Introduction To Elliott Wave Theory (EWT)
A Short History
A Word Of Caution
Why It Matters
A Short History
Elliott Wave Theory isn’t new. In fact, it’s been with us for literally decades. It’s named for Ralph Nelson Elliott, who was a corporate accountant by trade, and who studied and wrote about price movements in the financial markets.
Some of his conclusions are patently obvious and can be seen with a quick glance at any stock market price chart. Price changes are not linear. You’ll never find an instance where price moves up or down in a straight line. Any time the price of an asset rises or falls, it does so in a “sawtooth” pattern, so for instance, if the price is trending upward, it will go up for a time, then retreat, then trend higher before retreating again, and so on.
Here’s the magic of Elliott’s work though: When you look at that price chart, it seems to be totally random. It’s just this crazy zig-zag of increases and decreases. Elliott discovered though, that there was a strange kind of order lurking behind the apparent chaos. That in fact, those zig-zags aren’t random, but predictable, and not only that, they tend to follow a few set, repeating patterns, IF you know what to look for.
It’s not just stock prices, either. Elliott Wave Theory applies to the price of any good or service sold and can even be applied to politics (polling data and the like) and can be used to explain and predict the rise in popularity of various pop culture phenomenon. Just like “the Golden Ratio” appears everywhere in art and nature, so too are Elliott Wave patterns evident in every aspect of human behavior.
Even more interesting is the fact that the patterns are fractal.
Look at an asset’s price during the course of any given day, you see a pattern. Zoom out and look at it over the course of a month, and the same predictable, repeating patterns emerge. Zoom out to the monthly view, same thing. No matter how much you zoom in or out, you see those same predictable, repeating patterns.
The same is true if you look within a “set” of waves. You find another set of waves just like them. And another. And then another, regressing infinitely. That’s incredible, and its implications are impossible to ignore. In a very real sense then, the argument could be made that Elliott discovered fractals long before Benoit Mandelbrot did in 1975.
Even more recently, scientists have concluded that pattern formation is a fundamental characteristic of any complex system, and financial markets certainly fall into that category. Thus, decades after Elliott first published, science has proven him to be correct.
Obviously, when Elliott first published his work, there was some serious pushback. There were a lot of people who simply scoffed at the idea, insisting there was no way it could be true.
Even so, over the intervening decades, there were a small number of investment professionals who made regular use of EWT analysis and kept the flame alive, but it was very much a fringe theory. That began changing in 1977, when Robert Prechter and A. J. Frost brought Elliott Wave Theory to a wider audience with the publication of the book “Elliott Wave Principle: Key To Market Behavior.”
The book quickly became a bestseller, and Elliott Wave Theory became much more mainstream. Having said that though, its highly subjective nature makes it a somewhat controversial topic even to this day. Defenders point to their own impressive track records born of using this powerful analytic tool, while detractors point out that it’s easy to make price data fit the model in hindsight.
Both positions are true. The bottom line though, is that a lot of investors have spent time mastering the methodology, and they’ve been rewarded with handsome profits. The proof, as they say, is in the pudding.
Again, we underscore that Elliott Wave Theory is highly subjective. You can see this play out by visiting an Elliott Wave discussion forum. Different people will reach different conclusions to the same data. Of course, as time goes by, you’ll gradually see a consensus form about each developing trend, but in the early stages, you’ll often see very smart, experienced people reaching wildly different conclusions.
Because of this, we don’t recommend relying solely on Elliott Wave Theory when conducting analysis to make investment decisions. It’s at its strongest when used in conjunction with other analytic tools.
Ultimately, nobody learns to use Elliott Wave Theory because it makes a great topic of conversation at parties, or because it’s a good addition to your resume. No, people spend time mastering this form of analysis for one reason: To make better investment decisions.
While it’s certainly not a crystal ball, once you wrap your brain around it and get comfortable using it, it can sometimes feel a bit like having a crystal ball. Its main value lies in helping you find good entry and exit points for making investments.
Having a good sense of how far a price increase will run and when the price is likely to turn south again is worth its weight in gold to an investor and will dramatically increase your profits. That is, after all, the name of the game, right? By anticipating the behavior of “the herd,” you can avoid becoming part of it. So that’s why it matters.
- Elliott Wave Theory (EWT) has been around since the 30’s, but didn’t really start gaining popularity until the 1970’s
- Broadly speaking, EWT is an effort to explain and predict price behavior by studying waves, with the understanding that price movement never happens in a straight line, but with a series of advances and retreats, even as the price moves broadly up or down.
- It is (or can be) an extremely powerful analytic tool, BUT it is highly subjective
- Because of the above, it is at its most powerful when used in conjunction with other analytic tools
The main reason for using it is the same as the reasoning for using any other analytic tool. To identify optimal entry and exit points for making successful trades and locking in profits.