A Review of Market Models: Elliott Wave Theory
by D. R. Barton, Jr.
Last week we talked about the importance of having a “price discipline”. That’s just a fancy way of saying that you have a market model that you trust and believe in.
What market model describes the price action in a way that you understand and accept?
Some people become crazed and rabid fans of one type of market model. Anyone who doesn’t agree with their price discipline is labeled a heretic. I tend to find that the more subjective the model, the more fanatic the followers. But that may just be my personal biases coming out…
For the next few weeks, I’d like to take a look at some of the most prevalent price disciplines or market models and classify them according to my experience with them directly and with those that use them well (or not so well).
Let’s start today with one of the most controversial models and get that out of the way. Let the gnashing of teeth begin!
Elliott Wave Theory: Prophetic or Pathetic?
Who would have guessed that the work of Ralph Nelson Elliott would be causing such a non-stop stir 80+ years after it was developed? But before tackling the controversy, let’s have a quick review.
Elliott Wave Theory (EWT) belongs to a class of market models called cycle analysis. We’ll take a look at this broader category in another article. But Elliott theory is differentiated from its cycle brethren by the fact that it doesn’t require absolute time frames between its cycles (or waves). This is both a strength (since this makes it almost a purely price-based model) and a weakness (because it adds a good deal of subjectivity to the interpretations of the waves).
In simple terms, EWT holds that market prices move up in a five wave pattern and then down in a three wave pattern. This is a grossly over-simplified but captures the essence of the beast. If you’d like to learn more, just Google “Elliott Wave” and find literally hundreds of thousands of sites interested in helping you out.
So let’s put together a simple rubric to use in evaluating our market models:
Is it theoretically credible?
Who is it most useful for?
Is it being used by real-life traders?
For fun; How fanatic are its fans?
Is it theoretically credible? The basis of markets moving in cycles is pretty clear and repeatable. Elliott was clearly influenced by Dow’s work and the basis for the theory is sufficiently rigorous for trading purposes.
Who is it most useful for? The tongue-in-cheek answer: those with a thick skin, a flexible outlook and a high level of creativity. The more serious answer is that most serious traders should have a basic understanding of Elliott principles because it does give a useful interpretation of the market’s general “three steps up, two steps back” movement pattern.
Those who do choose to learn Elliott theory will quickly encounter the Achilles heel of this method: it is an extremely subjective method. (10,000 Elliott followers just put me on their “hit list” – but please hear me out!) Because waves have no absolute time constraints, they can be broadly interpreted in real time. (Everyone gets it right looking back on moves that have already happened).
Those who gain experience with this method can become very proficient at making high quality decisions. See the “real-life traders” section below.
If you like the concept of Elliott theory, but want to minimize the subjective issues, you might try out a few of the software products that are out there. They don’t all agree on the wave counts, but you can find one that aligns with your interpretations and then stick to it.
Is it being used by real-life traders? With the seemingly negative outlook presented, be prepared for a shocker. The answer is a resounding YES. I have several good friends who are excellent Elliott analysts and I have read the work of several other very good Elliott analysts. A general statement that can be made is: "When experienced traders and market observers combine that experience with a useful price discipline, they are generally successful."
As with all of the market models we’ll review, the usefulness of the model may have something to do with how many people are using that model and reacting to the price levels that it produces. But whether the model is a self-fulfilling prophecy or a real reflection of the underlying structure of the markets, if it works consistently, then it is useful.