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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. Here’s an excerpt from one of his most popular titles, Prechter’s 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. Webster’s 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.

You’ve 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 you’ve 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, you’ve 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. That’s frankly a very small group. I think everybody will find the idea of the Wave Principle fascinating. People who aren’t 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 can’t 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.

It’s 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 you’re over the fact that you’re 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. Let’s 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 you’re 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 isn’t 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. You’re 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 won’t allow you to justify riding a losing position like that. Of course, you can fight or rationalize the message of the market. I’ve done it. But that’s 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?

I’ve used stops in almost every issue of The Elliott Wave Theorist I’ve 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. There’s rarely been any loss as a result. And that’s a big plus, because if you can make a lot of money when you’re right and keep yourself from losing a bunch when you’re wrong, you’ve got a good system.

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