The Elliott Wave Principle – An Analysis

The Elliot Wave Principle is a theory about mass psychology applied to financial markets. The EW principle suggests that mass psychology swings from pessimism to optimism in a predictable and cyclical wave pattern and that this pattern can be seen in price movements in financial markets.

EW analysis is a form of technical analysis that attempts to forecast financial markets by identifying the beginning, middle and end of a predictable wave sequence. The theory was developed by Ralph Nelson Elliot, an accountant in the 1930s.

The EW principle posits that human collective behavior shifts between optimism and pessimism in a predictable natural sequence and that this sequence can be seen in market price movements. due to the predictable nature of the wave sequence, when one has accurately identified the beginning one can forecast behavior by the natural sequence of action and response that waves represent. this ability to predict the actions of the market allows one to profitably buy and sell financial products.

According to Elliot, all natural processes repeat themselves in constantly reoccurring waves in a definite pattern and number. his model, in Nature’s Law: The Secret of the Universe, argues that market prices alternate between five waves and three waves at all degrees within a trend. The dominant waves 1, 3, and 5 are called motive waves, and each motive wave itself subdivides into five waves. Waves 2 and 4 are known as corrective waves, and subdivide into three waves. Motive waves can be either pessimistic or optimistic depending on whether the market is bullish or bearish.

Elliott believed each wave had a personality. The personality is an expression of the collective psychology at that moment in time. To apply the wave principal effectively an investor must understand how and why the wave developed. one must understand the initial catalyst.

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.

The Elliott Wave Principle – An Analysis

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