, A, B, and C.

Waves 1, 2, 3, 4 and 5 form an impulse, and waves A, B and C form a correction. The five-wave impulse, in turn, forms wave 1 at the next-largest degree, and the three-wave correction forms wave 2 at the next-largest degree.

The corrective wave normally has three distinct price movements – two in the direction of the main correction (A and C) and one against it (B). Waves 2 and 4 in the above picture are corrections. These waves typically have the following structure:

Note that in this picture, waves A and C move in the direction of the trend at one-larger degree and, therefore, are impulsive and composed of five waves. Wave B, in contrast, is counter-trend and therefore corrective and composed of three waves.

An impulse-wave formation, followed by a corrective wave, forms an Elliott wave degree consisting of trends and countertrends.

As you can see from the patterns pictured above, five waves do not always travel net upward, and three waves do not always travel net downward. When the larger-degree trend is down, for instance, so is the five-wave sequence.

Wave Degrees

Elliott identified nine degrees of waves, which he labeled as follows, from largest to smallest:

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

Since Elliott waves are a fractal, wave degrees theoretically expand ever-larger and ever-smaller beyond those listed above.

To use the theory in everyday trading, a trader might identify an upward-trending impulse wave, go long and then sell or short the position as the pattern completes five waves and a reversal is imminent.

Elliott Wave Theory's Popularity

In the 1970s, the Elliott Wave principle gained popularity through the work of A.J. Frost and Robert Prechter. In their now-legendary book, Elliott Wave Principle: Key to Market Behavior, the authors predicted the bull market of the 1980s. Prechter would later issue a sell recommendation days before the crash of 1987.

The Bottom Line

Elliott Wave practitioners stress that simply because the market is a fractal does not make the market easily predictable. Scientists recognize a tree as a fractal, but that doesn’t mean anyone can predict the path of each of its branches. In terms of practical application, the Elliott Wave Principle has its devotees and its detractors like all other analysis methods.

One of the key weaknesses is that the practitioners can always blame their reading of the charts rather than weaknesses in the theory. Failing that, there is the open-ended interpretation of how long a wave takes to complete. That said, the traders who commit to Elliott Wave Theory passionately defend it.