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Does Elliott Wave Analysis Work on Individual Stocks?
Yes, but with one important caveat.
"Does the Elliott Wave Principle apply to individual stocks?"
This question is one of the most frequent that readers ask.
To answer it, you have to understand how the Wave Principle works and accept its two basic premises: 1) Markets trends reflect the collective emotions of investors, and 2) Markets are patterned, not random.
Of course, these assertions go against the mainstream investment assumptions which claim precisely the opposite -- that markets are rational, random and therefore rarely predictable. The dominant theory among these is the Efficient Market Hypothesis (EMH). First proposed in the 1960s, it states that the price of a market security is always “efficient” because investors are rational beings. Therefore, prices simply can't ever be too high or too low; they are always “just right.” Which is a comforting thought -- or, rather, it was a comforting thought until the EMH fell flat on its face in the current crisis.
The Wave Principle, on the other hand, says that market prices are inefficient, because they are regularly driven to extremes by mass psychology -- not by reason. Yes, individuals can be quite rational, but groups and crowds are not; they are emotional. In the financial markets -- which are nothing but large crowds buying and selling securities -- mass emotions swing from one extreme to the other, taking over individuals’ rational impulses. Most investors simply end up copying the actions of others, regardless of whether it’s rational to do so.
So when you count waves in your favorite market, you're really counting the turns and trends in the collective optimism and pessimism of people who trade it. And however illogical these swings can get, the good thing is that they occur in recognizable Elliott wave patterns; the Principle describes 13 of them. Once you learn to spot these patterns you can learn to forecast the market's next move -- just like Ralph Nelson Elliott first did back in the 1930s.*
The bigger and more liquid the market you follow, the stronger the influence of the herd psychology will be. That's why the answer to the question "Does the Wave Principle apply to individual stocks?" is always -- "Yes," but with a few caveats.
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One caveat is investor participation. Often, penny stocks won't have enough players to accurately reflect a true mass psychology, so they may not trace out consistent Elliott wave patterns. And even with large and mid-caps, investor participation at times may not be big enough to overpower outside influences -- e.g., what the competition is doing; government policy; whether the CEO is having personal problems, etc. With a single stock, those are often the decisive factors (besides investors' collective emotions).
How do you apply Elliott to individual stocks, then? Robert Prechter, EWI's president and a recognized Elliott wave authority, gives this simple advice: Avoid trying to analyze each issue on an Elliott basis unless a clear, unmistakable wave pattern unfolds before your eyes and commands attention. Decisive action is best taken only then.
* We owe the remarkable discovery of the Elliott Wave Principle to Ralph Nelson Elliott, born on July 28, 1871 in Marysville, Kansas. Bedridden at the age of 58, Elliott needed something to occupy his mind, and he turned his full attention to studying the behavior of the stock market. Investigating the possibility of form in the marketplace, Elliott examined yearly, monthly, weekly, daily, hourly and half-hourly charts of the various indexes covering 75 years of stock market behavior.
In May 1934, two months after his final brush with death, Elliott's observations of stock market behavior began coming together into a general set of principles that applied to all degrees of wave movement in the stock price averages. Today's scientific term for a large part of Elliott's observation about markets is that they are "fractal," coming under the umbrella of chaos science, although he went further in actually describing the component patterns and how they linked together.
As a result of Elliott’s pioneering research, today, thousands of institutional portfolio managers, traders and private investors use the Wave Principle in their daily investment decision-making. Ralph Elliott undoubtedly would be gratified to see it.
In celebration of R.N. Elliott's birthday (July 28, 1871), you can assemble your very own collection of books by Bob Prechter -- and get a 20% discount.