Elliott Wave Principle

From Wikipedia, the free encyclopedia

The Elliott Wave Principle is a form of technical

analysis that traders use to analyze financial market Economic Waves series
cycles and forecast market trends by identifying
extremes in investor psychology, highs and lows in (see Business cycles)
prices, and other collective factors. Ralph Nelson Cycle/Wave Name Years
Elliott (1871–1948), a professional accountant, Kitchin inventory 3–5
discovered the underlying social principles and Juglar fixed investment 7–11
developed the analytical tools in the 1930s. He Kuznets infrastructural investment 15–25
proposed that market prices unfold in specific Kondratiev wave 45–60
patterns, which practitioners today call Elliott waves,
or simply waves. Elliott published his theory of
market behavior in the book The Wave Principle in 1938, summarized it in a series of articles in
Financial World magazine in 1939, and covered it most comprehensively in his final major
work, Nature’s Laws: The Secret of the Universe in 1946. Elliott stated 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."[1]

Contents
 1 Overall design
 2 Degree
 3 Elliott Wave personality and characteristics
 4 Pattern recognition and fractals
 5 Elliott wave rules and guidelines
 6 Fibonacci relationships
 7 After Elliott
 8 Rediscovery and current use
 9 Criticism
 10 See also
 11 Notes
 12 References
 13 External links

[edit] Overall design

From R.N. Elliott's essay, "The Basis of the Wave Principle," October 1940.

The Elliot Wave Principle posits that collective investor psychology, or crowd psychology,
moves between optimism and pessimism in natural sequences. These mood swings create
patterns evidenced in the price movements of markets at every degree of trend or time scale.

In Elliott's model, market prices alternate between an impulsive, or motive phase, and a
corrective phase on all time scales of trend, as the illustration shows. Impulses are always
subdivided into a set of 5 lower-degree waves, alternating again between motive and corrective
character, so that waves 1, 3, and 5 are impulses, and waves 2 and 4 are smaller retraces of
waves 1 and 3. Corrective waves subdivide into 3 smaller-degree waves starting with a five-
wave counter-trend impulse, a retrace, and another impulse. In a bear market the dominant trend
is downward, so the pattern is reversed—five waves down and three up. Motive waves always
move with the trend, while corrective waves move against it.

[edit] Degree
The patterns link to form five and three-wave structures which themselves underlie self-similar
wave structures of increasing size or higher degree. Note the lower most of the three idealized
cycles. In the first small five-wave sequence, waves 1, 3 and 5 are motive, while waves 2 and 4
are corrective. This signals that the movement of the wave one degree higher is upward. It also
signals the start of the first small three-wave corrective sequence. After the initial five waves up
and three waves down, the sequence begins again and the self-similar fractal geometry begins to
unfold according to the five and three-wave structure which it underlies one degree higher. The
completed motive pattern includes 89 waves, followed by a completed corrective pattern of 55
waves.[2]

Each degree of a pattern in a financial market has a name. Practitioners use symbols for each
wave to indicate both function and degree—numbers for motive waves, letters for corrective
waves (shown in the highest of the three idealized series of wave structures or degrees). Degrees
are relative; they are defined by form, not by absolute size or duration. Waves of the same degree
may be of very different size and/or duration.[2]
The classification of a wave at any particular degree can vary, though practitioners generally
agree on the standard order of degrees (approximate durations given):

 Grand supercycle: multi-century

 Supercycle: multi-decade (about 40-70 years)
 Cycle: one year to several years (or even several decades under an Elliott Extension)
 Primary: a few months to a couple of years
 Intermediate: weeks to months
 Minor: weeks
 Minute: days
 Minuette: hours
 Subminuette: minutes

[edit] Elliott Wave personality and characteristics

Elliott wave analysts (or Elliotticians) hold that each individual wave has its own signature or
characteristic, which typically reflects the psychology of the moment.[2][3] Understanding those
personalities is key to the application of the Wave Principle; they are defined below. (Definitions
assume a bull market in equities; the characteristics apply in reverse in bear markets.)

Five wave pattern (dominant trend) Three wave pattern (corrective trend)
Wave 1: Wave one is rarely obvious at its
inception. When the first wave of a new bull Wave A: Corrections are typically harder to
market begins, the fundamental news is almost identify than impulse moves. In wave A of a
universally negative. The previous trend is bear market, the fundamental news is usually
considered still strongly in force. Fundamental still positive. Most analysts see the drop as a
analysts continue to revise their earnings correction in a still-active bull market. Some
estimates lower; the economy probably does not technical indicators that accompany wave A
look strong. Sentiment surveys are decidedly include increased volume, rising implied
bearish, put options are in vogue, and implied volatility in the options markets and possibly a
volatility in the options market is high. Volume turn higher in open interest in related futures
might increase a bit as prices rise, but not by markets.
enough to alert many technical analysts.
Wave 2: Wave two corrects wave one, but can
never extend beyond the starting point of wave
Wave B: Prices reverse higher, which many see
one. Typically, the news is still bad. As prices
as a resumption of the now long-gone bull
retest the prior low, bearish sentiment quickly
market. Those familiar with classical technical
builds, and "the crowd" haughtily reminds all
analysis may see the peak as the right shoulder
that the bear market is still deeply ensconced.
of a head and shoulders reversal pattern. The
Still, some positive signs appear for those who
volume during wave B should be lower than in
are looking: volume should be lower during
wave A. By this point, fundamentals are
wave two than during wave one, prices usually
probably no longer improving, but they most
do not retrace more than 61.8% (see Fibonacci
likely have not yet turned negative.
section below) of the wave one gains, and prices
should fall in a three wave pattern.
Wave 3: Wave three is usually the largest and Wave C: Prices move impulsively lower in five
most powerful wave in a trend (although some waves. Volume picks up, and by the third leg of
research suggests that in commodity markets, wave C, almost everyone realizes that a bear
wave five is the largest). The news is now market is firmly entrenched. Wave C is
positive and fundamental analysts start to raise typically at least as large as wave A and often
earnings estimates. Prices rise quickly, extends to 1.618 times wave A or beyond.
corrections are short-lived and shallow. Anyone
looking to "get in on a pullback" will likely miss
the boat. As wave three starts, the news is
probably still bearish, and most market players
remain negative; but by wave three's midpoint,
"the crowd" will often join the new bullish trend.
Wave three often extends wave one by a ratio of
1.618:1.
Wave 4: Wave four is typically clearly
corrective. Prices may meander sideways for an
extended period, and wave four typically retraces
less than 38.2% of wave three (see Fibonacci
relationships below). Volume is well below than
that of wave three. This is a good place to buy a
pull back if you understand the potential ahead
for wave 5. Still, fourth waves are often
frustrating because of their lack of progress in
the larger trend.
Wave 5: Wave five is the final leg in the
direction of the dominant trend. The news is
almost universally positive and everyone is
bullish. Unfortunately, this is when many
average investors finally buy in, right before the
top. Volume is often lower in wave five than in
wave three, and many momentum indicators start
to show divergences (prices reach a new high but
the indicators do not reach a new peak). At the
end of a major bull market, bears may very well
be ridiculed (recall how forecasts for a top in the
stock market during 2000 were received).

[edit] Pattern recognition and fractals

Elliott's market model relies heavily on looking at price charts. Practitioners study developing
trends to distinguish the waves and wave structures, and discern what prices may do next; thus
the application of the wave principle is a form of pattern recognition.

The structures Elliott described also meet the common definition of a fractal (self-similar
patterns appearing at every degree of trend). Elliott wave practitioners say that just as naturally-
occurring fractals often expand and grow more complex over time, the model shows that
collective human psychology develops in natural patterns, via buying and selling decisions
reflected in market prices: "It's as though we are somehow programmed by mathematics.
Seashell, galaxy, snowflake or human: we're all bound by the same order."[4]

[edit] Elliott wave rules and guidelines

A correct Elliott wave "count" must observe three rules: 1) Wave 2 always retraces less than
100% of wave 1; 2) Wave 3 cannot be the shortest of the three impulse waves, namely waves 1,
3 and 5; 3) Wave 4 does not overlap with the price territory of wave 1, except in the rare case of
a diagonal triangle. A common guideline observes that in a five-wave pattern, waves 2 and 4 will
often take alternate forms; a sharp move in wave 2, for example, will suggest a mild move in
wave 4. Corrective wave patterns unfold in forms known as zigzags, flats, or triangles. In turn
these corrective patterns can come together to form more complex corrections.[3]

[edit] Fibonacci relationships

R. N. Elliott's analysis of the mathematical properties of waves and patterns eventually led him
to conclude that "The Fibonacci Summation Series is the basis of The Wave Principle".[1]
Numbers from the Fibonacci sequence surface repeatedly in Elliott wave structures, including
motive waves (1, 3, 5), a single full cycle (5 up, 3 down = 8 waves), and the completed motive
(89 waves) and corrective (55 waves) patterns. Elliott developed his market model before he
realized that it reflects the Fibonacci sequence. "When I discovered The Wave Principle action of
market trends, I had never heard of either the Fibonacci Series or the Pythagorean Diagram".[1]

The Fibonacci sequence is also closely connected to the Golden ratio (1.618). Practitioners
commonly use this ratio and related ratios to establish support and resistance levels for market
waves, namely the price points which help define the parameters of a trend.[5] See Fibonacci
retracement.

Finance professor Roy Batchelor and researcher Richard Ramyar, a former Director of the
United Kingdom Society of Technical Analysts and Head of UK Asset Management Research at
Reuters Lipper, studied whether Fibonacci ratios appear non-randomly in the stock market, as
Elliott's model predicts. The researchers said the "idea that prices retrace to a Fibonacci ratio or
round fraction of the previous trend clearly lacks any scientific rationale". They also said "there
is no significant difference between the frequencies with which price and time ratios occur in
cycles in the Dow Jones Industrial Average, and frequencies which we would expect to occur at
random in such a time series".[6]

Robert Prechter replied to the Batchelor–Ramyar study, saying that it "does not challenge the
validity of any aspect of the Wave Principle...it supports wave theorists' observations," and that
because the authors had examined ratios between prices achieved in filtered trends rather than
Elliott waves, "their method does not address actual claims by wave theorists".[7] The
Socionomics Institute also reviewed data in the Batchelor–Ramyar study, and said these data
show "Fibonacci ratios do occur more often in the stock market than would be expected in a
random environment".[8]
Example of the Elliott Wave Principle and the Fibonacci relationship

From sakuragi_indofx, "Trading never been so easy eh," December 2007.

The GBP/JPY currency chart gives an example of a fourth wave retracement apparently halting
between the 38.2% and 50.0% Fibonacci retracements of a completed third wave. The chart also
highlights how the Elliott Wave Principle works well with other technical analysis tendencies as
prior support (the bottom of wave-1) acts as resistance to wave-4. The wave count depicted in
the chart would be invalidated if GBP/JPY moves above the wave-1 low.

[edit] After Elliott

Following Elliott's death in 1948, other market technicians and financial professionals continued
to use the wave principle and provide forecasts to investors. Charles Collins, who had published
Elliott's "Wave Principle" and helped introduce Elliott's theory to Wall Street, ranked Elliott's
contributions to technical analysis on a level with Charles Dow. Hamilton Bolton, founder of
The Bank Credit Analyst, provided wave analysis to a wide readership in the 1950s and 1960s.
Bolton introduced Elliott's wave principle to A.J. Frost, who provided weekly financial
commentary on the Financial News Network in the 1980s. Frost co-authored Elliott Wave
Principle with Robert Prechter in 1978.

[edit] Rediscovery and current use

Robert Prechter came across Elliott's works while working as a market technician at Merrill
Lynch. His prominence as a forecaster during the bull market of the 1980s brought the greatest
exposure to date to Elliott's work, and today Prechter remains the most widely known Elliott
analyst.[9]

Among market technicians, wave analysis is widely accepted as a component of their trade.
Elliott's Wave principle is among the methods included on the exam that analysts must pass to
earn the Chartered Market Technician (CMT) designation, the professional accreditation
developed by the Market Technicians Association (MTA).
Robin Wilkin, Ex-Global Head of FX and Commodity Technical Strategy at JPMorgan Chase,
says "the Elliott Wave principle ... provides a probability framework as to when to enter a
particular market and where to get out, whether for a profit or a loss."[10]

Jordan Kotick, Global Head of Technical Strategy at Barclays Capital and past President of the
Market Technicians Association, has said that R. N. Elliott's "discovery was well ahead of its
time. In fact, over the last decade or two, many prominent academics have embraced Elliott’s
idea and have been aggressively advocating the existence of financial market fractals."[11]

One such academic is the physicist Didier Sornette, visiting professor at the Department of Earth
and Space Science and the Institute of Geophysics and Planetary Physics at UCLA. In a paper he
co-authored in 1996 ("Stock Market Crashes, Precursors and Replicas") Sornette said,

It is intriguing that the log-periodic structures documented here bear some similarity with the
"Elliott waves" of technical analysis ... A lot of effort has been developed in finance both by
academic and trading institutions and more recently by physicists (using some of their statistical
tools developed to deal with complex times series) to analyze past data to get information on the
future. The 'Elliott wave' technique is probably the most famous in this field. We speculate that
the "Elliott waves", so strongly rooted in the financial analysts’ folklore, could be a signature of
an underlying critical structure of the stock market.[12]

Paul Tudor Jones, the billionaire commodity trader, calls Prechter and Frost's standard text on
Elliott "a classic," and one of "the four Bibles of the business":

[Magee and Edwards'] Technical Analysis of Stock Trends and The Elliott Wave Theorist both
give very specific and systematic ways to approach developing great reward/risk ratios for
entering into a business contract with the marketplace, which is what every trade should be if
properly and thoughtfully executed.[13]

[edit] Criticism
The premise that markets unfold in recognizable patterns contradicts the efficient market
hypothesis, which states that prices cannot be predicted from market data such as moving
averages and volume. By this reasoning, if successful market forecasts were possible, investors
would buy (or sell) when the method predicted a price increase (or decrease), to the point that
prices would rise (or fall) immediately, thus destroying the profitability and predictive power of
the method. In efficient markets, knowledge of the Elliott Wave Principle among traders would
lead to the disappearance of the very patterns they tried to anticipate, rendering the method, and
all forms of technical analysis, useless.

Benoit Mandelbrot has questioned whether Elliott waves can predict financial markets:

But Wave prediction is a very uncertain business. It is an art to which the subjective judgement
of the chartists matters more than the objective, replicable verdict of the numbers. The record of
this, as of most technical analysis, is at best mixed.[14]
Robert Prechter had previously stated that ideas in an article by Mandelbrot[15] "originated with
Ralph Nelson Elliott, who put them forth more comprehensively and more accurately with
respect to real-world markets in his 1938 book The Wave Principle."[16]

Critics also warn the wave principle is too vague to be useful, since it cannot consistently
identify when a wave begins or ends, and that Elliott wave forecasts are prone to subjective
revision. Some who advocate technical analysis of markets have questioned the value of Elliott
wave analysis. Technical analyst David Aronson wrote:[17]

The Elliott Wave Principle, as popularly practiced, is not a legitimate theory, but a story, and a
compelling one that is eloquently told by Robert Prechter. The account is especially persuasive
because EWP has the seemingly remarkable ability to fit any segment of market history down to
its most minute fluctuations. I contend this is made possible by the method's loosely defined
rules and the ability to postulate a large number of nested waves of varying magnitude. This
gives the Elliott analyst the same freedom and flexibility that allowed pre-Copernican
astronomers to explain all observed planet movements even though their underlying theory of an
Earth-centered universe was wrong.