Elliott Wave Introduction
The principles behind modern Elliott Wave theory had their origins in the 1930s, when they were discovered by Ralph Elliott. He, in turn, had been inspired by a trader by the name of Charles Dow and several others. The most referred to textbook about Elliott Wave analysis for the modern trader is undoubtedly ‘The Elliott Wave Principle: Key to Market Behavior’ by Robert Prechter and A.J. Frost.
Prechter rose to fame when he used Elliott waves to correctly predict the stock market crash of 1987. 19th October 1987 is known in the annals of history as ‘Black Monday’, since on that day the stock markets saw an unprecedented drop of 23% in a single day.
Unfortunately, Prechter had much less success, towards the end of the 20th century, in correctly predicting market movements using his understanding of Elliott Wave theory.
Elliott Waves Defined
Elliott was, in the first place, an astute observer of crowd behaviour. He noticed that a period of mass optimism was nearly always followed by a period of darkness or pessimism. By studying this behaviour he was able to determine certain patterns, which he was later able to apply to stock market prices.
The basic Elliott wave structure can be seen in Fig. 1.19(a). It consists of five waves, three of which are fairly large and follow the main trend (Waves 1, 3 and 5) and two of which are smaller, countertrend movements, (Waves 2 and 4).
The two countertrend waves are vital for the overall directional movement to take place. Although there are a number of different variations of Elliott waves, they all fit into the basic structure you see in Fig. 1.19(a). The stock market is, at any given moment, somewhere on this five-wave Elliott chart.
How it Works
The basic Elliott waves repeat themselves over time. Elliott noticed that after the initial five-wave pattern, three of which follow the same direction as the main trend, there is normally a three-wave movement going against the main trend, which is upwards in this case.
This can clearly be seen in Fig. 1.19(b). Waves one, three and five follow the main, upward, trend, while waves two and four are merely corrections. After wave five, we see a three-wave corrective pattern, with waves a and c heading down and b being a smaller corrective upward wave.
The Moment of Truth
The moment of truth arrives after wave c. If this abc wave pattern is merely a correction during a longer term bull run, we will see a new five-wave pattern heading upwards again.
This is what happens in Fig. 1.19(c). After the red line, at the end of the abc corrective pattern, we see that the market resumes the previous up-trend with a new series of five Elliot waves, three of which head north (waves one, three and five) and three of which are smaller, corrective waves, (two and four). Eventually we get a three-wave abc corrective pattern again, after which we hope the market will resume its upward trend.
If, on the other hand, the abc pattern was no mere correction, but the start of a major downtrend, the market will not recover after wave c, but we will rather see something like the following:
The thick red line in Fig. 1.10(d) corresponds to the end of the abc wave pattern in Fig. 1.19(b), which we initially hoped to be a corrective wave. What happens after this shows that this was indeed no mere corrective wave, but the beginning of a major downtrend.
Problems in Paradise
The problems the world’s foremost Elliott Wave expert, Robert Prechter, had with correctly applying Elliott Wave analysis during the latter part of the 20th century serve to remind us that it is not as easy as it looks.
Theoretically, smaller wave patterns like the ones above, form part of bigger, long-term wave patterns. Whether the scenario in Fig. 1.19(c) or the one in Fig. 1.19(d) will unfold would therefore depend on how many smaller five-wave patterns we have already had, which were in the direction of the main up-trend.
The longer-term wave patterns should follow the same pattern we see in Fig. 1.19(a). Any major up-trend should therefore consist of three upward wave patterns, after which we will see a reversal. This can be seen below in Fig. 1.19(e).
The first two times, the market headed back north after the abc wave corrective pattern, in other words we had the scenario in Fig. 1.19(c). The third time, we had a major turn in the market and we saw the same scenario we had in Fig. 1.19(d); the market started heading south.
Elliott Wave analysis will deliver the best results when used in combination with one or more other technical indicators, such as Fibonacci analysis. It takes years of practice to become an experienced Elliott Wave analyst.