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 the concept in the 1930s, proposing that market prices unfold in specific patterns, which practitioners today call Elliott waves, or simply waves. He published his views of market behavior in the book ''The Wave Principle'' (1938), in a series of articles in ''Financial World'' magazine in 1939, and most fully in his final major work, ''Natures Laws The Secret of the Universe'' (1946).R.N. Elliott, ''R.N. Elliott's Masterworks'', ed. Robert R. Prechter, Jr. (New Classics Library, 1994, P.O. Box 1618 Gainesville Georgia 30503), 70, 217, 194, 196. Elliott 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."
==Overall design==
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 micro or macro.
[[Image:Elliott wave.svg|thumb|250px|right|From R.N. Elliott's essay, "The Basis of the Wave Principle," October 1940.]]
Elliott's model proposes that market prices alternate between five waves and three waves at all degrees of trend, as the illustration shows. 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.
==Degree==
The patterns link to form five and three-wave structures of increasing size or "degree." Note the lowest 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 one larger degree 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. The completed motive pattern includes 89 waves, followed by a completed corrective pattern of 55 waves.
Each degree of the 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 cycles). 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.
The classification of a wave at any particular degree can vary among practitioners, though the standard order of degrees is generally agreed as follows (approximate durations given):
* Grand Supercycle - multi-decade to multi-century
* [[Supercycle]] - from a few years to a few decades
* Cycle - from one year to a few years
* Primary - from a few months to a couple of years
* Intermediate - weeks to months
* Minor - weeks
* Minute - days
* Minuette - hours
* Subminuette - minutes
== Pattern recognition and fractals ==
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]] ([[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: "It's as though we are somehow programmed by mathematics. Seashell, galaxy, snowflake or human: we're all bound by the same order." John Casti (31 August 2002). "I know what you'll do next summer". ''New Scientist'', p. 29.
== Fibonacci relationships ==
R. N. Elliott's analysis of the mathematical properties of waves and patterns eventually led him to conclude that "The Fibonacci Summation Series is the basis of The Wave Principle." Numbers from the [[Fibonacci number|Fibonacci sequence]] surface repeatedly in Elliott wave structures, including motive waves (1, 3, 5), a single full cycle (5 up, 3 down = 8 waves), and the completed motive (89 waves) and corrective (55 waves) patterns. Elliott developed his market model before he realized that it reflects the Fibonacci sequence. "When I discovered The Wave Principle action of market trends, I had never heard of either the Fibonacci Series or the Pythagorean Diagram."
The Fibonacci sequence is also closely connected to the [[Golden ratio]] (1.618). Practitioners commonly use this ratio and related ratios to establish support and resistance levels for market waves, namely the price points which help define the parameters of a trend. Alex Douglas, "Fibonacci: The man & the markets," Standard & Poor's Economic Research Paper, February 20, 2001, pp. 8-10. [http://www.analistademercado.com.br/Fibonacci01.pdf PDF document here]
Finance Professor Roy Batchelor and researcher Richard Ramyar studied whether the Fibonacci sequence appears non-randomly in the stock market, as the work of Elliott and Prechter predicts. The researchers state the "idea that prices retrace to a Fibonacci ratio or round fraction of the previous trend clearly lacks any scientific rationale." From their empirical work they conclude "there is no significant difference between the frequencies with which price and time ratios occur in cycles in the Dow Jones Industrial Average, and frequencies which we would expect to occur at random in such a time series." Roy Batchelor and Richard Ramyar, "Magic numbers in the Dow," 25th International Symposium on Forecasting, 2005, p. 13, 31. [http://www.cass.city.ac.uk/media/stories/resources/Magic_Numbers_in_the_Dow.pdf PDF document here]
Robert Prechter replied to the Batchelor-Ramyar study, saying that it "does not challenge the validity of any aspect of the Wave Principle...it supports wave theorists' observations." Robert Prechter (2006), "Elliott Waves, Fibonacci, and Statistics," p. 2. [http://www.socionomics.org/pdf/EW_Fibo_Statistics.pdf PDF document here] The Socionomics Institute also reviewed data in the Batchelor-Ramyar study, and said this data shows that "Fibonacci ratios do occur more often in the stock market than would be expected in a random environment."' Deepak Goel (2006), "Another Look at Fibonacci Statistics." [http://www.socionomics.net/pdf/Fibo_Statistics.pdf PDF document here]
According to Steven Poser, author of "Applying Elliott Wave Theory Profitably" (Wiley, July 2003), and Member of the Board of the Market Technicians Association, states that studies that seek to prove or disprove Fibonacci Retracements and projections fail to use Elliott's principles in calculating proper price levels. Each swing does not necessarily result in a Fibonacci retracement, and all moves are not measured from actual high to low. Any attempt to disprove Elliott Wave via such incorrect methods, in the end, merely proves that the authors have not properly learned the Elliott Wave Principle itself.
== After Elliott ==
Following R.N. Elliott's death in 1948, other market technicians and financial professionals continued to use the wave principle and provide forecasts to investors. Charles Collins, who had published Elliott's "Wave Principle" and helped introduce Elliott's theory to Wall Street, ranked Elliott's contributions to technical analysis on a level with [[Charles Dow]]. Hamilton Bolton, founder of [http://www.bankcreditanalyst.com/ The Bank Credit Analyst], provided wave analysis to a wide readership in the 1950s and 1960s. Bolton introduced Elliott's wave principle to A.J. Frost, who provided weekly financial commentary on the Financial News Network in the 1980s. Frost co-authored ''Elliott Wave Principle'' with Robert Prechter in 1979.
== Rediscovery and current use ==
[[Robert Prechter]] came across R.N. Elliott's works while working as a market technician at [[Merrill Lynch]]. His notoriety as a forecaster during the bull market of the 1980s brought the greatest exposure to date to Elliott's theory, and today Prechter remains the most widely known Elliott analyst.
Among market technicians, wave analysis is widely accepted as a component of their trade. Elliott Wave Theory is among the methods included on the exam that analysts must pass to earn the [[Chartered Market Technician]] (CMT) designation, the professional accreditation developed by the [[Market Technicians Association]] (MTA). Comprehensive coursework (including Elliott theory) is offered by the MTA and the [http://www.nyif.com/index.html New York Institute of Finance]. The U.S. Securities and Exchange Commission's recent recognition of the CMT designation has provided further creditability to the technical analyst profession.[https://www.mta.org/EWEB/DynamicPage.aspx?webcode=NYSENASD] [http://www.sec.gov/rules/sro/nasd/34-51240.pdf]
Robin Wilkin, Global Head of FX and Commodity Technical Strategy at [[JPMorgan Chase]], says "the Elliott Wave principle provides a probability framework as to when to enter a particular market and where to get out, whether for a profit or a loss." Robin Wilkin, [http://www.lbma.org.uk/publications/alchemist/alch43_elliott3.pdf Riding the Waves: Applying Elliott Wave Theory to the Financial and Commodity Markets] ''The Alchemist'' June 2006
Jordan Kotick, Global Head of Technical Strategy at [[Barclays Capital]] and past President of the Market Technicians Association, has said that R.N. Elliott's "discovery was well ahead of its time. In fact, over the last decade or two, many prominent academics have embraced Elliotts idea and have been aggressively advocating the existence of financial market fractals." Jordan Kotick, [http://www.lbma.org.uk/publications/alchemist/alch40_elliott.pdf An Introduction to the Elliott Wave Principle] ''The Alchemist'' November 2005
One such academic is physicist [http://www.er.ethz.ch/people/sornette Didier Sornette], visiting professor at the Department of Earth and Space Science and the Institute of Geophysics and Planetary Physics at [[UCLA]]. A paper he co-authored in 1996 ("Stock Market Crashes, Precursors and Replicas") said,
::"''It is intriguing that the log-periodic structures documented here bear some similarity with the 'Elliott waves' of technical analysis . A lot of effort has been developed in finance both by academic and trading institutions and more recently by physicists (using some of their statistical tools developed to deal with complex times series) to analyze past data to get information on the future. The 'Elliott wave' technique is probably the most famous in this field. We speculate that the 'Elliott waves', so strongly rooted in the financial analysts folklore, could be a signature of an underlying critical structure of the stock market''."Sornette, D., Johansen, A., and Bouchaud, J.P. (1996). "Stock market crashes, precursors and replicas." Journal de Physique I France 6, No.1, pp. 167-175.
[[Paul Tudor Jones]], the billionaire commodity trader, calls Prechter and Frost's standard text on Elliott "a classic," and one of "the four Bibles of the business" --
::"''[McGee and Edwards']'' Technical Analysis of Stock Trends ''and'' The Elliott Wave Theorist ''both give very specific and systematic ways to approach developing great reward/risk ratios for entering into a business contract with the marketplace, which is what every trade should be if properly and thoughtfully executed''."Mark B. Fisher, ''The Logical Trader'', p. x (forward)
==Criticism==
The premise that markets unfold in recognizable patterns contradicts the weakest form of the [[efficient market hypothesis]], which states that prices cannot be predicted from past market data such as prices and volume. According to this reasoning, if such simple prediction were possible, enough investors would buy (sell) when the method predicted a price increase (decrease), that the price would increase (decrease)immediately, thus destroying the profitability and predictive power of the method. If the Elliott wave theory were true, in efficient markets the knowledge of it among investors would lead to the instantaneous disappearance of the very patterns they were trying to anticipate, rendering the method useless.
[[Benoit Mandelbrot]] has questioned whether Elliott waves can predict financial markets:
"But Wave prediction is a very uncertain business. It is an art to which the subjective judgement of the chartists matters more than the objective, replicable verdict of the numbers. The record of this, as of most technical analysis, is at best mixed.""The (mis)Behavior of Markets," by Benoit Mandelbrot and Richard L. Hudson, 2004, Basic Books, p. 245
Robert Prechter had previously argued that ideas in an article by Mandelbrot Benoit Mandelbrot (February 1999). ''Scientific American'', p. 70. "originated with Ralph Nelson Elliott, who put them forth more comprehensively and more accurately with respect to real-world markets in his 1938 book ''The Wave Principle''." [http://www.elliottwave.com/response/default.htm Details here.]
Critics claim that the wave principle is too vague to be useful, since it cannot always identify when a wave begins or ends, and that Elliott wave forecasts are prone to subjective revision. Some who advocate [[technical analysis]] of stocks have questioned the value of the Elliot wave theory. Technical analyst David Aronson wrote:David R. Aronson ''Evidence-Based Technical Analysis: Applying the Scientific Method and Statistical Inference to Trading Signals'' (Wiley, 2006), p. 41
The Elliott Wave Principle, as popularly practiced, is not a legitimate theory, but a story, and a compelling one that is eloquently told by Robert Prechter. The account is especially persuasive because EWP has the seemingly remarkable ability to fit any segment of market history down to its most minute fluctuations. I contend this is made possible by the method's loosely defined rules and the ability to postulate a large number of nested waves of varying magnitude. This gives the Elliott analyst the same freedom and flexibility that allowed pre-Copernican astronomers to explain all observed planet movements even though their underlying theory of an Earth-centered universe was wrong.
== Notes ==
==References==
* ''Elliott Wave Principle: Key to Market Behavior'' by A.J. Frost & [[Robert Prechter|Robert R. Prechter, Jr.]] Published by John Wiley & Sons, Ltd. ISBN 0-471-98849-9
*''Mastering Elliott Wave: Presenting the Neely Method: The First Scientific, Objective Approach to Market Forecasting with Elliott Wave Theory'' by [[Glenn Neely]] with Eric Hall. Published by Windsor Books. ISBN 0-930233-44-1
==See also==
* [[Chartered Market Technician]]
* [[Business cycle]]
* [[Grand supercycle]]
* [[The Wisdom of Crowds]]
* [[Dead cat bounce]]
==External links==
*[http://www.stockcharts.com/education/MarketAnalysis/elliotwavetheory.html Elliott Wave Theory - ChartSchool - StockCharts.com]
*[http://www.investorwords.com/1688/Elliott_Wave_Theory.html investorwords.com glossary - Elliott Wave Theory]
*[http://www.elliottwave.com/education/welcome/1.htm Elliott Wave International - What Is the Wave Principle?]
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