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Alternatives to the Elliott Wave Theory

Updated on 2013-06-04 by Guest

There had always been continuous researches to get better understanding of the capital markets, so as to earn abnormal returns from investments. Elliott Wave Theory is one such attempt, where the market movements of share prices are simplified through few basic rules and guidelines.

The theory was developed by R.N.Elliott and was made popular among the investors by Robert Prechter. This theory ascertains that the crowd behavior of investors in the market could be simplified into trends and patterns which could be relied on to make investment decisions.

Elliott Wave Theory classifies the market waves into two broad categories namely impulse waves and corrective waves. Impulse waves are those which move in the larger direction of the market and corrective waves are those which move against the direction of the market. Though Elliott theory had been further developed into many complex patterns of market movements, the two basic sequences which are commonly adopted by investors are the 5 wave impulse sequence and the 3 wave corrective sequence which when put together form the complete 8 wave cycle for a market.

In the 5 wave sequence, as could be observed from the following figure, the three waves 1, 3 and 5 moves upwards along the direction of the market and are impulse waves. On the other hand, waves 2 and 4 are corrective waves as they move downwards against the market.

For a 3 wave corrective sequence, there would be two waves say a and c which are impulse and one corrective wave – b. All the 8 waves – 5 impulse waves and 3 corrective waves put together form the complete 8 wave cycle which is the most simplified pattern explained by Elliott Wave Theory. The theory lays down certain basic guidelines and rules as follows to give better understanding of the waves and thereby make effective investment decisions in the market.

The rules laid down by Elliott Wave Theory are as follows:

Rule 1: Wave 2 will always retrace less than 100 percent of the extent of wave 1

Rule 2: Wave 3 will never form the shortest in length of the waves in a 5 wave impulse sequence

Rule 3: Wave 4 will never overlap the Wave 1 in a 5 wave impulse sequence

Further, the theory had also laid down certain guidelines based on analysis of patterns of share price movements in the market.

Guideline 1:       In the 5 wave sequence, when Wave 3 is the longest wave among the impulse waves, then Wave 5 will be equal in length to Wave 1

Guideline 2:       The level of correction of Waves 2 and 4 will be alternate. If Wave 2 forms a flat correction, then Wave 4 will form a sharp correction and vice versa.

Guideline 3:       The corrective sequence of 3 waves a,b and c which follow the 5 wave impulse sequence will usually end at the level of lowest point of Wave 4 of the impulse sequence.

As could be observed from the above guidelines and rules, Elliott Wave Theory simplifies the share price movements by generalizing them to follow certain patterns and trends. Thus if you follow these rules and guidelines to understand the present condition of the market, then you could make better entry – exit and buy – sell decisions so as to earn abnormal returns. Elliott Wave theory, thereby pronounces that abnormal returns are possible from the capital markets alternative to the Random Walk Hypothesis which propagates that markets move in random and thereby earning abnormal returns from the market is not possible.

The Efficient Market Hypothesis or the Random Walk Hypothesis proves to be an alternative way of understanding the movements in the share prices of the market. In this Efficient Market Hypothesis, it had been put forth that the market moves at random and thereby does not follow any patterns or trends.
As the observation of patterns or trends in the market movements is completely ruled out in the Efficient Market Hypothesis, earning abnormal returns also becomes impossible as you cannot predict what the next move of the market would be. This theory thus puts out the idea of earning abnormal returns just through the use certain thumb rules as put forward by Elliott Wave Theory.

According to Random Walk Hypothesis, the market absorbs all information into its price and volume data and thereby adjusts itself effectively to be back to its original level. Thereby, whatever information is available to the investors had already been absorbed into the market movements and hence they cannot intend to make any abnormal returns out of such information.
Based on the level of information which determines the efficiency of the market, Random Walk Hypothesis states that the market movements are observed to be in three states of efficiency namely weak form, semi strong form and strong form.

In the weak form efficiency, all basic information related to price and volume of the shares had already been absorbed into the market movements. Thus the price and volume data cannot be used to determine the next movement in the market, so as to earn abnormal returns. This form of efficiency is a direct alternative to the Elliott Wave Theory as it proposes that price of shares in the market cannot be used to earn abnormal returns. On the other hand, the Wave theory proposed that the price movements in the market would follow certain patterns and trends, which if correctly tapped could enable the investors to earn abnormal returns.

The semi strong form of efficiency proposes that any information related to the company specific details of the shares will be absorbed into the market as soon as it received. Hence this form of efficiency lays down that information on bonus issues, stock splits, buyback of shares etc cannot be used to earn abnormal returns.

Finally, the strong form efficiency of markets lays down that even privately held insider information cannot be used to influence the market movements of share prices.

As could be observed, the Elliott Wave Theory and the Random Walk Hypothesis are direct alternative methods to understand the market movements. While Elliott Wave Theory proposes that the market movements could be simplified to trends and patterns which follow certain rules and guidelines, the Random Walk Hypothesis proposes that the markets are highly efficient in three forms and do not hold any prospects for abnormal returns.

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