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Putting Elliott Wave to Work in the MarketsFor many investors who are new to the Wave Principle, successfully applying wave analysis to real-worldmarket situations can sometimes prove difficult. So what better way to learn how to reap the most from itspractical applications, than a conversation with the man who wrote the book on it, Robert Prechter. Heres anexcerpt from one of his most popular titles, Prechters Perspective, that provides an in-depth commentary onthis subject.Is the Wave Principle truly accessible to the average individual investor?

I believe that Elliott is accessible to the average investor. Two evenings with the book, and theessential idea is clear to most anyone.

Is applying it an art or a science?

The study of the market must be, and is, a science, albeit one in its early stages ofdevelopment, as most social sciences are. Therefore, as Charles Collins often said,application of the Wave Principle is an objective discipline. For this reason, only rigorouslyhonest interpretations can be accepted as valid. If you want your hopes or whims fulfilledregardless of the evidence, the market will punish you for that weakness. Take it fromsomeone who had to figure that out the hard way. The worst interpreters of the theory arethose who view it as art, to be painted with their own impulsive or imprecise interpretations.Until the probabilities of the various patterns and ratios can be quantified, applying the WavePrinciple will retain many of the characteristics of a craft to be mastered not only by thinkingbut by doing. Websters defines a craft as a skill acquired by experience or study; asystematic use of knowledge.That being said, it probably takes an artistic mind to do it well, because the market drawspictures, and you must decide if they are proportioned correctly enough to call themcompleted. There are types of minds that are rational, yet unsuited for this task.

Youve said the Wave Principle is relatively easy to understand. How about application?

The basic idea is easy to understand. The intricacies can take a fair amount of time to learn.But once youve learned them, it becomes an easy step to recognize forms in the market.When you can recognize five wave moves, A-B-C corrections and Elliott triangles, a glancethrough your commodity charts will show definite buys and sells with no additional workwhatsoever. It offers the best reward-for-the-effort-expended ratio I know.

On the other hand, however, youve also said that it is mastered by a relative few. Out of all investors,how many do you think the Elliott Wave method is geared for?

Only people who want to put in the extra effort. Thats frankly a very small group. I thinkeverybody will find the idea of the Wave Principle fascinating. People who arent even in themarket find it an interesting concept. But the people who should actually apply it are only thepeople who want to make the market a very large part of their lives. You cant make money atsomething without working at it. The Elliott Wave Principle demands that much because the

market demands that much. They are one and the same.

Its deceptive a construct that is simple and easy to understand, but because of the inherentuncertainty, it demands rigorous and disciplined application.

Well, the rules of chess are simple, but winning the game is not so easy.

The essence of the task is to order the probabilities correctly. How is this accomplished on anongoing basis?

The first thing you have to do is eliminate the impossible by applying the rules of waveanalysis. At any market juncture, there are certain events that are impossible. For instance,for reasons specifically spelled out, a small five wave rally following a large five wave declinecannot possibly constitute the entire advance from the low. While a small pullback may occur,further advance is required. Therefore, calling for new lows to occur immediately must berejected as one of the possible paths for the market. Remaining may be a formidable list ofpossible interpretations. However, each possible interpretation must then be judged accordingto its adherence to the guidelines of the Wave Principle, including alternation, channeling,Fibonacci relationships, relative sizes of waves, typical targeting methods based on waveform, and volume and breadth, if appropriate.The interpretation that (1) satisfies the most guidelines and (2) does so the most satisfactorilyis the one that must be considered as indicating the most likely path of the market. The nextmost satisfactory interpretation indicates the next most probable path, and so on. These aresometimes referred to as preferred and alternate interpretations.The analyst must then monitor the market closely to determine if and when any one of theless probable interpretations becomes the most probable due to the elimination or decline inprobability of other interpretations.

This sounds complicated.

Not really. Often, the best interpretation is so clearly superior that an investment decision iseasy. Similarly, sometimes, the top two or three interpretations have the same implicationsregarding market behavior, also making an investment decision easy. At other times,interpretations with different implications carry nearly equal weight, dictating a stand asideposture. In the latter case, sooner or later the scales always tip in favor of one particularconclusion.

Once youre over the fact that youre going to be just plain wrong sometimes, what contingencies doyou establish to preserve your investment capital?

The key, in terms of making money, is having a plan for managing losses, which meanscutting them short. Trend followers must use arbitrary rules for placing stops. The WavePrinciple, on the other hand, is one of the best possible approaches for doing that because itrelies entirely on price patterns, which provide a reason for placing stops at certain levels.Lets say that a forecasted weak economy is expected to hurt the stock market. The economystays weak, but the market keeps going up. If you follow this traditional fundamental line ofthinking, what is the basis for deciding youre wrong? If interest rates are high, and the marketkeeps going up, when are you going to bail out? But the Wave Principle has a built-in methodfor keeping losses small. When a price pattern that you think is unfolding isnt doing what itshould for your opinion to be correct, you must change your mind you are forced to changeit, unless you evade the implications. The Wave Principle is unbeatable for determining whereto place a stop-loss order. Youre given an objective place to put a stop. It forces you to be

disciplined, and in the long run, that is the only way you can have a good track record.Even a technical indicator, like a put-call ratio, might give a sell signal, and if the marketkeeps going up, what are you going to do? A market sentiment indicator will tell you there aremany bulls around and may give you, based on historical figures, a sell signal at Dow 1000 so you sell. But then the Dow moves to 1100 and it still says sell, and then 1200, and then1300. What is your recourse? Nothing, except bankruptcy. You would lose money and losemoney and lose money. The Wave Principle wont allow you to justify riding a losing positionlike that. Of course, you can fight or rationalize the message of the market. Ive done it. Butthats a personal problem, not an Elliott problem. As Elliott once said in a letter to Collins, Theapplication of rules requires considerable practice and a tranquil mind.

Do you use stops?

Ive used stops in almost every issue of The Elliott Wave Theorist Ive ever put out. Very fewhave been triggered. Those that have been triggered have been worthwhile, because theymeant I was dead wrong, and they usually stopped us out very close to where the marketrecommendation was made. Theres rarely been any loss as a result. And thats a big plus,because if you can make a lot of money when youre right and keep yourself from losing abunch when youre wrong, youve got a good system.I have also gone a few times without a stop because I was so certain. That has worked everytime but one, when I shorted stocks and they kept on going up. Live and learn.

When you were in the trading championship, what kind of a percentage did you establish as the limitfor how much you were going to allow yourself to lose?

I didnt. You cant successfully use a fixed percentage to take a loss. All stop-loss decisionsmust be objective, that is, based on a reason to say Im wrong. Lets suppose Im bearish onthe market, and we get an up day, and I buy a put, and then the next day is up. That meansone of two things. It either means Im wrong, or its an opportunity to buy another put cheaper.If all the evidence is still saying Im right, Ill buy another put. That way, Im using the WavePrinciple properly. The decision is not arbitrary. Lets suppose the market continues in thedirection I did not expect. It may still be well within the bounds of a corrective process, inwhich case I would use the opportunity to buy another put. But if something happens in thewave structure to say Im wrong, thats when I get out, right then and there. So I use themarket itself to tell me when Im wrong. Thats my stop. Any other type of stop is arbitrary.

Whats wrong with saying before you get in, if this loses 10%, Im out of there?

You will take a lot of losses that are unnecessary. What happens after you take the loss andthe market goes the way your method said? Do you then re-enter the trade at a worse price?With another arbitrary stop that can be hit again? That is a formula for disaster. A 10% stop isarbitrary. You cannot base a system on the arbitrary.

Arbitrary if you say, Im not going to lose more than 10%, thats it?

Why not 9%? Why not 11%?

You have the choice...

To decide on what grounds? Look, your intellectual goal is to be right on your analysis. Your

practical goal is to trade according to it. Ideally you should know before taking the trade atwhat point in your market analysis you will come to the conclusion that your prior conclusionwas incorrect.

Is trading with options the same in that regard?

Well, you cant put stops on an options trade; you have to pick up the phone and call in a sale.So you have to approach options from a little different frame of mind than you would a futurescontract. If your option is down 50%, by the time your phone call hits the floor, it might bedown 80%, in which case youre probably selling the low. In fact, at that point, it may be ascreaming buy. You might want to add to your position so that a bounce back to 50% of theoriginal price will get you even. The whole point is, what does the wave structure say? If itsays youre still right the trend is going to turn in this particular direction then you maywant to add to your position.

Lets switch to your thoughts about the profession of investing. Why is it that most mutual fundmanagers are not able to consistently beat the S&P?

There is only a small percentage of independent thinkers in the money management field. Thestatistics on how well the funds have done proves that. You find that 80% underperform theS&P 500, and except in big bull markets, a large percent underperform passbook savingsaccounts. Obviously, the number of independent thinkers is very small in relationship to thetotal. You can see it in the excellent records of some managers over long periods of time.They think independently, they do their own research, they are contrarians, and they look forvalue and all the things that you hear people say over and over but hardly ever do. Butsomeone has to pay the costs of having a market in other words, paying brokers andmarket makers to do their job. All those transaction costs come out of peoples accounts.Theyre paying to keep the machine oiled, which means that everybody cant beat theaverages.

Youre saying that trading long-term trends makes the most economic sense, but you made afantastic return trading 200 times in three months in the U.S. Trading Championships.

On top or not, I paid my broker as much as I made in profits. In other words, I spent as muchon commissions as I profited, back in 1984 when commissions were high. You have to bereally right to do that.

Much of what youve said so far speaks to traders and investors alike, but it seems like your overallfocus is more like that of a trader. For those that dont want to speculate, are all the guidelines thesame?

All investment is speculation, and there is no speculation more dangerous than one that isconfidently viewed by the majority as an investment. Take long term bonds in 1946, forinstance. Or gold in 1980. Or stocks here in 2000.

Youve stated that the waves are there to the smallest possible degree. But can a short term traderuse Elliott to manage the micro-waves profitably?

One of the great things about the Wave Principle is that you can choose which of the trendsyou want to trade with. If you bought stocks in 1982 and said Im just going to hold these untilthis giant cycle is over, Id say thats a perfectly good investment strategy. It is also perfectlyall right to have attempted to exit for the intermediate corrections. Some people are day

traders, and the Wave Principle is applicable to that, too. R.N. Elliott discovered the basicpattern of market movements, and he found this pattern over and over, even on the smallestdegree charts. If you chart tick by tick, you can see it recurring, and I know some super short-term floor traders who try to trade off of that. Of course, they dont pay commissions.

This ability to reflect both microscopic and telescopic price trends is one of the things that makesthe Wave Principle a unique instrument of stock market observation. But what about when themicroscope is telling you one thing, and the telescope is telling you the other, do you play favorites?

Very rarely during the bull trend of the 1980s did I recommend shorting stocks. Selling yes,but not shorting. Obviously there were periods of time when shorting would have beenlucrative. However, my philosophy of recommended action is to use the underlying trend to thebest advantage. Its very difficult, for instance, to make money on the long side in bear marketrallies. If youve seen the start of a bull market, you know the difference. Then people areeager to sell because the profits have come so easily they cant believe their luck. Thus whenI perceive that the major trend is up, I will suggest buying, selling and re-buying. When themajor trend appears to be down, I will suggest shorting, covering and re-shorting. This wayerrors in timing will have a better chance of being redeemed by the overall trend. When youassess the underlying trend incorrectly, you lose money, of course, but even then, becauseyou are trading the moves at one smaller degree, you dont get hurt too badly. Unless yourewrong on both, which has certainly happened! But the odds of that occurring are low enoughto survive it happening from time to time.

For you, the difference between investing and trading is more a matter of reasoning down from theGrand Supercycle degree. Thats more subtle than what most market observers would argue. Mostsay that trading is buying and selling and investing is buying and holding. Youve always made yourviews on the buy and hold approach quite clear whether we acknowledge it or not, were allmarket timers.

The difference between investing and trading is simply a matter of the degree of trend.Speculating on the minor trends is called trading, while speculating on the major trends iscalled investing. There is no other difference. Thats why I use the words interchangeablywhen I discuss strategies. Everyone must have a market opinion at some degree of trend,even if he denies that he does. A buy-and-holder is bullish because of recent history, so he isbullish at Primary, Cycle or perhaps Supercycle degree. Or all three. If he sells later becausehes worried, he has made a market timing decision. If he doesnt sell, he has retained hisopinion. But he still has one. Investors actions require a timing of entry, whether the timing isapproached emotionally or rationally. Sometimes peoples timing is unrelated to a markettiming decision. For instance, someone might sell a stock because there is a family medicalemergency. But it is preferable to have good timing reasons behind your decision.

You've just read an excerpt from Prechter's Perspective. Prechters Perspective reveals trading knowledgethat took Bob Prechter three decades to build. You get Bobs thoughts on how Fibonacci ratios can help youtime the markets and set stops. You also get his tips on using discipline to overcome emotional tendenciesand keep the markets in your favor more often. Elliott Wave International asks all new employees to readthis 221-page tome as their first assignment because Prechters Perspective is the best overview of theWave Principle you can get.So if youre a newcomer to Elliott Wave or if youre looking for the right resource to give a friend, familymember or colleague, this newly revised edition of Prechters Perspective is the perfect place to start. Getyour copy now for just $27 (plus s&h). Just click on the button below.

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