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THE LONDON BULLION MARKET ASSOCIATION

An Introduction to the Elliott Wave Principle


By Jordan Kotick, Global Head of Technical Strategy, Barclays Capital

Beginning with Robert Prechter’s 1978, The Elliott Wave Principle.This book still they are, at the same time, always different.
stands as the single best articulation of Elliott’s While this may seem a contradiction, it is not.
call for a strong bull market in ideas.While many books have been written Imagine looking at a forest from one kilometre
since, the reader who understands Frost and away. From this distance, every tree looks the
the 1980s – at a time when few Prechter understands all they need to know same. Now imagine that forest from one
about the principles of Elliott Wave. meter away – every tree looks different. So it
were looking for strong gains – is with Elliott Waves: while the overall pattern
Theoretical Foundation is the same, the internal make-up (length,
the Elliott Wave Principle has and Fractals amplitude, wave relationships) will
Elliott’s main advocacy was differ despite the fact that the
continued to gain in popularity, that crowd behaviour overall pattern is self-similar.B
trends and reverses in It is not a co-incidence that
though it is often considered consistent and B the words arboration or
recognisable patterns. arborate have been used
daunting to master.What lies Elliott named and in conjunction with
illustrated patterns or Elliott Wave analysis.
beneath this intricate look at “waves” that recur in A
markets and are
financial market movements? repetitive in form but
A
not necessarily in time
What does it say not only about or amplitude.
He further described how
trading, but also about crowd these structures link together
to form larger versions of the same
B
and, potentially, social psychology? patterns and how those in turn become the
building blocks for patterns of the next larger
In this first of a two-part series, size etc. Regardless of the size, the form
B
remains constant.
Jordan Kotick looks at the theory This discovery was well ahead of its time.
In fact, over the last decade or two, many
and practise of Elliott Waves. prominent academics have embraced Elliott’s
idea and have been aggressively advocating the
existence of financial market fractals. Figure 1:
However, it is important to understand the The fractility A
A Brief History type of fractal pattern that Elliott Wave of maps
The Elliott Wave Principle was developed by represents.The traditional line of thought has illustrates that
Ralph Nelson Elliot (1871-1948). A financial been that fractals are either self-identical
A (each navigating London can be easy or complex
accountant by trade, Elliott spent years component of the pattern is exactly the same depending on the degree of observation.
intensely studying price charts with a focus on as the whole) or indefinite (self-similar to the
stock market behaviour. He eventually extent that it is similarly irregular at all
articulated his theory in a series of twelve levels). Elliott discovered a third type of self- Drink Deep, or Taste not the
articles for Financial World magazine in 1939. similar fractal that Prechter in his later works Elliotician Spring
Elliott concluded that his observations coined a “robust fractal.”This pattern has Alexander Pope was right: a little knowledge
ultimately encompassed not only the action of highly variable components that fall within a is a dangerous thing. He could have been
equity market averages but actually a much certain defined structure. Prechter noted that writing about Elliott Waves, for it is not
larger law that he believed governed “component patterns do not simply display unusual for a trader/strategist/salesperson to
everything from social interaction to the discontinuity similar to that of larger patterns, embrace a basic understanding of Elliott, use it
patterns seen in natural phenomena. In but they form, with a certain defined latitude, for while, ultimately lose money and then
essence, Elliott believed he came up with an replicas of them.”This latitude reflects nature’s conclude that Elliott does not work.This all-
intricate theory that ultimately explained the robustness and variability within overall too-common scenario is based on the false
behaviour of crowds, exposing their determined forms.While it may be an open premise that you do not have to know the
dichotomous and ongoing swings between question whether every nuance of this latitude entire theory in order to use Elliott profitably.
optimism and pessimism. is determined, the Wave Principle This is an expensive oversight. Elliott, like
The Elliott Wave Principle, essentially the unquestionably rests on the premise that any other technical or fundamental
cyclical quantification of investor psychology, certain essential aspects of the design always methodology, is not an art, it is not a science –
rose to prominence in recent times on the prevail. it is a skill that needs to be honed over time.
back of the now-famous book by A.J. Frost In essence, the robust fractal suggests that The skilled Elliottician should be able to
and Robert Prechter, released in November as much as the patterns are always self-similar, differentiate all types of waves from the

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ALCHEMIST ISSUE FORTY

impulsive (waves 1,2,3,4,5) to the corrective


(waves a,b,c,d,e,w,x,y,z).While it seems
overly complex, with time and study, the
real-time recognition and application of these
patterns do come to light. Analogously, while
the rules of billiards are simple, winning
a game of billiards is more complicated.
This applies to Elliott Wave in principle
and Elliott Wave in practice.

Application
In financial markets, Elliott wave patterns
occur in any market with sufficient volume
and liquidity.While the real-time application
of Elliott varies between, for example,
a commodity market and foreign exchange
market, or a 5-minute chart and a 5-decade
chart, the basic principles governing Elliott
are equally applicable. Some debate whether
Elliott is most applicable in some markets
versus others. Aside from this being a
subjective debate, it should be realised that Figure 5: An intraday chart shows a complete Elliott Wave pattern for USDJPY
Elliott can and is widely utilised across
commodity, equity, fixed income and foreign The Basic Picture
exchange markets on all time frames. Financial markets ultimately progress in an
“impulsive” or five wave sequence regardless
of whether they are bull or bear markets.The
impulsive waves – waves 1, 3 and 5 as seen in
the basic pattern shown in Figure 1– are the
directional or trending
Figure 2: The basic pattern waves.Waves 2 and 4
are the corrective or
Fig. 2 counter trend waves.
This principle applies to
5 Corrective
Impulsive
(Numbered) (Lettered) all time frames. As
W
av

Phase B Phase mentioned before, the


e
A
e5

B
e
av fractal nature of the Figure 4: A weekly chart shows a complete
v

3
Wa

W
W
av
W

patterns implies that the Elliott Wave pattern for the US Five Year Note
e
av

C
e

A
4

smaller patterns are


e3

1 Future
v
Wa

4 C building blocks of the


W
av
e

larger patterns while the market is, for example, in wave two of three,
2
e1
v

larger patterns, or four of five…same markets, same


Wa

2 © July 1996 Elliot Wave International. Inc.


correspondingly, can be timeframes, same conclusions – just different
broken into their modes of expression.
smaller subcomponents. It is worth remembering that successful
Figure 3: The fractal nature of the basic pattern Just as market analysts market forecasting is based on probability and
refer to degrees of trend percentages. Elliott is particularly valuable at
Fig. 3 (intraday, short term, helping to identify where the market is in a
1
medium term, etc.), the particular trend and thus helps ascertain not
(5)
Elliottician refers to only buying and selling peaks, but also suitable
5 wave degree. places to commit capital based on location of
2 (b) Thus while the the overall wave pattern that is unfolding. If
3 4 c
(3)
1 a 2 trader/strategist may one can correctly identify where the market is
5 1 4 conclude that the within an overall pattern (Elliott or otherwise)
b 3 b 4
3 5 1 market is in a short- and can reliably project how the patterns are
2
(1) a (a) 3
5 1 c 5
term downturn within a likely to complete, then a market opportunity
b 4
(4) (c) medium-term bull exists.
3 2 2 trend, the Elliottician
1 a
4 c 1 and 2 = 2 waves may refer to the same
(2) chart by saying that the
(1), (2), (3), (4), (5), (a), (b), (c) = 8 waves
2
1, 2, 3, 4, 5, a, b, c, etc =34 waves

© July 1996 Elliot Wave International. Inc.

page 13
THE LONDON BULLION MARKET ASSOCIATION

Part 2: Making Money Makes it Right


In real time, you are only right if you make money. Fibonacci, Elliott & Co.
A correct interpretation of fundamental data, or correct
momentum interpretation of Elliott Wave count, is of While Fibonacci is worth a few articles in and of itself, for the
minimal value if it does not specifically help you commit purpose of this article it is worth noting that one of Elliott’s most
capital.While there is always room for interpretations in important discoveries was that the Fibonacci sequence and its
any methodology, Elliott Wave has an inherent advantage corresponding ratios governed the progression and regression
over some in that there are rules that can never be broken. inherent in an unfolding Elliott wave.The sequence, the relationship
These rules are not subjective and of the numbers in the sequence (referred to as phi or .618 and its
answer the key question that all too many reciprocal 1.618) and the ongoing mathematical calculations
strategists often take great pains to avoid: associated with these numbers (the ongoing squaring of .618 or
“Where are you wrong?”This question 1.1618, for example), helps to determine everything from the
will be further explored and will form relationship between the waves to their inherent length and
the basis of Part 2 of this series. ■ amplitude.

Jordan Kotick,
a Chartered Market Technician, is the
Global Head of Technical Strategy for Barclays and is the
President of the Market Technicians Association in New York.
Previous positions include vice president, technical market
strategist at JPMorgan Chase in New York and senior technical
strategist at Elliott Wave International.
He is a featured author in the recently released book,
Market Analysis for the New Millennium and is currently
co-authoring a textbook on technical strategy.

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