In the 1930s, Ralph Nelson Elliott introduced an entirely new paradigm for market analysis and prediction. Instead of viewing the marketplace as inherently chaotic and prone to random activity, Elliott argued that it is possible to observe noticeable, repetitive patterns. These patterns, or "waves" as Elliott referred to them, move in fractal patterns and provide analysts with the ability to predict upcoming market action. Understanding the fine details of the Elliott Wave Theory stock market tools and its use in making market predictions requires analysts to understand the different types of waves defined by Elliott and the implications of their behavior.
Elliott Wave Theory provides analysts with the tools they need to identify market trends and leverage this knowledge as part of smart investing. Although there is no surefire method for predicting the actions of the marketplace, the Elliott Wave Theory is one of several tools which can help investors maximize their returns and reduce risk.
The Basics of Elliott Wave Predictions
On a fundamental level, Elliott defined two primary forms of waves that influence market behavior: impulse waves and corrective waves.
An impulse wave can be defined as a significant swing in the price of an asset which largely coincides with more broad trend lines of the asset or market. According to Elliot Wave Theory, there is no specific limitation on the time frame that must be used in order to assess the appearance of or legitimacy of an impulse wave. For example, impulse waves can be observed on a scale ranging from hours to years and even decades.
Generally speaking, it is possible to label market activity as an impulse wave if it continues in the same direction as market trends by at least one additional degree. In order for an impulse wave to exist, it must consist of five individual sub-waves which, as a whole, demonstrate net movement in the direction of the trend line for the market as a whole.
Analysis of Impulse and Corrective Waves
There are three concrete rules that govern the behavior and characteristics of impulse waves, as demonstrated by Elliott. They are the following:
- The second leg of the impulse wave cannot retrace the first leg of the wave by more than 100 percent.
- The third leg of the impulse wave will never be the shortest of legs 1, 3 or 5.
- The retrace occurring as part of leg 2 will never take this specific section of the impulse wave below the peak (during a market uptrend) or trough (during a market downtrend) of leg 1.
In addition to impulse waves, corrective waves also play a large role in market analysis. Unlike impulse waves, corrective waves move counter to the trend line of the market as a whole. These three sub-waves exist in combination with impulse waves to create what Elliott believed to be a predictable pattern of market activity.
Exploring Elliot Wave Theory Foundations
Central to Elliott's theory is the concept that there is a deeply embedded set of behavioral patterns in all waves. Essentially, one should be able to "zoom in" on a larger wave and discover the same recurring patterns of impulse waves and corrective waves, albeit it on a smaller scale.
Elliott believes that market activity always followed a clear "5-3" pattern. Essentially, there would always be 5 wave motions in the same direction as current trends, followed by 3 corrective waves moving against the main trend. No matter what duration of time one uses to analyzes market activity, the same 5-3 pattern should be present.
Although the terms "impulse" and "corrective" clearly define the direction a wave is traveling, they do not provide any real measure of the size or strength of the wave. With this idea in mind, Elliott also defined nine specific sizes of waves that could occur. In order from largest to smallest, these wave sizes are: grand supercycle, supercycle, cycle, primary, intermediate, minor, minute, minuette and sub-minuette. According to the rules of the theory, the fractal nature of these waves means that within a grand supercycle wave, one could find virtually all other wave sizes.
Predicting Price Motion Using Elliott Wave Theory
Now that the types of waves involved in the theory have been discussed, it is possible to explore how they interact with one another during market action. As mentioned previously, Elliott's theory states that an impulse wave is composed of five distinct movements in the direction of market trend. Following this fifth and final movement either up or down, the price should reverse direction as part of a series of corrective waves. There should be three corrective waves that occur during this time.
This description does not mean to imply that there will be no small reversals during the impulse wave. In fact, each of the five elements of the impulse moving in the direction of market trend will often be followed by a very short price reversal. However, Elliott's Wave Theory states that it is only after the fifth wave segment of the impulse that one can expect a true reversal of price action.
Applying Wave Theory in Common Practice
Although Elliott's theory clearly establishes a means of analyzing and defining action within the market, those who use the theory on a regular basis agree that the fractal nature of the theory and its observable nature in the marketplace do not necessarily mean that the market should be considered predictable. This is likely due to the fact that the fractal nature of these waves can also make it somewhat difficult to observe precisely when a wave is ending and when the next is beginning.
For those who defend the accuracy of Elliot Wave Theory and its practicality in modern market applications, a specific historical example is often mentioned. In 1987, Robert Prechter – an expert in Elliot's wave theory – noticed a series of market parameters which, according to his own understanding of wave theory and the recent history of the marketplace, signaled the beginning of a significant decline in market value.
On Friday, Oct. 2, 1987, Prechter advised traders to exit their positions. Beginning the next Monday, the market experienced what is now referred to as "Black Monday," a 23 percent drop in market value that spearheaded a total drop of 34 percent over a span of two weeks. This particular event, no doubt one of the most historic events in the history of the modern financial markets, cemented the credibility of Elliott Wave theory and Prechter himself for the foreseeable future.
Criticism of Elliott Wave Theory
Perhaps one of the most common criticisms of Elliott's wave predictions is that the ever-fluctuating forces of supply and demand embed a degree of randomness within the market that Elliott Wave Theory simply cannot account for. Although it is true that supply and demand do influence the behavior of the market, advocates of the Elliot Wave Theory argue that this does not necessarily void any element of pattern recognition and analysis due to the fact that individuals acting en masse as part of global supply and demand help void randomness and help create predictable patterns that often occur in crowd mentality.
Yet another common criticism of Elliott Wave Theory is the idea that the fractal nature of the waves renders any real identification of the terminal points for impulse/corrective waves next to impossible. As proof, critics of the theory point to numerous instances in recent years where analysts applying these techniques to market analysis have predicted the exact opposite of what actually occurred in the marketplace.
For example, an analyst may predict a market downturn when, in fact, the market climbed significantly. In situations such as this, defenders of the theory have argued that the mistake was due to a misinterpretation of available data rather than the theory itself. This explanation, however, does help reinforce the idea that a truly accurate analysis of market trends using Elliott Wave Theory can be extremely difficult, even for professional market researchers. Although much criticism exists, there has been no definitive criticism which has made the Elliott Wave Theory debunked.
Moving Ahead With Wave Theory
For many individuals, researching the fine details of the wave theory and its applicability to modern markets is more of a recreational pursuit than a full-time profession. That being said, those who are serious about leveraging the predictive potential of the theory should be aware that tools such as these are best used as part of a larger analytical toolkit rather than on its own. The ability to reinforce or challenge predictions supported by Elliott Wave Theory with other data-driven tools will help investors make informed and confident decisions with regard to their investments.
As with any investment strategy, it is always important to remember there are no guarantees in the marketplace. Although the Elliott Wave Theory has proven itself to be an effective analytical tool for many investors, this does not mean that you will achieve an identical level of profitability or success.
Before making your own decision regarding the merits of Elliott Wave Theory, it is strongly recommended that you take the time to further explore writings and research that cover this particular analytical tool. Given its popularity and controversy, there have been numerous books and writings published on Elliott Wave Theory which can help you supplement your knowledge of this exciting element of market analysis.
Practicing With Elliott Wave Theory Today
Given the significant degree of interpretation and subjective measure involved in this theory, you will benefit immensely from practicing your predictive skills before entering the market place. A variety of stock simulators are available online which you can use to "invest" in stocks using fake currency. Use your interpretations of market activity as part of Elliott Wave Theory to make your picks.
You may discover that the analytical tools presented in the theory are consistent with market activity. It is equally possible that you will discover that you are not yet ready to apply this theory with real investing. In either case, practicing the application of Elliott Wave Theory will ensure that you are fully prepared to make a wise choice in the marketplace using your own specific skill set.
A variety of sophisticated computer modeling algorithms are modeling Elliott Wave Theory today which can help take some of the analytical subjectivity and "guesswork" out of the theory. If you are serious about mastering the application of this particular trading strategy, you may benefit from exploring the computer-driven analysis tools being offered today.
Ryan Cockerham is a nationally recognized author specializing in all things business and finance. His work has served the business, nonprofit and political community. Ryan's work has been featured on PocketSense, Zacks Investment Research, SFGate Home Guides, Bloomberg, HuffPost and more.