Understanding Elliott Wave Theory

Elliott Wave Theory is named after Ralph Nelson Elliott (28 July 1871 – 15 January 1948). He was an American accountant and author. Inspired by the Dow Theory and by observations found throughout nature, Elliott concluded that the movement of the stock market could be predicted by observing and identifying a repetitive pattern of waves.

Elliott proposed that trends in financial prices resulted from investors' predominant psychology. He found that swings in mass psychology always showed up in the same recurring fractal patterns, or "waves," in financial markets. Elliott first published his theory of the market patterns in the book titled The Wave Principle in 1938

Elliott believed that as market seems to be behaving in a random and chaotic manner but it is not true. He recognized the "fractal" nature of markets. Fractals are mathematical structures, which on an ever-smaller scale infinitely repeat themselves. He discovered stock index price patterns were structured in the same way.

Price of any share does not vertically go up or down, if share has to go in any direction it does so in waves

An impulse wave, which net travels in the same direction as the larger trend, always shows five waves in its pattern.

A corrective wave, on the other hand, net travels in the opposite direction of the main trend shows three waves in its pattern.

These patterns repeats themselves infinitum at ever-smaller scales. Elliott uncovered this fractal structure in financial markets in the 1930s, but only decades later would scientists recognize fractals and demonstrate them mathematically.

Interpretation Elliott Wave Theory

The Elliott Wave Theory is interpreted as follows:

There are two trends, first one is main trend called as Motive wave (or Impulse trend) and second is Corrective wave

Five waves move in the direction of the main trend, followed by three waves in a correction (totalling a 5-3 move). The underlying 5-3 pattern remains constant, though the time span of each wave may vary.

Let's have a look at the following chart made up of eight waves (five net up and three net down) labelled 1, 2, 3, 4, 5, A, B, and C.

Waves 1, 2, 3, 4 and 5 form an impulse, and waves A, B and C form a correction. The corrective wave normally has three distinct price movements – two in the direction of the main correction (A and C) and one against it (B). Waves 2 and 4 in the above picture are corrections.

Ideally, smaller patterns can be identified within bigger patterns. In this sense, Elliott Waves are like a piece of broccoli, where the smaller piece, if broken off from the bigger piece, does, in fact, look like the big piece. This information (about smaller patterns fitting into bigger patterns), coupled with the Fibonacci relationships between the waves, offers the trader a level of anticipation and/or prediction when searching for and identifying trading opportunities with solid reward/risk ratios.

Following chart will explain how Elliot waves are formed within itself

Wave 1, 3 and 5 are motive waves and they are subdivided into 5 smaller degree impulses labelled as ((i)), ((ii)), ((iii)), ((iv)), and ((v)). Wave 2 and 4 are corrective waves and they are subdivided into 3 smaller degree waves labelled as ((a)), ((b)), and ((c)). The 5 waves move in wave 1, 2, 3, 4, and 5 make up a larger degree motive wave (1)

Corrective waves subdivide into 3 smaller-degree waves, denoted as ABC. Corrective waves start with a five-wave counter-trend impulse (wave A), a retrace (wave B), and another impulse (wave C). The 3 waves A, B, and C make up a larger degree corrective wave (2)

In a bear market the dominant trend is downward, so the pattern is reversed—five waves down and three up

Wave Degrees

Elliott Wave degree is an Elliott Wave language to identify cycles so that analyst can identify position of a wave within overall progress of the market. Elliott acknowledged 9 degrees of waves from the Grand Super Cycle degree which is usually found in weekly and monthly time frame to Subminuette degree which is found in the hourly time frame

1. Grand Super cycle – Multi century

2. Super cycle – Multi decade

3. Cycle – One to several year

4. Primary – Few months to couple of years

5. Intermediate – Weeks to months

6. Minor - Weeks

7. Minute - Days

8. Minutte - Hours

9. Sub-Minnutte - Minutes

There are three main rules for Elliott wave counting as follows,

1) Wave 2 never retraces more than 100% of Wave 1

2) Wave 3 can never be shortest of the three waves

3) Wave 4 does not cross the final point of wave 1 except in diagonal

Elliot impulsive and corrective waves are further categorized into different categories based on sub waves patterns

Elliot Impulse wave - Nifty bull market from March 2009 till Jan 2020

If we look at super cycle Elliot wave pattern for nifty, five Elliot waves for nifty can be identified as seen from following chart

Elliot Correction Wave - Nifty Bear Market from January 2020 to May 2020

Nifty corrected from 12000+ level to near 7500 and it was the fastest fall in history of stock market. Panic level was so high that index hit 2 lower circuits. There was no liquidity in the market, investors panicked as if there is no tomorrow amid fear of community spread of covid and breakdown of medical infrastructure. Even stock markets were shut, shortsellng was banned in many countries.

Generally in bear market correction, Elliot wave C correction is more than wave A but this time panic was so high during first wave that wave C fall was much less

Another possibility is that we were already in bear market correction wave A since start of 2018, when small and mid-caps started correction, but nifty levels were intact because market leaders like reliance, TCS, Infosys, HDFC and Bajaj twins did not fall and protected nifty and this entire fall was part of wave C

But in both cases it is evident that market is not going to hit 7500 level again and bottom was already made in March month.

Nifty is already above to 200 EMA at 10500. Strong rebound and out performance of quality stocks confirms the Elliot wave 1 of bull market and you should be fully invested before public joins the rally and it enters into wave 3