Elliott Wave Theory

Hundreds of theories have been advanced concerning the ups and downs of the so-called business cycle. Pigou an English economist reduced the fluctuations to the human equation. He believed the upward and down-ward swings were caused by excesses of human optimism followed by excessive pessimism. The pendulum swings too far one way and then there is a glut; it swings too far the other way and there is a scarcity. As pointed out previously Charles Dow noted a certain repetition also in the markets. Ralph N. Elliott, who at the time he evolved his theory, had probably never heard of Pigou. Out oh his own private analysis and study Elliott discovered the same repetitious phenomena as Dow. In developing his theory through historical observation, study and thought he incorp-orated what Dow had discovered but went well beyond Dow's theory in comprehension and exactitude. Both men had sensed the involutions of the human equation that dominated market movements, but where Dow painted with broad-brush strokes, Elliott painted with greater breath and clarity of detail.

In the 1930's Ralph Nelson Elliott discovered that stock market prices trend and reverse in recognisable patterns. The patterns he discovered are repetitive in form, but not necessarily in time or amplitude. Elliott isolated thirteen such patterns, or "waves, that recur in market data. He named, defined and illustrated the patterns. He then described how they link together to form larger versions of themselves, how they in turn link to form the same patterns at the next larger size, and so on, producing a structured progression. He called this phenomenon THE WAVE PRINCILPE. Although it is the best forecasting tool in existence, the wave principle is not primarily a forecasting tool; it is a detailed description of how markets behave. The primary value of the wave principle is that it provides a context for market analysis. This context provides both a basis for disciplined thinking and a perspective on the market's general position and outlook.

Basic Tenets
Under the wave principle, every market decision is both produced by meaningful information and produces meaningful information. Each transaction, while at once an effect, enters the fabric of the market and by communicating transactional data to investors, joins the chain of causes of others' behaviour.

The Five-Wave Pattern
The markets progress ultimately takes the form of five waves of a specific nature. Three of these waves, which are labelled 1,3 and 5 actually effect the direction of the movement.They are separated by the counter-trend interruptions, which are labelled 2 and 4. (See Fig. below). Elliott noted three consistent aspects of the five-wave form. They are wave 2 never moves beyond the start of wave 1; wave 3 is never the shortest wave; wave 4 never enters the price territory of wave 1.

At any time the market may be identified as being somewhere in the basic five-wave pattern, at the largest degree of trend, because the five-wave pattern is the overriding form of market progress, thus all other patterns are subsumed by it.

 

Wave Mode
There are two modes of wave development: Motive and Corrective.
Motive waves have a five-wave structure (1,2,3,4,5) while corrective waves have a three-wave structure (A,B,C).

Wave Structure Example

                                                          5.
                                                                   A.
                                                                             B.
                                       4.                                                       C.

 

                    3.

 

        2.

 

 

1.

 


Thus a complete cycle comprises of eight wave movements, 5 motive and 3 corrective. The crucial point to remember is that motive waves do not always point upward and corrective waves do not always point down-
ward. In an upward cycle each wave would conform to the following market analysis:

Motive Form:
1.          Rebound from market bottom
2.          Testing of lows
3.          Powerful move up on fundamentals
4.          Earnings concerns
5.          Final excess advance

Corrective Form:
A.          Technical breakdown
B.          Emotive advance
C.          Bear market collapse

Application
Without Elliott (or Dow for that matter), there appear to be an infinite number of possibilities for market action. What the wave principle provides is a means of first limiting the possibilities and then ordering
the relative probabilities of possible future market paths.

 

Ratio Analysis and Fibonacci Numbers
As noted by Dow in his study of the markets, retracements usually conform to standard ratios of 1/3, 1/2 or 2/3. Knowledge of this trending tendency lends greater probability to the timing of wave movements.                                                                          

WWW.Wealthbuilder.ie 2007
Christopher M. Quigley B.Sc., M.M.I.I., M.A.