Technical Analysis - Elliott Wave Theory

This article introduces Elliott Wave Theory.

Background

R. N. Elliott developed his wave theory in the early 1934. It is a method for explaining stock market movements. Actually, Elliott wave theory helps explain economics in general, but the stock market tends to have three attributes that make it quite applicable:

1. It is a true free market (i.e., prices are not fixed by the supplier, but rather set by the consumer).
2. It provides consistent and regular metrics that can be measured.
3. It is manipulated by a statistically significantly large group of people.

Assumptions behind Elliott Wave theory

First, the market is NOT efficient. Rather it is an inefficient market place that is controlled by the whims of the masses. The masses consistently overreact and will make things over and under priced consistently. This was, and until recently, in direct opposition to prevailing theories that the market place was an efficient mechanism. The efficient marketplace was the theory that was taught in B-schools and often continues to be taught until this day.

Second, given the assumption that the market is not efficient, then you should be able to do a "sociological" survey of stock prices independent of other news that effects stock prices. ie., you will be measuring the global effects that the masses will have on the stock. (An interesting aside. We have all observed that stock prices move independently or in the opposite direction that news about the company, the economy, or the stock would tend to let us believe. The general explanation for this behavior is that the masses tend to listen for the news they are ready to hear, and that the movement that actually happens depends on other effects.)

General Principle of Elliott Waves

There are many things that have to be accounted for when doing e-wave studies of stocks, and that one of the most difficult things to overcome is the personal ability to separate your own emotions from affecting your analysis. You as a person have the same types of fear/greed internal mechanisms that affect the entire market place as a whole and without being able to work to dismiss those emotions you will not be able to sit in a position that allows you to understand and profit from the sociological effects that you are measuring. That basic fear/greed mechanism is so inbred to our existence that will keep the Elliott wave a valid study regardless the number of people that know and understand it.

This is an important point: Elliott Theory measures sociological performance of the masses and these sociological functions are so ingrained that even if individuals or many individuals are able to understand and dismiss those actions the majority of the people will not be able to.

Elliott waves describe the basic movement of stock prices. It states that in general there will be 5 waves in a given direction followed by usually what is termed and ABC correction or 5 waves in the opposite direction.

Wave Description

The following wave description applies to a market moving upwards. In a down market (perhaps the stock is truly overpriced and the market has turned), you will generally see the same types of behavior in reverse that you saw watching the stock on the way up.

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 previous price of the stock was cheap and therefore worth buying, causing the price to go up.

Wave 2

The stock is considered overvalued. 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 in general the stock will not make it to it's previous lows before the stock is considered cheap again.

Wave 3

This is usually the longest and strongest wave. More people have found out about the stock, more people want the stock and they buy it for a higher and higher price. This wave usually exceeds the tops created at the end of wave 1.

Wave 4

At this point people again take profits because the stock is again considered expensive. This wave tends to be weak because their are usually more people that are still bullish on the stock and after some profit taking comes wave 5.

Wave 5

This is the point that most people get on the stock, and is most driven by hysteria. People will come up with lots of reasons to buy the stock, and won't listen to reasons not to. At this point contrarians will probably notice that the stock has very little negative news and start shorting the stock. And at this point is where the stock becomes the most overpriced. At this point the stock will move into one of two patterns, either an ABC correction or starting over with wave 1.

An ABC correction is when the stock will go down/up/down in preparing for another 5 way cycle up. During this time frame volatility is usually much less then the previous 5 wave cycle, and what is generally happening is the market is taking a pause while fundamentals catch up. It is interesting to note here that you can have many ABC corrections happening. For instance if the fundamentals do not catch up you will have two ABC corrections and then the stock will have a 5 wave down cycle. (Odd number of ABC corrections lead to the stock going up, even numbers lead to the stock going down.)

Length and quantity of the moves

People tend to think of something being too expensive or cheap for the very same reasons that they think something is attractive or not attractive. This subjective judgement is called aesthetics. A measure of what is aesthetically pleasing has to do with fibonacci sequences. They are all around us, they describe art, snail shells, galaxies, flower petals, and yes, our own internal feelings of value.

The quantity of time and movement of a stock through a wave cycle tends to measured reasonably well by fibonacci sequences. The measurement and prediction of waves tends to be bound by these numbers and by the fibonacci fractions (Roughly 5/8 and 1 5/8 and their inverses)