wave principle is a form of technical analysis that attempts to forecast
trends in the financial markets and other collective activities.
It is named after Ralph Nelson Elliott (1871-1948), an accountant
who developed the concept in the 1930s: he proposed that market
prices unfold in specific patterns, which practitioners today
call Elliott waves. Elliott published his views of market behavior
in the book The Wave Principle (1938), in a series of articles
in Financial World magazine in 1939, and most fully in
his final major work, Nature™s Laws “ The Secret of the Universe
Elliott argued that because humans are themselves rhythmical,
their activities and decisions could be predicted in rhythms,
too. Critics argue the theory is unprovable and inconsistent with
the efficient market hypothesis and at
odds with modern social science.
The wave principle
posits 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
at every degree of trend.
Elliott's essay, "The Basis of the Wave Principle," October
model says 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 "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
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.
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.
of a wave at any particular degree can vary, though practitioners
generally agree on the standard order of degrees (approximate
supercycle: multi-decade to multi-century
a few years to a few decades
one year to a few years
a few months to a couple of years
weeks to months
characteristics and wave "signature"
analysts (or "Elliotticians") hold that it is not necessary to
look at a price chart to judge where a market is in its wave pattern.
Each wave has its own "signature" which often reflects the psychology
of the moment. Understanding how and why the waves develop is
key to the application of the Wave Principle; that understanding
includes recognizing the characteristics described below.
characteristics assume a bull market in equities. The characteristics
apply in reverse in bear markets.
wave pattern (dominant trend)
wave pattern (corrective trend)
1: Wave one is rarely obvious at its inception. When the
first wave of a new bull market begins, the fundamental news
is almost universally negative. The previous trend is considered
still strongly in force. Fundamental analysts continue to
revise their earnings estimates lower; the economy probably
does not look strong. Sentiment surveys are decidedly bearish,
put options are in vogue, and implied volatility in the options
market is high. Volume might increase a bit as prices rise,
but not by enough to alert many technical analysts.
A: Corrections are typically harder to identify than impulse
moves. In wave A of a bear market, the fundamental news is
usually still positive. Most analysts see the drop as a correction
in a still-active bull market. Some technical indicators that
accompany wave A include increased volume, rising implied
volatility in the options markets and possibly a turn higher
in open interest in related futures markets.
2: Wave two corrects wave one, but can never extend beyond
the starting point of wave one. Typically, the news is still
bad. As prices retest the prior low, bearish sentiment quickly
builds, and "the crowd" haughtily reminds all that the bear
market is still deeply ensconced. Still, some positive signs
appear for those who are looking: volume should be lower during
wave two than during wave one, prices usually do not retrace
more than 61.8% (see Fibonacci section below) of the wave
one gains, and prices should fall in a three wave pattern.
B: Prices reverse higher, which many see as a resumption
of the now long-gone bull market. Those familiar with classical
technical analysis may see the peak as the right shoulder
of a head and shoulders reversal pattern. The volume during
wave B should be lower than in wave A. By this point, fundamentals
are probably no longer improving, but they most likely have
not yet turned negative.
3: Wave three is usually the largest and most powerful
wave in a trend (although some research suggests that in commodity
markets, wave five is the largest). The news is now positive
and fundamental analysts start to raise earnings estimates.
Prices rise quickly, corrections are short-lived and shallow.
Anyone looking to "get in on a pullback" will likely miss
the boat. As wave three starts, the news is probably still
bearish, and most market players remain negative; but by wave
three's midpoint, "the crowd" will often join the new bullish
trend. Wave three often extends wave one by a ratio of 1.618:1.
C: Prices move impulsively lower in five waves. Volume
picks up, and by the third leg of wave C, almost everyone
realizes that a bear market is firmly entrenched. Wave C is
typically at least as large as wave A and often extends to
1.618 times wave A or beyond.
4: Wave four is typically clearly corrective. Prices may
meander sideways for an extended period, and wave four typically
retraces less than 38.2% of wave three. Volume is well below
than that of wave three. This is a good place to buy a pull
back if you understand the potential ahead for wave 5. Still,
the most distinguishing feature of fourth waves is that they
often prove very difficult to count.
5: Wave five is the final leg in the direction of the
dominant trend. The news is almost universally positive and
everyone is bullish. Unfortunately, this is when many average
investors finally buy in, right before the top. Volume is
lower in wave five than in wave three, and many momentum indicators
start to show divergences (prices reach a new high, the indicator
does not reach a new peak). At the end of a major bull market,
bears may very well be ridiculed (recall how forecasts for
a top in the stock market during 2000 were received).
recognition and fractals
market model relies heavily on looking at price charts. Practitioners
study developing price moves to distinguish the waves and wave
structures, and discern what prices may do next; thus the application
of the wave principle is a form of pattern recognition.
Elliott described also meet the common definition of a fractal
(self-similar patterns appearing at every degree of trend). Elliott
wave practitioners say that just as naturally-occurring fractals
often expand and grow more complex over time, the model shows
that collective human psychology develops in natural patterns,
via buying and selling decisions reflected in market prices: "It's
as though we are somehow programmed by mathematics. Seashell,
galaxy, snowflake or human: we're all bound by the same order."
R. N. Elliott's
analysis of the mathematical properties of waves and patterns
eventually led him to conclude that "The Fibonacci Summation Series
is the basis of The Wave Principle."
Numbers from the Fibonacci sequence surface repeatedly in Elliott
wave structures, including motive waves (1, 3, 5), a single full
cycle (5 up, 3 down = 8 waves), and the completed motive (89 waves)
and corrective (55 waves) patterns. Elliott developed his market
model before he realized that it reflects the Fibonacci sequence.
"When I discovered The Wave Principle action of market trends,
I had never heard of either the Fibonacci Series or the Pythagorean
sequence is also closely connected to the Golden ratio (1.618).
Practitioners commonly use this ratio and related ratios to establish
support and resistance levels for market waves, namely the price
points which help define the parameters of a trend.
Roy Batchelor and researcher Richard Ramyar, a former Director
of the United Kingdom Society of Technical Analysts and Head of
UK Asset Management Research at Reuters Lipper, studied whether
Fibonacci ratios appear non-randomly in the stock market, as Elliott's
model predicts. The researchers said the "idea that prices retrace
to a Fibonacci ratio or round fraction of the previous trend clearly
lacks any scientific rationale." They also said "there is no significant
difference between the frequencies with which price and time ratios
occur in cycles in the Dow Jones Industrial Average, and frequencies
which we would expect to occur at random in such a time series."
replied to the Batchelor-Ramyar study, saying that it "does not
challenge the validity of any aspect of the Wave Principle...it
supports wave theorists' observations."
The Socionomics Institute also reviewed data in the Batchelor-Ramyar
study, and said this data shows "Fibonacci ratios do occur more
often in the stock market than would be expected in a random environment."'
of The Elliott Wave Principle and The Fibonacci Relationship
"Trading never been so easy eh," December 2007.
currency chart gives an example of a fourth wave retracement apparently
halting between the 38.2% and 50.0% Fibonacci retracements of
a completed third wave. The chart also highlights how the Elliott
Wave Prinicple works well with other technical analysis tendencies
as prior support (the bottom of wave-1) acts as resistance to
wave-4. The wave count depicted in the chart would be invalidated
if GBP/JPY moves above the wave-1 low.
Elliott's death in 1948, other market technicians and financial
professionals continued to use the wave principle and provide
forecasts to investors. Charles Collins, who had published Elliott's
"Wave Principle" and helped introduce Elliott's theory to Wall
Street, ranked Elliott's contributions to technical analysis on
a level with Charles Dow. Hamilton Bolton, founder of The Bank
Credit Analyst, provided wave analysis to a wide readership in
the 1950s and 1960s. Bolton introduced Elliott's wave principle
to A.J. Frost, who provided weekly financial commentary on the
Financial News Network in the 1980s. Frost co-authored Elliott
Wave Principle with Robert Prechter in 1979.
and current use
came across Elliott's works while working as a market technician
at Merrill Lynch. His fame as a forecaster during the bull market
of the 1980s brought the greatest exposure to date to Elliott's
theory, and today Prechter remains the most widely known Elliott
technicians, wave analysis is widely accepted as a component of
their trade. Elliott Wave Theory is among the methods included
on the exam that analysts must pass to earn the Chartered Market
Technician (CMT) designation, the professional accreditation developed
by the Market Technicians Association (MTA).
Global Head of FX and Commodity Technical Strategy at JPMorgan
Chase, says "the Elliott Wave principleâ€¦ provides a probability
framework as to when to enter a particular market and where to
get out, whether for a profit or a loss."
Global Head of Technical Strategy at Barclays Capital and past
President of the Market Technicians Association, has said that
R. N. Elliott's "discovery was well ahead of its time. In fact,
over the last decade or two, many prominent academics have embraced
Elliottâ€™s idea and have been aggressively advocating the existence
of financial market fractals."
One such academic
is the physicist Didier Sornette, visiting professor at the Department
of Earth and Space Science and the Institute of Geophysics and
Planetary Physics at UCLA. A paper he co-authored in 1996 ("Stock
Market Crashes, Precursors and Replicas") said,
is intriguing that the log-periodic structures documented
here bear some similarity with the 'Elliott waves' of technical
analysis â€¦. A lot of effort has been developed in finance
both by academic and trading institutions and more recently
by physicists (using some of their statistical tools developed
to deal with complex times series) to analyze past data
to get information on the future. The 'Elliott wave' technique
is probably the most famous in this field. We speculate
that the 'Elliott waves', so strongly rooted in the financial
analystsâ€™ folklore, could be a signature of an underlying
critical structure of the stock market."
Jones, the billionaire commodity trader, calls Prechter and Frost's
standard text on Elliott "a classic," and one of "the four Bibles
of the business" --
and Edwards'] Technical Analysis of Stock Trends and
The Elliott Wave Theorist both give very specific and
systematic ways to approach developing great reward/risk
ratios for entering into a business contract with the marketplace,
which is what every trade should be if properly and thoughtfully
that markets unfold in recognizable patterns contradicts the efficient market hypothesis, which
says that prices cannot be predicted from market data such as
moving averages and volume. By this reasoning, if successful market
forecasts were possible, investors would buy (or sell) when the
method predicted a price increase (or decrease), to the point
that prices would rise (or fall) immediately, thus destroying
the profitability and predictive power of the method. In efficient
markets, knowledge of the Elliott wave principle among investors
would lead to the disappearance of the very patterns they tried
to anticipate, rendering the method, and all forms of technical
has questioned whether Elliott waves can predict financial markets:
prediction is a very uncertain business. It is an art to which
the subjective judgement of the chartists matters more than
the objective, replicable verdict of the numbers. The record
of this, as of most technical analysis, is at best mixed."
had previously said that ideas in an article by Mandelbrot
"originated with Ralph Nelson Elliott, who put them forth more
comprehensively and more accurately with respect to real-world
markets in his 1938 book The Wave Principle."
say the wave principle is too vague to be useful, since it cannot
consistently identify when a wave begins or ends, and that Elliott
wave forecasts are prone to subjective revision. Some who advocate
technical analysis of markets have
questioned the value of Elliott wave analysis. Technical analyst
David Aronson wrote:
Wave Principle, as popularly practiced, is not a legitimate
theory, but a story, and a compelling one that is eloquently
told by Robert Prechter. The account is especially persuasive
because EWP has the seemingly remarkable ability to fit any
segment of market history down to its most minute fluctuations.
I contend this is made possible by the method's loosely defined
rules and the ability to postulate a large number of nested
waves of varying magnitude. This gives the Elliott analyst the
same freedom and flexibility that allowed pre-Copernican astronomers
to explain all observed planet movements even though their underlying
theory of an Earth-centered universe was wrong.
R.N. Elliott, R.N. Elliott's Masterworks (New Classics
Library, 1994), 70, 217, 194, 196.
Steven W. (2003). Applying Elliott Wave Theory Profitably,
John Wiley and Sons , pages 2-17.
John Casti (31 August 2002). "I know what you'll do next summer".
New Scientist, p. 29.
Alex Douglas, "Fibonacci: The man & the markets," Standard
& Poor's Economic Research Paper, February 20, 2001, pp.
Roy Batchelor and Richard Ramyar, "Magic numbers in the Dow,"
25th International Symposium on Forecasting, 2005, p. 13,
31. PDF document here
Robert Prechter (2006), "Elliott Waves, Fibonacci, and Statistics,"
p. 2. PDF
Deepak Goel (2006), "Another Look at Fibonacci Statistics."
Robin Wilkin, Riding the Waves: Applying Elliott Wave Theory to the Financial
and Commodity Markets The Alchemist June 2006
Kotick, An Introduction to the Elliott Wave Principle The Alchemist
D., Johansen, A., and Bouchaud, J.P. (1996). "Stock market
crashes, precursors and replicas." Journal de Physique I France
6, No.1, pp. 167â€“175.
B. Fisher, The Logical Trader, p. x (forward)
Mandelbrot, Benoit and Richard L. Hudson (2004). The (mis)Behavior
of Markets, New York: Basic Books, p. 245
Mandelbrot, Benoit (February 1999). Scientific American,
Aronson, David R. (2006). Evidence-Based Technical Analysis, Hoboken, New Jersey:
John Wiley and Sons, p. 41
Wave Principle: Key to Market Behavior by A.J. Frost &
Robert R. Prechter, Jr.
Published by John Wiley & Sons, Ltd.
Elliott Wave: Presenting the Neely Method: The First Scientific,
Objective Approach to Market Forecasting with Elliott Wave Theory
Neely with Eric Hall. Published by Windsor Books.
Elliott Wave Theory Profitably by Steven W. Poser Published
by John Wiley & Sons, Ltd.