Elliot Wave Theory Tutorial

Basic Thesis of Elliot Wave Theory: In 1939, R. N. Elliott established the Elliot Wave Theory, which believed markets had well-structured waves that could be used to predict market direction. It stated that stock prices are governed by cycles founded upon the Fibonacci series (1-2-3-5-8-13-21...). Elliott believed the market moved in distinct waves: five on the upside and three on the downside.

Assumptions of Elliot Wave Theory: market is not efficient
1.It is a true free market (i.e., prices are set by the consumer's beliefs).
2.It provides consistent and standard metrics that can be measured.
3.It is manipulated by a statistically significantly large group of people.

Wave Description:
The following description applies to a market moving upwards. In a down market you will generally see the same types of behavior in reverse that you saw watching the stock go up. The description of the wave (ie Wave 1) is shown visually in the chart above.

Wave 1
The stock makes its initial move upwards. This is usually caused by a small number of people that all of the sudden (for a variety of reasons) feel that the previous price of the stock undervalued and therefore worth buying, causing the price to go up. Usually sophisticated investors.

Wave 2
The stock is considered overvalued. Now, enough people who were in the original wave consider the stock overvalued and sell to make a profit. This causes the stock to go down. However in general the stock will not go down to its previous lows before the stock is considered cheap again. More and more people start to hear about the stock.

Wave 3
This is generally the longest wave. It has become a "popular" stock, and more people want the stock and they buy it for a higher and higher price. This wave usually exceeds the peaks created at the end of wave 1.

Wave 4
At this point people again take profits because the stock is again considered expensive. This wave tends to be weak because their are usually more people that are still bullish on the stock and after some profit taking comes wave 5.

Wave 5
This is where most people get on the stock, and is mostly driven by emotion. People will carelessly purchase the stock. They will act in an irrational manner and will be hard to persuade them not to buy the stock. At this time, this is where the stock becomes the most overpriced. Then the stock will move into either one of two patterns; an ABC correction, or starting again with wave 1.

An ABC correction is when the stock will go down/up/down in preparation of another 5 way cycle up. During this time frame volatility is usually much less then the previous 5 wave cycle, and what is generally happening is the market is taking a pause while fundamentals catch up. You may have more than one ABC correction- if the fundamentals do not catch up you will have two ABC corrections and then the stock will have a 5 wave down cycle. (An odd number of ABC corrections point to the stock going up, and an even number of ABC corrections point to the stock going down.)

Here is applied example:
Centex Corporation, from November 2005 to February 2006

After Wave 5, you can see that Centex had 2 ABC wave corrections, and thus the stock continued downwards on another 5-wave cycle.

Criticism of the Elliot Wave Theory:
Critics believe that the wave principle is too vague to be useful, since it cannot always identify the beginning or end of a wave. In fact, it is very difficult to identify what portion of the wave pattern is occurring and where it will go in the future. They feel Elliott wave forecasts are often subjective and easily revised. It is easily applied in retrospect. Skeptics also say that if the theory did hold true, common knowledge of it among investors would force the pattern useless because all investors would try to profit from the pattern, and the waves would no longer hold true to the theory. This same argument is made against other predictive methods that are based on market-wide data and patterns.

Sources:
•CapitalIQ Charting
•http://www.acrotec.com/ewt.htm
•Kurganov, Yury. http://www.elliottwavemarkettiming.com/ 2006.
•Investopedia. http://www.investopedia.com/articles/technical/111401.asp November 14, 2001
•Lott, Christopher. http://invest-faq.com/articles/tech-an-elliott.html 12 Dec 1996