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Putting Elliott Wave to Work in the Markets
For many investors who are new to the Wave Principle, successfully applying wave analysis to real-world
market situations can sometimes prove difficult. So what better way to learn how to reap the most from its
practical applications, than a conversation with the man who wrote the book on it, Robert Prechter. Heres an
excerpt from one of his most popular titles, Prechters Perspective, that provides an in-depth commentary on
this 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 the
essential 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 of
development, as most social sciences are. Therefore, as Charles Collins often said,
application of the Wave Principle is an objective discipline. For this reason, only rigorously
honest interpretations can be accepted as valid. If you want your hopes or whims fulfilled
regardless of the evidence, the market will punish you for that weakness. Take it from
someone who had to figure that out the hard way. The worst interpreters of the theory are
those 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 Wave
Principle will retain many of the characteristics of a craft to be mastered not only by thinking
but by doing. Websters defines a craft as a skill acquired by experience or study; a
systematic use of knowledge.
That being said, it probably takes an artistic mind to do it well, because the market draws
pictures, and you must decide if they are proportioned correctly enough to call them
completed. 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 glance
through your commodity charts will show definite buys and sells with no additional work
whatsoever. 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 think
everybody will find the idea of the Wave Principle fascinating. People who arent even in the
market find it an interesting concept. But the people who should actually apply it are only the
people who want to make the market a very large part of their lives. You cant make money at
something 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 inherent
uncertainty, 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 an
ongoing basis?

The first thing you have to do is eliminate the impossible by applying the rules of wave
analysis. 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 decline
cannot 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 be
rejected as one of the possible paths for the market. Remaining may be a formidable list of
possible interpretations. However, each possible interpretation must then be judged according
to its adherence to the guidelines of the Wave Principle, including alternation, channeling,
Fibonacci relationships, relative sizes of waves, typical targeting methods based on wave
form, and volume and breadth, if appropriate.
The interpretation that (1) satisfies the most guidelines and (2) does so the most satisfactorily
is the one that must be considered as indicating the most likely path of the market. The next
most satisfactory interpretation indicates the next most probable path, and so on. These are
sometimes referred to as preferred and alternate interpretations.
The analyst must then monitor the market closely to determine if and when any one of the
less probable interpretations becomes the most probable due to the elimination or decline in
probability of other interpretations.

This sounds complicated.

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

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

The key, in terms of making money, is having a plan for managing losses, which means
cutting them short. Trend followers must use arbitrary rules for placing stops. The Wave
Principle, on the other hand, is one of the best possible approaches for doing that because it
relies 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 economy
stays weak, but the market keeps going up. If you follow this traditional fundamental line of
thinking, what is the basis for deciding youre wrong? If interest rates are high, and the market
keeps going up, when are you going to bail out? But the Wave Principle has a built-in method
for keeping losses small. When a price pattern that you think is unfolding isnt doing what it
should for your opinion to be correct, you must change your mind you are forced to change
it, unless you evade the implications. The Wave Principle is unbeatable for determining where
to 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 market
keeps going up, what are you going to do? A market sentiment indicator will tell you there are
many 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 then
1300. What is your recourse? Nothing, except bankruptcy. You would lose money and lose
money and lose money. The Wave Principle wont allow you to justify riding a losing position
like that. Of course, you can fight or rationalize the message of the market. Ive done it. But
thats a personal problem, not an Elliott problem. As Elliott once said in a letter to Collins, The
application 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 few
have been triggered. Those that have been triggered have been worthwhile, because they
meant I was dead wrong, and they usually stopped us out very close to where the market
recommendation 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 a
bunch 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 every
time 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 limit
for 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 decisions
must be objective, that is, based on a reason to say Im wrong. Lets suppose Im bearish on
the market, and we get an up day, and I buy a put, and then the next day is up. That means
one 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 Wave
Principle properly. The decision is not arbitrary. Lets suppose the market continues in the
direction I did not expect. It may still be well within the bounds of a corrective process, in
which case I would use the opportunity to buy another put. But if something happens in the
wave structure to say Im wrong, thats when I get out, right then and there. So I use the
market 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 and
the 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 is
arbitrary. 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 at
what point in your market analysis you will come to the conclusion that your prior conclusion
was 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 futures
contract. If your option is down 50%, by the time your phone call hits the floor, it might be
down 80%, in which case youre probably selling the low. In fact, at that point, it may be a
screaming buy. You might want to add to your position so that a bounce back to 50% of the
original price will get you even. The whole point is, what does the wave structure say? If it
says youre still right the trend is going to turn in this particular direction then you may
want to add to your position.

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

There is only a small percentage of independent thinkers in the money management field. The
statistics on how well the funds have done proves that. You find that 80% underperform the
S&P 500, and except in big bull markets, a large percent underperform passbook savings
accounts. Obviously, the number of independent thinkers is very small in relationship to the
total. 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 for
value and all the things that you hear people say over and over but hardly ever do. But
someone has to pay the costs of having a market in other words, paying brokers and
market 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 the
averages.

Youre saying that trading long-term trends makes the most economic sense, but you made a
fantastic 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 much
on commissions as I profited, back in 1984 when commissions were high. You have to be
really right to do that.

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

All investment is speculation, and there is no speculation more dangerous than one that is
confidently viewed by the majority as an investment. Take long term bonds in 1946, for
instance. 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 trader
use Elliott to manage the micro-waves profitably?

One of the great things about the Wave Principle is that you can choose which of the trends
you want to trade with. If you bought stocks in 1982 and said Im just going to hold these until
this giant cycle is over, Id say thats a perfectly good investment strategy. It is also perfectly
all 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 basic
pattern of market movements, and he found this pattern over and over, even on the smallest
degree charts. If you chart tick by tick, you can see it recurring, and I know some super shortterm 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 makes
the Wave Principle a unique instrument of stock market observation. But what about when the
microscope 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 been
lucrative. However, my philosophy of recommended action is to use the underlying trend to the
best advantage. Its very difficult, for instance, to make money on the long side in bear market
rallies. If youve seen the start of a bull market, you know the difference. Then people are
eager to sell because the profits have come so easily they cant believe their luck. Thus when
I perceive that the major trend is up, I will suggest buying, selling and re-buying. When the
major trend appears to be down, I will suggest shorting, covering and re-shorting. This way
errors in timing will have a better chance of being redeemed by the overall trend. When you
assess the underlying trend incorrectly, you lose money, of course, but even then, because
you are trading the moves at one smaller degree, you dont get hurt too badly. Unless youre
wrong on both, which has certainly happened! But the odds of that occurring are low enough
to survive it happening from time to time.

For you, the difference between investing and trading is more a matter of reasoning down from the
Grand Supercycle degree. Thats more subtle than what most market observers would argue. Most
say that trading is buying and selling and investing is buying and holding. Youve always made your
views on the buy and hold approach quite clear whether we acknowledge it or not, were all
market 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 is
called investing. There is no other difference. Thats why I use the words interchangeably
when 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 is
bullish at Primary, Cycle or perhaps Supercycle degree. Or all three. If he sells later because
hes worried, he has made a market timing decision. If he doesnt sell, he has retained his
opinion. But he still has one. Investors actions require a timing of entry, whether the timing is
approached emotionally or rationally. Sometimes peoples timing is unrelated to a market
timing decision. For instance, someone might sell a stock because there is a family medical
emergency. 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 knowledge
that took Bob Prechter three decades to build. You get Bobs thoughts on how Fibonacci ratios can help you
time the markets and set stops. You also get his tips on using discipline to overcome emotional tendencies
and keep the markets in your favor more often. Elliott Wave International asks all new employees to read
this 221-page tome as their first assignment because Prechters Perspective is the best overview of the
Wave Principle you can get.
So if youre a newcomer to Elliott Wave or if youre looking for the right resource to give a friend, family
member or colleague, this newly revised edition of Prechters Perspective is the perfect place to start. Get
your copy now for just $27 (plus s&h). Just click on the button below.
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