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The Elliott wave principle or wave principle is a form of technical analysis that investors use to forecast trends in the financial markets and other collective activities. Ralph Nelson Elliott, a professional accountant, developed a financial market model that he called The Wave Principle. He published his views of market behavior in the book The Wave Principle (1938), and in a series of articles in Financial World magazine in 1939. Elliott proposed that market prices unfold in specific patterns that he called waves. (Practitioners today call these components Elliott waves, or simply waves.)

In 1946 Elliott published his final major work, Nature's Law, which "includes almost every thought Elliott ever had concerning the theory of the Wave Principle." Elliott believed this law to be "the secret of the universe," and said 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.".

Overall design

The wave principle begins with the premise that collective investor psychology (or crowd psychology) moves from optimism to pessimism and back again. These swings create patterns, as evidenced in the price movements of a market.

Elliott's model proposes that market prices alternate between five waves and three waves at all degrees of trend, as the illustration shows. As these waves develop, the larger price patterns unfold in a self-similar fractal geometry. Within the dominant trend, waves 1, 3, and 5 are called "motive" waves, and each motive wave itself subdivides in five waves. Waves 2 and 4 are "corrective" waves, and subdivide in three waves. In a bear market 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.

The patterns link to form five and three-wave structures of increasing size or "degree." Note the lowest of the three idealized cycles. In the first small five-wave sequence, waves 1, 3 and 5 are motive, while waves 2 and 4 are corrective. This signals that the movement of one larger degree is upward. It also signals the start of the first small three-wave corrective sequence. After the initial five waves up and three waves down, the sequence begins again and the self-similar fractal geometry begins to unfold. The completed motive pattern includes 89 waves, followed by a completed corrective pattern of 55 waves.

Degree

Each degree of the pattern in a financial market has a name. Practitioners use symbols for each wave to indicate both function and degree -- numbers for motive waves, letters for corrective waves (shown in the highest of the three idealized cycles). Degrees are relative; they are defined by form, not by absolute size or duration. Waves of the same degree may be of very different size and/or duration.

Criticism

Critics claim it is too vague to be useful, since it cannot always identify when a wave begins or ends, and that Elliott wave forecasts are prone to subjective revision.

Skeptics also say that if the theory is true, widespread knowledge of it among investors would lead to distortions of the very patterns they were trying to anticipate, rendering the method useless. This same argument is made against other predictive methods that are based on public, market-wide data.

The Classic Elliot Wave Truism: "Elliot Wave always works, unless of course it doesn't"

Notes

1. ^ R.N. Elliott, R.N. Elliott's Masterworks, ed. Robert R. Prechter, Jr. (New Classics Library, 1994, P.O. Box 1618 Gainesville Georgia 30503), 70, 217.

References

Elliott Wave Principle: Key to Market Behavior by A.J. Frost & Robert R. Prechter, Jr. Published by John Wiley & Sons, Ltd. ISBN 0-471-98849-9

See also

• Business cycle
• Grand supercycle
• The Wisdom of Crowds
• Dead cat bounce

External links

• Elliott Wave Theory - ChartSchool - StockCharts.com
• CyclePro Elliott Wave Rules and Guidelines - Updated 11/1/98
• Elliott Wave International - What Is the Wave Principle?

• Technical analysis