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Elliott wave principle
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The Elliott wave principle is a form of technical analysis that attempts to forecast trends in the financial markets and other collective activities. It is named after Ralph Nelson Elliott (1871–1948), an accountant who developed the concept in the 1930s: he proposed that market prices unfold in specific patterns, which practitioners today call Elliott waves. Elliott published his views of market behavior in the book The Wave Principle (1938), in a series of articles in Financial World magazine in 1939, and most fully in his final major work, Nature’s Laws – The Secret of the Universe (1946).[1] Elliott argued that because humans are themselves rhythmical, their activities and decisions could be predicted in rhythms, too. Critics argue that the Elliott wave principle is pseudoscientific and contradicts the efficient market hypothesis.
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[edit] Overall design
The wave principle posits 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 at every degree of trend.
Practically all developments which result from (human) socialeconomic processes follow a law that causes them to repeat themselves in similar and constantly recurring series of waves of definite number and pattern. R. N. Elliott's model, in Nature’s Law: The Secret of the Universe says that market prices alternate between five waves and three waves at all degrees within a 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 "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 opposite 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 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-decade to multi-century
- Supercycle: a few years to a few decades
- Cycle: one year to a few years
- Primary: a few months to a couple of years
- Intermediate: weeks to months
- Minor: weeks
- Minute: days
- Minuette: hours
- Subminuette: minutes
[edit] Behavioral characteristics and wave "signature"
Elliott Wave analysts (or "Elliotticians") hold that it is not necessary to look at a price chart to judge where a market is in its wave pattern. Each wave has its own "signature" which often reflects the psychology of the moment. Understanding how and why the waves develop is key to the application of the Wave Principle; that understanding includes recognizing the characteristics described below.[2]
These wave characteristics 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 market begins, the fundamental news is almost universally negative. The previous trend is considered still strongly in force. Fundamental analysts continue to revise their earnings estimates lower; the economy probably does not look strong. Sentiment surveys are decidedly bearish, put options are in vogue, and implied volatility in the options market is high. Volume might increase a bit as prices rise, but not by enough to alert many technical analysts. | Wave A: Corrections are typically harder to identify than impulse moves. In wave A of a bear market, the fundamental news is usually still positive. Most analysts see the drop as a correction in a still-active bull market. Some technical indicators that accompany wave A include increased volume, rising implied volatility in the options markets and possibly a turn higher in open interest in related futures markets. | |
| Wave 2: Wave two corrects wave one, but can never extend beyond the starting point of wave one. Typically, the news is still bad. As prices retest the prior low, bearish sentiment quickly builds, and "the crowd" haughtily reminds all that the bear market is still deeply ensconced. Still, some positive signs appear for those who are looking: volume should be lower during wave two than during wave one, prices usually do not retrace more than 61.8% (see Fibonacci section below) of the wave one gains, and prices should fall in a three wave pattern. | Wave B: Prices reverse higher, which many see as a resumption of the now long-gone bull market. Those familiar with classical technical analysis may see the peak as the right shoulder of a head and shoulders reversal pattern. The volume during wave B should be lower than in wave A. By this point, fundamentals are probably no longer improving, but they most likely have not yet turned negative. | |
| Wave 3: Wave three is usually the largest and most powerful wave in a trend (although some research suggests that in commodity markets, wave five is the largest). The news is now positive and fundamental analysts start to raise earnings estimates. Prices rise quickly, 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 C: Prices move impulsively lower in five waves. Volume picks up, and by the third leg of wave C, almost everyone realizes that a bear market is firmly entrenched. Wave C is typically at least as large as wave A and often extends to 1.618 times wave A or beyond. | |
| 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. 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, the most distinguishing feature of fourth waves is that they often prove very difficult to count. | ||
| 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 lower in wave five than in wave three, and many momentum indicators start to show divergences (prices reach a new high, the indicator does 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 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 (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."[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 (ca 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.[4]
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."[5]
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."[6] The Socionomics Institute also reviewed data in the Batchelor-Ramyar study, and said this data shows "Fibonacci ratios do occur more often in the stock market than would be expected in a random environment."'[7]
Example of The Elliott Wave Principle and The Fibonacci Relationship
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 1979.
[edit] Rediscovery and current use
Robert Prechter came across Elliott's works while working as a market technician at Merrill Lynch. His fame as a forecaster during the bull market of the 1980s brought the greatest exposure to date to Elliott's theory, and today Prechter remains the most widely known Elliott analyst.
Among market technicians, wave analysis is widely accepted as a component of their trade. Elliott Wave Theory 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, 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."[8]
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."[9]
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. A paper he co-authored in 1996 ("Stock Market Crashes, Precursors and Replicas") 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."[10]
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" --
- "[McGee 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."[11]
Pauline Novak-Reich in her provocatively entitled book, "The Bell Does Ring; Timing the Australian Stock Market with Gann and Elliott Strategies" counters the claims of the Efficient Market Hypothesis of Eugene Fama in an exposition that integrates Elliott Wave Theory with the Gann approach. [12]
[edit] Criticism
The premise that markets unfold in recognizable patterns contradicts the efficient market hypothesis, which says 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 investors 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."[13]
Robert Prechter had previously said that ideas in an article by Mandelbrot[14] "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."[15]
Critics also say 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:[16]
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.
However, Robert R. Prechter Jr. set an all time record in the United States Trading Championship by returning 444.4% in a monitored real-money options account in the four month contest period.[17] During the contest, he traded using the Elliott Wave Principle. In December 1989, Financial News Network named him "Guru of the Decade".[17]
