Trading with the Elliott Wave Theory

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Imagine a technical analysis methodology that can tell you when you are wrong long before your stops are hit. Imagine a technical tool that allows you to make money even when your analysis is wrong. Imagine an analytical framework that permits you to develop a likely road map for prices that you can easily use to support or supplant other technical, or even fundamental, indicators. Imagine that this way of analyzing prices was developed with the basis for technical analysis—crowd psychology—in mind. Imagine a tool so flexible that there is little difference between applying it to five-minute bars and applying it to monthly bars. Imagine a tool that though complex, dovetails perfectly with traditional trendline and pattern analysis as well as the venerable Dow Theory. Imagine that you can use this form of technical analysis on stocks, bonds, currencies, commodities, or virtually any liquid and free market.


This methodology not only exists but has been around for more than seventy years. It is not a black box system. Price is this method’s only indicator—not the relative strength index, not a stochastics oscillator. Nobody trades the relative strength index; your trading account is not marked to market based on a stochastics oscillator. Your account is marked based on the difference between the current price of the item you bought or sold and where it stood when the trade was initiated.

This wonderful technical tool is the Elliott Wave Theory, one of the few technical tools that is predictive in nature. The astute trader or investor can employ the principle to accurately forecast market extremes. Most forms of technical analysis, although generally more accurate in terms of price determination than fundamental research, tend to be reactive and lag price action. Moving averages cross price well after the trend has changed. Confirmation of a head and shoulders reversal or triangle breakout occurs long after the most advantageous price levels to enter or exit a trade were achieved. Oscillators are based on smoothed prices and tend to trail price activity. In general, oscillators also work well only during periods of range trading in the markets.

The wave principle can be used on a stand-alone basis or in conjunction with indicators to help the trader better focus on buying and selling opportunities by identifying likely “energy points” in the market. Elliott Wave Theory’s predictive nature means that the trader or investor will be prepared to take action as soon as the market acts according to expectations.

History of Elliott Wave Theory
Ralph Nelson Elliott (1871–1948) developed the Elliott Wave Theory. Elliott was an accountant by trade who spent much of his career working for international railroad companies. He also had an interest in restaurant management and wrote articles and even a book on the subject (Tea Room and Cafeteria Management). Elliott fell ill following a stint as Auditor General of the International Railways of Central America in Guatemala. It was during his long convalescence that Elliott began his study of the U.S. stock market.

Elliott had a keen analytical mind. Even in his book on restaurant management, Elliott perceived that markets and the economy moved in cycles, or waves. This perspective led him to the work of Robert Rhea, whose tomes describing Dow Theory are still considered classics. It should come as no surprise that Elliott Wave Theory shares a great deal with its elder cousin, Dow Theory (see also Chapter 1).

It was not just the basic phases of a bull market that Elliott and Dow had in common. Both of these great market analysts detailed the market action based on how investors and traders acted and reacted at each point during a trend’s development (see Figure 8.1).

Figure 8.1: Trend Development in Dow Theory/Elliott Wave Theory

The two theories differ in many ways. Dow described bear markets in similar terms to bull markets. A primary bear market had a period of distribution, technical trader entry, and public participation (or in the case of a bear market, more likely, capitulation). Elliott saw bear markets as developing in two broad legs trending lower with a corrective period in between.

The most significant difference between the two theories is that Dow Theory is reactive, whereas the Elliott Wave Theory is proactive. Dow Theory offers a detailed framework describing how to determine whether or not a trend has already changed. To signal the end of a bull trend a lower high and a lower low of some degree is required. Dow Theory offers little guidance with regard to price projections. Dow Theory does offer vague ideas regarding possible retracement targets and equally vacuous ideas regarding how long a primary or secondary trend can be expected to last, but few tools are offered that give the user the ability to pinpoint possible market turning dates, times, and prices.

Elliott approached his analysis from a somewhat different point of view. He fully believed that the markets were deterministic. He argued that, by proper usage of the wave principle, one could accurately forecast market turning points—both in time and price—years in advance. Although no one has achieved that degree of accuracy yet, Elliott Wave Theory does provide an incredibly precise method for finding places of high probability where trend changes may occur. And, to add to its usefulness, its very nature quickly tells the user when the analysis is incorrect.
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Trading with the Elliott Wave Theory