Elliott Wave analysis is a form of technical analysis based on a theory developed by accountant Ralph Nelson Elliott. He published his theory of stock market behavior in 1938 in a book called ‘The Wave Principle’. More recently, Elliott’s work was popularized by market analyst Robert Prechter during the 1970s and 80s.
The principle of Elliott’s theory is that human behavior is cyclical, and as a result, collective investor behavior follows a sequence which can be analyzed and charted. The patterns formed by these behavioral sequences can be used to predict probable future price movement. As with most forms of technical analysis, Elliott Wave analysis relies primarily on price data.
A Revolutionary Theory
The Elliott Wave Principle was a groundbreaking development in stock market analysis, as it offered a rationale to investor behavior, and as a result price movement, which was previously widely considered to be erratic and unpredictable. Elliott proposed, and demonstrated, that over any time period, investor behavior follows repetitive wave-like patterns, and that by studying these patterns, future price movement could be anticipated with ‘justification and certainty’ that had formerly been considered unachievable.
Structure of the Elliott Wave Model
The basic Elliott Wave model comprises a pattern of five waves which keep the price movement going in the direction of the developing trend, followed by three waves which take it back in the opposite direction. In an upward trend or bull market, these initial five waves are zig-zagging in an upward direction, and are then followed by three waves progressing downward. During a downtrend or bear market cycle, this pattern is reversed, with the five waves moving in a downward direction, followed by three waves bearing upward.
Elliott Wave analysis describes the five-wave trend-following phase as the impulsive, or motive, phase. The subsequent three-wave component of the cycle is called the corrective phase. The waves in each phase alternate between impulsive and corrective, meaning that in a uptrend, the first, third and fifth waves depict definite movement upward, and are interspersed by a partial retracement downwards on the second and fourth waves. The corrective phase to this uptrend shows a strong downward movement on the first of the three waves, followed by a partial retracement upwards on the second, and further downward movement on the third wave.
Understanding the 'Waves' in Elliott Wave Analysis
Each wave represented in Elliott Wave analysis has its own distinct characteristics. The first wave of the motive phase is frequently discounted by most market players, as there is still a commonly held belief in the previous trend. The second wave takes the price back in the direction of the preceding trend, giving the naysayers some evidence that they were correct in their support of the prior trend, however, the wave never fully retraces the movement of the first wave. The statistical measure of retracement is typically no greater than 61.8% which aligns with the Fibonnaci numbers which Elliott came to realize are reflected in his model.
The third wave of the motive phase is frequently the most powerful in the series, and the price movement gathers popular support from analysts and investors by the mid-to-end segment of this wave. The fourth wave is generally easy for most observers to define as a correction, rather than the beginning of a reversal. Much of the movement is often sideways, and in total, does not retrace more than 38.2% of the movement experienced during the third wave.
The fifth wave, which is the final wave in the motive phase, is a period of price movement which is almost universally supported. The danger in this is that many investors leave their entry into the trade until close to the peak of the wave, when everyone is proclaiming the strength of the trend. This leaves little time to benefit from the movement, and they will often end up holding their position well into the ensuing corrective phase in the hope that the prices will once again continue moving in the previous direction.
Entering the corrective phase, the first wave is often mistaken as simply a correction in the preceding trend which was represented by the motive phase. It can be helpful to note that this wave is generally accompanied by greater volume and increased implied volatility.
The second wave of this corrective phase sees a partial retracement of the movement experienced in the first wave. While the prices do not fully retrace the most recent movement, many observers optimistically see this as return to the prior trend. Chart patterns may help alert traders that a reversal is underway, and the waves can represent a head and shoulders reversal pattern. The volume during this second wave is generally lower than the volume of the first wave in this phase.
The third wave is accompanied by increased volume, and during the course of this wave, it becomes a generally recognized fact that the tide has turned, and the prices are genuinely moving steadily in the current direction. The extent of this wave is normally at least equal to the first wave of this phase, and often greater.
Elliot Wave analysis provides a practical model for understanding the method in the ‘madness’ that often seems to represent the movement of stock market prices. Respected by many leading traders and analysts, and compatible with both chart patterns and mathematical theory, the Elliott Wave Principle offers a useful method of analyzing market trends and cycles.