ELLIOTT WAVE PRINCIPLE - BASICS

 

Even though I am a strong believer in a buy and hold strategy for the long term investor, I think investors who are more active in markets could look to ride the market cycles for greater profits. I have found the Elliott wave principle quite useful in predicting these cycles.

As anyone who has been in the stock markets long enough, knows fully well that markets follow cycles of boom and bust. Ralph N.Elliott, an American who worked in Mexico as a wireless operator, observed these cyclical movements of stock markets, by observing historical data of the indices while convalescing from a long illness in the 1930'. He postulated a principle that markets move in clearly identified waves over periods of time ranging from a couple of centuries down to movements in hours and minutes. Each wave can be subdivided into its component waves and each sub wave can be further subdivided and so on. This science is now known as fractals. Accordingly waves are classified from the "Grand Super Cycle" being the largest to the "Sub Minuette" being the smallest practically measurable wave.

As per the Elliott wave principle, an uptrend comprises of 5 waves, 3 up and 2 down. Each up wave is followed by a down wave. Up waves or impulse waves are labelled as Waves 1,3 and 5 and down waves or corrective waves are labelled as waves 2 and 4. Waves 1,3,5 comprise of 5 component waves each and waves 2, 4 comprise of 3 component waves each. At the completion of wave 5 a new market high is achieved. This is followed by a cycle of severe destruction comprising of 3 waves, which seek to erase most of the gains of the previous bull market. These three waves are labelled as A,B and C. Waves A and C, which are down waves each comprise of 5 component waves because the trend is now down. Wave B, which is an up wave comprises of 3 component waves.

The task before an investor is to identify the stage in the above cycles, which the market is presently in. Once this is correctly done, the investor can decide how the market is going to behave in the future and act accordingly. This can be particularly beneficial for longer term investors to decide when to liquidate their holdings or when not to enter the markets, so that they do not have to suffer the agony of seeing their portfolios diminish in value such as at the present moment. Also it prevents longer term investors from selling prematurely and thus not being able to capture the full extent of the bull run.

A drawback of this principle is that it calls for a lot of judgement on the part of the investor and has no rigid rules to go by. In fact this method is so flexible that different analysts can have different opinions on the present stage in the markets. But since markets do not follow any rules it seems only justified that any system which aims to predict market movements, similarly do not lend themselves to the rigidity of rules, but have an inherent flexibility to account for the vagaries of the markets. Therein lies the beauty of the Elliott Wave Principle, as it attempts to forecast market trends while at the same time is open to account for erratic market movements caused by sudden news flows, which cause a temporary aberration in the wave patterns.