Elliot Wave Theory

In today's discussion we will be looking at Elliot Wave Theory. There are some analysts who swear by this technique and as we haven't covered this often we decided to revisit this today. The theory was developed by Ralph Nelson Elliot in the 1920s. The theory was generally forgotten after the death of the founder in 1948 however in the 1970s this technical analysis was revived by A J Frost and Robert Prechter. They co-authored a book entitled “Elliot Wave Principle – Key to Stock Market Profits”. When the book was released in the 1970s many 'new age' chartists applied the theory to future's markets.

R N Elliot basically concluded that the movements of the stock market and therefore stock prices could be predicted by identifying repetitive patterns. More specifically, Elliot Wave Theory suggest that stock prices are governed by certain cycles that are based upon the Fibonacci series. These cycles appear on the chart in the shape of waves. The rhythm of the cycles is exhibited as five waves up and three waves down.

The diagram above indicates the basic shape of the Elliot Wave. The numbered points, 1 to 5, occur during a rise, while the letters, A to C show the waves during a decline. Interestingly Elliot waves can vary in size and therefore time, but the can also appear within a wave. For instance, the diagram below highlights the waves within waves. The diagram below is just the same as the diagram above however the red lines highlight the waves that occur within the wave.

The theory goes on to state that every action is followed by a reaction. Also, there are five waves in the direction of the main trend, 1 to 5, followed by three corrective waves, A to C. This is called the 5-3 move. Once the 5-3 move has been completed the cycle has finished. This 5-3 move becomes a smaller section of a much larger 5-3 move. The above diagram highlights this, The initial red lines indicate the completion of a 5-3 move, however this move is a small section of a much larger move. The time span of each cycle varies, it doesn't remain constant.

The theory then goes further and identifies the existence of different categories of waves. They are mentioned from largest to smallest. The Grand Supercycle, Supercycle, Cycle, Primary, Intermediate, Minor, Minute, Minuette and finally Sub-Minuette. To use this technique for trading the trader must be able to successfully identify where the share price is in relation to it's cycle and therefore predict the direction of the stock.

Example

The chart below is of BHP from December 2005 to June 2006. Notice how the share price actually moved as the Elliot Wave Theory suggests.

Have a look at your own charting packages at home and see if you can identify waves within waves on BHP during this period. The theory is more complex then the above discussion and many readers will find some similarities between this theory and Dow Theory.