At first glance, an exchange-traded fund may seem like a simple way to invest in many stocks at once with just one purchase.
A closer look reveals that ETFs are even more complex than individual stocks because of their unique structure.
ETFs may consist of multiple assets, have uneven shares outstanding and usually have low trading volume.
These factors do not show up in straightforward technical analysis because there is no historical data representing the underlying holdings and no record for the number of shares currently available.
However, with custom software, Elliott wave analysts can take advantage of these unique properties to predict future market behaviour with increased accuracy. This analysis shows how an ETF’s price reflects this complicated web of supply and demand.
Before delving into the technical analysis, we will look at the history and purpose of an ETF.
Developed in 1993 as a marketable security that tracks an index (stock market or another kind), ETFs have multiplied over 20 years.
A rising number of investors use these funds to trade stock markets worldwide because it is possible to buy one share and track many different stocks simultaneously.
How ETFs are created
One interesting point about ETFs is how they are created. When someone wants to invest in a particular index, he has two options:
- buying multiple shares of each stock on the index, or
- purchasing one share of an ETF that represents the entire index. State Street Global Advisors introduced the latter method with their S&P 500 fund or SPDR.
This novel approach was an instant success. The company quickly expanded its product line to cover most major stock indices, including the Nasdaq 100 ( QQQQ ), Dow Jones Industrial Average ( DIA ) and the S&P MidCap 400 ( MDY ).
SPDR ETFs are simple financial instruments, but more complex products like leveraged ETFs were created soon after these first funds.
A leveraged ETF has rules that multiply price changes on a particular index by two or three, making it possible to gain more exposure than with a non-leveraged ETF of the same index.
Custom software is needed to analyze each special fund with all its complexities. However, once this powerful tool is created, it can be used time after time with no additional effort because specific rules govern how an ETF’s price behaves based on its underlying assets.
These rules were initially defined by R.N . Elliott and made famous by A.J . Frost and Robert Prechter in their 1979 book, “Elliott Wave Principle: Key to Market Behavior.”
There are five steps needed to perform an ETF analysis based on this theory:
- Determine the correct time frame for each wave pattern. It is done using a standard technical indicator such as the Relative Strength Index (RSI) or another oscillator that fluctuates between low and high levels.
- Draw all three waves ( A, B and C ) within one structure labelled with numbers 1 through 5 according to Fibonacci ratios of their lengths. Highlight the ending points of the A-B trendline and the B-C trend line to determine the approximate location of wave 4.
- Label waves 2 and 4 as either “impulse” (continuation) patterns or “corrective” (countertrend) patterns . The first category includes waves 1, 3 and 5, while waves 2 and 4 fall into the latter group.
Either type of wave can end at a Fibonacci level that corresponds with its number in Elliott’s notation system.
For example, if wave 1 is a strong impulse up from where it started, it will probably come to an end at a price that corresponds with a Fibonacci ratio of 23.6% from where it began.
- Draw a zigzag pattern within each impulse or corrective wave. The A-B trendline of the zigzag should be parallel to the B-C trend line.
Their ends can cross each other, but this is not necessary.
- Carefully study the effects of volume and RSI levels during each impulse and corrective wave.
For example, if a specific ETF closes below its opening price (a bearish sign), it will often indicate that a correction has started.
An extreme drop in volume usually signals a significant change within these waves.
An RSI level above 70 usually means there is enough bullish strength left for the current wave to move higher after reaching its price peak (see Figure1); however, when this indicator falls below 30.