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The Elliott Wave Theory is a sensational trading tool used for all markets. Traders familiar with Elliott Wave or who want to learn more about it will know the basics of the theory, which Ralph Nelson Elliott created in 1938, and effectively forecast market trends.

The Elliott wave illustrates how much time it will take price action

More than just knowing where prices are headed in terms of up, down or sideways market movements, this theory also illustrates how much time it will take price action to reach its destination. The wave theory shows the pattern of stock prices through five waves in either direction.

 

Once complete, retracement is returned into a correction before starting again. When viewed on a chart, these two moves run concurrently, creating what looks like an “M” moving pattern. Traders and investors widely use the Wave Theory, but how to use it specifically with Exchange Traded Funds (ETFs), famous for their low costs, diversification benefits and tax efficiency.

Understanding the Elliott Wave

Before getting started to find these complex market patterns on an ETF chart, first, understand what Elliott Wave or 5-3 wave system is all about.

 

  • ‘Five’ refers to the main direction, i.e. either up or down (1-2-3-4-5).
  • The middle number ‘3’ shows that after three consecutive waves of the same direction, there’s then a retracement into the opposite direction to complete another three waves (this can be shown as 1-2-3 up turns into 1-2-3 down).
  • The ‘5’ refers to the final move being up or down, i.e. 3-3-3-3-5, which can be illustrated as a five-wave pattern in either direction.

Forecast the market trends

The Elliott Wave theory is commonly used to forecast market trends and identify significant highs and lows with three elements: motive, corrective and consolidative patterns. It’s also used for analyzing financial markets by technical analysts who believe that stock prices are not random but go through predictable phases that can be seen with a visual trend analysis by plotting price movements on a chart.

 

Most traders use these charts to compare where a share price is now against past price action, but there’s more involved than this since, very often, patterns aren’t symmetrical (i.e. they don’t always look the same).

 

If you want the best results when trying something new, it’s good to familiarize yourself with what you’re doing and why before starting. So let’s get started by sharing some of the basics of our theory on ETF trading using 5-3 wave patterns:

Determine which way a market is moving

Start with a longer-term timeframe such as a daily chart, then identify ten waves in either direction. Fast-moving markets can often go through this stage quickly, while slower trending markets will take more time to filter out these moves (remember that each Up 3 move must be followed by an equivalent Down three move back into the corrective phase). If you see only five waves in either direction, then possibly you started on the wrong timeframe.

Define the pattern

Once you have ten Up three moves, followed by ten Down three moves over some time, use smaller timeframes to get more accurate wave patterns (i.e. 5m chart, 1m chart or even intra-minute for short term movements). Tick charts or line charts can be used successfully with this theory since they don’t rely on time information but instead prices closing at their highs/lows.

 

What does this mean? It means do not select bar charts when trying to find Elliot Wave patterns because these charts rely on time and not prices closing at highs or lows, which we want to use with the Wave pattern.

Draw the wave pattern

Once you have a series of ten moves in either direction, then start to draw in these waves into an accurate and consistent pattern. Some patterns will be symmetrical, while others may be more sporadic looking. In this case, it doesn’t matter since both situations are considered valid when using this theory for technical analysis on ETFs or stocks.

 

Lastly, don’t forget that there can be flat corrections within the motive phase (these look like a sideways flag).

 

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