Prechter's 6 Critical Money-Making Rules for Investors

Whether they know it or not, all successful investors follow six money-making rules. In this free report, financial analyst and EWI President Robert Prechter identifies each rule and describes what it takes to put it into action.

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Discover what it takes to succeed in the cut-throat business of trading

Why six? Because that's all you need, says famed financial analyst Robert Prechter.

Simply knowing Prechter's rules is a far cry from putting them into action. It's the how-to details you'll find inside this free 30-page report that make it truly extraordinary. You'll read dozens of Prechter's very own trading tips and personal investing experiences. He gives you the brutal truth about speculative investing and describes what it takes to succeed in the cut-throat business of trading.

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A Note to the Reader:
The following free report is an excerpt from Prechter's Perspective: Conversations with Bob Prechter, Legendary Market Theorist, edited by Peter Kendall.

What qualities do you feel contributed most to your success as an investor?

When I have been successful, it was due to discipline, which usually means taking decisive action immediately when called for. When I've lost money, it is because I did not do that.

Describe that discipline.

When I first began trading, I did what many others who start out in the markets do: I developed a list of trading rules. The list was created piecemeal, with each new rule garnered from books on trading. I would typically add a new one following the conclusion of an unsuccessful trade. I continually asked myself, what would I do differently next time to make sure this mistake would not recur? The resulting list of do's and don'ts ultimately comprised 16 statements. About six months after the completion of my carved-in-stone list of trading rules, I balled up the paper and threw it in the trash.

I'll bite. Why?

Well, after attempting to apply the "rules," I realized that I made not merely a mistake here and there in the list, but a fundamental error in compiling the list in the first place. The error was in taking aim at the last trade, as if the next trading situation would present a similar situation. When rules are situation-specific, you can't apply them generally. In fact, they lead to contradictions.

Like what?

O.K., here's an example of the kind of ironies that result. One of the most popular maxims is, "You can't go broke taking a profit." The brokers invented that one, which is one reason that new traders always hear it. This trading maxim appears to make wonderful sense, but only when viewed in the context of a recent trade with a specific outcome. When you have entered a trade at a good price, watched it go your way for a while, then watched it go against you and turn into a loss, the maxim is a pronouncement of divine wisdom. What you're really saying, however, is, "I should have sold when I had a small profit."

Now let's see what happens on the next trade. You enter a trade, and after just a few days of watching it go your way, you sell out, only to stare in amazement as it continues to go in the direction you had expected, racking up paper gains of several hundred percent. You ask a more experienced investor what your error was. He advises you sagely while peering over his glasses, "Remember this forever: Cut losses short; let your profits run." So you reach for your list of trading rules and write this new maxim, which means, of course, "I should not have sold when I had a small profit."

So now your trading rules #2 and #14 are in direct conflict. Is this an isolated incident? What about rule #3, which reads, "Stay cool; never let emotions rule your trading," and #8, which reads, "If a trade is obviously going against you, get out of the way before it turns into a disaster." Stripped of its fancy attire, #3 says "Don't panic," and #8 says "Go ahead and panic!" Such formulations are in the final analysis utterly useless. And believe me, this is the typical method used to generate lists of trading rules.

But there must be some steps you can advise for the average investor?

Well, my best advice to the average investor is stop being an average investor. You cannot survive as an average investor. The pros will beat the pants off of you, and the markets will, too, because what seems logical is exactly what will not happen. That is one of the first keys to understanding how not to lose money in markets. So step one is: stop being the average guy. Get a foundation. And the only way to do that is to start reading.

Can you just imagine deciding tomorrow, "I think I'm going to be a structural engineer, and I'm going to build a skyscraper. I'm going to go get some wood and some bricks and get going." You haven't read the first thing about it. You haven't studied it. People reach the ripe old age of 60, they've worked all their lives in a business that they know inside and out. They know a competitor couldn't walk in and take over from them without knowledge and work and study and experience. But they decide to put all their money into silver futures because they're sure they'll go up. They don't study the craft. They don't realize this is work. It takes effort and study. To do it right, to be a winner, you've got to understand how the markets work and what's going on. If you want to take risks, become an expert. Otherwise, put your money in areas that have as little risk as possible and forget about investing. Before you make that decision, understand what's involved. Making money in the market requires a good deal of education, like any craft or business. If you've got the time, the drive and the right psychological makeup, you can enter that elite realm of the truly successful trader or investor.

Assuming one decides to go for it, what does it take to be a successful investor?

Well, let's define "successful investor" as someone who can profit consistently through the exchange of speculative goods for ones of higher value without himself adding value (other than liquidity to the marketplace). Now you have to gather the necessary tools to do it.

How did you proceed in your own search for an investment philosophy?

What I finally desired to create was a description not of each of the trees but of the forest. After several years of trading I came up with -- guess what? -- another list! But this is not a list of "trading rules." It's a list of requirements for successful trading. Most worthwhile truths are simple, and this list contains only six items. In fact, most are actually subsets of the first one.

* * * * * * * * * * * * * * *

Commonly accepted Wall Street wisdom can provide plenty of reasons to buy and sell at any given time. But over the years, Robert Prechter was asked for investment guidelines over and above the Wave Principle. He developed six general rules.

The Elliott Wave Theorist

November 1986

What Every Trader Needs to be Successful

#1: A method. Any time you enter or exit a market, it must be for a predetermined reason that will also apply in the future.

#2: Discipline to follow the method. Without discipline, you really have no method in the first place.

#3: Experience. The School of Hard Knocks is the only school that will teach you the emotional aspects of investing, and the tuition is expensive.

#4: Acceptance of responsibility. Don't blame the news, "insiders," "floor traders," or "THEM" for your losses. Accept responsibility, and you will retain control of your ultimate success to the extent that the market allows.

#5: Accommodation of losses. The perfect trading system does not exist, so your method must deal with taking losses.

#6: Acceptance of huge gains. When the big winner finally comes along, you need the self-esteem and confidence in your method to take all that it promises.

* * * * * * * * * * * * * * *

What is the first requirement?

Get a method. I mean an objectively definable method -- one you've thought out in its entirety, so that if someone asks how you make your decisions, you can explain it. And if he asks you again in six months, the answer will be essentially the same. It must be developed as a totality before it is implemented.

It arrives full blown?

The point is that it must be in place before you start trading. It doesn't typically "arrive" though. While a method has to reflect market reality, which is difficult enough, it also has to suit the user's psychological makeup. To that extent, it must be built.

So you build your house and then live in it.

That's a good analogy. You can redecorate; in other words, alter and improve your method from time to time. You can even move to an entirely new house. But don't move in before the roof is on or all the walls are built. Above all, don't tear down the doorway because the piano didn't fit through it. Accepting the fact that you cannot achieve a perfect trading record is prerequisite for obtaining a reliable method. People who demand it are wasting their time searching for the Holy Grail. The number of people who waste time at it is amazing, and they never get beyond this first step of obtaining a method. They spend all their time designing and rebuilding, and never move into the house.

We don't need three guesses to figure out what your method is?

Not unless you tuned into this discussion right here. In my opinion, the Wave Principle is the best way to understand the framework of a market and where prices are within that framework. Choose the degree appropriate to your trade and buy and sell according to whether the best Elliott wave interpretation is bullish or bearish. And if the odds are too closely matched, stand aside.

There are a hundred other methods that will work if successful trading is your only goal. As I have often said, a simple ten-day moving average of the daily advances minus declines, one of the first indicators that many stock market technicians learn, can be used as a trading tool when objectively defined rules are created for its use. You don't even have to understand in detail how the market works to make money with a tool like that. All you need to know is one aspect of market behavior: that the market usually stays within certain bounds of persistence as it moves up and down.

What is the first thing you must do?

Sit down and admit, "I need reasons for making my decisions." Then spell out those reasons.

I'm not sure that would be so easy.

Obtaining a method comes down to one thing: creating parameters for making decisions for entering and exiting markets. There are two areas involved: opinion generation and money management. Money management tools are techniques to allocate and protect capital.

While this step is the easiest to apply among the requirements for successful investing, it can be a huge hurdle if you have not done all that reading I mentioned earlier. It is also time consuming. Most investors don't even bother with it. So they guarantee they will lose before their first position is taken.

How about requirement #2?

You need the discipline to follow your method. Among the true professionals, this requirement is so widely understood that it's almost a cliché. Nevertheless, it is such an important cliché that it cannot be sidestepped, ignored or excepted.

Any system with a decent track record will be profitable if you apply it rigorously and honestly. As I indicated before, using the ten-day advance/decline oscillator with reasonable parameters, you can make money seven times out of ten. But very few people have the discipline to do it. Discipline is much more difficult to obtain than a method.

More often than not, a well constructed system will work, but the investor doesn't?

Well, certainly a lot of work is required. But that's not the only aspect of the task. Lots of workaholics fail at trading. What you need is the guts to do what is right when it feels wrong. That takes immense courage and discipline. It struck me one day that among a handful of consistently successful professional options and futures traders of my acquaintance, three of them are former Marines. In fact, the only advisor, as ranked by Commodity Traders Consumer Report, consistently to beat my Telephone Hotline record from 1983 to 1985 was a former Marine.

The few, the proud?

The few, for sure! Among my acquaintances anyway, this is a ratio way out of proportion to the ratio of former Marines as a percentage of the general population. This anomaly implies to me that discipline is extremely important. At some point in their lives, these guys volunteered to serve in an organization which requires discipline and stamina. These are people who asked for the opportunity to go charging through a jungle pointing a bayonet and pitching grenades, surviving on roots and bugs when necessary. That's an overdramatization perhaps, but you get the point. These people knew they were "tough" and wanted the chance to prove it. Being "tough" in this context means having the ability to suppress a host of emotions in order to act in a manner which would cause most people to shrink back in fear.

But you don't seem like the Marine type.

No, I'm not. But years ago while attending summer school with Georgia's Governor's Honors Program, I was given a psychological test and told that one of my skewed traits was "tough-mindedness." I didn't exactly know what that meant, but after trading and forecasting the markets since 1972, it is clear that without that trait I would have been forced long ago to elect another profession. The pressures are enormous, and they get to everyone, including me. If you are not disciplined, forget the markets.

Can't anyone follow rules if he puts his mind to it?

A lot of people will tell you that they have that discipline, but when it comes to actually doing it, they don't. The markets aren't merely an intellectual exercise. They're an emotional one as well. By the time the emotions have eaten away at you for several months, it's even physical. Trading is incredibly difficult to do, and it's one reason I do not like trading.

The most important factor in the market strategy is learning to stand fast if your system tells you to do so, even when the news, your friends and the tape are screaming at you to do the opposite. Outside forces don't really affect the market and never have. People hear horrible things on the news -- the assassination of President Kennedy is a good example -- and they panic and sell. A crisis may influence where prices go that afternoon, but not overall. You have to learn to avoid that natural human reaction to what looks catastrophic or hopeful. Stick with your system; never second-guess it; always follow it.

You've made this point clear. It doesn't pay to play the news or follow your emotions. But aren't there times when traders can use the news to gauge how strong a trend is? Let's say the news is all bad and the market holds up or only goes down a little, can that be used to say that there is underlying strength in the market?

It's sometimes said, "Because the market is holding up in the face of bad news, that's bullish." That little chestnut is a false belief. It once cost me a pile of money in my more naive days, and I've never forgotten it.

When was that mistake made exactly?

The 1979 stock market rally ended after holding up "beautifully" day after day for a month despite terrible news, heartening many an investor. The situation resolved with the "October massacre." When searching for characteristics of a major market low or a continuation of an uptrend, pervasive bearish sentiment is more important than bad news per se.

The truth is that news is virtually irrelevant to explaining and forecasting market trends. I say "virtually," because there is a relationship in that social news lags market trends. There is some forecasting utility in that fact, but only if you have a trading method that recognizes degree, such as the Wave Principle or time cycles. Then certain types of news can be a confirming indicator. In fact, some of the best analysts I know use certain types of media reports as market indicators. Paul Montgomery and Ned Davis use magazine covers, for instance. When a national general news magazine finds a trend so exciting that it makes the cover, the trend is generally one to three months from ending.

News doesn't cause any market movement?

It sometimes appears to affect the market for a few minutes, maybe up to an hour. When it moves the market in the direction you expected, it is irrelevant. If it moves it in the other direction, you can use it to your advantage by quickly increasing your position. Otherwise, news is irrelevant to trends. Sometimes it appears to fit a day's trading so perfectly that everyone "knows" what the cause of the day's move was. Other times the market does the opposite of what everyone would have expected. This unreliability proves that news is not determining the trend. There is almost always enough news to make causal claims in retrospect, which is what media people do constantly. It's occasionally funny to hear a commentator say, "Well, the market is way up today, so investors must not be focusing on the dramatic shutdown of the U.S. government and the impasse between Congress and the president; they must be focusing on the PPI figures, which were unchanged from last month...." And when they can't find a reason in all the day's news for a movement in the market, then they say the move was "technical."

You've established that news and events are not behind market movement. But if you're able to predict at all, something must be causing the market to move the way you say it does. What is that causal agent?

The psychology of human interaction is the basic fundamental. The one thing that never changes is the dynamics of social psychology. I think it was Bernard Baruch who said that the stock market was nothing but everyone's combined hopes and fears about the future. I take it one giant step further and say that the market is the direct recording of the psychology that later creates the future.

Does discipline mean you should stick to one or two markets?

Not in my opinion. One of the most important characteristics of a successful commodity trader is the flexibility to go into any tradable market. If he is "married" to particular markets, he may find himself forcing a trade where none exists. The flexible trader can ignore 80% of the charts that are saying nothing and concentrate on the 20% that are calling for action. On the other hand, if one's method is market-specific to some degree, then specialization can add value.

* * * * * * * * * * * * * * *

Elliott Wave Principle

When the market rests, do the same.

* * * * * * * * * * * * * * *

What about requirement #3?

Get experience. I can't stress that enough. I don't care how much you read or how brilliant you are, you won't find out how easy it is to lose the market game until you trade with your own real money.

If you buy a computer baseball game and become a hitting expert with the joystick while sitting quietly alone on the floor of your living room, you may conclude that you are one talented baseball player. Now let the Mean Green Giant reach in, pick you up, and place you in the batter's box at the bottom of the ninth inning in the final game of the World Series with your team behind by one run, the third base coach flashing signals one after another, a fastball heading toward your face at 90 m.p.h., and 60 beer-soaked fans in the front row screaming, "Yer a bum! Yer a bum!" Guess what? You feel different! Suddenly you can't approach the task with the same cool detachment you displayed in your living room. This new situation is real, it matters, it is physical, it is dangerous, other people are watching, and you are being bombarded with stimuli. This is what your life is like when you are actually speculating. You know it is real, you know it matters, you must physically pick up the phone or click the mouse and place orders. You perform under the scrutiny of your broker or clients, your spouse and business acquaintances, and you must operate while thousands of conflicting messages are thrown at you from the financial media, the brokerage industry, analysts, the market itself, and your own inner demons. In short, trading real money successfully requires you to conquer a host of problems, most of which relate to your own inner strength in battling powerful forces and your emotional reaction to them.

Isn't requirement #3 just a reiteration or warning about #2?

Yes, this is a derivative rule, just as #2 is derivative of #1.

In essence, you're saying something is going to come into play to make following requirement #2 really hard.

Exactly. And to the extent that it ruins novices, it is worth listing separately. You must learn that if you get emotional over the market, you are immediately vulnerable. It is emotion that creates movement in the market. Of course, few people really want to admit that most of their decisions are emotionally based and emotionally driven rather than rationally based and rationally driven. There was a study that showed up in USA Today several years ago. They surveyed something like 200 average investors. They asked "How many of you read the annual reports before you bought your stocks?" I think they got a "yes" from three people. The rest did it on tips and reading the paper, which of course, is influence from other people. That's what it's all about: other people influencing your emotions and your decisions and, in turn, your decision influencing them until a trend is in force.

Emotions are always harmful?

Once you get emotional, your objectivity decreases dramatically. If it were not for that impediment, normally intelligent people would make money continually via trading. Obviously, that is not the case.

Beating the market requires a transcendence of emotional involvement. That is not to say you must deny your emotions. Quite the opposite. You must yank them out of your unconscious and view them in the cold light of reason. Then you can devise ways to deal with them.

And beat them. How is this accomplished?

The first step is to try to invert your emotions. Don't use a market rise as a reason to buy and a drop as a reason to sell. Take each move as a potential opportunity to do the opposite. That way, you're more attuned to buying low and selling high, which is the opposite of what everyone else does. Eventually it will become a habit. While this change will not solve the investment problem, it deters you from making the worst mistakes.

So when an investor is in the minority, he's often rewarded, both financially and psychologically.

An investor is, yes. He can be quite serene when everyone disagrees with him, and he's rewarded for his independence. But that doesn't go for professional market analysts. In fact, this could be the least rewarding profession imaginable in terms of psychic rewards.

How come?

When you are about to be proved right, by definition you are in the minority, so everyone shuns or ridicules you because they disagree with you. When you are about to be proved wrong, most people agree with you, so you get a burst of adulation; then you get blamed and condemned for having blown it. So most of the time, you are either ridiculed or wrong, not a great choice for people who like to be appreciated for their work.

Is it possible that the markets are evolving away from the rule of emotion? At some point, will trading be so highly computerized or so heavily hedged through derivatives trading that emotion will cease to be a significant force in the markets?

No way, ever. First, I expect most derivative stock market products to be outlawed sometime during or shortly following the next major bear market. For emotional reasons, of course. Second, and this also applies to the futures markets, a lot of computer programs have the emotional factors built in. Remember portfolio insurance? Its strategy was to sell more as the market declined, just like people in panic. Those programs participated with gusto in the 1987 crash. The same idea applies to all trading programs. To the same extent that the world of investors is divided into those who sell rallies and buy declines versus those who buy rallies and sell declines with "stop" strategies, this ratio will persist in the computer programs, which of course are designed by people. Entries and stops will all be triggered at points that the same people would presumably have chosen anyway. Even today, you can often predict "emotional" days by observing times when the market is about to break a 40-week moving average, which many computerized strategies employ as a trigger point. As new programmers try to anticipate such days by triggering action earlier or to scalp in the opposite direction, what will ultimately emerge is the same market action that would have existed otherwise.

Is there any way to ease into the experience? To take your method and discipline and put it to the test without risking your neck?

Before trading real money, satisfy yourself that your method works. Paper trading is useful for testing methodology. Some people advocate it as a learning tool, but it is of no value in learning about speculating with real money. Paper trading omits the emotional factor, which is precisely the obstacle that one must overcome to be successful. In fact, it can be detrimental by imbuing the novice with a false sense of security. He may know that he has successfully paper-traded the past six months, thus believing that the next six months with real money will be no different. In fact, nothing could be further from the truth.

Has any specific trading experience decreased your trading success?

Yes. My first trade in 1973 was wildly successful, and I was hardly wrong in my first six years at it. Then I had a big trading loss in 1979, and that taught me more than the wins. The best way to develop an optimal state of mind for trading is to fail a few times first and understand why it happened. When you start, you're better off speculating with small amounts of real money. Using large amounts of money will bankrupt you early, which, while an excellent lesson, is rather painful. If you want to be a trader, it is good to start young. Then when you lose your first two bundles, you can gain some wisdom and rebound.

It sounds painful. Is there any way at least to reduce the hard knocks?

There is one shortcut to obtaining experience, and that is to find a mentor.

Did you have a mentor?

In 1979, I sat with a professional trader for about a year. The most important thing he taught me was to keep trades small relative to your capital. It reduces the emotional factor.

How would one select a mentor?

The best way to select one is to find a person who is doing exactly what you would like to do for a living, then get to know him well enough to ask if he will tutor you or at least let you watch while he works. Locate someone who has proved himself over the years to be a successful trader or investor, and go visit him. Listen to him. Sit down with him, if possible, for six months. Watch what he does. More important, watch what he doesn't do. Finding a guy who knows what he is doing is the best lesson you could ever have. You will undoubtedly find that he is very friendly as well, since his runaway ego of yesteryear, which undoubtedly got him involved in the markets in the first place, has long since been humbled, matured by the experience of trading. He will usually welcome the opportunity to tell you what he knows.

Requirement #4?

Accept responsibility. There are many evasions of responsibility that automatically disqualify millions of people from joining the ranks of successful speculators. For instance, to moan that "pools," "manipulators," "insiders," "they," "the big boys," "program trading" or Fed chairmen are to blame for one's losses is a common fault. Anyone who utters such a conviction is doomed before he starts. He has philosophically conceded that the market is random or "fixed." If he believes that, then there is no case to be made for trying to make money at it. Take every gain and loss as your due, and you will retain control of your ultimate success to the extent that the market will allow.

Requirement #5?

You need the mental fortitude to accept the fact that losses are part of the game. My observation, after twenty years in the business, is that most people's biggest obstacle to successful speculation is a failure even to recognize and accept this simple fact. Expecting, or hoping for, perfection is a guarantee of failure. Speculation is akin to developing a batting average in baseball. It will never be 1.000, but the higher it is, the better you are. A player hitting .300 is good. A player hitting .400 is great. But even the great player fails to hit successfully 60% of the time! He strikes out often. But he still earns a seven-figure salary because, although not perfect, he has approached the best that can be achieved. You don't have to be perfect to win in the markets, either; you "merely" have to be better than almost everybody else, and that's hard enough. The amazing thing is that people accept this idea with respect to baseball without a second thought, but they don't accept it in investing. When they lose, they immediately question their ability or the value of their method or advisor, even though they may have a great percentage of success overall.

* * * * * * * * * * * * * * *

The Elliott Wave Theorist

January 7, 1985

Take responsibility for your own successes and failures in trading.
It still makes me ill to read whining complaints. "Some game!" says one
writer. "The big players bet on a sure thing and all the other investors are
left to hold the bag." "A sure thing?" Give me a break. The market is very
tough, but it isn't rigged. Don't sing the "loser's lament." Learn the craft,
and you'll use all the market's noise to your advantage.

* * * * * * * * * * * * * * *

Are there specific techniques you use for coping with losses?

The coping part should come before the loss. If you take a position large enough to inflict serious financial damage upon yourself, you are a loser going out of the gate. You should determine an appropriate amount of risk in advance. It is important to be honest with yourself. Most people cope with losses by lying to others and sometimes even to themselves. If you can't be honest, you're probably not handling losses well.

Is this where money management comes in -- handling the losing trades?

Yes. Practically speaking, you must include an objective money management system when formulating your trading method in the first place. There are many ways to do it. Some methods use stops. I prefer using analysis to change opinion. Leverage is also crucial to manage. You need to decide how much of your funds to place at risk. Most people commit too much each time to futures or options and eventually get killed. After all is said and done, learning to take and handle losses will be your greatest triumph.

What about accepting gains, requirement #6? This doesn't sound like a problem. Besides, you've got a nice round Fibonacci number of rules without it.

You've got a point! And when I advocate having the mental fortitude to accept huge gains, the comment usually gets a hearty laugh. Which merely goes to show how little most people have determined it actually to be a problem. But to win the game, you have to understand why you are in it. I have seen this problem stymie lifelong traders, guys who have gained or lost one point for a living for so long that they cannot make the big money when it comes, even when they say they know what is happening. The big moves in markets only come once or twice a year. Those are the ones that will pay you for all the work, fear, sweat and aggravation of the previous 11 months or even 11 years. Don't miss them for reasons other than those required by your objectively defined method. Stay with a position during those rare times when it is hugely successful. Most people can't do it. Even though their method is telling them don't sell yet, they can't stand it. If they get double their usual profit, they get out, and they're thankful.

O.K., so once again, this is a derivative of requirement #1. But what's wrong with a 100% return?

What's wrong with it is that it may not make up for all your 15% losses. Let me give you an example of what can happen when you focus on how much money you're making instead of how it is you make it. Let's say for a full year, you trade futures contracts, making $1000 here, losing $1500 there, making $3000 here and losing $2000 there. Once again, you enter a trade because your method told you to do so. Within a week, you're up $4000. Your friend/partner/acquaintance/broker/advisor calls you and, looking out only for your welfare, tells you to take your profit. You have guts, though, and you wait. The following week, your position is up $8000, the best gain you have ever experienced. "Get out!" says your friend. You sweat, still hoping for further gains. The next Monday, your contract opens limit against you. Your friend calls and says, "I told you so. You got greedy. But hey, you're still way up on the trade. Get out tomorrow." The next day, on the opening, you exit the trade, taking a $5000 profit. It's your biggest profit of the year, and you click your heels, smiling gratefully, proud of yourself. Then, day after day for the next six months, you watch the market continue to go in the direction of your original trade. You try to find another entry point and continue to miss. At the end of six months, your method finally, quietly, calmly says, "Get out." You check the figures and realize that your initial entry, if held, would have netted $450,000. You gave up on a trade that was going to deliver 4,000%.

So what was your problem? Simply that you had allowed yourself unconsciously to define your "normal" range of profit and loss. You looked at a job requiring the services of a Paul Bunyan and decided that you were just a Wee Willie Winkie. Who were you to shoot for such huge gains? Why should you deserve more than your best trade of the year? You then abandoned both method and discipline. In other words, it comes down to a question of self-esteem and personal limits. But perhaps more often, it is simply that you have substituted an unconscious, undisciplined observation -- that the market had some kind of permanent "normal range" of fluctuation -- and then superseded your method with that false idea. This is requirement #1 again, but it is such a common method of failing that I include it explicitly.

Some people, probably even a lot of people, are simply unable to accept the fact that they can earn a windfall just sitting around watching a monitor and guessing that a line on the screen is headed up instead of down.

But it's not a windfall. That's my point. There's no easy money on Wall Street. You earned it. By taking all those losses correctly and with the required discipline, you earned the big trade.

Doesn't the IRS categorize capital gains as "unearned income"?

Yes, but that's baloney. It's hard to make money in the market. You deserve your losses, don't you? Well, you richly deserve every dime you can make, too. Don't ever forget that.

What is the biggest mistake experienced futures traders make?

They're either too scared or not scared enough.

* * * * * * * * * * * * * * *

The Elliott Wave Theorist

December 9, 1979

"Trading consists of long hours of boredom punctuated by moments of sheer panic." -- Richard A. Trader.

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What percentage of success in the markets is a direct result of a good forecasting method as opposed to money management?

In one sense, it's 50/50. That is to say, you need each to be successful, in equal measure. However, a good system is far easier to come by. It is the conquest of human nature that separates the winners from the losers. Psychologically speaking, then, money management skills are 100% responsible for an investor's success.

Do you feel that close contact with the markets is necessary for success?

If you're not close to the markets, you'll lose money. If you're too close to the markets, you'll lose money twice as fast. You should be just as close to the markets as you need to be in order to monitor and protect your investments.

How often do you personally trade?

It all depends. When it comes to proving a point, like what I wanted do with the U.S. Trading Championship, I was trading pretty fiendishly. I made almost 200 trades in four months.

What was the point you were trying to prove?

I did it to advance the publicity for Elliott. But winning actually served a better purpose. If anyone declares Elliott's theories worthless, the burden of proof will be on him, not me.

What percentage of time is the Principle right for you?

The principle, I think, is operating all the time. But I'm not right all the time. I've made plenty of mistakes. As a matter of fact, one of the reasons, I think, I did well in the contest is that I took a lot of losses. That may sound counterproductive, but it's the people who emotionally can't bring themselves to take losses that always lose money. So I took losses all the time. As a matter of fact, about 50% of the trades that I made were losers. I've heard some of the best traders in the world make profits on only 10% or 15% of their trades. I think that's a good key, being able psychologically to call your broker and say, "I was a dummy, I was wrong, I blew it, get me out of my position."

Do you get out right away when you find something going wrong? I mean, the minute?

The minute I decide I'm on the wrong side of a market, for real technical, objective reasons, I get out. Sometimes it's at a profit. If you're really good at your entry, sometimes the market can go your way for a couple of days, turn around, and do something that you didn't expect. You immediately call and you find out, "Hey, I wasn't hurt after all." Other times you take a bath. With lye soap and pumice.

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The Elliott Wave Theorist

December 1983

If you do not take action when the opportunity presents itself, your next decision will always be an agonizing one.

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How did you generate your trading signals in the trading championship?

Most of the decisions were made watching the fluctuations in the hourly chart of the Dow Jones Industrial Average and buying or selling puts and calls on index options. A secondary consideration was where some short term momentum oscillators were on a short term basis. A third consideration was where the time cycles were, though that always deferred to the condition of the momentum oscillators.

So you looked for situations where these factors indicated opportunities?

Mostly, I was looking for points at which the wave structure said that a change in trend was imminent. Most of that period, February through May of 1984, was a choppy market with a downside bias, not a one-way trend, so it was tough. But it serves the purpose of precluding anyone saying it was just a lucky guess on the trend. The market overall lost ground during that period, so when I saw five waves down, which I did from time to time, I would expect a three wave rally. I would play for that, selling the top of the C wave and looking for a decline, and so forth.

Did you find ways to leverage your Elliott wave insights?

I'd say 90% of the trades I made were in OEX options. So I was trading the indexes, which is really the best basis on which to make money using Elliott.

Did you nail a couple big moves or catch a lot of smaller ones?

A lot of short term trades. No big hit or a lucky move. I think that's the way to trade options. If you go for the big hit, you usually get hit.

And were you mostly just buying and selling calls?

I was mostly buying and selling puts, because wave 2 was in force, and I knew it.

What type of options were you trading -- at-the-money, out-of-the-money or in-the-money?

Mostly in-the-money.

No liquidity problems?

I had to manage my money very strenuously because I started with a small amount of money, a little over $5000. The whole point was to show that you could start with a small amount of money and turn it into something. So the lack of liquidity was very important factor, yes. It added to the pressure. I quadrupled my money from February 1 through May 31. Of course, with all those trades, I paid the broker an equal additional amount in commissions.

It must have been fun for both of you.

Frankly, it was awful. I didn't find the experience pleasant at all. It was very time consuming and emotionally draining. I had other difficulties to contend with. One of the oldest adages that traders will tell you is, don't trade when you have personal problems or when you're dealing with something important in your personal life, and I thought, "I'm stronger than this, I can handle it." Which I did, but I couldn't have continued.

Did the personal problems affect your trading?

After the first month of the contest I was up 380% in options. I thought, "This is great, if I can just keep this going, I'll reach 1000%." Right after the first month, there were extreme complications. My wife was ordered to lie flat on her back with our second child, or she would deliver prematurely. She was not allowed to get up even to eat. So I was taking care of her and our two-year-old daughter at the same time as trading. They're both in the house, I'm trying to run a business, and I'm trying to trade this account all at the same time. I'm running up and down the stairs taking care of our young daughter who regressed at the time because she thought her mother was dying. The account fell to a gain of 190% as I lost money for two months.

Talk about contractions. Then what?

One night, the phone rang. It was the doctor. He was speaking to my wife. He said, "You know you could stay on medication for another couple of weeks, but the baby is big enough now, you can come off it whenever you want." I hollered from the other end of the room because I could tell what my wife was saying on the phone. I said, "You just took the last pill." And sure enough, 48 hours later, our son was born, and the last month of the contest, I traded great and finished up 444%.

Would you want to do that again?

It's something I wouldn't want to do for a living. But I think that I could do it for a living if I had to. As long as I scheduled time off every quarter!

What did dealing with those kinds of pressures teach you about trading?

That the essence of trading is to be disciplined enough to fight your emotional human nature. Of course, the stock market movement and the Wave Principle are a direct reflection of natural human behavior. In other words, to be on the correct side of the trend, you must act in a way opposite to what your emotions usually tell you to do in the market. You have to be a decoding machine interpreting your indicators. To fight your emotions is very tough. I recall one afternoon when I had to go upstairs and lie down to avoid making the wrong move. My indicators were bearish and the market was rallying hour after hour. I was about to cave, and probably would have if I had stayed in front of the TV. I was in the fetal position for an hour, then came down to look at how they'd closed. Turns out, I got away from the market within about thirty minutes from the high. The really successful traders of the world have learned how to stay there in front of the screen and not flinch.

What type of investor do you feel stock index options or futures are suitable for?

If you're a hot-shot speculator and you know what you're doing, then I think stock index futures and options are ideal vehicles to be using with the Wave Principle. However, there are pitfalls outside Elliott that make these instruments difficult to use, such as the extreme leverage involved and the desperate need for a disciplined money management approach.

So you recommend trading index options?

I would never recommend options to anybody. Sometimes people will write or call and say, "What options do you recommend?" We say we don't recommend them at all. We'd be happy to give you a short term market opinion, but what you do with that is entirely up to you.

Would you advise a typical investor to stay away from highly leveraged investments?

If there is such a thing as a typical investor, he should unquestionably stay away from those vehicles, because they can separate him from his money in a flash. They provide great opportunities for true professionals, people who wish to make a living trading. If you learn how the market operates, you can have a good record of success in calling even the shortest term bottoms and tops. With reasonable stops to contain errors, you can make money with futures and options. But you must dedicate yourself to it and do it full time, as you would any other business where you expect to be successful.

Don't options sometimes fail to move with the market?

Yes. Out-of-the-money options do not necessarily move when the market goes your way. So you're betting on a whole bunch of additional factors when you play out-of-the-money options.

Don't most little guys buy out-of-the-money options?

Joe Granville used to say that he could tell the option traders because their hands would shake when they asked him what the market was going to do tomorrow. In that regard, I was willing to bet that the subscriber who called up and chewed out one of my secretaries because the Telephone Update message was twenty minutes late was an owner of out-of-the-money options. Out-of-the-money options make you angry. They make you angry because if you're wrong on the market's trend, you lose money, and 9 times out of 10, if you were right, you lose money. What's worse, you usually lose 100% of it! Like gambling, these vehicles offer the prospect of a huge return but only at tremendous odds. I've heard all sorts of excuses, but the bottom line is that if your option expires worthless, you weren't right, even if the stock or index upon which you bought your call is 5% higher. If the underlying stock or index doesn't cross the strike price by a sufficient margin by the expiration date, your decision to buy was wrong.

So you would never touch them?

Not precisely. Out-of-the-money options can be huge money-makers about once a year. If you can buy them just before the onset of a powerful third wave -- not four weeks early -- and then sell them right at the end of that third wave at maximum momentum -- not four weeks late -- you reap huge rewards. But playing them as a matter of continuing preference is a road to disaster.

What about at-the-moneys?

For the short term trader, the only options to play are at-the-money because that's where the liquidity is. For the position trader, the worst options to play are at-the-money. You're paying complete premium for something that isn't worth anything.

So the best way for a position trader is...?

The safest and the most productive way to play options is to trade deep in-the-money options. They are worth what you're paying for them. They are forced to move if the market goes in the direction you expect. If you speculate with deep in-the-money options, which carry almost no premium, you will win every time you're right on market direction, lose much less when you're wrong, and lose almost nothing when you're right but early. If you're caught in the out-of-the-money option rut, just think about the mathematics, and you'll see why you keep watching them expire worthless. The time to change your tactics is now.

Can you limit your losses on options, say, to 10%?

Impossible. If you can't accommodate big percentage losses, you can't trade options. Sometimes an option can make or lose 50% in an hour. That's why you need defensive money management techniques other than stop-loss.

Should you weight your trades?

Yes. If you have three or four technical analytical indicators all calling for the same direction, you should make a heavier commitment.

Which atmosphere do you like to trade in more, a bull or a bear?

I prefer bear markets, for reasons I mentioned in At the Crest of the Tidal Wave. Bear markets are faster, so you get more action to trade around. Bull markets can be excruciatingly boring at times. Being on the right side of a bear market also brings satisfaction in knowing that only a small minority is capable of handling a downtrend successfully. It's professionally fulfilling to make money while the majority makes excuses and wonders when the trend will reverse to its "natural" direction.

Aren't bear markets also more dangerous?

The January 1987 issue of Futures magazine made a reference to turnstiles at the CBOT:

Aisles in the CBOT Treasury bond pit were becoming jammed by two-way traffic, so the CBOT copied a CBOE idea by putting in turnstiles -- two to enter the pit and one to get out.

So the physical reality at the pit represents the market reality. It's always easy to get in. As for getting out, you can exit early, like a gentleman, but if you wait until everybody wants out...well, that's why bear markets move faster. But that really doesn't mean they are more dangerous. Being on the wrong side of a bull market can be worse. The losses are potentially bigger, and they move slower, keeping your hopes up until your capital is eaten away.

Let's look closer at your method, which is first of all a technical approach.
How do you sort out all the indicators that are out there? How do you decide which ones you should listen to and which ones you should ignore?

I like to use indicators that help me anticipate. I don't like indicators that make me wait until after the turn has occurred, so I've spent all of my time looking at anticipatory indicators. If I get into the common situation where there are two or sometimes three valid interpretations under the Wave Principle, I use the indicators to help me decide which is more likely. But if an indicator fails me in a big way, I throw it away. An indicator that gives a completely false signal should be discarded.

So which ones have you settled on?

I don't like stochastics or other price velocity indicators that have ceilings. Unrestricted momentum indicators -- percent rates of change, for instance -- are better. Take the current day's price and compute its percentage difference from its price X time units ago, and do that over a broad time spectrum. Moving averages give signals far too late, as far as I'm concerned. Your goal as a trader should be to buy weakness and sell strength. While top and bottom pickers who don't have a method get destroyed, trend followers by design buy strength and sell weakness, which is a big strike against their potential profit and loss. What's more, every computer jock on the planet uses stochastics and a moving average system, so you're often buying and selling with the crowd, at least on a short term basis. You need to use indicators that allow you to buy or sell ahead of the moving average contingent.

What about volume? Does it give you any clues as to where you are in the wave structure?

Other than price, volume is one of the most important things to watch. Generally, increasing volume on a fifth wave means that the wave will extend. Light volume in a supposed third wave means it's not a third wave. Both of these situations present invaluable information. Remember, it's happening at all degrees, so there is a lot of information to assess.

How do you weight various indicators?

The winningest formula is: (1) The Wave Principle, applied thoroughly and with discipline to price and volume activity; (2) percent rate-of-change indicators of varying lengths, from hours to years, to help confirm the wave status of the market and confirm trend change indications by divergence; (3) a few tried and true sentiment indicators.

Do your indicators as a whole affect the way you view any given indicator? Or does a certain ratio of bulls to bears or a certain divergence from a moving average always mean the same thing?

Many indicators have suffered tremendously because people treat them as absolutes instead of relating them to the rest of the market environment. It is never their levels that matter; it is their relationships to recent behavior. A momentum divergence, for instance, i.e., a lower high in a momentum indicator against a higher high in the market, is more important than the level of the oscillators.

When the markets are moving against you, what changes your mind?

I don't change my opinions based on how much the market goes up or down. If it goes up, it doesn't turn me bullish. If it goes down, it doesn't turn me bearish. Usually it's the other way around. The higher the market goes, the more negative your indicators get.

In late 1986, gold stocks started up; we had a terrific run-up, more than I thought. But at the beginning I said, "There's going to be a nice rally, but it'll be a bear market rally." Gold got up to something like $390 an ounce, and I said it looked bearish. Well, gold pushed quite a bit further than that, reaching $500 months later. But the technical figures just continued to deteriorate to the point that they were signaling a top of major significance. So it's rare that if a market goes another ten bucks, I would say, well, now I have to turn bullish. Still, there are Elliott wave patterns that require the market to stop before reaching a certain level, which, if breached, means you have to abandon your previous opinion. Sometimes that means reversing it.

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MTA Journal

Summer-Fall 1994

Fundamental analysts rarely appreciate the fact that they must incorporate technical thinking at some point for their analysis to have any validity. Sadly, many technicians don't know it, either. You must always, always think technically.

Let me give you some examples of what I mean.

Suppose you make a good call on the market, a sector, a group or a stock, and your clients tell you they are too afraid to follow it. The market goes your way and seven or eight weeks later you get a call congratulating you on your work. You might just say thanks and hang up the phone and be very self satisfied. Or, you might understand that the phone call has a technical meaning. If you get three more calls that day, you may want to take a good look at your indicators.

Similarly, if you are ever so fortunate and simultaneously unfortunate as to be granted a certain measure of fame...or will find that publicly distributed attacks against you for all sorts of real and imagined sins are excellent market indicators, and the more vicious and inaccurate they are, the better they are as indicators. The same is true of widespread praise. In other words, instead of taking such things at face value, see if they are a comment on the prevailing psychology.

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What do you think of other methods of analysis that come out from time to time?

I look at them all when they come out. Almost every one is some variation, usually very minor, on a momentum indicator. You only need two or three types, and you only need the simplest construction. Advance-decline oscillators and rates of change on the broad market are all I feel I need.

If you want to use an exponential moving average, that's O.K. If you want to have a fancy combination of volume and advance-decline numbers and 60 other things, that's O.K., too. But when you plot them on a chart, they behave in exactly the same way as the simple ones. They give you signals for the same reason -- either divergence or extreme readings. So the fact that people can formulate a few new twists on the same old theme and sell them on a disk for $3000 apiece has always been a source of amazement to me.

Do hourly, daily and weekly charts work differently in different markets?

No. The market is fractal, so they all behave the same way. Of course, one degree of trend can be sideways while the other is trending. One of the most interesting comments in R.N. Elliott's Market Letters is his comment, "In fast markets, the daily range is essential, and the hourly useful...On the contrary, when the daily range becomes obscure due to slow speed and long duration of waves, condensation into weekly range clarifies." In other words, keep them all and trade with the clear one.

If hourly charts are sometimes useful in ways that daily or monthly charts are not, wouldn't intra-hour, say 10-minute pricing charts on the DJIA, sometimes give you an advantage in short term trading?

Sometimes. But more important, you should use what fits your style. Personally, my entries in options were better if I decided that sometime in the next forty-five minutes or hour and a half, we were going to complete a five-wave sequence and then used any further trend intra-hour to take positions. If I put my bids under the market at that time, I usually come out much better than waiting to count every last tiny little tick. This is particularly true with options. Usually by the fifth of the fifth of the fifth, the professional traders can smell the turn. They can feel momentum waning already. It's too late. The option you wanted to buy at 2¹⁄₈ is already 2³⁄₈, 2½. You want to be there at the bid, saying, "I'll buy some at 2¼, I'll buy some at 2¹⁄₈, and I'll buy some at 2." I prefer to be there anticipating the low, buying what is coming in for sale. Once the market turns, it's too late. With futures you can sometimes buy them at a discount or sell them at a premium, which often occur right at turns.

What are the characteristics of a good technician?

One of the best that I know is Arthur Merrill. Arthur's most intriguing characteristic is his combination of open-mindedness and close-mindedness. He is open-minded in being willing to explore any idea that could be construed as reasonable, yet close-minded with regard to the fact that he requires statistical proof before relying on anyone's assumptions about the effectiveness of an indicator. Through the years, he validated numerous indicators while rejecting, for instance, the utility for stock market timing of the occurrence of full moons -- a darling of the astro-economists--and also the forecasting value of earnings -- a darling of fundamentalists. He also wrote a concise exposition of the Wave Principle as an appendix to his Behavior of Prices On Wall Street book.

What did Robert Farrell, who hired you at Merrill Lynch when you were first starting, teach you?

Patience, among other things. It wasn't just market-oriented patience, but professional patience in general. Letting things have time to take their course. And, really, this goes back to the philosophy of the Wave Principle itself: You've got to let trends develop to their fullest extent in their own time. What you can do is recognize the pace and adapt to it, and that brings a lot of peace of mind.

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Robert Prechter

Robert R. Prechter Founder and President, Elliott Wave International

Robert R. Prechter’s name is familiar to market observers the world over. Since founding EWI in 1979, Prechter has focused on applying and enhancing the Wave Principle, R.N. Elliott’s fractal model of financial pricing. Prechter shares his market insights in The Elliott Wave Theorist, one of the longest-running financial publications in existence today. Prechter has developed a theory of social causality called socionomics, whose main hypothesis is endogenously regulated waves of social mood prompt social actions. In other words, events don’t shape moods; moods shape events. Prechter has authored and edited several academic papers. He has written 18 books on finance and socionomics, including a New York Times bestseller.