The Elliott Wave principle was first developed by an accountant, Ralph Nelson Elliott, to describe, and ideally predict, market cycles. Utilizing technical analysis and group psychology, it identifies patterns over the long and short term that relate to the way people buy and sell securities.
The principles espoused by Elliott remain at the core of Elliott Wave International, an independent market forecasting firm founded in 1979. Equities.com talked with Jeffrey Kennedy, one of their top educators on Elliott Wave analysis, about what Elliott Waves are and how the average investor can make use of them.
EQ: Elliott waves represent a pretty interesting approach to the markets. Can you offer up a brief explanation of what this theory is and why it matters?
Jeffrey Kennedy: The Wave Principle is a form of technical analysis based on crowd psychology and pattern recognition. It matters because it puts price action into a context that traders and investors can use to their advantage. Elliott wave patterns allow you to identify trend, maturity of trend, and countertrend moves within a trend. Moreover, it can tell you where your analysis is wrong.
EQ: Elliott wave, at first blush, appears to be the sort of technical approach to the markets that’s heavy on math and can be largely opaque to the average investor. What would you say to the self-directed investor about how understanding Elliott waves can help them make decisions about their portfolio?
Jeffrey Kennedy: As with any technical tool, the correct application of the Wave Principle takes time and practice to learn. Even so, with only five core patterns to work with, it is a form of market analysis that anyone can easily master.
EQ: Elliott waves are perceived to take place over time periods ranging from less than a minute to multiple centuries. How should investors think about long-term trends? If you’re planning for your retirement, to what degree can you maximize returns by looking at where your time frame might fall in relation to these broader market trends?
Jeffrey Kennedy: Yes, the Wave Principle is fractal in nature, meaning that wave patterns form larger and smaller versions of themselves. For the investor, one whose investment horizon is months to years, I recommend analyzing price charts using the weekly, monthly, or even quarterly time frames. Traders, those who might be in a trade for a few weeks to a few months, should focus their attention on weekly, daily and intraday price charts.
EQ: Elliott wave principles are based on group psychology and understanding human behavior. To what degree do you think the advent of algorithmic and high frequency traders might change things? Will the principles need to shift, or will they remain fundamentally the same?
Jeffrey Kennedy: Algorithmic and high-frequency trading can distort price action on the very short-term time frame, but it doesn't outweigh the overall psychology of the crowd, which is how wave patterns form. So no, the Wave Principle does not need to shift or adapt to this kind of player.
EQ: Along the same lines, given the way time periods are subdivided for Elliott waves, does the world of high-speed trading, were minute fractions of a second become incredibly important, indicate that Elliott waves are going to start taking on meaning in smaller and smaller time frames?
Jeffrey Kennedy: Elliott wave patterns already have meaning on the smaller time frames. Anyone can examine a 1-minute chart of the e-mini S&P 500 and see Elliott wave patterns form again and again. In fact, many of my own trades, which typically last 1–3 days are based on 1, 3, and 5-minute Elliott wave patterns.
Elliott Wave International, founded in 1979, is the world's largest independent market forecasting firm. EWI specializes in Elliott wave analysis, a form of technical analysis based on crowd psychology and pattern recognition. Based in Gainesville, Ga., EWI is a firm of 80 people, including 20 full-time analysts. EWI covers the world's major markets – stocks, currencies, bonds and commodities – 24 hours a day.
For more information on Jeffrey Kennedy's Trader's Classroom, an educational service that teaches how to use Elliott wave and supporting analysis in your trading, go to: http://www.elliottwave.com/products/ewj/default.aspx.