A. Rediscovery and current use

Ralph Nelson Elliott died in 1948.After his death other analyst continued the use of wave theory. Charles Collins, published Elliot’s “Wave Principle” and ranked Elliot’s contribution in the fi eld of technical analysis at par with Charles Dow. Hamilton Bolton Founder of The Bank Credit Analyst provided Wave analysis. Many other analysts wrote on wave theory but today most widely known wave analyst after Elliott is Robert Prechter. He forecasted the bull run of 1980s and this increased awareness about Elliott’s work across financial markets.

Today Elliott wave theory is important part of technical analysis and Elliot Wave theory is part of Chartered Market Technician (CMT), the professional certification developed by the Market Technicians Association (MTA).Now it’s part of National Stock Exchange Module on Technical Analysis.

A lot of work has been done on Wave theory, both on academic front and trading front. Wave theory is widely used by retail and institutional investors.

B. Criticism

Criticism is an integral part of life. Critics would criticize you for doing something and they will even criticize if you don’t do same thing.

Firstly efficient market theory states that prices cannot be predicted from market data i.e. price and volume. It says that successful market forecast is not possible, otherwise each market participant would buy when prices are about to rise and sell when prices are about to decline, thus destroying the profitability and price predictive power of the method. This theory criticizes not only wave theory but all forms of technical analysis.

Secondly price prediction using wave theory is an art with a subjective judgment of an analyst. Hence some critics say it is an uncertain business.

Thirdly critics say wave theory does not identify when wave begins and ends. Basically wave is identified when some distance has been covered but if anybody wants to buy at bottom and sell at top then Wave theory is not be blamed.

Fourthly critics say it’s only a popular theory and not a valid theory. How can theory become popular if it’s not profit making.

C. Practical Application:

1. Trading stock markets using wave theory is not an easy path to walk. It requires lot of hard work and practice. To begin with, 70% of the Elliot Wave patterns are simple
whereas remaining 30% are complex. Hence first recommendation is to trade 70 % of the patterns which are clear at least for beginner.

2. Corrections are difficult to trade as these are short lived and moreover corrective waves have potential to come to an end overnight. Hence second recommendation is that one should not trade in direction of the corrective waves i.e. Wave 2, Wave 4 and Wave A.

3. Third recommendation is to take position in the market when Wave 4 ends. This is subdivided into two parts-

(i) Buying at the end of Wave 4 when prices are advancing.

• Before buying at end of Wave 4, make sure that Wave 4 is not more than 61.8%
retracement level of Wave 3, otherwise odds for Wave 5 failure increases.
• Stop Loss for buying at end of Wave 4 is placed below the 61.8 % retracement level of Wave 3.

• Use Fibonacci relationship to predict Wave 5 target. Then observe risk reward ratio as both stop loss and target is known. If reward is less than 1.5 times the risk, then one should strictly avoid taking buy side position.

• (Figure 26) illustrates buy setup in Dollar when Wave 4 ends. Here Wave 2 is a flat correction whereas Wave 4 is sharp correction and Wave 4 finds support around 50% retracement level of Wave 3 i.e. at 49 levels for Dollar during February 2012.

• The best method to confirm that Wave 4 has found support is to look for first higher top-higher bottom formation near Wave 4 support area. Here first higher top-higher bottom is formed at 49.85 levels on 2nd March 2012 and thereafter Wave 5 made new high around 57 levels.

(ii) Selling at the end of Wave 4 when prices are declining.

• Before selling at end of Wave 4, make sure that Wave 4 is not more than 61.8% retracement level of Wave 3, otherwise odds for Wave 5 failure increases.

• Stop Loss for selling at end of Wave 4 is placed above the 61.8 % retracement level of
Wave 3.

• Use Fibonacci relationship to predict Wave 5 target. Then observe risk reward ratio as both stop loss and target is known. If reward is less than 1.5 times the risk, then one should strictly avoid taking sell side position.

• (Figure 27) illustrates sell setup in Bank Nifty Index when Wave 4 ends. Here Wave 4 finds resistance at 50% retracement level of Wave 3 i.e. at 10080 levels during October 2011.

• The best method to confirm that Wave 4 has found resistance is to look for first lower bottom-lower top formation near Wave 4 resistance area. Here first lower bottom-lower top is formed at 9300 levels on 11th November 2011 and thereafter Wave 5 made new low around 7770 levels on 20th December 2011.

4. Fourth recommendation is to take position in the market when Wave 5 ends. This is subdivided into two parts-

(i) Selling at the end of Wave 5 when prices are advancing.

• Before selling at end of Wave 5, make sure that prices are near to Wave 5 target as suggested by Fibonacci Relationship. One should preferable sell when immediate
bottom is taken off after Wave 5 is completed.

• Stop Loss for selling at end of Wave 5 is placed above previous highs.

• Use Fibonacci relationship to predict Wave C target. Then observe risk reward ratio as both stop loss and target is known. If reward is less than 1.5 times the risk, then one should strictly avoid taking sell side position.

• (Figure 28) illustrates sell setup in Nifty Index when Wave 5 ends. Here one sells when immediate bottom is taken off after Wave 5 is formed i.e. at 5675 levels on
21st January 2008 and thereafter Nifty vertically crashed with a lower circuit freeze within two days of selling level being taken off.

(ii) Buying at the end of Wave 5 when prices are declining.

• Before buying at end of Wave 5, make sure that prices are near to Wave 5 target as suggested by Fibonacci Relationship. One should preferable buy when immediate
top is taken off after Wave 5 is completed.

• Stop Loss for buying at end of Wave 5 is placed below previous lows.

• Use Fibonacci relationship to predict Wave C target. Then observe risk reward ratio as both stop loss and target is known. If reward is less than 1.5 times the risk, then one should strictly avoid taking buy side position.

• (Figure 29) illustrates buy setup in Nifty Index when Wave 5 ends. Here one buys when immediate top is taken off after Wave 5 is formed i.e. at 4800 levels on 10th
January 2012 and thereafter Nifty rallied with a momentum to 5600 levels within 30 trading days.

5. Fifth recommendation is to take position in the market when Wave 3 emerges. This is subdivided in two parts-

(i) Buying when Wave 3 emerges in the advancing market.

• Here one buys when high of Wave 1 is taken off.

• Stop loss is placed below the bottom of Wave 2.

• Use Fibonacci relationship to predict Wave 3 target. Then observe risk reward ratio as both stop loss and target is known. If reward is less than 1.5 times the risk, then one should strictly avoid taking buy side position.

• (Figure 30) illustrates buy setup in Jindal Steel and Power as Wave 3 emerges. Here buying is recommended when top of wave 1 is taken off and Wave 3 is confirmed
i.e. at 180 levels during March 2009 and thereafter stock rallied to 500 levels in a straight line without any significant correction.

(ii) Selling when Wave 3 emerges in the declining market.

• Here one sells when low of Wave 1 is taken off

• Stop loss is placed above the top of Wave 2.

• Use Fibonacci relationship to predict Wave 3 target. Then observe risk reward ratio as both stop loss and target is known. If reward is less than 1.5 times the risk, then one should strictly avoid taking sell side position.

• (Figure 31) illustrates sell setup in Reliance Infrastructure as Wave 3 emerges. Here selling is recommended when bottom of wave 1 is taken off and Wave 3 is confi rmed
i.e. at 1025 levels during November 2010 and thereafter stock declined to 500 levels by February 2011.