So much for W. D. Gann. Now for Elliott wave analysis, probably the most complicated of all technical methods. Those who follow Elliott wave analysis tend to make very bold predictions. Based upon the principles Elliott set out at the end of the 1930s, Elliottitians, as they are known, use wave analysis to predict the point a market will reach.

As with many highly complex techniques, the Elliott wave theory has its roots in something that is simple and familiar to most people, the motion of the sea on the shore. Elliott was an accountant who contracted a serious illness in South America and underwent a protracted convalescence in a beach house. During this time, Elliott observed the crashing of the waves on the shore and noted how the waves increased in amplitude and then subsided. With lots of free time on his hands, Elliott started to look at the stock market and noticed that the prices there seemed to move in waves also.

From this realization, Elliott became a little overambitious and came to believe that his theory of wave motion guided not only stock prices but just about everything else that people do. Does he have a point? Are biorhythms, for example, a part of Elliott's master wave theory? I don't know and do not much care. The basic points of wave theory are reasonable, and they do actually relate to the way markets move. It's just when you start to use them to make far-off predictions that things come a little unstuck. Elliott wave analysis is all based around a count of highs and lows, and when an Elliottitian gets one of the grand predictions—which the theory constantly suggests—wrong, the defense is always that the analyst got the count wrong but the prediction was correct. In defense of Elliott, his analysis led him to predict the start of the long bull run that began after the crash of 1929. Many market gurus, it seems, get one major prediction right, then milk it for all it's worth.

Elliott's analysis led him to believe that markets and individual securities move in a five-leg formation up, followed by a three-leg formation down, which is illustrated in the below figure.

This figure shows a full market cycle. The five-leg bull formation is designated by numbered waves (one through five), whereas the bear formation is designated by waves A, B, and C. Legs that are in the direction of the trend are known as impulse waves, and those against the main trend are termed corrective waves. Elliottitians will see these formations in all stages of a market cycle. Essentially, this means that the eight-leg formation of the figure may appear as one impulse wave in a larger formation. If ever you hear Elliottitians talk about the fifth wave of a fifth wave, you know that they are anticipating a major market correction.

Trying to fit this model to any real charts of price action is not an easy task. Elliott did, however, devise a number of rules to assist in identifying which parts of market price action correspond to which leg of the eight-leg model.

First, Elliott stated that markets move in the eight-leg formation described, five up and three down. He then went on to be more specific about the ratio of the legs that make up this pattern. Wave three is never the shortest wave, and wave four should never extend lower than the top of wave one. If you start a count and your wave four does extend below the top of wave one, you must recount; it means that you are still in the wave-one phase. Elliott was comfortable with this type of recounting. He saw that price action moves in a zig-zag formation, so he did not mind each wave consisting of several zig-zags in themselves.

If this hasn't put you off Elliott and his theories yet, let's look at some of the formations Elliott mapped out, beginning with the three types of correction, zig-zag, flat, and triangle. These correction patterns have different counts, and we will look at each one in turn.

The zig-zag correction has a count of 5–3–5, as shown in the below figure. In this figure, the Elliott zig-zag correction corrects an existing downtrend, and the 5–3–5 formation constitutes the corrective upward trend prior to a new downward trend beginning. As you can see, the A wave consists of a five-leg pattern, the B wave of a three-leg countermove, which is followed by the five-leg C wave. A flat correction identifies a time during which the price action remains fairly constant and is identified with a 3–3–5 count. The triangular correction is identified by the extremes of waves one through five being contained within a triangular boundary, much like the ones we drew when we looked at triangles in a security's price action.

So, given that we know that the market will not always follow the perfect five-wave upward and three-wave downward formation, how are we going to use these more complex forms? Well, I don't know. If you're still not put off, let's look at one more segment of the Elliottitians' armory of possibilities, Elliott wave extensions. As I said, there always seems to be an escape clause for those practicing Elliott wave theory. When the grand prediction does not work out, there is always a justification for a recount of where the waves really are.

Elliott himself stated that impulse waves, those that form in the direction of the prevailing trend, can be extended. Corrective waves cannot. He also said that only one of the three impulse waves in the basic five-wave formation can be extended, either wave one, wave three, or wave five. Elliott made this refinement to his theory because at times, strong buying in an upward trend will overcome areas of resistance without a substantial pullback. Essentially, the rationale behind extensions is that a wave may consist of several zig-zag legs, as illustrated in the below figure, which shows a wave-three extension, so there are nine legs in the five-wave formation.

When Elliott made his post-1929 predictions, he was alone in believing them. Most analysts were still nervous about future prospects. Likewise, if you read an Elliott wave-based prediction, treat it with caution, and do not let it impact what your more basic chart pattern analysis tells you.

Although I have come across several analysts who promote the use of the Gann and Elliott forms of analysis, they tended to make their money writing newsletters about the technique or selling systems that use the technique, rather than successfully trading it. You can see how the complexity of these techniques might make them worthy subjects for ongoing newsletters. There is always something there that can be interpreted—and argued—as relevant to current market conditions.