The Elliott Wave Principle is a detailed description of how groups of people behave.
It reveals that mass psychology swings from pessimism to optimism, are creating specific and always measurable patterns.
The idea is that if you can identify repeating patterns in prices, and figure out where in those repeating patterns you are today, then you can predict where you will be going in the future.
The Elliott Wave Principle is named for its discoverer, Ralph Nelson Elliott (1871 - 1948), who completed the bulk of his work in the 1930s and 1940s.
This principle interprets market actions in terms of recurrent price structures.
The wave is a movement in the market, either up or down.
The size of the wave depends upon the period of time that is being analyzed.
Basically, market cycles are composed of two major types of Waves:
A. The Impulse Wave:
It is a wave that moves in the direction of the main trend of the market.
Every impulse wave can be sub-divided into a 5 - wave structure (1 - 2 - 3 - 4 - 5).
B. The Corrective Wave:
It is a wave that moves counter to the direction of the main trend of the market.
Every corrective wave can be sub-divided into a 3 - wave structure (a - b - c).
An important feature of the principle is that it is "Fractal" in nature.
"Fractal" means market structure is built from similar patterns on a larger or smaller scales.
Therefore, we can count the wave on a long-term yearly market chart as well as short-term hourly market chart.
The stock market has three attributes of the principle that make it quite applicable:
1. It is a true free market.
2. It provides consistent and regular metrics that can be measured.
3. It is manipulated by a statistically significantly large group of people.
There are also two assumptions behind the Elliott Wave Principle:
A. The market is not efficient.
It is an inefficient market place that is controlled by the whims of the masses.
The masses consistently overreact and will make things over and under priced consistently.
B. If the above is true, then you should be able to do a "sociological" survey of stock prices independent of other news that effects stock prices.
The general explanation for this behavior is that the masses tend to listen for the news they are ready to hear, and that the movement that actually happens depends on other effects.
When doing wave studies of stocks, one of the most difficult things to overcome is the personal ability to separate your own emotions from affecting your analysis.
As an individual you have the same fear and greed internal mechanisms that affect the entire market place as a whole.
Without being able to work to dismiss those emotions you will not be able to stay in a position that will allow you to fully understand and profit from the sociological effects that you are measuring.
The following 5 waves description applies to a market moving upwards.
In a down market there are generally the same types of behavior in reverse:
The stock makes its initial move upwards.
This is usually caused by a relatively small number of people that all of the sudden feel that the previous price of the stock was cheap and therefore worth buying, causing the price to go up.
The stock is considered overvalued.
At this point enough people who were in the original wave consider the stock overvalued and start taking profits. This causes the stock to go down.
This is usually the longest and strongest wave. More people have found out about the stock, more people want the stock and they buy it for a higher and higher price.
This wave usually exceeds the tops created at the end of wave 1.
At this point people again take profits because the stock is again considered expensive.
This is the point that most people get on the stock, and is most driven by hysteria.
People will come up with lots of reasons to buy the stock, and won't listen to reasons not to.
At this point is where the stock becomes the most overpriced.
At this point the stock will move into one of two patterns, either towards a correction (a - b - c) or it will start over again with wave 1.
A correction (a - b - c) is when the stock will either go down or up in preparing for another 5 way cycle.
During this time volatility is usually much less than the previous 5 wave cycle, and what is generally happening in the market is taking a pause while fundamentals catch up.
"On a moderately philosophical level, the Wave Principle suggests that the nature of mankind has within it the seeds of social change." * (*www.elliottwave.com).
Prosperity ultimately breeds reactionism, while adversity eventually breeds a desire to achieve and succeed!
The social mood is always in flux at all degrees of trend, moving toward one of two polar opposites in every conceivable area, from a preference for heroic symbols to a preference for anti-heroes, from joy and love of life to cynicism, from war to peace, from love to hatred, from a desire to build and produce to a desire to destroy.
Most important to individual investors, portfolio managers and investment corporations is that the Wave Principle can sometimes indicate in advance the relative magnitude of the next period of social progress or regress.
Living in harmony with those trends can make the difference between success and failure in financial affairs.
As the Easterners say: "Follow the Way"
As the Westerners say: "Don't Fight the Tape"
In order to heed these nuggets of advice, however, it is necessary to know what is the Way.
There is no better method for answering that question than the Wave Principle.