Elliot Wave Theory and the Madness of Crowds

Elliot Wave Theory and the Madness of Crowds

The famed analyst and market technician Robert Prechter came across Ralph Elliott’s work while working as a market technician at the investment bank Merrill Lynch. His prominence as a forecaster, during the bull market of the 1980s, brought the greatest exposure to Elliott’s work.

Prechter remains the most widely known Elliott analyst. Robert Prechter is an author and co-author of 14 books, his book “Conquer the Crash” was a New York Times bestseller. He published his monthly financial commentary in the newsletter “The Elliott Wave Theorist” from 1979 and is the founder of Elliott Wave International. Prechter served on the board of the Market Technicians Association for nine years. In recent years Prechter has supported the study of socionomics, a theory about human social behaviour.

Ralph Elliott was a professional accountant, who discovered the underlying social principles and developed the analytical tools of what was later to be known as the Elliot Wave Principle in the 1930s. He proposed that market prices unfold in specific identifiable patterns, which practitioners today call Elliott waves, or simply “waves”. Elliott published his theory of market behaviour in the book “The Wave Principle” in 1938 and covered it comprehensively in his major work, “Nature’s Laws: The Secret of the Universe” in 1946. Elliott stated 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”.

The Elliott Wave Principle is a detailed description and ‘formula’ of how groups of people think and as a consequence behave. EWP reveals that mass psychology causes swings from pessimism to optimism and back in a natural rhythmic sequence, thereby creating specific and measurable patterns. The Elliott Wave Principle can be clearly seen ‘at work’ in the financial markets, where changing investor psychology is recorded in the form of price movements. If you can identify the repeating price patterns and figure out where price is in those repeating patterns you can hopefully predict (with reasonable levels of probability) where price is headed next.

The EWP is, however, still fundamentally an exercise in probability. An Elliottician is someone who is able to identify the markets’ structure and anticipate the most likely next move based on the position within those structures. By knowing the wave patterns, you’ll know what the markets are likely to do next and just as importantly what they will probably not do next. By using EWP it’s possible to identify the highest probable moves with the least risk.

In Elliott’s model market price alternates between an impulsive motive phase and a corrective phase on all time scales of the trend. Impulses are subdivided into a set of 5 lower-degree waves, alternating between the motive and corrective character, 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 waves starting with a five-wave counter-trend impulse, a retrace, and another impulse. In bear markets 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.

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Source: FX Central Clearing Ltd. (FXCC BLOG)