Technical Analysis of Stocks - Elliott Wave Theory
Elliott Wave Theory
Elliott wave principle is a form of technical analysis that investors use to forecast trends in the financial markets and other collective activities. Ralph Nelson Elliott, a professional accountant, developed a financial market model that he called The Wave Principle. He published his views of market behavior in the book The Wave Principle (1938), and in a series of articles in Financial World magazine in 1939. Elliott proposed that market prices unfold in specific patterns that he called waves (sometimes called Elliott waves).
The wave principle begins with the premise that collective investor psychology (or crowd psychology) moves from optimism to pessimism and back again. These swings create patterns, as evidenced in the price movements of a market.
Elliott's model proposes that market prices alternate between five waves and three waves at all degrees of trend, as the illustration shows. As these waves develop, the larger price patterns unfold in a self-similar fractal geometry. Within the dominant trend, waves 1, 3, and 5 are called "motive" waves, and each motive wave itself subdivides in five waves. Waves 2 and 4 are "corrective" waves, and subdivide in three waves. 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.
The patterns link to form five and three-wave structures of increasing size or "degree." Note the lowest 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 one larger degree 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. The completed motive pattern includes 89 waves, followed by a completed corrective pattern of 55 waves.
Elliott's market model relies heavily on looking at price charts. Practitioners study developing price moves 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, in that the patterns are self-similar at every degree of trend. Elliott wave practicioners 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.
R. N. Elliott's analysis of the mathmatical properties of waves and patterns eventually led him to conclude that "The Fibonacci Summation Series is the basis of The Wave Principle." 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. It is interesting to note that Elliott developed his market model before he realized that it reflects the Fibonacci sequence.
The Fibonacci sequence is also closely connected to the Golden ratio (1.618). Practicioners 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.
Critics claim the wave principle is too vague to be useful, since it cannot always identify when a wave begins or ends, and that Elliott wave forecasts are prone to subjective revision. Skeptics also say that if the theory is true, widespread knowledge of it among investors would lead to distortions of the very patterns they were trying to anticipate, rendering the method useless. This same argument is made against other predictive methods that are based on public, market-wide data.
Also, the premise that markets unfold in recognizable patterns contradicts other market models such as the Efficient market hypothesis, which assumes that prices move randomly and cannot be predicted.
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