Friday, October 20, 2006

Elliott Wave Trading

What a Trader Really Needs to be Successful - By Robert Prechter

Ever since winning the United States Trading Championship in 1984, subscribers have asked for a list of tips on trading, or even a play-by-play of the approximately 200 short term trades I made while following hourly market data over a four month period. Neither of these would do anyone any good. What successful trading requires is both more and less than most people think. In watching the reports of each new Championship over the past three years, it has been a joy to see what a large percentage of the top winners have been Elliott Wave Theorist subscribers and consultation clients. (In fact, in the latest 'standings' report from the USTC, of the top three profit producers in each of four categories, half are EWT subscribers!) However, while good traders may want the input from EWT, not all EWT subscribers are good traders. Obviously the winners know something the losers don't. What is it? What are th! e guidelines you really need to meet in order to trade the markets successfully?

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 added, usually, following the conclusion of an unsuccessful trade. I continually asked myself, what would I do differently next time to make sure that this mistake would not recur? The resulting list of 'do's' and 'don'ts' ultimately comprised about 16 statements. Approximately six months following the completion of my carved-in-stone list of trading rules, I balled up the paper and threw it in the trash.

What was the problem with my list, a list typical of so many novices who think they are learning something? After several months of attempting to apply the 'rules,' it became clear 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 each time, as if the next trading situation would present a similar problem. By the time 16 rules are created, all situations are covered and the trader is back to square one.

Let me give you an example of the ironies that result from the typical method of generating a list of trading rules. One of the most popular trading maxims is, 'You can't go broke taking a profit.' (The brokers invented that one, of course, which is one reason that new traders always hear of 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 sounds like a prounouncement of divine wisdom. What you are really saying, however, is that in the context of the last trade, '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 trader what your error was, and he advises you sagely while peering over his glasses, 'Remember this forever: Cut losses short; let profits run.' So you reach for your list of trading rules and write this maxim, which means only, of course, 'I should NOT have sold when I had a small profit.'

So 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 their fancy attire, #3 says, 'Don't panic during trading,' and #8 says, 'Go ahead and panic!' Such formulations are, in the final analysis, utterly useless.

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 five items. (In fact, the last two are actually subsets of the first two.) Whether this list is true or complete is arguable, but in forcing myself to express my conclusions, it has helped me understand the true dimensions of the problem, and thus provided a better way of solving it. Like most rewards life offers, market profits are not as easy to come by as the novice believes. 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 professional, or at least successful, trade! r or investor. Here's what you need:

1) A method. I mean an objectively definable method. One that is thought out in its entirety to the extent that if someone asks you how you make your decisions, you can explain it to him, and if he asks you again in six months, he will receive the same answer. This is not to say that a method cannot be altered or improved; it must, however, be developed as a totality before it is implemented. A prerequisite for obtaining a method is acceptance of the fact that perfection is not achievable. People who demand it are wasting their time searching for the Holy Grail, and they will never get beyond this first step of obtaining a method. I chose to use, for my decision making, an approach which was explained in our book, Elliott Wave Principle – Key To Market Behavior. I think the Wave Principle is the best way to understand the framework of a market and where prices are within that framework. There are a hundred other methods, which will work if su! ccessful trading is your only goal. As I have often said, a simple 10-day moving average of the daily advance-decline net, probably the first indicator a stock market technician learns, can be used as a trading tool, if objectively defined rules are created for its use. The bad news is that as difficult and time consuming as this first major requirement can be, it is the easiest one to fulfill.

(Stay tuned for more of Bob Prechter's trading tips in the upcoming issues of the A.M. Trader. You can also read Bob's latest thoughts about the markets right now in his Elliott Wave Theorist.)

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