Elliott wave analysis appeals to the instincts and to the intellect, but sometimes it's difficult to see how to trade using Elliott waves. The beauty is that the practical application is within anyone's reach. In today's Market Perspective, we'll see how Bob Prechter explains the Wave Principle and its application. (This excerpt is taken from the latest edition of Prechter's Perspective, published 2004.)
Editor's note: If you would like some help from market forecasting based on wave analysis when you trade, please see the information about our Specialty Services at the end of this Q&A.
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You've said that the Wave Principle is relatively easy to understand. How about application?
Bob Prechter: The basic idea is easy to understand. The intricacies can take a fair amount of time to learn. 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, 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?
Bob Prechter: 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 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.
Bob Prechter: Well, the rules of chess are simple, but winning the game is not so easy.
So the essence of the task is to order the probabilities correctly. How is this accomplished on an ongoing basis?
Bob Prechter: 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. 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 to be 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.
Bob Prechter: 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.
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