A Brief of the Elliott Wave Theory
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| Foreign Currency Exchange Information: The Elliott Wave Theory |
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Elliott Wave Theory
The Elliott Wave Theory was developed about eighty years ago by Ralph Nelson
Elliott, and on the face of it is just a more detailed extension of the Dow Jones
Theory that the market moves in cycles. What Ralph Elliott did was to assert that the
market movements were not random, but were truly cyclical and to some extent
capable of being anticipated, for those who were prepared to take the time to study
them.
It must be said that some traders regard the Elliott Wave Theory as at best as a
retrospective indication, i.e. “You show me what happened, and I’ll explain how it fits
the pattern.” There are others who believe it is a key indicator of market movement,
and some who say that it is particularly applicable to the foreign exchange market.
The fact is that there are a great many followers, and even entire websites devoted
to the Elliott Wave, which suggests that people who take the time to study it have
found some value. One fact that has helped instill faith in the theory is that Robert
Prechter used it to identify a bull market in 1982 and to identify the top in 1987, just
before a market crash.
The principle involves identifying patterns in market movements, which reflect the
underlying psychology of the market participants. At its most basic, the theory states
that prices move in five steps, or “impulsive waves”, three of which are upwards,
punctuated by two which are counter to that trend. Importantly, these counter moves
do not retrace all of the progress of each impulse. This move is followed by a
“corrective wave” in the opposite direction, which would be two downward moves
separated by an upward movement, which as a whole would not retrace all of the
gains from the impulse wave.
There are no restrictions on the length or duration of these waves, so they are
subject to interpretation, which provides some reason for the skeptics view that they
can be drawn after the fact, but are difficult to anticipate in advance. However, this
is also part of the overall Elliott Wave Theory, in that the pattern is said to repeat on
all time scales – in scientific terms, the pattern is “fractal”. The overall pattern that
you have been considering may just be, say, the third section of a larger Elliott
Wave, and the original pattern will contain an Elliott Wave within each primary wave –
and so ad infinitum, in theory.
Fractal patterns have been popularized in recent years with the fascinating research
and images by Benoit Mandelbrot. They can be thought of like a coastline, initially
viewed from space, which shows some indentations. When you view it from an
airplane, you can see that each promontory is made up of further projections and
inlets. With a map, each of these can be further broken down, and when you walk
on the beach, the irregularities of each grain of sand give a microcosm of the
undulating coastline.
The psychology of the Elliott Wave Theory is sometimes summarized as follows.
The initial move upwards, wave one, which is rarely recognized as such at the time,
is caused by a small number of people who suddenly perceive that a stock is
undervalued, and this trading is accompanied by a small increase in volume. As this
is by definition following on a bearish move, the general perception of the stock is
still negative. The second move, a retracement, as mentioned above never exceeds
the initial move. The negative sentiment still pervades the market, and the stock is
considered overvalued, so early buyers may take their profits. The level to which it
falls can vary, but often will accord with a Fibonacci value, say losing 61.8% of its
initial rise.
The third wave is often the largest and strongest. It will normally exceed the top of
wave one, and is driven by an increasing optimism about the prospects. Again
following Fibonacci, this may typically be as much as 1.618 times the initial wave.
The fourth wave, and the second retracement, is usually not as big as the first, and
may be the Fibonacci value of 38.2% of the third wave. Sentiment is still in favor of
the stock, but some people are tempted into taking profits.
In the fifth and final wave, optimism is universal, and many average investors buy in,
unfortunately for them too late for the main profits. Volume is less than wave three,
and indicators may start showing it to be overbought. Contrarians and astute
technical traders will think about going short on the stock.
What happens next depends on the actual fundamentals, and whether the overall
trend is supported. In classic Elliott Wave Theory, there is a three wave corrective
pattern before another five wave up cycle. Whether this occurs does depend on the
stock’s underlying strength, but according to Dow Jones Theory the trend will
continue unless there is a reason for it to change, and the three step correction will
occur before repeating the pattern from the start, at a higher price level.
The three corrective waves are labeled with the letters A, B and C to clarify their
difference from the five initial waves. Wave A, the first drop, is still in an optimistic
market, and is usually seen as a simple correction, although it may be accompanied
by increased volume. In wave B, with a reduced volume, the stock appears to
resume its rise. Wave C confirms a bearish mood, and is often larger and more
definite than the drop at wave A, sometimes hitting 1.618 times the initial move down,
in a similar way to wave three of the first section.
At this stage, if the trend does not continue, as discussed above, and the stock
enters a bearish trend, it will typically be with a second three wave A-B-C corrective
pattern – but in a bullish direction – followed by a five wave down cycle.
As mentioned above, the use of Fibonacci ratios has been adopted as an inherent
part of the Elliott Wave Theory by many practitioners, and this gives an indication of
the expected turning points, although its use is not necessary or required in order to
be a believer in the Elliott Wave.
The Elliott Wave Theory the long version
The Elliott Wave Theory was developed about eighty years ago by Ralph Nelson
Elliott, and on the face of it is just a more detailed extension of the Dow Jones
Theory that the market moves in cycles. What Ralph Elliott did was to assert that the
market movements were not random, but were truly cyclical and to some extent
capable of being anticipated, for those who were prepared to take the time to study
them.
It must be said that some traders regard the Elliott Wave Theory as at best as a
retrospective indication, i.e. “You show me what happened, and I’ll explain how it fits
the pattern.” There are others who believe it is a key indicator of market movement,
and some who say that it is particularly applicable to the foreign exchange market.
The fact is that there are a great many followers, and even entire websites devoted
to the Elliott Wave, which suggests that people who take the time to study it have
found some value. One fact that has helped instill faith in the theory is that Robert
Prechter used it to identify a bull market in 1982 and to identify the top in 1987, just
before a market crash.
The principle involves identifying patterns in market movements, which reflect the
underlying psychology of the market participants. At its most basic, the theory states
that prices move in five steps, or “impulsive waves”, three of which are upwards,
punctuated by two which are counter to that trend. Importantly, these counter moves
do not retrace all of the progress of each impulse. This move is followed by a
“corrective wave” in the opposite direction, which would be two downward moves
separated by an upward movement, which as a whole would not retrace all of the
gains from the impulse wave.
There are no restrictions on the length or duration of these waves, so they are
subject to interpretation, which provides some reason for the skeptics view that they
can be drawn after the fact, but are difficult to anticipate in advance. However, this
is also part of the overall Elliott Wave Theory, in that the pattern is said to repeat on
all time scales – in scientific terms, the pattern is “fractal”. The overall pattern that
you have been considering may just be, say, the third section of a larger Elliott
Wave, and the original pattern will contain an Elliott Wave within each primary wave –
and so ad infinitum, in theory.
Fractal patterns have been popularized in recent years with the fascinating research
and images by Benoit Mandelbrot. They can be thought of like a coastline, initially
viewed from space, which shows some indentations. When you view it from an
airplane, you can see that each promontory is made up of further projections and
inlets. With a map, each of these can be further broken down, and when you walk
on the beach, the irregularities of each grain of sand give a microcosm of the
undulating coastline.
The psychology of the Elliott Wave Theory is sometimes summarized as follows.
The initial move upwards, wave one, which is rarely recognized as such at the time,
is caused by a small number of people who suddenly perceive that a stock is
undervalued, and this trading is accompanied by a small increase in volume. As this
is by definition following on a bearish move, the general perception of the stock is
still negative. The second move, a retracement, as mentioned above never exceeds
the initial move. The negative sentiment still pervades the market, and the stock is
considered overvalued, so early buyers may take their profits. The level to which it
falls can vary, but often will accord with a Fibonacci value, say losing 61.8% of its
initial rise.
The third wave is often the largest and strongest. It will normally exceed the top of
wave one, and is driven by an increasing optimism about the prospects. Again
following Fibonacci, this may typically be as much as 1.618 times the initial wave.
The fourth wave, and the second retracement, is usually not as big as the first, and
may be the Fibonacci value of 38.2% of the third wave. Sentiment is still in favor of
the stock, but some people are tempted into taking profits.
In the fifth and final wave, optimism is universal, and many average investors buy in,
unfortunately for them too late for the main profits. Volume is less than wave three,
and indicators may start showing it to be overbought. Contrarians and astute
technical traders will think about going short on the stock.
What happens next depends on the actual fundamentals, and whether the overall
trend is supported. In classic Elliott Wave Theory, there is a three wave corrective
pattern before another five wave up cycle. Whether this occurs does depend on the
stock’s underlying strength, but according to Dow Jones Theory the trend will
continue unless there is a reason for it to change, and the three step correction will
occur before repeating the pattern from the start, at a higher price level.
The three corrective waves are labeled with the letters A, B and C to clarify their
difference from the five initial waves. Wave A, the first drop, is still in an optimistic
market, and is usually seen as a simple correction, although it may be accompanied
by increased volume. In wave B, with a reduced volume, the stock appears to
resume its rise. Wave C confirms a bearish mood, and is often larger and more
definite than the drop at wave A, sometimes hitting 1.618 times the initial move down,
in a similar way to wave three of the first section.
At this stage, if the trend does not continue, as discussed above, and the stock
enters a bearish trend, it will typically be with a second three wave A-B-C corrective
pattern – but in a bullish direction – followed by a five wave down cycle.
As mentioned above, the use of Fibonacci ratios has been adopted as an inherent
part of the Elliott Wave Theory by many practitioners, and this gives an indication of
the expected turning points, although its use is not necessary or required in order to
be a believer in the Elliott Wave.
The Elliott Wave Theory the long version
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