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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.
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 didn’t. You
can’t successfully use a fixed percentage to take a loss. All
stop-loss decisions must be objective, that is, based on a reason to
say “I’m wrong.” Let’s suppose I’m 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 I’m wrong, or it’s
an opportunity to buy another put cheaper. If all the evidence is
still saying I’m right, I’ll buy another put. That way, I’m
using the Wave Principle properly. The decision is not arbitrary.
Let’s 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 I’m wrong,
that’s when I get out, right then and there. So I use the market
itself to tell me when I’m wrong. That’s my stop. Any other type
of stop is arbitrary.
What’s
wrong with saying before you get in, if this loses 10%, I’m 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, “I’m not going to lose more than 10%, that’s 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 can’t 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 you’re 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 you’re
still right — the trend is going to turn in this particular
direction — then you may want to add to your position.
Let’s
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 people’s accounts. They’re
paying to keep the machine oiled, which means that everybody can’t
beat the averages.
You’re
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 you’ve 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 don’t 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.
You’ve
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
“I’m just going to hold these until this giant cycle is over,”
I’d say that’s 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 short-term floor traders who try to
trade off of that. Of course, they don’t 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. It’s
very difficult, for instance, to make money on the long side in bear
market rallies. If you’ve 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 can’t 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 don’t get hurt too badly. Unless you’re 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. That’s more subtle
than what most market observers would argue. Most say that trading is
buying and selling and investing is buying and holding. You’ve always
made your views on the buy and hold approach quite clear — whether we
acknowledge it or not, we’re 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. That’s 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
he’s worried, he has made a market timing decision. If he doesn’t
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 people’s 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.
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