The Elliott 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 (1946).[1] Elliott argued that because humans are themselves rhythmical, their activities and decisions could be predicted in rhythms, too. Critics argue the theory is pseudoscience: it is unprovable, is inconsistent with the generally accepted efficient market hypothesis and is at odds with modern social science.
In a recent article on the theory of Elliott wave analysis, we said that while it's easy to follow professional wave counts in market charts, doing them on your own – especially in real time, while you're trading – can be a challenge. Yet learning Elliott is well worth it. Why?
For the answer, let's turn to someone who has 12+ years of experience in wave analysis and trading – Jeffrey Kennedy, Elliott Wave International's Senior Commodity Analyst. Here is how Jeffrey once answered the question, "How does the Wave Principle help traders?" (Adapted from Jeffrey's 2-volume Trader's Classroom collection of trading lessons, which comes as a free bonus with a Futures Junctures Service subscription.)
Elliott Wave Benefit #1: It identifies the trend.
Elliott wave analysis is based on two types of wave development: impulsive and corrective. Impulse waves, or five-wave moves, identify the direction of the larger trend: A five-wave advance tells you the trend as up and a five-wave decline tells you it's down. As traders, we always want to trade in the direction of the trend. We want the wind at our backs: That is the path of least resistance, and the probability of success is much greater if you are long a stock when all major indexes are also rallying.
Benefit #2: Elliott wave analysis identifies countertrend moves within the trend.
Corrective waves are simply a response to the preceding impulse wave; corrections always move against the trend. They typically subdivide into three waves (A-B-C) and give us, the traders, an opportunity to position our trades in the direction of the market's larger trend.
Benefit #3: Elliott wave analysis identifies upcoming changes in trend.
Elliott waves are fractal: Larger five-wave moves are comprised of smaller impulses. This enables you to identify the maturity of the trend. For example, if prices are advancing in wave 5 of a larger five-wave advance, and wave 5 has already completed most of its smaller waves, as a trader, you know that this is not the time to be adding to long positions. Instead, some profit taking is in order, or your protective stops need to be raised.
Benefit #4: Elliott wave analysis confirms the resumption of the trend.
Corrections typically unfold in three waves – A-B-C – and when price exceeds the extreme of wave B, confirming the pattern as a three-wave structure, that implies that the larger trend has resumed.
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Benefit #5: Elliott wave analysis provides high probability price targets.
When R.N. Elliott wrote Nature's Law, he specifically stated that the Fibonacci sequence was the mathematical basis for the Wave Principle. And as time has proven, he was right. Elliott waves, both impulses and corrections, adhere to specific Fibonacci proportions.
Benefit #6: Elliott wave analysis provides specific points of ruin.
Where are you wrong? This seems to be the eternal question for traders. And once again, Elliott wave analysis provides us with the answer via the Three Rules of Elliott:
Cardinal Rule 1: Wave 2 can never retrace more than 100% of wave 1.
Cardinal Rule 2: Wave 4 may never end in the price territory of wave 1.
Cardinal Rule 3: Out of the three impulse waves 1, 3 and 5, wave 3 can never be the shortest.
Bottom line, wave analysis is not a crystal ball, but it helps you accomplish three crucial goals: Identify the trend, stay with it, and get out when the trend is likely over.
