Elliott Wave Principle - Key to Market Behaviour Book Review
Author: A.J Frost & Robert R. Prechter, Jr
Subject: Technical Analysis & Market Behaviour
Audiobook: 8 hrs and 7 mins
First Published: 1978
Who’s it for: Traders looking to better understand market behaviour and specifically those looking for a predictive indicator
Reputation: A masterpiece of technical analysis and market mechanics
The Good: Comprehensive overview of an extremely powerful market analysis methodology
The Bad: Extremely dense, a lot of complexity for the casual reader
Recommendation: Very Valuable Reading
Buy it HERE
Elliott Wave Principle by Frost and Prechter is widely considered to be the most comprehensive overview of Elliott Wave Theory ever written. First published in 1978 and written by two men who understood Elliott’s ideas better than anyone, it has stood the test of time and continues to find new print runs and new fans.
This book is a must read for anyone who is truly interested in the way markets move on both short and long time frames. But it comes with a warning - this is one seriously dense book! At times it reads more like a mathematical proof; at times like an economic history textbook.
Upon opening the book, it is immediately clear that this was written by serious economists for serious economists or traders. Prechter has garnered himself a reputation as a world-leading market theorist, and, in truth, this book is more market theory than trading manual. As the authors write on the first page of chapter 1: “the Wave Principle is not primarily a forecasting tool; it is a detailed description of how markets behave”’. But, of course, the authors knew who the real audience for their book would be - anyone looking to make a buck by predicting future market movements.
Not for Everyone
If you are not naturally academic or struggle to read and absorb densely written concepts and mathematical principles, then this may not be the book for you. There are many simpler trading systems out there that will yield positive results if traded well. If, however, you are up for the challenge, then I believe that Elliott Waves could hold the key to some blockbuster trading results.
Hopefully you have been reading Two Blokes Trading long enough now to follow that up with the sceptics question: ‘If Elliott Waves are so great why aren’t you trading them?’
Well, frankly, Elliott Wave Theory (Wave Theory for short) is anything but easy to master. This probably explains why something that seems to me to be the answer to all my trading dreams isn’t altogether that popular. It is just really really hard to do.
The difficulty stems from the sheer complexity of the system. When reading the chapter entitled ‘The Broad Concept’ you could be forgiven for giving up in despair - if this is only ‘broad’ then what on earth does detail look like?
The problem is not in the ‘idealised wave’ - indeed, as you can see from their diagram reproduced below, it is quite basic. The problem is that this idealised wave almost never occurs. And there are lots of variations and it is very very difficult to work out which variation you are looking at.
Frost and Prechter admit as much when they say that when looking for a pattern you should have a ‘preferred count’ and an ‘alternative count’. They acknowledge that, even for them, as absorbed as they are in the system, it is almost impossible to call it correctly every time. There is a lot of room for interpretation.
Similarly, Wave Theory shares the problem that affects all technical trading systems - the patterns are usually far more obvious in hindsight than they were when only half the pattern was complete. This, of course, makes trading it for profit far more difficult than drawing historic waves.
So What Is the Elliott Wave Principle?
Elliott Wave analysis is predicated upon pattern recognition. Proponents of Wave Analysis believe that there are hard and fast rules of the universe that govern mathematical ‘golden’ ratios in many things, from DNA spirals to Galaxies. This is accepted science, and Wave Theorists suggest that group human investment behaviour is no different.
This leads inexorably to the belief that if you can identify these ratios and the patterns they cause then you can predict, with a large enough degree of accuracy to turn a profit, the movements of market prices.
The waves themselves are like Russian dolls. The inherent 5-3-5-3-5 pattern is mirrored by the same pattern one level up in timeframe and one level down. This mirroring goes from epoch level (this book genuinely includes a wave chart going back to the Dark Ages) to minute charts and below. Each 5 wave motive or 3 wave correction is part of a larger motive or correction wave and also contains smaller motives and corrections.
Elliott Wave Structure is more easily explained visually:
Most Wave Theory charts will have 5 motive waves (numbered 1 to 5) and 3 corrective waves (lettered A - C). There are many variations on this, but this is the ideal structure. As you can see, each wave then has the same pattern of waves one level down and is similarly a part of a larger wave.
This can be hard to get your head around at first, and I fancy that if this book was written today for a retail trading audience it would be laid out in an easier to follow manner. But, persevere (or just be smarter than me) and you will understand it in good time.
As with all forms of technical analysis, I believe it is important to understand why it is that your little squigly lines actualyl add up to trading opportunities. Wave Theory is no different. The most famous image from the book is probably Prechter’s ‘Idealized Elliott Wave Progression’. As you can see, there are clear reasons that the waves progress the way they do. The reasons themselves are different in detail depending on timeframe but are typically based on the relationship between overconfidence and fear, and swings between the two.
You Don’t Need to Read the Whole Book
All the basic(and more!) are contained in the first chapter, and frankly if you don’t want to become an Elliott Wave trader you could probably just stop there. You will have a great idea of what it is all about, but you won’t be able to go away and trade profitably using Wave Theory any time soon. There is benefit to this - it is the most comprehensive view of market mechanics that I have ever seen; everyone could get something from at least a basic understanding of Wave Theory.
If you progress into chapter two and compete that, then you will have all you need for basic Wave Analysis and trading. Chapter 3 is the historical and mathematical background of Elliott Waves and Fibonacci numbers, but while fascinating reading, isn’t going to impact your bottom line.
Chapter 4 onwards is ‘Part II’ of the book - ‘Elliott Applied’. But, in my opinion, this part is actually more theoretical. What I mean is that the authors now really go off the deep end in detail. They go into severe depth on Ratio Analysis and Fibonacci Time Sequences. They use examples over many decades to illustrate the moves they describe, but unless you are a buy-and-hold investor, then the interest here is little more than theoretical.
Perhaps this is the flaw in the book - it is quite inaccessible at first and made worse by the sixty or seventy percent of the material that you probably don’t need to know. But, ultimately, this wasn’t written as a guide for retail traders in 2017, trading an online account with access to all the graphs they could possibly need. This was written for professional traders, investors and economists in the 1970s .
Is it Relevant for Active Traders?
The focus of Frost and Prechter in this book is on calling long term bull and bear runs in the stock market. This may or may not be the way you trade, but I suspect that many people reading this will be currency or commodities traders, looking at day or swing trading. I count myself amongst this group, so I have to ask: is Wave Theory applicable to short term traders?
Well, the answer to that question is not in the book. First published in 1978 it has been reprinted with new post scripts but not particularly updated for the modern reader. So we have to look wider afield.
Fortunately, although I cannot claim to be trading Wave Theory for profit myself, I know someone who is...
A Profitable Wave Trader
I first got interested in Elliott Waves when we interviewed Anil Mangal for Episode 24 of the Two Blokes Trading podcast. Anil is the most viewed and highest rated trader on TradingView and his track record of uncannily accurate predictions is there for all to see. I was struck by the way Anil could predict not only the change in direction of a market, but also the change after that. I looked at his ideas that predicted a coming dip in the market, drawing a line to show where and when the market would fall, before indicating the buy entry and showing how the market would subsequently rise.
Then, sure enough, more often than not, when the idea played out in real time, the actual market movements almost exactly mirrored the lines Anil had drawn, both the dip and subsequent rise, or vice versa.
This piqued my interest, but he had my full attention after he came on the podcast and talked through his thoughts on the market. He trades Elliott Waves because he believes they are the best way that one can accurately forecast market movement. This is because they are based on predictable, repeatable, human behaviour.
This wasn’t trying to spot overbought or oversold situations, this wasn’t trying to find out where Barrier Options were expiring or what the Interest Rate decision would be. He claimed that for time immemorial, traders have acted in the same way, destined to forever repeat their actions.This means that the price moves according to these patterns, and if you can recognise the patterns, then you can predict how they are about to move. Or at least accurately enough to make consistent profits.
And not just in stock markets. Anil trades currency pairs, Oil, Gold...a whole gamut of products. And his loyal following and proven track record convince me that this is something that can be used to make consistent profits in the markets in 2017.
It All Just Makes Sense
Quite apart from the demonstrable proof of Anil and others’ success, I believe in Elliott Waves because it makes logical sense to me.
I want to go on record again and make it very clear that at the time of writing (Feb 2017) I do not trade Wave Theory in a live account and have never personally proven that you can make money doing this. But, it is my intention to throw myself into learning Wave Theory because I have never come across another methodology that just rings so true to me.
If the depth and detail of just this one book is indicative of Wave Theory as a whole, then I know that this is going to be a long and hard path. Just sitting looking at the screens I cannot see what Anil and other Wave traders can see. This is a skill that will have to be learned. It is not an easy or quick win like trading moving average crossovers or the MACD or other lagging indicators. But I believe the payoff could be something much greater.
All Other Technical Trading Systems Are Part of Wave Theory
One of the most enlightening parts of the book is chapter 7 when they look at other approaches to the market, specifically when they talk about Technical Analysis. They make a compelling case that other popular patterns - wedges, double tops, flags and pennants, even Head and Shoulders, are in reality just small parts of the larger Elliott Wave Theory.
They suggest that a successful H&S pattern is a normal Elliott top, an unsuccessful H&S is just an expanded flat correction in Wave Theory. The difference being that trading H&S only gives you the opportunity to trade it if it is a successful setup - Wave Theory can let you trade both because both mean something within the wider analysis.
A big part of the attraction of Wave Theory is that it is not a lagging indicator but a predictive indicator. It doesn’t just tell you what the market has done but actually predicts what it will do. Another predictive indicator that I have had some recent success with is Fibonacci retracements and Fibonacci extensions. But, the authors show that even this is just part of wider Wave Theory and in fact gently deride traders who just use Fibonacci retracements:
“Unfortunately, that is where most analysts place an inordinate focus because measuring retracements is easy”.
But they are right, I like trading Fibonacci Retracements because they are a predictive indicator and because they are easy. Wave Theory is anything but easy. However, I suspect that if I can get it nailed I’ll become ten times the trader I am right now, and I further suspect that is the case for many people reading this.
Elliott Wave Principle - Final Thoughts
Wave Theory itself seems to me to be a gateway to true understanding of the markets (or as close as it is possible to get). The book, Elliott Wave Principle, is not the easiest entry into this methodology, but it is certainly the most comprehensive. There are other works on Wave Theory available, some seemingly more simple. I am keen to read those too, but, despite its complexity this is the book I would recommend for those wishing to learn the fundamentals of Elliott Wave Analysis.
It won’t be to everyone’s taste, and perhaps some people will feel that it stretches the point somewhat. It is tempting to think that there are so many ‘variations’ to the idealised wave structure as to effectively negate the utility of the patterns entirely. I don’t believe this, but I am not surprised that some people level this criticism. If you can get past the large barrier to entry then it seems that this is a way of trading that can yield great rewards.
If you have the time and inclination to get yourself stuck into this book then I truly believe that you will be better informed as a result, and perhaps inspired, as I am, to give Elliot Wave Theory a real crack.
Buy it HERE