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Friday, August 20, 2010

The Elliott Wave Principle

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.