Charts are basically simple representations of price history, but they are often endowed with some almost mystical qualities by over-complicated analysis of obscure patterns. The most reliable patterns, however, are those that are based on repeated human behavior rather than esoteric math, which brings us to Elliott Wave Theory.
It was developed in the 1920s by Ralph Nelson Elliott, and has been a basic method of technical analysis ever since. It is based on the observation that human psychology leads to a cyclicality in financial markets, and that is its strength and the main reason it has been so durable. Technology, information flow, and a host of other things that can influence price may change, but the human condition remains constant.
Most of us understand the concept of Elliott Wave Theory, even if we don’t recognize it as that. Think of every cartoon depiction of a chart that you have seen, and I’m sure that most of them show a zig-zag movement either up or down. The fact is that price rarely, if ever, moves in a straight line, and that is the basis of the concept.
For the purpose of simplicity, I will refer here only to an upward move, but the same applies in reverse when a price is declining.
Humans tend to think that the most recent thing to happen will continue to happen, so when a price is moving upward, it attracts other buyers. That leads to an overshoot of the logical endpoint of a move, followed by a correction once that is recognized.
However, assuming that the fundamental conditions that led to the move up in the first place remain constant, that move down ends at the point that the stock, or whatever you are tracking the price of, represents value again and the upward move resumes. That pattern is then repeated.
What Elliott observed is that the moves up most often come in threes, leading to a pattern of five distinct moves, or waves.
There are a few things that define a true Elliott pattern. First, no correction can pass the starting point of the move that precedes it, so wave 2 in the above chart is shorter than wave1 and 4 is shorter than 3. In addition, 3 must be longer than 1, and 4 cannot continue past the top of 1.
In real life, of course, the chart is never as clean as that, but the pattern is still often recognizable. The chart below is for Amazon (AMZN) in the fall of last year, for example.
Elliott Wave Theory, like most technical analysis, can be as simple or as complex as you wish to make it. There are extensions of the theory that predict the scope and slope of each wave and a lot of analysis based on the fractal nature of the moves (a fancy way of saying that each big wave contains a bunch of little ones that also conform to the pattern).
If you intend to use it for analysis, you should familiarize yourself with some of those ideas, but to me the most useful thing about Elliott is the understanding it gives us of cyclicality.
Once you understand the basic idea that securities tend to move, correct, move, correct, then move again it informs any and every analysis you perform thereafter. And understanding that once a correction reverses and the price moves above the previous high it is likely that that upward move will continue helps to identify opportunities, or at least reinforce the timing of trades suggested by other factors.
Elliott Wave Theory is, like every type of analysis, not perfect. Overall market conditions or fundamental factors specific to the traded instrument can and will change, and that can easily nullify your calculations and even the best possible setup. It is important to remember that, and to always have an exit strategy and not to become too slavishly attached to any one theory.
That said, Elliott Wave is such a widely used and logical analysis that a basic understanding of the principles behind it is important to all traders and investors. Hopefully, if you have got this far, you now have that.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of NASDAQ, Inc.