Using the Elliott Wave Principle is a famous way to analyze price movements in markets. It focuses on cycles and trends, with a basis in psychological motivations of market participants. It was invented by the accountant/analyst Ralph Nelson Elliott, and released in his book The Wave Principle in 1938.
Elliott’s book was not how his principle became famous, though. In the 1970s two analysts named Frost and Prechter published their own book about the principle called Elliott Wave Principle: Key to Stock Market Profits. This work garnered much attention in the trading world, turning Elliott waves into common knowledge for traders.
The basis of the theory is that the market is not strongly rooted in rationality. Instead the market moves between having a positive and negative outlook, in waves that form repetitive patterns. Elliott codified these patterns so that traders could understand the psychology of the markets and work with it in their trading, rather than against it.
The Basics of the Elliott Waves Principle:
Elliot Waves are based around the idea that the same cycles will inevitably show themselves in the price movements of markets. The principle is based on a series of waves. The following is explained in a market that is trending upwards.
The first and most important part of the sequence is a set of five waves. Waves 1, 3, and 5 (seen on the diagram) take the price upward strongly. Between these are waves 2 and 4, which take the price downward mildly compared to the upward waves. These five waves together form a strong upward trend that looks like a lightning bolt. Elliott dubbed the upward waves in this set as impulsive waves.
The second part of the sequence in the Elliott wave principle is a set of three waves (A,B,C on the diagram). These waves form a trend that follows a similar lightning bolt pattern, except it is smaller and has a downward direction. The first and third waves of this sequence move strongly down, with a mild upward move from the second wave. Elliott called the downward waves in this set the corrective waves.
This 5&3 pattern forms the basis of Elliott waves. It does not stop there, though. There is a second level of detail, which is identical to the first. In other words, each single upward impulsive wave is actually comprised of a set of 5 waves as described at the start of this section. The waves are comprised of fractals, meaning that the same shapes repeat on smaller and smaller levels. This pattern is put forth as the basis of price movements by Elliott wave principle.
The different levels seen in the principle are even given their own names. There are 9 different levels that have Elliott names. In order they are: Grand Supercycle, Supercycle, Cycle, Primary, Intermediate, Minor, Minute, Minuette, and Sub-Minuette. Traders are meant to determine the Supercycle and use that backdrop to analyze all the occurring waves.
At this point it is useful to highlight that a key underlying fact about Elliott waves are that they are on the border between being an art and a science. This creates the problem of not really knowing if you failed at judging the waves and Supercycle or if there is a defect in the principle that harms its predictions. This also nods to the fact that Elliott waves are most useful when the overall trend in the market is crystal clear. Some other long-standing trading theories have this quality too, such as Fibonacci levels. They sound good and cannot be disproven, which trumps their inability to be proven fully effective.
One final thought is that the time that Elliott formulated this principle was different. It could be that the modern savviness of traders combined with automated trading could have undermined a large chunk of the psychological basis it was founded on.