Want an edge up on the competition for your finance interview? Impress the recruiter with your technical analysis skills: the Elliot Wave Theory

Ever wondered about technical analysis? Have you ever thought about patterns in a stock’s price chart? Take a look at one popular technique, deemed the Eliot Wave Theory.
Basic Thesis of Elliot Wave Theory: In 1939, R. N. Elliott established the Elliot Wave Theory, which believed markets had well-defined waves that could be used to predict market direction. It stated that stock prices are governed by cycles founded upon the Fibonacci series (1-2-3-5-8-13-21...). Elliott believed the market moved in distinct waves: five on the upside and three on the downside.
Assumptions of Elliot Wave Theory: market is not efficient
It is a true free market (i.e., prices are set by demand and not by monopolistic price setting).
It provides consistent and regular metrics that can be measured.
It is manipulated by a statistically significantly large group of people. [1]
[2]
Wave Description:
The following description applies to a market moving upwards. In a down market you will generally see the same types of behavior in reverse that you saw watching the stock go up. The description of the wave (ie Wave 1) is shown visually in the chart above.
Wave 1
The stock makes its initial move upwards. This is usually caused by a small number of people that all of the sudden (for a variety of reasons) feel that the previous price of the stock undervalued and therefore worth buying, causing the price to go up.

Wave 2
The stock is considered overvalued. Now, enough people who were in the original wave consider the stock overvalued and sell to make a profit. This causes the stock to go down. However in general the stock will not go down to its previous lows before the stock is considered cheap again.
Wave 3
This is generally the longest wave. It has become a “popular” stock, and more people want the stock and they buy it for a higher and higher price. This wave usually exceeds the peaks created at the end of wave 1.
Wave 4
At this point people again take profits because the stock is again considered expensive. This wave tends to be weak because their are usually more people that are still bullish on the stock and after some profit taking comes wave 5.
Wave 5
This is where most people get on the stock, and is mostly driven by emotion. People will carelessly and without research purchase the stock, and will be hard to persuade not to. At this time, this is where the stock becomes the most overpriced. Then the stock will move into either one of two patterns; an ABC correction, or starting again with wave 1.
An ABC correction is when the stock will go down/up/down in preparation of another 5 way cycle up. During this time frame volatility is usually much less then the previous 5 wave cycle, and what is generally happening is the market is taking a pause while fundamentals catch up. You may have more than one ABC correction- if the fundamentals do not catch up you will have two ABC corrections and then the stock will have a 5 wave down cycle. (An odd number of ABC corrections point to the stock going up, and an even number of ABC corrections point to the stock going down.)[3]

Here is applied example:
Centex Corporation, from November 2005 to February 2006
[4]
After Wave 5, you can see that Centex had 2 ABC wave corrections, and thus the stock continued downwards on another 5-wave cycle.
Criticism of the Elliot Wave Theory:
Many critics believe that the wave principle is too vague to be useful, since it cannot always identify the beginning or end of a wave. They feel Elliott wave forecasts are often subjective and easily revised after the fact. Also, many say that if it actually did work, common knowledge of it among investors would force the pattern useless because all investors would try to profit from the pattern, and the waves would reverse and no longer hold true to the theory.

Sources:
CapitalIQ Charting
http://www.acrotec.com/ewt.htm
Kurganov, Yury. http://www.elliottwavemarkettiming.com/ 2006.
Investopedia. http://www.investopedia.com/articles/technical/111401.asp November 14, 2001
Lott, Christopher. http://invest-faq.com/articles/tech-an-elliott.html 12 Dec 1996

[1] Lott, Christopher. http://invest-faq.com/articles/tech-an-elliott.html 12 Dec 1996

[2] http://www.investopedia.com/articles/technical/111401.asp
[3] Lott, Christopher. http://invest-faq.com/articles/tech-an-elliott.html 12 Dec 1996

[4] Historical Price Data from Capital IQ





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