Elliott Waves

In 1946 Ralph Nelson Elliott wrote a book called “Nature’s Law – The Secret of the Universe”.  Prior to writing this book, he had completed a truly a monumental amount of research using market data. He analyzed over seventy-five years worth of charts across all timeframes from half an hour to a year. Note that this was almost a half a century before first computers became available for the same purpose.

The result of these studies was a conceptual breakthrough in understanding the market as a natural phenomenon with all the attendant consequences. As we all know, the market is driven by two integral forces: fear and greed. However, these emotions are innate behavioral traits of our species Homo Sapiens. Just like the courtship dances of birds in the forests of the Amazon, our fear and greed are pre-programmed responses to specific types of external stimuli.

Elliott’s main achievement was that through systemic analysis of market data – the final cumulative result of the actions of a large number of players – he was able to identify the basic structure of the market and to show that it is governed by specific rules. While the behavior of a single individual is difficult to predict, the psychology and behavior of a crowd is a natural phenomenon (like, for example the weather) that can be quantified and analyzed. The significance of Elliott’s work in understanding mass psychology and the natural phenomenon that we call the market can by all means be compared with the impact that Darwin’s “Origin of Species” had on our view of biological evolution. Maybe one day, humanity will appreciate Elliott’s invaluable contribution to science.

In 1978, A.J. Frost and Robert Pretcher published the book “Elliott Waves: A Comprehensive Course on the Wave Principle” which I highly recommend. This book is a generalization with small amendments to the wave theory. Based on his keen understanding of the wave principle, Robert Pretcher was able to make some quite accurate predictions about the gold and stock markets, and in 1984 he won a national trading championship in the U.S. by showing a 444% return on his options trading account.

However compelling the wave principle appears, you should never attempt to trade based on the wave principle alone. The fractal nature of markets renders prediction ineffectual. The predictive qualities of the wave analysis are of limited value. The true value of the wave principle is that it reveals the basic structure of the market, which will help you develop a successful trading strategy.

Wave theory for the traders is analogous to anatomy for doctors. A doctor who does not know the correct locations of a patient's vital organs should not to practice medicine!