What is the Elliott Wave Theory?

The Elliott Wave Theory, or Elliott Wave Principle, is a type of technical analysis used to predict trends in the stock markets. It accomplishes this by the monitoring of unique characteristics in the wave patterns of prices and crowd psychology. It is somewhat based on the Dow Theory, which states that the market is trending upward if one of its averages is higher than a previous important high, and thus the market trend flows in waves of highs and lows.

In 1938, Ralph Nelson Elliott (1871–1948) published his book The Wave Principle, in which he first presented his idea that instead of chaotic waves, the market cycles in a rhythmical pattern, allowing accurate predictions for well into the future. Up until Elliott's time, investors had noticed that outside events seemed to have no consistent effect on the progress of the stock market, leading those investors to conclude that the outside world has no influence on the market cycles. Elliott had noticed that investor psychology fluctuates between optimism and pessimism in rhythmical, reoccurring patterns and theorized that this is the real engine behind market trends.

The Elliott Wave Theory divides waves made of important highs and lows into two sets: impulsive waves, which are made up of five smaller waves, and corrective waves, which are made up of three. On a smaller scale within the impulse wave, these five wave patterns can again be found along with the three of the corrective waves, and this pattern continues to repeat itself ad infinitum. By analyzing the patterns in current and past trends, an investor is able to predict where the market will head next or when it is most likely to turn with an impressive accuracy.

Each of these sets of five moves and then three moves completes a cycle, categorized by the Elliott Wave Theory to define different time scales. Grand Supercycle is the category of the longest Elliot wave, extending over several centuries. Next is the Supercycle, or Kondratiev wave, which lasts about 40 to 70 years.

The next category is called simply a Cycle, and it generally lasts one to several years, though it can last for decades under certain circumstances. A cycle that spans over a few weeks or months is called a Primary, and a Minor lasts only a few weeks at most. A Minute represents a few days, a Minuette lasts a few hours, and a Subminuette lasts only a few minutes.

The way that the Elliott Wave Theory works to make accurate predictions can be seen in a simple example. If an investor looks at the latest Primary wave, he or she will see the particular pattern present for those few years. Upon finding that pattern, the investor can then increase the size of the scale and, using the very same pattern, can determine when the next Cycle will most likely occur. Increasing the size of that scale, the investor will then have an accurate prediction of the highs and lows of the market trends for the next 40 to 70 years. The Elliott Wave Theory works in probabilities, so it isn't necessarily a guarantee of what will happen, it's just a very careful and mathematical way of exploiting the odds in the investors' favor.