Elliott Waves and Elliott Wave Theory

What is an Elliott Wave? What is Elliott Wave Theory?

A theory named after Ralph Elliot, who contended that the stock market tends to move in discernible and predictable patterns reflecting the basic harmony of nature and extended by other technical analysts to futures markets.

In technical analysis, Elliott Waves are a charting method based on the belief that all prices act as waves, rising and falling rhythmically. (Source: CFTC)

The Elliott wave principle or 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. (Practitioners today call these components Elliott waves, or simply waves.)

In 1946 Elliott published his final major work, Nature's Law, which "includes almost every thought Elliott ever had concerning the theory of the Wave Principle." Elliott believed this law to be "the secret of the universe," and said that "because man is subject to rhythmical procedure, calculations having to do with his activities can be projected far into the future with a justification and certainty heretofore unattainable."

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 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.

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 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." (Source: Wikipedia)

Related Resources:
Elliott Wave International (Website)
Elliott Wave Principle: Key to Market Behavior (Book)