An Introduction to the Elliott Wave Principle

A Brief History

The Elliott Wave Principle was developed by Ralph Nelson Elliot (1871-1948). A financial accountant by trade, Elliott spent years intensely studying price charts with a focus on stock market behaviour. He eventually articulated his theory in a series of twelve articles for Financial World magazine in 1939. Elliott concluded that his observations ultimately encompassed not only the action of equity market averages but actually a much larger law that he believed governed everything from social interaction to the patterns seen in natural phenomena. In essence, Elliott believed he came up with an intricate theory that ultimately explained the behaviour of crowds, exposing their dichotomous and ongoing swings between optimism and pessimism.

The Elliott Wave Principle, essentially the cyclical quantification of investor psychology, rose to prominence in recent times on the back of the now-famous book by A.J. Frost and Robert Prechter, released in November 1978, The Elliott Wave Principle. This book still stands as the single best articulation of Elliott’s ideas. While many books have been written since, the reader who understands Frost and Prechter understands all they need to know about the principles of Elliott Wave.

Theoretical Foundation and Fractals

Elliott’s main advocacy was that crowd behaviour trends and reverses in consistent and recognisable patterns. Elliott named and illustrated patterns or “waves” that recur in markets and are repetitive in form but not necessarily in time or amplitude. He further described how these structures link together to form larger versions of the same patterns and how those in turn become the building blocks for patterns of the next larger size etc. Regardless of the size, the form remains constant.

This discovery was well ahead of its time. In fact, over the last decade or two, many prominent academics have embraced Elliott’s idea and have been aggressively advocating the existence of financial market fractals. However, it is important to understand the type of fractal pattern that Elliott Wave represents. The traditional line of thought has been that fractals are either self-identical (each component of the pattern is exactly the same as the whole) or indefinite (self-similar to the extent that it is similarly irregular at all levels). Elliott discovered a third type of self-similar fractal that Prechter in his later works coined a “robust fractal. “This pattern has highly variable components that fall within a certain defined structure. Prechter noted that “component patterns do not simply display discontinuity similar to that of larger patterns, but they form, with a certain defined latitude, replicas of them. “This latitude reflects nature’s robustness and variability within overall determined forms. While it may be an open question whether every nuance of this latitude is determined, the Wave Principle unquestionably rests on the premise that certain essential aspects of the design always prevail.

In essence, the robust fractal suggests that as much as the patterns are always self-similar, they are, at the same time, always different. While this may seem a contradiction, it is not. Imagine looking at a forest from one kilometre away. From this distance, every tree looks the same. Now imagine that forest from one meter away – every tree looks different. So it is with Elliott Waves: while the overall pattern is the same, the internal make-up (length, amplitude, wave relationships) will differ despite the fact that the overall pattern is self-similar. It is not a co-incidence that the words arboration or arborate have been used in conjunction with Elliott Wave analysis.

Figure 1: The fractility of maps illustrates that navigating London can be easy or complex depending on the degree of observation.

Drink Deep, or Taste not the Elliotician Spring

Alexander Pope was right: a little knowledge is a dangerous thing. He could have been writing about Elliott Waves, for it is not unusual for a trader/strategist/salesperson to embrace a basic understanding of Elliott, use it for while, ultimately lose money and then conclude that Elliott does not work. This all-too-common scenario is based on the false premise that you do not have to know the entire theory in order to use Elliott profitably.

This is an expensive oversight. Elliott, like any other technical or fundamental methodology, is not an art, it is not a science – it is a skill that needs to be honed over time. The skilled Elliottician should be able to differentiate all types of waves from the impulsive (waves 1,2,3,4,5) to the corrective (waves a,b,c,d,e,w,x,y,z).While it seems overly complex, with time and study, the real-time recognition and application of these patterns do come to light. Analogously, while the rules of billiards are simple, winning a game of billiards is more complicated. This applies to Elliott Wave in principle and Elliott Wave in practice.