Have you been in a situation where you’ve put in weeks and months of effort to study a trading strategy, only to find out in the end that it simply doesn’t work? The disappointment can be so intense, that it can make many people quit the markets altogether. That’s a shame, because the financial markets are probably the biggest wealth creator known to man and successful methods to navigate them do exist. The one which has earned our trust over the years is called the Elliott Wave principle. In this article we aim to create realistic expectations. We’ll explain when it works, when it doesn’t, and how to tell the two apart.
The Two Camps
When it comes to the financial markets, there are innumerable analytical methods promising to improve your trading results. The two main schools of thought are fundamental analysis and technical analysis. The fundamental camp focuses on the economy, a separate industry or a specific company. Economic data, industry reports and company financial statements are the most important things fundamental analysis relies on. And even these, at first sight limited information sources, can lead to vastly different approaches such as value investing, growth investing, event-driven strategies, merger arbitrage and so on.
The technicians, on the other hand, primarily focus on the price charts of financial instruments, seeking repetitive patterns to give them a clue of the future. These include candle analysis, the classical head & shoulders, flags and triangle patterns, the cup and handle, Wyckoff and many, many others. This is the category, in which the Elliott Wave theory falls into, as well. Students of technical analysis also utilize a plethora of technical indicators to help them identify price reversals. There is volume trading, momentum, relative strength index, moving averages, Bollinger bands and the list goes on and on.
The two types of analysis, fundamental and technical, have one thing in common. They claim to have the ability to improve the trading results of everyone who devotes the time and energy needed to study them carefully. The main problem is that a 100% successful trading methodology simply does not exist. Neither fundamental, nor technical analysis can be expected to work every time.
Mistakes Don’t Deter Warren Buffett
But in the modern world, we’re accustomed to things working perfectly every single time. Unless broken, your iPhone, computer, TV or car will switch on and off every time you push the button. That’s not how things work in the financial markets, though. It is simply not an exact science. Even Warren Buffett, arguably the best investor to have ever lived, who’s a firm fundamental value investing proponent, doesn’t get it right all the time. For example, he lost money on ConocoPhillips, Dexter Shoes and Tesco, among others.
He did not, however, abandon value investing, because he knew that despite the occasional mistake, the approach is still sound. So the key to long-term success in the markets is to find and master a method with a high-enough success rate, and then stick with it. Does value investing work? Yes. Does it work all the time? Of course not, Buffett would confirm, and that’s fine.
What About Elliott Wave Analysis?
We’ve also been practicing value investing to pick stocks for The EWM Interactive Portfolio with great success for years now. But when it comes to short-term trading, we think that nothing beats Elliott Wave analysis. Not that we haven’t tried other less-complicated technical methods, because we have. It is only that it turned out that their win rate was similar to a coin toss. That’s probably because anything that is simple enough for everyone to learn, will sooner or later lead to mediocrity. The regression to the mean guarantees that.
Elliott Wave analysis, by contrast, is not easy to master. This is both a blessing and a curse. A blessing, because the regression to the mean phenomenon is not so strong here. A curse, because it puts off many not-so-patient students, who often prefer to declare that Elliott Wave doesn’t work long before they’ve learned how to apply it properly. Every trading method has its own rules and Elliott Wave analysis is no exception. You can’t expect to get the results you hope for, if you don’t follow the rules and don’t conduct your analysis correctly. Alas, many beginners in Elliott Wave analysis don’t. The good news is that there is plenty of information on how to conduct proper Elliott Wave analysis out there, including our eBook and video course.
Unfortunately, even experienced analysts will often find it hard to put theory into practice. They’ll make costly and discouraging mistakes, which can drain even the best analyst’s trading account. That’s because knowing the rules and how to apply them is not enough. A lot has been said and written about the importance of patience and discipline in the financial markets. These are vital skills, indeed. Lack of patience and discipline will make you close otherwise good positions too early, while they’re still trading at a loss. Or lead to rash decisions and push you into trades you never had to open in the first place.
But here, we want to show how patience and discipline must be applied to Elliott Wave analysis. And the single biggest mistake both beginners and experts make is to imagine Elliott Wave patterns where there are none. Humans are pattern-seeking animals. Our ability to recognize complex structures in nature has helped us survive as a species. But when faced with a price chart, our pattern-recognition ability can easily go into overdrive if left unchecked. The truth is that every chart is quite similar to the next one, so it is not difficult to start seeing patterns everywhere. We even saw a giant face on the surface of Mars in the 1970s, which turned out to be nothing more than a hill.
Pick Your Battles
The point here is that successful traders and investors pick their battles very carefully. They know how a real opportunity looks like and patiently wait for it to present itself. They don’t try to guess what pattern is going to form or which money-losing startup is going to be “the next Amazon”. Instead, they wait for the pattern to actually form and then decide whether and how to trade it. True, you can occasionally guess the pattern or pick the next Wall Street darling and make a lot of money off it. But the odds are slim and it will be the result of pure luck, instead of skill. This is simply not a reliable long-term strategy. Doing nothing is a lot better than acting on an ill-shaped pattern, because of fear of missing out.
This is why we usually write no more than three free articles on our website per week and our Elliott Wave Pro service only includes updates on weekends and Wednesdays. We don’t want to make the mistake of constantly looking at the charts, since we’re humans and we might see some patterns that aren’t really there. Reliable patterns take time to form. By doing nothing when there is nothing to be done, you’ll reduce the number of mistakes you make by about two-thirds. Even if you feel that you’re wasting your time, remember that it is preferable to wasting your money, as well. This is the only way to consistently make more accurate forecasts than incorrect ones and profit from them. The only way for your wins to outnumber your losses in the long run.
You Cannot Win Every Time
Now, imagine that you’ve mastered Elliott Wave analysis or any other method you’ve found out to be reliable. Imagine also that you’re a Buddhist monk with infinite patience, who has his emotions under total control. You’ve waited for the perfect trading setup to present itself and acted on it with the complete knowledge that the odds are on your side.
Then, suddenly some kind of a shocking piece of news remotely related to your trade comes out of nowhere. The price spikes through your stop-loss order and forcefully closes your very promising position at a loss. The average person would throw a big tantrum, break a thing or two in the house, switch to a new trading method and maybe even quit trading right there and then.
Fortunately, you’re an Elliott Wave Zen master, so you tell yourself that losses do happen. The market doesn’t owe us anything. It only provides opportunities with better or worse odds, but which never reach 100%. You then remind yourself that your trading method is sound and puts you in a winning position more often than not. With good risk management, discipline and patience, that’s all you really need.
Warren Buffett lost $3.5 billion on Dexter Shoes. It certainly didn’t feel good to kiss such a big sum goodbye. But it was just a small part of his vast portfolio. He never bets Berkshire’s entire cash balance on a single stock, because even the most promising opportunity may end up being a loser. That’s called discipline and risk management, and it applies to Elliott Wave trading, as well.
So, does the Elliott Wave theory work in practice? Yes.
Does it work every time? Of course not. Sometimes it fails spectacularly.
Is it worth it, though? Absolutely!