In 1938, a book called The Wave Principle was published by Ralph Nelson Elliott (1871 – 1948). In this book, he had presented his idea that the market waves were not random, but in fact, moved in a rhythmic pattern, where future market patterns could be predicted. This was called the Elliott Wave theory, and the price pattern waves are based on the social psychology of the crowds in the market. Previously, investors would believe that events that occurred outside the stock market had no influence over the market. However, Elliott observed and then theorized that the psychology of the investors would fluctuate between their optimism and pessimism in the market.
The theory basically divides the distinctive high and lows of the waves into two sets, which are impulsive waves made out of five smaller waves, and corrective waves made out of three smaller waves. Within the impulse waves, five wave patterns would exist along the three corrective waves. This pattern is continuous. Thus, when an investor analyzes the past and current Elliott wave count, they can predict which direction the market might be heading towards. The sets of five and then three waves will complete a cycle to indicate the different time scales.
The longest wave is categorized as Grand Supercycle which can last for centuries, followed by the Supercycle wave which can last between 40 to 70 years. Next would be the Cycle, which can last between one to a few years, followed by Primary, which lasts for a few weeks or months, and then Minor, that lasts only a few weeks. The Minute wave refers to a few days, Minuette lasts a few hours, and the smallest wave, Subminuette lasts a few minutes.
Applying the theory to real life market trends is not difficult. To make predictions, an investor can find out the current Elliott wave count. They can start with the latest Primary wave, where a pattern will exist for a couple of years. From there, they can increase the scale’s size and then predict the next Cycle. Simply by increasing the size of the scale, an investor is able to make a prediction for the following waves. However, as the theory works on probabilities, the market might not happen exactly as predicted.
Elliot wave theory enjoys massive popularity – being described as advanced technical analysis, by many brokers and publishers.
Elliot wave theory has a huge and devoted following – shame the theory has no basis of sound logic that can help you make money!
Let’s look at Elliott wave theory in more detail and then look at sensible market analysis.
The theory was named after Ralph Nelson Elliott, who concluded in his book “natures law” that the movement of financial markets could be predicted by observing, and identifying a repetitive pattern of waves.
Elliott’s Profound Observation
Elliott came to the stunning conclusion that all natural phenomena are cyclical – and this includes the financial markets. This is true, but we know that anyway – we know that at some time in our lives, we will feel rain when we venture outside, the question is when exactly?
So, markets are cyclical – big deal! What we want from an investment theory, is the probability of the event – i.e. when is it most likely to occur.
Elliott wave theory is an objective investment theory – but there isn’t any objectivity in it at all!
It’s all a subjective interpretation of peaks and troughs, in any time frame you like!
Does this sound a logical predictive theory to you?
Based on rhythms found in nature, the theory suggests that the market moves up in a series of five waves and down in a series of three waves.
The difference between the Elliott wave principle and other cyclical theories is that the theory suggests no absolute time requirements for a cycle to complete – well that’s a lot of help!
The subjectivity is so great in Elliott wave, that like most theories, everything is explainable in hindsight – but the difficulty is actually predicting the future.
There are so many interpretations of the actual peaks and troughs in various time frames, that everyone will see them differently, this is hardly the basis of a predictive theory.
Elliott wave theory claims to be able to predict the market – but gives no objective way of doing it in practice.
Who uses Elliott Wave Theory?
1. Investors who want an easy way to make money, and are attracted to the mysticism of such tools as the Fibonacci number sequence, to predict market retracements.
2. Investors who believe in the false assumption that you can predict market behavior in advance – and want an easy way to make money.
How Markets Really Move
Market prices are a reflection of the following:
Supply and demand fundamentals + human psychology = price action
This looks simple, but is in reality, complicated equation – which is impossible to predict in advance.
Trading markets via technical analysis is all about putting the odds and probability in your favor, and no more than that. It is NOT a way of predicting the future.
Are there better theories than Elliott wave around, for making money from the markets? – A good exercise would be to poll the entire top performing fund managers in the world and see how many of them take the theory seriously.
Predictive and subjectivity don’t mix!
The Elliott wave theory is a predictive theory that leaves everything to subjective analysis.
If Elliott had worked out a predictive theory, why didn’t he give an objective way to make money from it? – Like most predictive theories it doesn’t work.
This is just one man’s opinion to the on-line discussion of the Elliott Wave theory by Mr. Stephen Todd. I hope to generate interest and comments from other seasoned market traders, whose experience and insight are probably more valuable than any one of the technical analysis methodologies that traders use.
My comments follow:
If one uses the Elliott Wave theory in conjunction with other technical analytical methods and does not blindly follow any one to the T, one could in fact arm oneself with the arsenal of knowledge and his/her analytical mind (actually, this is the fundamental requirement) to make money in the market. After all, many of the traders out there have made money, and they don’t do that by rolling the dice. After all, why are big names like Bill Gates and Michael Dell (among so many) become so rich? They in fact have made more money in stock and options trading than from the companies they own.
The Elliott wave theory has relationship to the human psyche, and thus the more we understand psychology of the masses, the more the cyclical phenomenon becomes predictable.
Stephen Todd is right by saying that there is no absolute crystal ball reading of the exact timing. But then, at the point of exit, the timing really depends on the investor himself or herself. There is a decision to be made solely depending on the investor’s need at that moment. As far as the entry point is concerned, yes, we should always trust probability, which is statistics. The general science of bioinformatics is essentially it. The biomedical world is so complicated (e.g., protein structural analysis, polymer conformational analysis, to name a few) and the exact structures (mind you, not just the sequence of amino acids that linked up to form them, but the structural probability of conformation and isomerism) of many high molecular weight proteins may not be 100% precisely known, with our current stage of scientific advancement. Hence, the significance of statistical analysis as to improve the probability of the exact structure and conformation known.
The objectivity here is the striving toward higher and higher accuracy in the human methods of analysis. As long as we do not start out with the expectation of a 100% predictive theory, and as long as we trade the market with discipline and stay objective, it does not matter we predict the timing wrong, so long there is already an exit or repair strategy. There isn’t much difference from running a business or making choices in life in general. There is got to be a strategy, a plan and the tactical discipline to go with them.
We lose money in the market because we are overrun by our emotions: fear, greed, conceit, arrogance, just to name a few.