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| Ralph Nelson Elliott |
- Elliott Wave Theory
Ralph Nelson Elliott
Back in the old school days of the 1920-30s, there was this mad genius and professional accountant named Ralph Nelson Elliott.
By analyzing closely 75 years worth of stock data, Elliott discovered that stock markets, thought to behave in a somewhat chaotic manner, actually didn't.
When he hit 66 years old, he finally gathered enough evidence (and confidence) share his discovery with the world.
He published his theory in the book entitled The Wave Principle.
According to him, the market traded in repetitive cycles, which he pointed out were the emotions of investors caused by outside influences (ahem, CNBC, Bloomberg, ESPN) or the predominant psychology of the masses at the time.
Elliott explained that the upward and downward swings in price caused by the collective psychology always showed up in the same repetitive patterns.
He called these upward and downward swings "waves".
He believes that, if you can correctly identify the repeating patterns in prices, you can predict where price will go (or not go) next.
This is what makes Elliott waves so appealing to traders. It gives them a way to identify precise points where price is most likely to reverse. In other words, Elliott came up with a system that enables traders to catch tops and bottoms.
So, amidst all the chaos in prices, Elliott found order. Awesome, huh?
Of course, like all mad geniuses, he needed to claim this observation and so he came up with a super original name: The Elliott Wave Theory.
But before we delve into the Elliott waves, you need to first understand what fractals are.
- Fractals
You don't need to go far to find examples of fractals. They can found all over nature!
A sea shell is a fractal. A snow flake is a fractal. A cloud is a fractal. Heck, a lightning bolt is a fractal.
So why are fractals important?
One important quality of Elliott waves is that they are fractals. Much like sea shells and snow flakes, Elliott waves could be further subdivided into smaller Elliot waves.
Ready to be an Elliottician now? Read on!
The 5 - 3 Wave Patterns
Mr. Elliott showed that a trending market moves in what he calls a 5-3 wave pattern.The first 5-wave pattern is called impulse waves.
The last 3-wave pattern is called corrective waves.
In this pattern, Waves 1, 3, 5 are motive, meaning they go along with the overall trend, while Waves 2 and 4 are corrective.
Do not confuse Waves 2 and 4 with the ABC corrective pattern (discussed in the next section) though!
Let's first take a look at the 5-wave impulse pattern. It's easier if you see it as a picture:
That still looks kind of confusing. Let's splash some color on this bad boy.
Here is a short description of what happens during each wave.
We're going to use stocks for our example since stocks are what Mr. Elliott used but it really doesn't matter what it is. It can easily be currencies, bonds, gold, oil, or Tickle Me Elmo dolls. The important thing is the Elliott Wave Theory can also be applied to the foreign exchange market.
Wave 1
The stock makes its initial move upwards. This is usually caused by a relatively small number of people that all of the sudden (for a variety of reasons, real or imagined) feel that the price of the stock is cheap so it's a perfect time to buy. This causes the price to rise.Wave 2
At this point, enough people who were in the original wave consider the stock overvalued and take profits. This causes the stock to go down. However, the stock will not make it to its previous lows before the stock is considered a bargain again.Wave 3
This is usually the longest and strongest wave. The stock has caught the attention of the mass public. More people find out about the stock and want to buy it. This causes the stock's price to go higher and higher. This wave usually exceeds the high created at the end of wave 1.Wave 4
Traders take profits because the stock is considered expensive again. This wave tends to be weak because there are usually more people that are still bullish on the stock and are waiting to "buy on the dips."Wave 5
This is the point that most people get on the stock and is most driven by hysteria. You usually start seeing the CEO of the company on the front page of major magazines as the Person of the Year. Traders and investors start coming up with ridiculous reasons to buy the stock and try to choke you when you disagree with them. This is when the stock becomes the most overpriced. Contrarians start shorting the stock which starts the ABC pattern.Extended Impulse Waves
One thing that you also need to know about the Elliott Wave Theory is that one of the three impulse waves (1, 3, or 5) will always be "extended". Simply put, there will always be one wave that is longer than the other two, regardless of degree.According to Elliott, it is usually the fifth wave which is extended. As time went by, this old school style of wave labeling has changed because more and more people started labeling the third wave as the extended one.
