By Scott Downing
The Elliott Wave Principle focuses on the behavior of humans and how that behavior impacts the stock market. Rather than acting in an unpredictable manner, Ralph Nelson Elliott (in the late 1920s) noticed that the market actually ran in repetitive cycles – which were a result of investors’ reactionary behavior to outside influences. The principle was published in Elliott’s books The Wave Principle and Nature’s Laws – The Secret of the Universe. Elliott believed that humans are rhythmical beings, so all human decisions and actions could be predicted in rhythms. So basically, we have a stock principle based on human behavior.
While Elliott’s Wave Principle is based partially on the Dow Theory, it expands on the belief thanks to individual wave aspects that Elliott uncovered. According to Elliott, an impulsive wave follows the main trend – and it is comprised of five other waves, a pattern that runs infinitely (these are wave degrees). Each impulse wave is followed by a corrective wave, which occurs in threes – creating a five/three pattern.
Robert Prechter et al are among the biggest proponents of Elliott Wave theory. The long-term record of such analysis is a bit spotty though — they have called some big market moves very well, yet also been on the wrong side of some gigantic long-term moves.
There are waves inside the waves – you can notice that in each of the uptrends (1, 3, and 5). Waves 2 and 4 are the corrective waves, completing the cycle. Each of those impulsive waves is made of other five/three patterns, as this pattern occurs infinitely. An Elliott Wave is fractal – meaning that each wave can be broken into parts in an infinite manner.
For those who utilize these techniques, they break down waves into degrees of the pattern, each with its own name. These degrees are not classified by their form; not by their size or duration. Therefore, waves of the same degree may have different sizes or durations. The waves are named:
o Grand Supercycle (the longest) o Supercycle o Cycle o Primary o Intermediate o Minor o Minute o Minuette o Subminuette (the shortest)
The Grand Supercycle can take years to complete while the subminuette can take mere minutes to run its course. Bottom Line: Elliott Wave (and Wave Theory in general) is fairly hard to quantify and utilize as a practical trading technique. Certainly there is a logical basis to the fact that “waves” occur both in nature and the stock market — and the psychological implications of various waves/trends from investor behavior are important, as well. Wave Theory technical analysis practitioners tend to be “true believers”, but testing and measuring indicators for short-term active investing based on these theories/methods can be difficult.
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About the Author
Scott Downing is a Research Analyst with BigTrends.com. Scott’s columns are published in the Daily TrendWatch and Market Commentary. He also manages the SMARToptions recommendation service.
