Ralph N. Elliott

Ralph Nelson Elliott (1871 - 1948) is known as the founder of the Elliott Wave Principle or Elliott Wave Theory. He was born in Marysville, Kansas on 28 July 1871 and became a qualified account in the mid-1890s and worked mainly for railroad companies in Central America. During his time in Central America, Elliott contracted an intestinal illness, which forced him into retirement in 1929. It was during his battle with his illness that Elliott undertook a study of the behavior of the US stock market to occupy his mind. During this study he noticed the presence of a repetitive cyclic wave pattern on the price charts of the Dow Jones industrial averages. This wave pattern was first described by Elliott in a booklet entitled The Wave Principle in 1938 and was elaborated on in his book entitled Nature's Law: The Secret of the Universe in 1946. Elliott identified these as natural cycles in collective investor psychology, or crowd psychology, that moves from optimism to pessimism and back again.

On January 15th, 1948, two years after the publication of Nature's Law: The Secret of the Universe, and at the age of 76, Elliott passed away.

Unfortunately, Nature's Law: The Secret of the Universe has been out of publication for a few decades now, but the Elliott Wave Principle has been popularized in the 1980s following the work of A.J. Frost and Robert R. Prechter. Prechter had discovered Elliott's works while working as an analyst at Merrill Lynch in the min-1970s. In 1978 Frost and Prechter published the book, Elliott Wave Principle: Key To Market Behavior. The following year Prechter left Merrill Lynch and started the Elliott Wave Theorist. Prechter used Elliott wave analysis to correctly forecast the bear market in gold and the bull market in stocks in the 1980s. These forecasts led to the popularization of Elliott's wave principle.

Elliott Waves
Elliott Wave Structure

Elliott's Wave Principle

In Elliott's wave principle, the market price moves in an alternating cycle of five wave and three wave patterns, with the five wave pattern being an impulsive or motive phase, and the three wave pattern being a corrective phase. These two patterns form a complete cycle. Furthermore, Elliott found that these waves were present in all timeframes and discovered that a wave would consist of smaller subwaves, or waves of a lesser degree, although these smaller subwaves did not necessarily correspond to a smaller timeframe.

Elliott divided waves into two categories: impulse or motive waves and corrective waves, with impulse wave generally subdividing into 5 subwaves, and corrective waves generally subdividing into 3 subwaves. This is a general characteristic as these waves may have extensions, making them longer, without changing their technical significance.

Elliott also noticed that impulse waves do not always indicate a price advance and a corrective wave does not always indicate a price decline. Instead, impulse waves move in the direction of the wave one higher degree. Thus, in an impulse wave, subwaves 1, 3, and 5 are also impulse waves while subwaves 2 and 4 are corrective and move against the direction of the higher wave. Similarly, in a corrective wave, subwaves A and C are impulsive while subwave B is corrective.

The 3 Rules of Elliott Waves

There are only three simple rules in Elliott Wave Theory that apply to impulse waves and should never be broken. The rules are:

  1. Wave 2 may not retrace beyond the start of Wave 1. If it does, then it is part of a corrective phase.
  2. Wave 3 cannot be the shortest of the three motive waves, namely waves 1, 3 and 5. It does not need to be the longest of the three, but it cannot be the shortest.
  3. Wave 4 must not penetrate and overlap the price action of wave 1, except in the case of a diagonal triangle.

In addition to these three rules are a few guidelines that are typical of Elliott waves but do not occur in every 5-3 wave cycle. These guidelines include the extension of impulse waves, truncation of the fifth wave, alteration of the shape and length of the corrections at waves 2 and 4, and channeling of the motive wave.

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Wealth Warning

Trading equities, options, derivatives, currencies, commodities or any other financial security can offer significant returns BUT can also result in significant losses if the market moves against your position. It requires a strong commitment to skill development, knowledge acquisition, and emotional control. It should be treated as a business with a clear business plan, a risk analysis, and set of attainable goals. The risk associated with trading the vagaries of the stock markets is probably the most important consideration as it has a profound effect on emotional control. You should not trade the stock markets with money you cannot afford to lose as there is considerable exposure to risk in any stock market transaction.

Furthermore, the past success of any trading method, strategy, or system is only indicative of future success. Under no circumstances should past success be construed as a guarantee of future success!