Elliot Wave Theory – One of the illusions in Trading

May 9, 2013 07:07 AM

Technical analysis, the study of past market data to predict future price moves, has its doubters, but there is no doubt that many traders around the world are able to make good livings out of price patterns and technical indicators.

In the investment community, traders typically use a number of different ways to analyse the markets; moving averages, Bollinger Bands, RSI, MACD etc. The list goes on and on. There is, however, one form of technical analysis that polarises many traders, with some calling the method nothing but an illusion. That method is the Elliot Wave Theory.

Elliot Wave theory

Elliot Wave Theory was invented by an accountant named Ralph Nelson Elliot in the 1930’s after many years analysing the rhythmical nature of financial markets. Whilst those around him saw the nature of markets as inherently chaotic, Elliot was convinced that this was not the case and that markets were the product of mass psychology between market participants. As a result, Elliot believed markets exhibit the same repetitive patterns over and over again which can then be used to predict market direction. He put all this together in a book called The Wave Principle, which shows how markets move in upward and downward swings called waves.

Fractals

To understand Elliot Wave Theory it is not essential to know the ins and outs of fractal mathematics but it is important to know what the theory is based upon. Essentially, fractals are structures that can be split into millions of smaller and smaller parts, each being a smaller copy of the last. Just as a cauliflower or snowflake when broken down forms the same recurring pattern over and over again, the price chart of a stock, shows the same patterns over different time frames, from monthly charts to 5 minute charts.

Elliot showed through his book that markets move in what was called 5-3 wave patterns.  The market basically moves up on the 1, 3 and 5 patterns and corrects during the 2 and 4 waves.

During the first wave, the stock moves up as people think the market is cheap. This causes the stock to rise until wave 2, where enough people take profits to ensure the stock corrects a little. Wave 3 is usually the strongest wave, as the masses take notice of the advancing stock and buy it up, causing it to shoot upwards. In wave 4, traders take profits as the stock is now expensive and the stock corrects again. However, trades on the sidelines waiting to buy the dips end up pushing the market back up and into a mass hysteria, bubble phase.

This then leads to Elliott’s ABC stage where contrarian short sellers then enter the market.

This ABC stage is like the 5-3 wave but in reverse and with only three waves which are much sharper in velocity and shorter in duration.

Complexity

And it is here that we get to a major problem when using the Elliot Theory. Not only are the various waves and patterns completely subjective to the individual trader, there are over 21 different corrective patterns in the ABC series alone. If this was not enough for a trader to get his head round, the waves are then categorised into 9 groups; Grand Supercycle, Supercycle, Cycle, Primary, Intermediate, Minor, Minute, Minuette, Sub-Minuette.

The theory behind the different groups is that the Grand Supercycle is made up of Supercycle waves, which are made up of Cycle waves, which are made up of Primary waves and so on. But this seems to be problematic. Since, if the markets are designed like fractals, where the market can be broken down into smaller and similar parts, then why is it necessary to have so many different categories?

And just to add to the difficulty of identifying the waves and remembering all the different formations, Elliot proposes three rules that must be followed when using the theory:

·  Rule 1: Wave 3 cannot be the shortest wave

·  Rule 2: Wave 2 cannot go beyond the start of Wave 1

·  Rule 3: Wave 4 cannot cross in the same price area as Wave 1

What this means is that there are too many variables, too much complexity and too much emphasis on past market movements to make this an easily usable strategy.

Subjectivity

The truth is, markets do not move in such clearly defined patterns, and as there is no scientific method for coming up with each wave, the patterns are completely open to a trader’s discretion. This means that any pattern placed upon a chart is subjective to a trader.

As an example, let us say that we are watching the market on a 30 minute chart below.

As you can see, the various lines represent the different waves that a trader might attribute to the market.

The first wave could represent the beginning ‘1’ wave at which point a trader might consider going long. However, the next move broke the pattern. This could cause a trader to think the market was in the ABC mode (sharp move downwards). The next move up would confirm this pattern, however, the third wave does not go down far enough, meaning that the ABC pattern is now broken. Meanwhile, another trader might see the smaller retracement wave as wave 2, meaning the 5-3 upward pattern is in place.

As you can see, the charts can be interpreted in many ways and a key consideration becomes where to start off the analysis.

Change the timeframe of the chart and it becomes even more clear how difficult it is to assign these subjective patterns to the price data as the waves change dramatically (almost doubling in quantity).

Illusion

And so we can see the illusion of the Elliot Wave Theory. The highly subjective nature of fitting waves to past data and the sheer number of waves which mean finding a pattern to fit the chart is nearly always possible but the future direction is never guaranteed.

The Elliot Wave Method is supposedly against the theory of chaos yet it is based on fractals, one of the key components of chaos theory. This is strange, and by giving the theory completely subjective patterns it seems in many ways to go against the underlying principles that the theory represents. Indeed, even the man attributed to inventing fractals, Benoit Mandelbrot, has his doubts regarding the Elliot Wave Theory:

“… Wave prediction is a very uncertain business. It is an art to which the subjective judgement of the chartists matters more than the objective, replicable verdict of the numbers. The record of this…is at best mixed.”

Mandelbrot, Benoit and Richard L. Hudson (2004). The (mis)Behavior of Markets, New York: Basic Books, p. 245


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