Elliott wave principle

Elliott wave principle

From Wikipedia, the free encyclopedia

The

Elliott wave principle

is a form of

technical analysis

that some

traders use to analyze financial market cycles and forecast

market

trends

by identifying extremes in investor psychology, highs and

lows in prices, and other collective factors.

Ralph Nelson

Elliott

(1871

–

1948), a professional accountant, discovered the

Proposed

Economic Waves

Cycle/Wave Name

Kitchin inventory

Years

3

–

5

Juglar fixed investment

7

–

11

Kuznets infrastructural investment

15

–

25

45

–

60

underlying social principles and developed the analytical tools in the

Kondratiev wave

1930s. He proposed that market prices unfold in specific patterns,

which practitioners today call Elliott waves, or simply waves. Elliott

published his theory of market behavior in the book

The Wave

Principle

in 1938, summarized it in a series of articles in

Financial

World

magazine in 1939, and covered it most comprehensively in

his final major work,

Nature’s Laws: The Secret of the Universe

in

1946. Elliott stated that

procedure, calculations having to do with his activities can be

Pork cycle

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projected far into the future with a justification and certainty heretofore unattainable.

[1]

The empirical

validity of the Elliott Wave Principle remains the subject of debate.

Contents

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1 Overall design

2 Degree

3 Elliott Wave personality and characteristics

4 Pattern recognition and fractals

5 Elliott wave rules and guidelines

6 Fibonacci relationships

7 After Elliott

8 Rediscovery and current use

9 Criticism

10 See also

11 Notes

12 References

13 External links

Overall desig n

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From R.N. Elliott's essay,

The Elliott Wave Principle posits that collective investor psychology, or

crowd psychology

, moves between

optimism and pessimism in natural sequences. These mood swings create patterns evidenced in the price

movements of markets at every degree of

trend

or time scale.

In Elliott's model, market prices alternate between an impulsive, or

motive

phase, and a corrective phase

on all time scales of trend, as the illustration shows. Impulses are always subdivided into a set of 5 lower-

degree waves, alternating again between motive and corrective character, so that waves 1, 3, and 5 are

impulses, and waves 2 and 4 are smaller retraces of waves 1 and 3. Corrective waves subdivide into 3

smaller-degree waves starting with a five-wave counter-trend impulse, a retrace, and another impulse. 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.

Degree

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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 lowermost 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 to 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):

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Grand supercycle

: multi-century

Supercycle: multi-decade (about 40

–

70 years)

Cycle: one year to several years (or even several decades under an Elliott Extension)

Primary: a few months to a couple of years

Intermediate: weeks to months

Minor: weeks

Minute: days

Minuette: hours

Subminuette: minutes

Elliott Wave personality and ch aracteristics

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Elliott wave analysts (or

Elliotticians

) hold that each individual wave has its own

signature

or characteristic,

which typically reflects the psychology of the moment.

[2][3]

Understanding those personalities is key to the

application of the Wave Principle; they are defined below. (Definitions 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.

Wave B:

Prices reverse higher, which many see as a

Typically, the news is still bad. As prices retest the

resumption of the now long-gone bull market. Those

prior low, bearish sentiment quickly builds, and

familiar with classical technical analysis may see the

crowd

peak as the right shoulder of a head and shoulders

still deeply ensconced. Still, some positive signs appear

reversal pattern. The volume during wave B should be

for those who are looking: volume should be lower

lower than in wave A. By this point, fundamentals are

during wave two than during wave one, prices usually

probably no longer improving, but they most likely

do not retrace more than 61.8% (see Fibonacci section

have not yet turned negative.

below) of the wave one gains, and prices should fall in

a three wave pattern.

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

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

analysts start to raise earnings estimates. Prices rise

wave A and often extends to 1.618 times wave A or

quickly, corrections are short-lived and shallow.

beyond.

Anyone looking to

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,

will often join the new bullish trend. Wave three often

extends wave one by a ratio of

1.618:1

.

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 (see Fibonacci relationships below).

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, fourth waves are often

frustrating because of their lack of progress in the

larger trend.

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 often lower in wave five than

in wave three, and many momentum indicators start to

show divergences (prices reach a new high but the

indicators do 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).

Pattern recognition and fractals

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Elliott's market model relies heavily on looking at price charts. Practitioners study developing trends 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:

programmed by mathematics. Seashell, galaxy, snowflake or human: we're all bound by the same order.

[4]

Elliott wave rules and guidelines

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A correct Elliott wave

1.

Wave 2 never retraces more than 100% of wave 1.

2.

Wave 3 cannot be the shortest of the three impulse waves, namely waves 1, 3 and 5.