The Elliott Wave Principle—Do You Love It or Do You Hate It?

05/25/2015 9:00 am EST

Focus: FOREX

Tom Cleveland, on ForexTraders.com, goes beyond simply outlining the basics of Elliott Wave Theory; he offers a historical view into where it came from, weighs its pros and cons, and shares the rules of what he believes is an important analytical tool in the field of technical analysis.

We learn from experience that one should never discuss politics or religion when in a group of people, the reason being that voices suddenly are raised; once civil individuals quickly become incensed and divide into factions and a once friendly discussion abruptly turns incendiary. If there happened to be traders in the room and you had also mentioned the Elliott Wave Principle, then head for the exits before the mayhem starts. EWP, as it is sometimes called, can incite an emotional riot among the trading community, but, like any other technical tool, if it works, use it; if not, discard it.

The major savings grace of the foreign exchange market for most forex traders is that it is so huge, $5.2 trillion a day in turnover at the last BIS accounting, and that, by being the most enormous financial market on the planet, it defies manipulation. Yes, central bankers have a way of influencing the market that spoils the odds for nearly any analytical method, but this form of event risk can generally be anticipated and then avoided. The absence of manipulation, however, fosters purity, which yields the best environment in which to measure the effectiveness of any technical method or market indicator. EWP aficionados swear by its tenets and defend its use with religious fervor, especially when analyzing various movements and patterns in the forex market.

What Are the Basics of Elliott Wave Theory?

The best way to start this discussion is by reviewing a current chart example:

chart
Click to Enlarge

Volumes have been written on this subject matter, which many opponents have never read, but nearly every introduction for Elliott Waves starts with an oversimplification by reviewing what is called an Impulse and Corrective Wave combination. Daily price action for the GBP/USD currency pair has recently produced a near perfect Impulse Wave for an uptrend, as noted by the 1 to 5 sequences. Each leg might also be broken down into smaller waveforms, but we do not need to go there for the moment. Elliott also postulated that this 5-legged wave would, on most occasions, be followed by a downward Corrective Wave, the A-B-C expectation for future price action.

Ralph Nelson Elliott (1871–1948) spent much of his career as a professional accountant, but, during the latter half of his life, he became intrigued with what he viewed as a harmony within the stock market that mimicked nature. Through an exhaustive study of the DJIA in the 1930s, he developed his general theory that market prices move in patterns of rationally formed waves that describe investor psychology and may be used as analytical tools for forecasting future behavior.

Elliott published many works, but the most comprehensive discussion of his theory may be found in his final major treatise of 1946, Nature’s Laws: The Secret of the Universe. Within this manuscript, Elliott summarized his basic tenet that "because man is subject to rhythmical procedure, calculations having to do with his activities can be projected far into the future with a justification and certainty heretofore unattainable."

NEXT PAGE: Basic Rules and Pros and Cons

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Elliott Wave Theory is an important analytical tool in the realm of technical analysis. All traders, whether they accept it or not, should—at a minimum—be aware of its rules and how this system can be used to an advantage to interpret action in the markets. It is a tool of unique value, whose most striking characteristics have been generality and accuracy. It is important to recognize that these rules have stood the test of time, especially displaying a level of accuracy in identifying changes in market direction that can only be described as remarkable. Critics argue that it is far too complex and subjective.

The Basic Rules that Govern EWP’s Interpretation of Wave Patterns

Here are the three unbreakable rules for an Impulse Wave:

  1. Leg 2 can never retrace more than 100% of Leg 1;
  1. Leg 3 is never the shortest of the three impulsive legs, 1, 3, or 5. Usually it is the longest, but this is not always the case;
  1. Leg 4 never retraces to a level below the peak of Leg 1 in an uptrend or above the trough of Leg 1 in a downtrend.

There are other corollaries to these rules, an example being that Legs 2 and 4 tend to be opposites; if one is short, then the other tends to be longer. Impulse waves can always extend when fundamental news is very positive, such that it is more difficult to identify true corrective wave patterns. If Leg A is truly the beginning of a corrective phase, then other indicators must be used for validation (i.e., implied volatility or net open interest positioning in the futures markets). Leg B will typically be lower than the peak of Leg 5 and Leg C tends to be greater than Leg A by 61.8%, a key Fibonacci ratio.

After careful mathematical analysis of various wave patterns and their inherent properties, Elliott concluded that, “The Fibonacci Summation Series is the basis of The Wave Principle. When I discovered The Wave Principle action of market trends, I had never heard of either the Fibonacci Series or the Pythagorean Diagram.” As a result of his findings, Fibonacci tools are now engrained in technical analysis to determine levels of support and resistance. If you look again at the chart on the previous page, Legs 1, 2, and 4 mark their respective ending points at key Fibonacci ratios, the red horizontal lines that pertain to the initial 1–3 legs of the impulse wave. 

EWP Criticism—A Review of Both Pros and Cons

Forex traders, however, are often mixed in their opinions when it comes to using Elliott Wave theory. Most detractors have tried it, lost a good sum of capital when it did not work and then suffer high blood pressure when the topic is ever raised. Elliotticians, the true believers and enthusiasts of this technical art form, are no different than any other analysts on The Street, they can be right and they can be wrong about how the future will unfurl. If there really were a perfect system, then we would all be using it, making tons of money, and lying on a warm beach somewhere with a cool drink in our hand.

NEXT PAGE: The Elliott Wave Opinion Spectrum

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The best advice is to have a sense of humor when you peruse any articles of praise or criticism of the theory. You will find the full gamut, as this ardent supporter suggests:

“It's interesting to me how frequently I encounter people who seem to have it in for Elliott Wave Theory. I have come to the conclusion that many folks simply don't understand it.  And for certain personalities, if they can't relate to something rationally, they relate to it emotionally, often in a negative way.  I have actually heard people state that Elliott Wave "must be some type of cult."  I assure you, in order to become an Elliott practitioner, I was not required to shave my head, nor was I forced to drink goat's blood by the light of the full moon while humming Hare Krishna (for the record, I was humming Jumpin' Jack Flash).”

This practitioner hints at the major issue that most traders have; EWP is complex. It requires time, study, and lengthy experience to develop and appreciate the technique. Even if we hate to admit it, the majority of traders today are impatient and believe that delayed gratification was from some bygone era, long, long ago. They then complain that it is too irrational, too subjective, and not worth the time and effort required. It does take time to develop trust in any technical method and we learn from experience that a combination of approaches is the best way to help tilt the odds in our favor.

The harshest criticism of EWP typically comes from academia or the scientific community that argues that randomness of financial markets prevents any forecasting scheme from ever having measurable positive results. These critiques are usually fashioned with highly technical terms that are designed to add credibility to the author’s claim, but, at the end of the day, markets are not totally random either. Supply and demand forces move markets, which are more often than not determined by herd mentality and the primary objective of any technical method is to discern the impact of herd psychology and how it will most likely move from a purely probabilistic perspective.

Concluding Remarks

Criticism of Elliott Wave Theory is generally a critique of the entire field of technical analysis. As long as academics and scientists expect 99% congruence of market data with any theory, there will always be a raging debate. Famous traders like Paul Tudor Jones have amassed billions using technical analysis methods, and his opinion of EWP is that, “Prechter and Frost's standard text on Elliott is "a classic," and one of the four Bibles of the business." Some analysts argue that EWP is outdated, but congruence today is even greater due to the abundance of software black boxes that incorporate its principles within their programmed decision-making processes. Fibonacci ratios abound for this very reason alone and EWP takes its lead from these estimation guideposts.

The fact remains that many people have made money and a lot of it with TA and EWP to guide their active trading experiences. The size of their bank accounts should be evidence enough that a 99% correlation is not necessary. A 60% figure is good enough to produce a consistent string of net gains over time in forex trading. Mastering the nuances of any wave theory does take time and patience. Find the aspects that work for you and integrate them into your own strategic positioning plans. After all, the more things that tilt the odds in your favor, the better in the long run.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.

By Tom Cleveland, Contributor, ForexTraders.com

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