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. Hereís an excerpt from one of his most popular titles, Prechterís 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 ďpaintedĒ with their own impulsive or imprecise ďinterpretations.Ē

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. Websterís defines a craft as a ďskill acquired by experience or study;Ē a ďsystematic use of knowledge.Ē

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.

Youíve 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 youíve 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, youíve 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. Thatís frankly a very small group. I think everybody will find the idea of the Wave Principle fascinating. People who arenít 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 canít 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.

Itís deceptive ó 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 ďstand asideĒ posture. In the latter case, sooner or later the scales always tip in favor of one particular conclusion.

Once youíre over the fact that youíre 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. Letís 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 youíre 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 isnít doing what it should for your opinion to be correct, you must change your mind ó 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. Youíre 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 ó 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 wonít allow you to justify riding a losing position like that. Of course, you can fight or rationalize the message of the market. Iíve done it. But thatís a personal problem, not an Elliott problem. As Elliott once said in a letter to Collins, ďThe application of rules requires considerable practice and a tranquil mind.Ē

Do you use stops?

Iíve used stops in almost every issue of The Elliott Wave Theorist Iíve 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. Thereís rarely been any loss as a result. And thatís a big plus, because if you can make a lot of money when youíre right and keep yourself from losing a bunch when youíre wrong, youíve 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 didnít. You canít successfully use a fixed percentage to take a loss. All stop-loss decisions must be objective, that is, based on a reason to say ďIím wrong.Ē Letís suppose Iím 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 Iím wrong, or itís an opportunity to buy another put cheaper. If all the evidence is still saying Iím right, Iíll buy another put. That way, Iím using the Wave Principle properly. The decision is not arbitrary. Letís 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 Iím wrong, thatís when I get out, right then and there. So I use the market itself to tell me when Iím wrong. Thatís my stop. Any other type of stop is arbitrary.

Whatís wrong with saying before you get in, if this loses 10%, Iím 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, ďIím not going to lose more than 10%, thatís it?Ē

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 canít 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 youíre 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 youíre still right ó the trend is going to turn in this particular direction ó then you may want to add to your position.

Letís 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 ó in other words, paying brokers and market makers to do their job. All those transaction costs come out of peopleís accounts. Theyíre paying to keep the machine oiled, which means that everybody canít beat the averages.

Youíre 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 youíve 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 donít 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.

Youíve 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 ďIím just going to hold these until this giant cycle is over,Ē Iíd say thatís 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 donít 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. Itís very difficult, for instance, to make money on the long side in bear market rallies. If youíve 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 canít 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 donít get hurt too badly. Unless youíre 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. Thatís more subtle than what most market observers would argue. Most say that trading is buying and selling and investing is buying and holding. Youíve always made your views on the buy and hold approach quite clear ó whether we acknowledge it or not, weíre 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 ďtrading,Ē while speculating on the major trends is called ďinvesting.Ē There is no other difference. Thatís 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 heís worried, he has made a market timing decision. If he doesnít sell, he has retained his opinion. But he still has one. Investorsí actions require a timing of entry, whether the timing is approached emotionally or rationally. Sometimes peopleís 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.