R.N. Elliott was born in the United States of America in 1871. Up until 1927 the majority of his life was spent in Central America in the railroad business. After a severe illness he was forced to retire from the railroad and embarked on an extensive study of the American stock market.

His research efforts analysed in depth the movements of the Dow Jones Index over the course of the previous century. Elliott was convinced that the market displayed repetitive patterns which could be used to identify trends in the future.

His work was first published in 1934 and he continued his research up until his death in 1948. Such was the strong belief in his own work that Elliott named his final work Nature's Law: The Secret of the Universe in 1946, two years before his death.

Cycles occur everywhere in nature. Cycles appear in the movements of the tides, the orbits of the planets, the seasons, the weather and so on. These cycles form the basis of natural law.

Natural law also embraces the extraordinary numerical series discovered by a 13th century mathematician named Fibonacci. Fibonacci made an incredible discovery of a sequence of numbers which tie very closely with nature.

The sequence of numbers that Fibonacci discovered are derived by starting with the number 1 and adding it to the pervious number in the series.

For example, we start with the number 1 and add to it 1 to equal 2. Continuing in this fashion is the Fibonacci sequence of numbers.

1 + 1 = 2
2 + 1 = 3
3 + 2 = 5
5 + 3 = 8
8 + 5 = 13
13 + 8 = 21
21 + 13 = 34 and so on.

The series of numbers starting at 1 is: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233 etc. The extraordinary thing about this sequence of numbers is the regularity with which they appear in nature. Elliott combined this observation with that of natural law to recognise certain manifestations occurring in markets. This was the origin of Elliott Wave theory.

[To learn more about this amazing series of numbers, click here]

Elliott first noted that the movement of the market in an 80 year period contained five upward moving periods and then declined in three downward moving phases. Elliott concluded that a single cycle in the market comprised of eight years. Note that 3, 5 and 8 are Fibonacci numbers.

Shown in the picture above is the basic form of the Elliott wave. The basis of the Elliott wave is five upward moving phases (1, 2, 3, 4, 5) and then three downward moving phases (A, B, C).

Author:

Each phase of the Elliott Wave can be defined, remembering that the market comprises entirely of human beings and humans are susceptible to negative and positive emotion.

With this in mind we can make a subjective description of each wave.

Wave 1
The security starts its first upward phase. At this stage of the cycle only a relatively small number of people feel that the price is cheap enough to warrant a purchase, this action causes the first wave movement.

Wave 2
There will always be a point where the market will rest and reach equilibrium. At point 2 enough market participants who joined the security in wave 1 feel as though the security is overvalued and start to sell to take profits. During this wave it is important to note that the security will not reach the lows experienced during the commencement of phase 1, this is because the security will be considered an attractive buy before it reaches this point.

Wave 3
Wave 3 is always considered to be the longest and most powerful wave. At this stage of the cycle more market participants have discovered the security and they buy it at continually higher and higher prices. This wave will exceed the highs of wave 1.

Wave 4
Market participants once again pause at this point and take profits. The security at this stage is considered expensive again. The downward momentum of this wave is usually considered to be weak as market participants are still bullish about the security.

Wave 5
At this point the entire market is aware of this security and most participants want to purchase. This stage of the cycle is typically driven by hysteria. During this wave the security becomes the most overpriced. The security will either commence again with wave 1 (starting the cycle over) or it will commence an ABC correction pattern.

The ABC pattern which is also shown on the picture above is when the security makes three downward movements in preparation for another commencement of wave 1. It is typically understood that during this time of correction the market is pausing while the fundamentals of the company catch up with the price action. During this time the volatility of the security is lower than during the five wave cycle.

Correction Wave A
This is the initial corrective wave and is usually seen as a minor pullback of the previous move.

Correction Wave B
This corrective wave is commonly referred to as a "sucker rally". The market participants who missed the previous opportunities to purchase the security are more than glad to "jump on the bandwagon".

Correction Wave C
The false optimism produced by wave B is often followed by a strong downward move in wave C. The presumption behind wave C is the same as wave 3, after wave 3 the majority of market participants are extremely bearish about the security.

One interesting observation made by Elliott is the direction of a future Elliott wave. The general rule observed is that an odd numbered ABC correction will lead to a upward moving five wave cycle while an even numbered ABC correction will lead to a downward commencing five wave cycle.

S&P ASX200 (Weekly)

On a weekly chart of the S&P ASX200 we can see the formation of a Elliott wave. The wave starts in November 2003 and concludes with an ABC correction in August 2004.

One problem which has faced many Elliott Wave theorists is the constant debate over the start and end points of waves. Where does one wave start and another finish, this is open to interpretation.

Fibonacci time spans are difficult to use for forecasting purposes. For this reason Elliott Wave theory is a subjective exercise as it is very difficult to determine the top and bottom of Elliott waves based upon the infinite permutations of Fibonacci time spans.