What Is the Elliott Wave Principle?

The Elliott Wave principle is a form of technical analysis of stock and commodity financial market trends versus the equally-used method of fundamental analysis of a company's value. Technical analysis is based on the collection of data on actual fluctuations in the price of a stock as a method of predicting future behavior. Fundamental analysis is based on economic factors that establish the net value of a company, such as its capitalization level, price-to-earnings ratio, and so on. Ralph Nelson Elliott, a career accountant, is credited with formulating the Elliott Wave principle in the 1930s. He utilized understanding of crowd psychology and social trends, known today as behavioral economics, to chart market cycles of rising and falling stock price structures.

Proponents of the Elliott Wave principle break it down into two types of market cycle waves, known as the Impulse Wave and the Corrective Wave. These are further divided into finer wave structures, with five for the Impulse Wave and three for the Corrective Wave. The waves follow a fractal pattern regardless of the time period for which they are examined, meaning that the chart for a yearly trend in a stock will look very much like the same chart for a hourly trend for the same stock when using Elliott Wave calculations.

The market trends predicted by Elliott Wave principle rules are fairly straightforward and logical. For instance, for a stock on the rise, wave count rules state that Wave Two should not break below Wave One, and Wave Three should not be the shortest wave among Waves One, Three, and Five. Nesting of these rules within further rules makes the Elliott Wave principle quite reliable. Traders who rely on the method base it on an overall principle that trends indicated by three Impulse Wave forms and six Corrective Wave forms are conclusive evidence as to where a stock is headed.

It took Ralph Elliott a long and detailed study of 75 year's worth of stock trends until he felt confident enough to publicly release the elements of his theory at age 66. He first published it in his book, The Wave Principle, in 1938, at the age of 67. The Elliott Wave principle is still widely accepted as legitimate today, and Elliott was considered something of a Renaissance man in his time. The US government thought so highly of his accounting skills that he was appointed as Chief Accountant to Nicaragua by the US State Department. His experiences in Central and South America led to such prominent outcomes as the financial development policies adopted by the World Bank.