Robert D. Edwards John Magee W.H.C. Bassetti
Routledge
Taylor & Francis Croup
A PRODUCTIVITY PRESS BOOK
Technical Analysis of Stock Trends Eleventh Edition
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
Technical Analysis of Stock Trends Eleventh Edition Robert D.
Edwards John Magee W. H. C. Bassetti
Routledge
Taylor & Francis Group
A PRODUCTIVITY PRESS BOOK
Routledge
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Library of Congress Cataloguing-in-Publication Data Names: Edwards,
Robert D. (Robert Davis), 1893- author. | Magee, John, 1901-author. |
Bassetti, W. H. C., author.
Title: Technical analysis of stock trends / Robert D. Edwards, John Magee,
W.H.C. Bassetti.
Description: Eleventh Edition. | New York : CRC Press, [2018] | Revised
edition of the authors' Technical analysis of stock trends, c2013. | Includes
bibliographical references and index.
Identifiers: LCCN 2018010151 | ISBN 9781138069411 (hardback : alk.
paper) Subjects: LCSH: Investment analysis. | Stock exchanges--United
States. | Securities--United States.
Classification: LCC HG4521 .E38 2018 | DDC 332.63/20420973--dc23
LC record available at https://lccn.loc.gov/2018010151
Visit the Taylor & Francis Web site at http://www.taylorandfrancis.com
and the Productivity Press site at http://www.ProductivityPress.com
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Figure 0.1 DOW 25000! What a birthday present for the 11th edition! The
Dow continues to set records since March of 2009, as vividly illustrated by
this chart.
Taylor & Francis
Taylor & Francis Group
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Contents
Preface to the tenth edition
Preface to the ninth edition
Preface to the eighth edition
In memoriam
Preface to the seventh edition
Preface to the fifth edition
Preface to the fourth edition
Preface to the second edition
Foreword
The Dow Theory is not infallible
Replacing Dow Theory with John Magee's Basing points
Procedure
Important Reversal Patterns
Important Reversal Patterns: continued
Important Reversal Patterns: the Triangles
More important Reversal Patterns
Other Reversal phenomena
Wedges on weekly and monthly charts
Which gaps are significant?
Support and Resistance
Trendlines and Channels
Major Downtrends
A summary and concluding comments
Perspective
The all-important details
Selection of stocks to chart
The probable moves of your stocks
What is a Bottom and what is a Top?
Use of Support and Resistance
Symmetrical Triangles
Automated trendline: the
Figure 37.26 Weekly, July 1961 through June 1962. This
chart shows the Head-and-Shoulders Top Formation in the
Industrial Average that preceded the collapse of April, May,
and June 1962. Normally, especially in the charts of
individual stocks, there would tend to be heavier volume on
the left shoulder. The price pattern alone is sufficient to mark
the pattern as a dangerously toppy situation. During the
entire period in which this formation took shape, many
individual stocks representing important companies were
showing Top Reversal symptoms, as might be expected.
Note, so far as this Head-and-Shoulders Pattern is
concerned, the Reversal Signal is not definite until the
neckline has been penetrated.
Balanced and diversified
Portfolio risk management
Appendix A: The Dow Theory in practice
Appendix B: Resources
Appendix C: Technical Analysis beyond Edwards & Magee
09 10 11 12 13 14 IS It 17
List of Illustrations and Text Diagrams
Alphabetic Index of Stock Charts
Glossary
Bibliography
Index
Range, 189, 193, 196, 197
Contents
Preface to the eleventh edition
Beyond Edwards & Magee
I would be remiss if I did not note the passing of two important figures in
the discipline of technical analysis—Richard Arms Jr. and Professor Hank
Pruden of Golden Gate University. Well liked and admired they leave large
gaps in the community. The article here by Arms is literally his last
contribution to the field. Long the central figure in San Francisco, Hank
Pruden, much loved and admired leaves the entire field with an enormous
gap. He was my particular friend and mentor. He will be infinitely missed.
The reader is advised to read the prefaces to previous editions. They are of a
piece with the internal text and some practices—of notation and treatment
may not make sense otherwise. Those who think gender should be catered
to will find my previous comments on that issue. Why repeat it here?
Let me address the central question focused on by this new edition: This
book has studiously ignored an entire field of technical analysis—number
driven and statistical analysis. This has left previous new readers without
the guidance they need if they are uneasy with the qualitative method as
invented (or discovered) by Edwards & Magee. That lack is resolved by
Appendix C. There the new reader will find number-driven material
presented from the point of view of an Edwards & Magee analyst. There
also the reader will find presentations of tools by their creators—a very
special treat, and extremely educational. I venture to say any analyst will
have his field of vision broadened by Mike Moody's presentation of Point
and Figure charting and the tools of Richard Arms, two prominent analysts
for whom many of us, especially we chartists, have not given their work the
study it deserves.
The list of acknowledgments is as long as a Hollywood awards night. I will
shorten it by pointing out previously acknowledged colleagues, assistants,
and supporters in previous prefaces. Generally speaking, it is the usual
suspects. Some especially merit additional mention here: Nehemiah Brown
III, my much-valued and sometime graduate student helps me keep my
spreadsheets rational and accurate. My old friend Mark Wainwright (a Tuck
graduate) helps me solve technological problems. Part of the pleasure of
preparing a new edition comes from interacting with these bright and
capable people.
I have not mentioned Ralph Vince (a formidable figure) or Chris Glon,
Richard Arms, and Mike Moody.
My efforts have been made easier by the support of Chip Anderson of
stockcharts.com, an invaluable resource. I am also indebted to thinkorswim.
If I mention them often it is a measure of their importance to my work—
and not a paid promotion.
W. H. C. Bassetti San Francisco, California June 15, 2018
Taylor & Francis
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Preface to the tenth edition
A 10th milestone
Sixty-three years. Sixty-three years and Technical Analysis of Stock Trends
still towers over the discipline of technical analysis like a mighty redwood.
An evergreen sequoia. And now a 10th edition. It is a propitious moment to
refresh it for the new millennium, to prune its solecisms and obsolescence,
and to further develop the sometimes prescient work of its originators.
With this premise in mind, I have attempted to make the book shorter,
simpler, and more usable in the modern context. I know there are still
manual chartists out there. Occasionally they are ecstatic when they find
that—as a profit-losing service—I still have TEKNIPLAT™ chart paper in
my attic. Like travelers in the desert finding an oasis.
But they are the 1%. Everyone else uses software, desktop or internet to do
his charting (See note “About Gender” in the Preface to the eighth edition.).
So, I have excised the material on manual charting from the new edition.
Budding manual chartists may always turn to the eighth and ninth editions.
I have also deleted Magee's chapters on “Composite Leverage” (Chapter 42
in the seventh edition, Appendix A in the eighth) as they are abstruse and
cumbersome in the modern context—not to mention being rooted in manual
chart analysis. I have made every attempt to summarize and replace
Magee's work, as I believe it has intellectual validity. Primarily this is done
in the present Chapter 42. I repeat, Magee's thinking and practical work
predated much modern portfolio management and volatility theory.
Additionally, Modern Portfolio Theory has still not caught up to his work
on trend analysis and risk. All this material is available in previous editions.
I have moved, perhaps, the most difficult chapter in the book, Chapter 4, to
Appendix A. Edwards' chapter on the minutiae of the operation of Dow
Theory has stopped more than one reader cold. Now it is available to the
detail scholar, and the general reader is relieved of the necessity of slogging
through it.
Many critics deplored Chapter 16 from the seventh edition, which I
relegated to an appendix in the ninth edition. This chapter covered an
analysis of futures and derivatives using number-driven analysis. Critics
said it was shallow. More important, it was completely extraneous to the
theme of the book, chart analysis, not the exploration of statistical routines
and indicators, which is a different branch of technical analysis. There are
numerous books on the subject, starting with Murphy, Kirkpatrick, and
Kaufman. I have deleted it along with other material in the book that was
not compatible with Edwards and Magee's original intent.
I quote here appropriate remarks from the preface to the eighth edition:
About apparent anachronisms
Critics with limited understanding of long-term trading success may think
that discussions of “what happened in 1929” or “charts of ancient history
from 1946” have no relevance to the markets of the present millennium.
They will point out that AT&T no longer exists in that form, that the New
Haven has long since ceased to exist as a stock, that many charts are records
of long-buried skeletons. This neglects the value of the charts as metaphor.
It ignores their representations of human behavior in the markets which will
be replicated tomorrow in some stock named today.com or
willtheynevergetit.com. Even more important, it ignores the significance of
the past to trading in the present. I cite here material from Jack Schwager's
illuminating book, The New Wizards of Wall Street. Schwager, in
conversation with Al Weiss: “Precisely how far back did you go in your
chart studies?” Answer: “It varied with the individual market and the
available charts. In the case of the grain markets, I was able to go back as
far as the 1840s.” “Was it really necessary to go back that far?” Answer:
“Absolutely. One of the keys in long-term chart analysis is realizing that
markets behave differently in different economic cycles. Recognizing these
repeating and shifting long-term patterns requires lots of history. Identifying
where you are in an economic cycle—say, an inflationary phase versus a
deflationary phase—is critical to interpreting the chart patterns evolving at
that time.
Identification of original manuscript and revisions
True believers (and skeptics) will find here virtually all of the original
material written by Edwards and Magee, including their charts and
observations on them. Changes and comments introduced by editors since
the fifth edition have been rearranged and, when appropriate, have been
identified as a revision by that editor.
Maintaining this policy, where updates to the present technological context
and market reality were necessary, the present editor has clearly identified
them as his own work by beginning such annotations with “EN” for Editor's
Note. (The eighth edition was the first to use editor's notes. Editor's notes
for the ninth edition are identified as EN9, and notes added for the present
edition are identified as EN10).
So, we have here a simpler, shorter, clearer edition of the famous book—
easier to read, easier to understand, and easier to use. None of the
considerable virtues of the book have been affected. I have attempted to add
to these virtues with my work on Magee's Basing Points Procedure (see
Chapter 28, 28.1, and 28.2) and portfolio control and risk (see Chapter 42).
In spite of my remarks, I have listened to critics of the hand-drawn charts in
this book. These charts are the glory of the book and of the discipline of
technical analysis. Their application to modern markets seems ridiculously
obvious to me—and I am perhaps a dinosaur. So, I have decided to take a
number of examples of the manual charts and post them at
http://www.edwards-magee.com along with the same data charted by
computer so skeptics can compare the two methods. These will be found at
http://www.edwards-magee.com/manualcharts.html.
The internet so extends one's capabilities and is so easy to use that it would
be irresponsible not to avail oneself. In Figures 9.2 and 9.3, I have printed
charts that demand— scream—to be viewed in a larger format. These will
be found at http://www.edwards-magee.com/supercharts.html.
The reader is urged to read the prefaces to the eighth and ninth editions. I
have not repeated here all the editorial conventions detailed in those
prefaces.
W. H. C. Bassetti San Francisco, California
Acknowledgments for the tenth edition
So many colleagues and friends contribute to a book like this that one is in
danger of getting into the Academy Awards syndrome—endless thank yous
and acknowledgments until they bring out the hook and pull you off stage.
So, I will not thank my parents and aunts and uncles and wife and family,
although they should be and by this mention are thanked.
More particularly, acknowledgments are due to my editorial and research
assistant, Carlos Bassetti.
My colleagues at Golden Gate University (GGU) are an invaluable source
of advice, wisdom, and support, particularly Professor Henry Pruden. It is
no mystery why he is internationally known and respected—besides being a
world authority on Wyckoff. GGU has also furnished me with an unending
supply of bright, formidable graduate students who have made major
contributions to my work and to my thinking. Nehemiah Brown does his
best to keep me semi-organized as to spreadsheets. Matt Mullens and Brian
Brooker have assisted me with many of the Basing Point studies herein.
Stergios Marinopoulos has stimulated and challenged me in my systems
work. All these people are members in the local technical analysis fraternity
and our much-valued organization, the Technical Securities Analysts
Association of San Francisco.
More remote colleagues have also assisted me in many invaluable ways—
Jack Schannep with Dow Theory data, Robert Colby, also with Dow data;
Tim Knight with Prophet data (now part of http://www.thinkorswim,
http://www.tdamertrade.com), Chip Anderson at
http://www.stockcharts.com, and Scott Brown of Metastock for support
with charting software.
I am indebted to Ralph Vince and Nelson Freeburg for material found
herein that increases the value of this book.
And finally, amigo Frangaise, and fellow chart enthusiast Chris Glon at
http://www. publicharts.com, for his charts, assistance, and friendship. He
has supplied some of the most interesting charts in this book.
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
Preface to the ninth edition
Warp speed universe. Warp speed financial markets. The eighth edition of
this classic book appeared when it seemed the millennium and paradise had
been achieved and that, like Mackay's Tulipomania, the price of stocks
would rise forever and men would rush from the world over and pay
whatever price was asked for what-was-its-name.com, internet groceries, or
ihype.com or icon.com or gotcha.com. and, feature this, Dow 36,000. The
bubble was just in the process of bursting, of course. Before it burst,
fabulous fortunes were made by roller blader and scooter tycoons and by
young geeks with nothing but chutzpah and a laptop. One of my favorite
stories is of the young entrepreneur who said, “Why don't I deserve it (the
$100 million he made in the IPO)? I've devoted three years of my life to this
project.” He is now dead.
Now, many of those people are in prison and the hangover lingers on along
with lying, cheating, and stealing on all sides. From Enron to Arthur
Anderson, billions, if not trillions, fell into a black hole. As all this
developed, I warned of the impending collapse in the John Magee
Investment Letters on the web. There was nothing magical or brilliant about
seeing what was going on; perspective and perception came from applying
the lessons taught in this book by Edwards and Magee. Like Benedict XVI
(in a different area), I am a humble worker in their vineyard.
I press on attempting to modernize (where necessary) and extend their
work, fit it to the modern situation, and make it even more useful to current
day traders and investors.
In this ongoing labor of love, I have been immeasurably assisted by my
graduate students and colleagues at Golden Gate University in San
Francisco. In constant interaction with them I have been stimulated to see
important aspects of Edwards and Magee's work and develop and
emphasize these elements in my teaching and in this new edition.
Specifically, both long-term and short-term traders will find important new
material in this edition. In my graduate seminars, I have seen the power of
what Magee called the “Basing Points Procedure” and so have extended the
treatment of this material. My interest in, and respect for, Dow Theory has
recently increased as the result of a paper done with Brian Brooker for the
Market Technicians Association (“Dissecting Dow Theory”). Material from
that paper will be found in this edition. Short-term traders and futures
speculators will appreciate extensive new material on commodity trading.
These traders have been entirely too influenced by mechanical number-
driven systems of recent years and need to restore perspective by mastering
the material of this book.
It was never the intent of this book to forecast or analyze current markets;
rather, its purpose was, and is, to learn from history and the past to better
deal with the present and the future. Current markets are analyzed (and
forecast?) at the John Magee website. Nonetheless, the very process of
keeping current involves picturing issues and instruments in play. The
major indexes themselves in 2005 are in play, along with gold, silver, and
oil. We don't know how they will pan out, but we can make an analysis with
the data we have, for this is the situation the analyst is faced with every day.
He doesn't know how it will turn out, but, by following the methods and
principles taught in this book, he can put himself on the right side of the
probabilities.
This is no idle remark. The power and effectiveness of classical chart
analysis can be seen by examining how it performed in the past at critical
times. At the John Magee Technical Analysis website, the following
comment was made in January 2000:
Dow: The Dow can expect to find support at 10000 and is buyable, but in
small commitments or portions of a portfolio or additions thereto. We
expect to see it in a very large see saw from 9-12000 for some time and
would hedge at the high end and increase commitments and lift hedges on
oversold conditions at the low end.
In November 2000, the following comment was made:
November 18, 2000
There is really only one chart pattern of significance in these markets, and
that is the big one, more than 12 months long now, and the pattern is a big
serpent, whipping back and forth and, as Shakespeare said, signifying
nothing. Nothing that is but more of the same. How will we know when it
signifies something? Well, we won't really know till we know, but we'll let
you know when we know. So, we would continue to pick likely shorts and
employ short term trading strategies for traders, and hedge at interim tops
and lift the hedges at bottoms. Based on the chart picture and last week's
anemic behavior, we would not trade for bounces in the NASDAQ. If
anything, it is a short, but a risky one.
These past letters, dramatically illustrating the effectiveness of the methods
of this book, may be found online through links at the address specified
below. Your editor, personally, is not a genius for having made these
analyses. It is the method which is to credit, and any number of my
graduate students can make the same analyses, as can any alert chart
analyst.
The reader should not skip the prefatory material to the eighth edition. The
same practices outlined there have been followed in this edition. Magee
said the reader should not skim through this book and put it on his library
shelf. Instead, it should be read and reread and constantly referred to and so
the reader should, yes, so he should.
Richard Russell, the dean of Dow Theory Analysts, has reportedly said the
price of the Dow and the price of gold will cross in coming years. He has
also remarked that the S&P appears to evince a 10-year head-and-shoulders
pattern. Robert Prechter believes we are at the crest of the tidal wave and
the tsunami cometh.
Dow 36,000. Dow 3,000. This book contains the best tools to cope with
whatever the future holds.
W. H. C. Bassetti San Francisco, California May 1, 2005
A special note concerning resources on the Web
In the age of instant and easy (and free) access to information on the
internet, it would be foolish to ignore the opportunities available to interact
with the material of this book. The reader will find free materials that
augment the book at http://www.edwards-magee. com. For example, when
the reader learns in Chapter 28 of the Basing Points Procedure, he will be
able to go to the website and print out a PDF of material that he can place
beside Figure 28.1 for instant and easy cross-reference, instead of having to
turn pages constantly back and forth from the chart to the keys and
commentary or having to bend the book into pretzels at a copy machine. In
general, wherever references are made in the text to the website, it is for
this purpose, to give the reader easy and flexible usage of the material. And,
likewise, at this address the reader will find links to past letters that show
how the method functioned in real time in real markets.
A special note about Dow Theory
Senator Everett Dirkson said one time that trying to get U.S. senators
herded together and moving in one direction was like trying to transport
bullfrogs in a wheelbarrow. Trying to synchronize the signals of the various
Dow Theory analysts is a similarly challenging proposition. No Ayatollah
exists to issue the final fatwa as to whether the signal is valid. Always one
to abhor a vacuum, I have organized a committee at Golden Gate University
to evaluate pronouncements of signals and opine as to whether the signals
are valid. This committee died an unnatural death, unfortunately, for lack of
demand as to its expertise.
Acknowledgments for the ninth edition
For professional assistance: Jack Schannep, Robert W. Colby, Curtis Faith,
Greg Morris, John Murphy, Tim Knight, and Chi Huang.
For assistance at Taylor and Francis: Richard O'Hanley, Raymond
O'Connell, Pat Roberson, Andrea Demby, and Roy Barnhill.
For research assistance and manuscript preparation: Brian Brooker and
Grace Ryan, my fearsomely bright and efficient teaching and research
assistants. And my inimitable technical assistant, Samuel W. D. Bassetti.
At Golden Gate University for ongoing support and assistance: Professor
Henry Pruden, Barbara Karlin, Janice Carter, Tracy Weed, and Cassandra
Dilosa.
Special appreciation goes to makers of software packages and their
supportive executives for software used in the preparation of this and
previous editions:
John Slauson Adaptick 1082 East 8175 South Sandy, UT 84094
http://www.adaptick.com
Steven Hill AIQ Systems P.O. Box 7530 Incline Village, NV 89452 702-
831-2999 http://www.AIQsystems.com
Alan McNichol Metastock Equis International, Inc.
3950 S. 700 East, Suite 100 Salt Lake City, UT 84107 http://www.equis.com
Taylor & Francis
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Preface to the eighth edition
Here is a strange event—a book written in the mid-20th century retains its
relevancy and importance to the present day. In fact, Technical Analysis of
Stock Trends remains the definitive book on the subject of analyzing the
stock market with charts. Knock-offs, look-alikes, and pale imitations have
proliferated in its wake like seagulls after a productive fishing boat. But the
truth is they have added nothing new to the body of knowledge Edwards
and Magee originally produced and Magee refined up to the fifth edition.
What accounts for this rare occasion of a book's passing to be a classic? To
be more, in fact, than a classic, to be the manual or handbook for current
usage?
To answer this question, we must ask another: What are chart formations?
Chart formations identified and analyzed by the authors are graphic
representations of unchanging human behavior in complex multivariate
situations. They are the depiction of multifarious human actions bearing on
a single variable (price). On price, converge a galaxy of influences: fear,
greed, desire, cunning, malice, deceit, naivete, earnings estimates, broker
need for income, gullibility, professional money managers' need for
performance and job security, supply and demand of stocks, monetary
liquidity and money flow, selfdestructiveness, passivity, trap setting,
manipulation, blind arrogance, conspiracy and fraud and double dealing,
phases of the moon and sun spots, economic cycles and beliefs about them,
public mood, and the indomitable human need to be right.
Chart formations are the language of the market, telling us that this stock is
in its death throes; that stock is on a rocket to the moon; that a life and death
battle is being waged in this issue; and in that other, the buyers have
defeated the sellers and are breaking away.
They are, in short, the inerasable fingerprints of human nature made graphic
in the greatest struggle in human experience, next to war.
As Freud mapped the human psyche, so have Edwards and Magee mapped
the human mind and emotions as expressed in the financial markets. Not
only did they produce a definitive map, they also produced a methodology
for interpreting and profiting from the behavior of men and markets. It is
difficult to imagine further progress in this area until the science of artificial
intelligence, aided by yet unimaginable computer hardware, makes new
breakthroughs.
If it is definitive, why offer a new edition?
Unlike Nostradamus and Jules Verne (and many current investment
advisors), the authors did not have a crystal ball or a time machine. Magee
did not foresee the electronic calculator and made do with a slide rule. And
while he knew of the computer, he did not anticipate that every housewife
and investor would have 1,000 times the power of a Whirlwind or Univac I
on his (her) desk (cf., “About Gender”). In short, the March of Time. The
Progress of Science. The Inexorable Advance of Technology.
Amazingly, the great majority of this book needed no update or
actualization. Who is to improve on the descriptions of chart formations and
their significance?
But insofar as updates are necessary to reflect the changes in technology
and in the character and composition of the markets, that is another story.
Human character may not change, but in the new millennium, there is
nothing but change in the character and composition of the markets. And
while regulatory forces might not be completely in agreement, the majority
of these changes have been positive for the investor and the commercial
user. Of course, Barings Bank and some others are less than ecstatic with
these developments.
The most important additions to this book to reflect changes in the times,
technology, and markets
Generally speaking, these additions, annotations, and updates are intended
to inform the general reader of conditions of which he must be aware for
investing success. In most cases, because of the enormous amount of
material, no attempt is made to be absolutely exhaustive in the treatment of
these developments. Rather, the effort is made to put changes and new
conditions in perspective and furnish the investor with the resources and
proper guide to pursue subjects at greater length if desired. In fact, an
appendix has been provided, entitled Resources (EN10: now Appendix B),
to which the reader may turn when he has mastered the material of the book
proper.
The stubborn individualist may realize investment success with the use of
this book alone (and paper, pencil, ruler, and chart paper [cf., Section on
TEKNIPLAT™ chart paper]).
Technology
In order to equip this book to serve as a handbook and guide for the markets
of the new millennium, certain material has been added to the text of the
fifth and seventh editions. Clearly, the astounding advances in technology
must be dealt with and put in the context of the analytical methods and
material of the original. To achieve success in the new, brave world, an
investor must be aware of and utilize electronic markets, the internet, the
microcomputer, wireless communications, and new exchanges offering
every kind of exotica imaginable.
The advanced investor should also be aware of and understand some of the
developments in finance and investment theory and technology—the Black-
Scholes Model, Modern Portfolio Theory, Quantitative Analysis.
Fortunately, all these will not be dealt with here because, in truth, one
intelligent investor with a piece of chart paper, a pencil, and a quote source
can deal with the markets, but that is another story we will explore later in
the book. Some of these germane subjects will be discussed sufficiently to
put them in perspective for the technical analyst, and then guides and
resources will be pointed out for continued study. My opinion is that the
mastery of all these subjects is not wholly necessary for effective investing
at the private level. What need does the general investor have for an
understanding of the Cox-Ross-Rubinstein (CRR) options analysis model to
recognize trends? The Edwards-Magee model knows things about the
market the CRR model does not.
Trading and investment instruments
The new universe of available trading and investment instruments must be
taken into account. The authors would have been in paradise at the
profusion of alternatives. In this future world, they could have traded the
Averages (one of the most important changes explored in this book); used
futures and options as investment and hedging mechanisms; practiced
arbitrage strategies beyond their wildest dreams; and contemplated a candy
store full of investment products. The value and utility of these products
would have been immeasurably enhanced by their mastery of the charting
world of technical analysis. As only one example, one world-prominent
professional trader I know has made significant profits selling calls on
stocks he correctly analyzed to be in down trends, and vice versa— an
obvious (or, as they say, no-brainer) to a technician, but not something you
should attempt at home without expert advice. Techniques like this
occasioned the loss of many millions of dollars in the Reagan Crash of
1987.
Changes and developments in technical analysis
Have any new chart patterns (that is to say, changes in human behavior and
character) emerged since the fifth edition? Not to my knowledge, although
there are those who take the same data and draw different pictures from
them. How else could you say that you had something new! different!
better!? There are other ways of looking at the data that are interesting,
sometimes valuable, and often profitable, which goes to prove that many
are the ways and gateless is the gate to the great Dow. Point and figure
charting have been used very effectively by traders I know, and candlestick
charting depicts data in interesting ways. Furthermore, since Magee's time,
aided by the computer, technicians have developed innumerable, what I
call, number-driven technical analysis tools: (the puzzlingly named)
stochastics, oscillators, exponential and other moving averages, etc., etc.,
etc. It is not the intent of this book to explore these tools in depth. That will
be done in a later volume. These concepts are briefly explored in an
appendix (Appendix C, 8th edition) supplied by Richard McDermott, editor
of the seventh edition.
I have also made additions to the book (see Chapter 18) to give a
perspective on longterm investing, since Magee specifically addressed the
second part of the book (on tactics) to the speculator. I have substantially
rewritten Chapters 24 and 42 to reflect current ideas on portfolio
management and risk management. I have expanded on the idea of
rhythmic trading—an idea which is implicit in the original. I have expanded
the treatment of runaway markets so the internet stocks of the 1990s might
be put in perspective (see Chapter 23).
And then, paradigms. Paradigms, as everyone should know by now, are the
last refuge of a fundamentalist when all other explanations fail.
Paradigm changes
Whenever the markets, as they did at the end of the 20th century, depart
from the commonly accepted algorithms for determining what their prices
ought to be, fundamentalists (those analysts and investors who believe they
can determine value from such fixed verities as earnings, cash flow, etc.)
are confronted with new paradigms. Are stock prices (values) to be
determined by dividing price by earnings to establish a reasonable
price/earnings (p/e) ratio? Or should sales be used, or cash flow, or the
phases of the moon, or—in the late 1990s—should losses be multiplied by
price to determine the value of the stock? Technicians are not obliged to
worry about this kind of financial legerdemain. The stock is worth what it
can be sold for today in the market.
The crystal ball
Investors will get smarter and smarter, starting with those who learn what
this book has to say. The professionals will stay one step ahead of them
because they are preternaturally cunning and spend all their time figuring
out how to keep ahead of the public, but the gap will narrow. Software and
hardware will continue to advance, but not get any smarter. Mechanical
systems will work well in some areas, yet not in others. Mechanical systems
are only as good as the engineer who designs them and the mechanic who
maintains them. Buying systems is buying trouble. Everyone should find
his own method (usually some variant of the Magee method, in my
opinion). All good things will end; all bad things will end. The bag of tricks
with which the insiders bilk the public will get smaller and smaller. New
and ingenious procedures will be developed by the insiders. The well of
human naivete is bottomless. For every one educated, a new one will be
born in a New York minute. It is deeply disturbing at the turn of the century
that the owners of the NASDAQ and the NYSE should be thinking of going
public. Could there be any more ominous sign that enormous changes are
about to occur?
Vigorous development of the systems, methods, procedures, and philosophy
outlined in this book is about the only protective shield I know of to guard
against inimical change.
W. H. C. Bassetti
San Geronimo, California January 1, 2001
About the editorial practices in this eighth edition
Needless to say, one approaches the revision of a classic work with some
trepidation. Every critic and reader has his or her (cf., “About Gender”)
opinion as to how revision should be done—whether the authors' original
text should be invisibly changed as though they had written the book in
2000 instead of 1948 and were omniscient, or whether errors and
anachronisms were to be lovingly preserved, or footnoted, or ... etc., etc. (I
have preserved Magee's favorite usage of “etc., etc., etc.” against the
protestation of generations of English composition teachers because I like
its evocation of an ever-expanding universe.)
Notwithstanding every reader having an opinion, I am certain all critics will
be delighted with the practices followed in this third millennium edition of
the most important book on technical analysis written in the second
millennium.
Integrity of the original text
By and large, the fifth edition has been the source of the authors' original
text. Amazingly, almost no stylistic or clarifying emendation has been
necessary to that edition. This is a tribute to the clarity, style, and content of
the original—one might almost say awesome if the word were not in such
currency on “Saturday Night Live” and the Comedy Central. Considering
its complex subject was written in the middle of the last century and the
markets were one-tenth of their present complexity, awesome may be the
appropriate word. No change or update has been necessary to the technical
observations and analysis. They are as definitive today as they were in
1950.
While I have preserved the authors' original intent and text, I have taken the
liberty of rearranging some of the chapters. Novices wishing to learn
manual charting will find the appropriate chapters moved to appendices at
the back of the book, along with the chapters on Composite Leverage and
Sensitivity Indexes.
About apparent anachronisms
Critics with limited understanding of long-term trading success may think
that discussions of “what happened in 1929” or “charts of ancient history
from 1946” have no relevance to the markets of the present millennium.
They will point out that AT&T no longer exists in that form, that the New
Haven has long since ceased to exist as a stock, that many charts are records
of long-buried skeletons. This neglects the value of the charts as metaphor.
It ignores their representations of human behavior in the markets which will
be replicated tomorrow in some stock named today.com or
willtheynevergetit.com. Even more important, it ignores the significance of
the past to trading in the present. I cite here material from Jack Schwager's
illuminating book, The New Wizards of Wall Street. Schwager, in
conversation with Al Weiss: “Precisely how far back did you go in your
chart studies?” Answer: “It varied with the individual market and the
available charts. In the case of the grain markets, I was able to go back as
far as the 1840s.” “Was it really necessary to go back that far?” Answer:
“Absolutely. One of the keys in long-term chart analysis is realizing that
markets behave differently in different economic cycles. Recognizing these
repeating and shifting long-term patterns requires lots of history. Identifying
where you are in an economic cycle—say, an inflationary phase versus a
deflationary phase—is critical to interpreting the chart patterns evolving at
that time.”
Identification of original manuscript and revisions
True believers (and skeptics) will find here virtually all of the original
material written by Edwards and Magee, including their charts and
observations on them. Changes and comments introduced by editors since
the fifth edition have been rearranged, and, when appropriate, have been
identified as a revision by that editor.
Maintaining this policy, where updates to the present technological context
and market reality were necessary, the present editor has clearly identified
them as his own work by beginning such annotations with “EN” for Editor's
Note. Figure insertions are identified as “x.1, x.2.”
Absolutely necessary revisions
Not too long ago my youngest son, Pancho, overheard a conversation in
which I referred to a slide rule. “What's a slide rule, Dad?” he asked. Well,
needless to say the world has, in general, moved on from the time of
Edwards and Magee when instead of calculators we had slide rules. Where
time has made the text useless, moot, or irrelevant, that problem has
unobtrusively been corrected.
Where the passage of time has made the text obsolete, I have either
footnoted the anachronism and/or provided a chapter-ending annotation,
which are marked in the text with “EN.” It is absolutely essential to read the
annotations; failure to do so will leave the reader stranded in the 20th
century.
In some cases, these annotations amount to new chapters—for example,
trading directly in the averages was difficult in Magee's time. Nowadays, if
there is not a proxy or option or index for some Index or Average or basket
of stocks, there will be one in less than a New York minute (which, as
everyone knows, has only 59 seconds). This new reality has resulted in
major additions to this new edition, which are detailed in the Foreword.
Major chapter additions necessary to deal with developments in technology
and finance theory have been clearly identified as this editor's work by
designating them as interpolations, viz., Chapter 18 (with the exception of
Chapter 23, which I have surreptitiously inserted).
Absolutely necessary revisions that arose in the 30 minutes since this
editorial note was written
In a number of instances, the book relayed information that, in those days of
fixed commissions and monopolistic control by the existing exchanges,
remained valid for long periods of time; for instance, brokerage
commissions and trading costs. It is no longer possible to maintain such
information in a printed book because of the rate of change in the financial
industry. It must now be filed and updated in real time on the internet.
Consequently, readers will be able to refer to the internet for this kind of
ephemeral data. The general importance of the ephemera to the subject is
always discussed.
About gender
I quote here from my foreword to the second edition of Magee's General
Semantics of Wall Street (charmingly renamed according to the current
fashions, Winning the Mental Game on Wall Street):
About Gender in Grammar
Ich bin ein feminist. How could any modern man, son of a beloved woman,
husband of an adored woman, and father of a joyful and delightful daughter
not be? I am also a traditionalist and purist in matters of usage, grammar,
and style. So where does that leave me and my cogenerationalists,
enlightened literary (sigh) men (and women), with regards to the use of the
masculine pronoun when used in the general sense to apply to the neuter
situation?
In Dictionary of Modern American Usage, Garner notes: “English has a
number of common-sex general words, such as person, anyone, everyone,
and no one, but it has no common-sex singular personal pronouns. Instead
we have he, she, and it. The traditional approach has been to use the
masculine pronouns he and him to cover all persons, male and female alike
... . The inadequacy of the English language in this respect becomes
apparent in many sentences in which the generic masculine pronoun sits
uneasily.”
Inadequate or not, it is preferable to s/he/it and other bastardizations of the
English language. (Is it not interesting that “bastard,” in common usage, is
never used of a woman, even when she is illegitimate?) As for the
legitimacy of the usage of the masculine (actually neuter) pronoun in the
generic, I prefer to lean on Fowler, who says, “There are three makeshifts:
first, as anybody can see for himself or herself; second, as anybody can see
for themselves; and third, as anybody can see for himself. No one who can
help it chooses the first; it is correct, and is sometimes necessary, but it is so
clumsy as to be ridiculous except when explicitness is urgent, and it usually
sounds like a bit of pedantic humor. The second is the popular solution; it
sets the literary man's (!) teeth on edge, and he exerts himself to give the
same meaning in some entirely different way if he is not prepared to risk the
third, which is here recommended. It involves the convention (statutory in
the interpretation of documents) that where the matter of sex is not
conspicuous or important the masculine form shall be allowed to represent a
person instead of a man, or say a man (homo) instead of a man (vir).”
Politically correct fanatics may rail, but so are my teeth set on edge; thus, I
have generally preserved the authors' usage of the masculine for the generic
case. This grammatical scourge will pass and be forgotten, and weak-willed
myn (by which I intend to indicate men and women) who pander to
grammatical terrorists will, in the future, be seen to be stuck with
malformed style and sentences no womyn will buy. What would Jane
Austen have done, after all?
About Gender in Investors
As long as we are on the subject of gender, we might as well discuss,
unscientifically, gender in investors. Within my wide experience as a
trading advisor, teacher, and counselor, it strikes me that the women
investors I have known have possessed certain innate advantages over the
men. I know there are women gamblers—I have seen some. But I have
never seen a woman plunger (shooter, pyramider, pie-eyed gambler) in the
markets, though I have known many men who fit this description. I have
also noted among my students and clients that, as a group, women seem to
have more patience than men. I refer specifically to the patience that a wise
investor must have to allow the markets to do what they are going to do.
These are wholly personal observations. I have made no study of the
question and can't speak to the entire class of women investors— and do not
personally know Barbra Streisand (who I understand is a formidable
investor, especially in IPOs). But just as I believe the world would be better
off if more women ran countries and were police officers, I expect the
world of finance will benefit from the steadily increasing number of women
investors and managers.
A crucial question: sensitivity indexes and betas
Long before the investment community had formalized the beta measure—
the coefficient measuring a stock's volatility relative to the market—Magee
and Edwards were computing a Sensitivity Index, which, for all practical
purposes, was the same thing. Readers interested in this aspect of their work
may find references in Resources (EN10: now Appendix B), which will
enable them to obtain betas to plug into the Composite Leverage formula
with which Magee intended to determine risk levels. The old appendix on
Sensitivity Indexes has been consigned to Appendix A (8th edition), along
with the chapter on Composite Leverage, both originals of which have been
emended to reflect current practices in finance theory and practice.
Betwixt and between, 1/8 of a dollar or 12.5 cents
As this edition went to press, the financial services industry was once again
threatening to implement decimals in stock prices. Pricing in eighths has
endured long past its time
because it was in the self-interest of the financial industry—it allowed
brokers and market makers to enforce larger bid-ask spreads and fatten their
profit margins. The importance for this book, and for traders, is what will
happen as full decimalization occurs. Often in these pages, Magee will
recommend placing a stop 1/8 off the low or high, or placing progressive
near stops in eighths. We do not yet know what the psychological interval
will be in the new era; it may be 12.5 cents, or more psychologically, 10
cents, or for gaming purposes, 9 or 11 cents. This remains to be seen. As all
the charts in this book are in the old notation, that usage has been preserved
in this edition.
The editorial “I”
Readers will quickly note the “editorial we” of Edwards and Magee has
been replaced by the first-person voice—or, the “editorial I” or perhaps the
“professorial I.” Well, there were two authors in Edwards and Magee, and
there is only one of me; my text is immediately noticeable as mine, and the
reader may discriminate quickly. As for the use of “I” as an expression of
ego, the reader is assured that after 40 years in the market, the editor has no
ego left to promote. Perhaps the best way to put the editor's sense of
importance in perspective is to quote Dr. Johnson's definition of
lexicographer from his dictionary. Some people might have thought
Johnson self-important in creating the first English dictionary; his definition
of his trade put that right: “Lexicographer: a writer of dictionaries. A
harmless drudge.” An editor is something like the same.
As this book goes to the printer, the publisher, recognizing the importance
of the work done on this edition, will credit the editor as co-author of the
eighth edition. John Magee would be pleased. We had a cordial master-
student relationship, and nothing pleases a Zen master more than to transfer
the dharma to a passionate student.
Acknowledgments
In General:
John Magee, for his ever-patient tutoring.
Blair Hull, for teaching me the mercurial nature of options.
Bill Dreiss, for teaching me the nature of trading systems.
Art von Waldburg, respected colleague and discoverer of the Fractal Wave
Algorithm. Fischer Black, who should have lived to get the Nobel Prize.
Bill Scott, friend and fellow trader.
For specific support and assistance in the preparation of this eighth edition:
Professor Henry Pruden, Golden Gate University, San Francisco, for
invaluable support and advice.
Martin Pring; Lawrence Macmillan; Mitch Ackles, Omega Research
Corporation; Carson Carlisle; Edward Dobson; David Robinson; Shereen
Ash; Steven W. Poser; Lester Loops, late of Hull Trading Company; Tom
Shanks, Turtle.
At St. Lucie Press, the dedication and support of the publisher, Drew
Gierman, and Production Associate, Pat Roberson, have been invaluable, as
has been the dedication of Gail Renard, the Production Editor.
And special acknowledgment to my Research Assistant, Don Carlos
Bassetti y Doyle.
Special appreciation goes to makers of software packages used in the
preparation of this and previous editions:
AIQ Systems P.O. Box 7530 Incline Village, NV 89452 702-831-2999
http://www.AIQsystems.com
Metastock Equis International, Inc. 3950 S. 700 East, Suite 100 Salt Lake
City, UT 84107 http://www.equis.com
Tradestation Omega Research 14257 SW 119th Avenue Miami, FL 33186
305-485-7599 http://www.tradestation.com
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
In memoriam
This book is a memorial for John Magee, who died on June 17, 1987. John
Magee was considered a seminal pioneer in technical analysis, and his
research with co-author, Robert D. Edwards, clarified and expanded the
ideas of Charles Dow, who laid the foundation for technical analysis in
1884 by developing the “Averages,” and Richard Schabacker, former editor
of Forbes in the 1920s, who showed how the signals, which had been
considered important when they appeared in the averages, were applicable
to stocks themselves. The text, which summarized their findings in 1948,
was, of course, Technical Analysis of Stock Trends, now considered the
definitive work on pattern recognition analysis. Throughout his technical
work, John Magee emphasized three principles: stock prices tend to move
in trends; volume goes with the trend; and a trend, once established, tends
to continue in force.
A large portion of Technical Analysis of Stock Trends is devoted to the
patterns which tend to develop when a trend is being reversed: Head and
Shoulders, Tops and Bottoms, “W” patterns, Triangles, Rectangles, etc.—
common patterns to stock market technicians. Rounded Bottoms and
Drooping Necklines are some of the more esoteric ones.
John urged investors to go with the trend, rather than trying to pick a
bottom before it was completed, averaging down a declining market. Above
all, and at all times, he refused to get involved in the game of forecasting
where “the market” was headed, or where the Dow-Jones Industrial
Averages would be on December 31st of the coming year. Rather, he
preached care in individual stock selection regardless of which way the
market “appeared” to be headed.
To the random walker, who once confronted John with the statement that
there was no predictable behavior on Wall Street, John's reply was classic.
He said, “You fellows rely too heavily on your computers. The best
computer ever designed is still the human brain. Theoreticians try to
simulate stock market behavior, and, failing to do so with any degree of
predictability, declare that a journey through the stock market is a random
walk. Isn't it equally possible that the programs simply aren't sensitive
enough or the computers strong enough to successfully simulate the thought
process of the human brain?” Then John would walk over to his bin of
charts, pull out a favorite, and show it to the random walker. There it was—
spike up, heavy volume; consolidation, light volume; spike up again, heavy
volume. A third time. A fourth time. A beautifully symmetrical chart,
moving ahead in a well-defined trend channel, volume moving with price.
“Do you really believe that these patterns are random?” John would ask,
already knowing the answer.
We all have a favorite passage or quotation by our favorite author. My
favorite quotation of John's appears in the short booklet he wrote especially
for subscribers to his Technical Stock Advisory Service: “When you enter
the stock market, you are going into a competitive field in which your
evaluations and opinions will be matched against some of the sharpest and
toughest minds in the business. You are in a highly specialized industry in
which there are many different sectors, all of which are under intense study
by men whose economic survival depends upon their best judgment. You
will certainly be exposed to advice, suggestions, offers of help from all
sides. Unless you are able to develop some market philosophy of your own,
you will not be able to tell the good from the bad, the sound from the
unsound.”
I doubt if any man alive has helped more investors develop a sound
philosophy of investing on Wall Street than John Magee.
Richard McDermott President, John Magee, Inc.
September 1991
Preface to the seventh edition
More than 100 years ago, in Springfield, MA, there lived a man named
Charles H. Dow. He was one of the editors of a great newspaper, the
Springfield Republican. When he left Springfield, it was to establish another
great newspaper, the Wall Street Journal.
Charles Dow also laid the foundation for a new approach to stock market
problems.
In 1884, he made up an average of the daily closing prices of 11 important
stocks, nine of which were rails, and recorded the fluctuations of this
average.
He believed the judgment of the investing public, as reflected in the
movements of stock prices, represented an evaluation of the future
probabilities affecting the various industries. He saw in his average a tool
for predicting business conditions many months ahead. This was true
because those who bought and sold these stocks included people intimately
acquainted with the industrial situation from every angle. Dow reasoned the
price of a security, as determined by a free competitive market, represented
the composite knowledge and appraisal of everyone interested in that
security—financiers, officers of the company, investors, employees,
customers—everyone, in fact, who might be buying or selling stock.
Dow felt this market evaluation was probably the shrewdest appraisal of
conditions to come that could be contained, since it integrated all known
facts, estimates, surmises, and the hopes and fears of all interested parties.
It was William Peter Hamilton who really put these ideas to work. In his
book, The Stock Market Barometer, published in 1922, he laid the
groundwork for the much-used and much-abused Dow Theory.
Unfortunately, a great many superficial students of the market never
understood the original premise of the “barometer” and seized on the bare
bones of the theory as a sort of magic touchstone to fame and easy fortune.
Others, discovering the “barometer” was not perfect, set about devising
corrections. They tinkered with the rules of classic Dow Theory, trying to
find the wonderful formula that would avoid its periodic disappointments
and failures.
Of course, what they forgot was the Averages were only averages at best.
There is nothing very wrong with the Dow Theory. What is wrong is the
attempt to find a simple, universal formula—a set of measurements that will
make a suit to fit every man, fat, thin, tall, or short.
During the 1920s and 1930s, Richard W. Schabacker reopened the subject
of technical analysis in a somewhat new direction. Schabacker, who had
been financial editor of Forbes Magazine, set out to find some new answers.
He realized whatever significant action appeared in the average must derive
from similar action in some of the stocks making up the average.
In his books, Stock Market Theory and Practice, Technical Market Analysis,
and Stock Market Profits, Schabacker showed how the “signals” that had
been considered important by Dow theorists when they appeared in the
Averages were also significant and had the same meanings when they
turned up in the charts of individual stocks.
Others, too, had noted these technical patterns, but it was Schabacker who
collated, organized, and systematized the technical method. Not only that,
he also discovered new technical indications in the charts of stocks;
indications of a type that would ordinarily be absorbed or smothered in the
averages, and, hence, not visible or useful to Dow theorists.
In the final years of his life, Richard Schabacker was joined by his brother-
in-law, Robert D. Edwards, who completed Schabacker's last book and
carried forward the research of technical analysis.
Edwards, in turn, was joined in this work in 1942 by John Magee. Magee,
an alumnus of the Massachusetts Institute of Technology, was well oriented
to the scientific and technical approach.
Edwards and Magee retraced the entire road, reexamining the Dow Theory
and restudying the technical discoveries of Schabacker.
Basically, the original findings were still good; however, with additional
history and experience, it was possible to correct some details of earlier
studies. Also, a number of new applications and methods were brought to
light. The entire process of technical evaluation became more scientific.
It became possible to state more precisely the premises of technical
analysis: that the market represents a most democratic and representative
criterion of stock values; that the action of a stock in a free, competitive
market reflects all that is known, believed, surmised, hoped, or feared about
that stock; and, therefore, that it synthesizes the attitudes and opinions of
all. That the price of a stock is the result of buying and selling forces and
represents the “true value” at any given moment. That a Major Trend must
be presumed to continue in effect until clear evidence of Reversal is shown.
And, finally, that it is possible to form opinions having a reasonably high
probability of confirmation from the market action of a stock as shown in
daily, weekly, or monthly charts, or from other technical studies derived
from the market activity of the security.
It is important to point out that the ultimate value of a security to the
investor or trader is what he or she ultimately receives from it. That is to
say, the price the investor gets when it is sold, or the market price
obtainable for it at any particular time, adjusted for dividends or capital
distribution in either case. If, for example, he or she has bought a stock at
$25 a share, and it has paid $5 in dividends and is now bid at $35, he or she
has realized an accrued benefit of $5 plus $10, or $15 in all. It is the
combination of dividends and appreciation of capital that constitutes the
total gain.
It seems futile to try to correlate or compare the market value of a stock
with the “book value” or with the “value” figured on a basis of capitalized
earnings or dividends, projected growth, etc. There are too many other
factors that may also affect the value, and some of these cannot easily be
expressed in simple ratios. For example, a struggle for control of a
corporation can as surely increase the value of its securities in the market as
a growth of earnings. Again, a company may lose money for years and pay
no dividends, yet still be an excellent investment on the basis of its
development of potential resources as perceived by those who are buying
and selling its stock. The market is not evaluating last year's
accomplishments as such; it is weighing the prospects for the year to come.
Then, too, in a time of inflation, a majority of stocks may advance sharply
in price. This may reflect a depreciation in the purchasing power of dollars
more than improvement in business conditions—but it is important,
nonetheless, in such a case to be “out of dollars” and “into” equities.
As a result of their research from 1942 to 1948, Edwards and Magee
developed new technical methods. They put these methods to practical use
in actual market operation. Eventually, in 1948, these findings were
published in their definitive book, Technical Analysis of Stock Trends.
This book, now in its seventh edition, has become the accepted authority in
this field. It has been used as a textbook by various schools and colleges
and is the basic tool of many investors and traders.
In 1951, Edwards retired from his work as a stock analyst and John Magee
continued the research, at first, independently, and then from January 1953
to March 1956 as Chief Technical Analyst with an investment counseling
firm.
Meanwhile, beginning in 1950, Magee started on a new road, which, as it
turned out, was destined to open up virgin fields of technical market
research.
Using the methods of Dow, Hamilton, Schabacker, and Edwards as a base,
he initiated a series of studies intended to discover new technical devices.
These investigations were long and laborious, and, often, they were
fruitless. One study required four months of work, involved hundreds of
sheets of tabulations, many thousands of computations, and proved nothing.
But from this type of work, eventually in late 1951, there began to emerge
some important new and useful concepts—new bricks to build into the
structure of the technical method.
The new devices are not revolutionary. They do not vitiate the basic
technical approach. Rather, they are evolutionary and add something to the
valuable kit of tools already at hand. The new studies often make it possible
to interpret and predict difficult situations sooner and more dependably than
any other method previously used.
Mr. Magee has designated these newest technical devices the Delta Studies.
They are basically an extension and refinement of the technical method.
There is no magic in the Delta Studies. They do not provide infallible
formulas for sure profits at all times in every transaction, but they have
proved eminently successful over a period of years in practical use in actual
market operations, as an auxiliary to the methods outlined in the book,
Technical Analysis of Stock Trends.
Through his technical work, John Magee emphasized these three principles:
1. Stock prices tend to move in trends.
2. Volume goes with the trends.
3. A trend, once established, tends to continue in force.
A large portion of the book, Technical Analysis of Stock Trends, is devoted
to the patterns that tend to develop when a trend is being reversed. Head
and Shoulders, Tops and Bottoms, “W” Patterns, Triangles, Rectangles, etc.,
are common patterns to stock market technicians. Rounded Bottoms and
Drooping Necklines are some of the more esoteric ones.
Magee urged investors to go with the trend, rather than trying to pick a
Bottom before it was completed or averaging down in a declining stock.
Above all, and at all times, he refused to get involved in the game of
forecasting where “the market” was headed, or where the Dow Jones
Industrial Average® would be on December 31st of the coming year.
Rather, he preached care in individual stock selection regardless of which
way the market “appeared” headed. Finally, his service recommended short
positions as regularly as it did long positions, based simply on what the
charts said.
Richard McDermott Editor and Reviser Technical Analysis of Stock
Trends, Seventh Edition January 1997
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
Preface to the fifth edition
During the 16 printings of the fourth edition of Technical Analysis of Stock
Trends, very few changes have been made in the original text, mainly
because the lucid presentation of market action by the late Robert D.
Edwards covered so thoroughly the basic and typical market action of
common stocks. There has seemed no reason, for example, to discard a
chart picture illustrating some important technical phenomenon merely
because it occurred several or many years ago.
Instead, over the various printings of the book, pages have been added
showing similar examples, or in some cases entirely new types of market
action taken from recent history; but these demonstrate mainly that the
inherent nature of a competitive market does not change very much over the
years, and that “the same old patterns” of human behavior continue to
produce much the same types of market trends and fluctuations.
The principal change in this fifth edition, and it is a spectacular
improvement, is that practically all of the chart examples drawn to the
TEKNIPLAT™ scale have been redrawn and new plates of these have been
substituted. In the course of this work, several minor errors of scaling,
titling, etc., previously undiscovered, came to light and have been corrected.
The difficult work of revision was initiated in our charting room by two
ambitious teenagers, Anne E. Mahoney and Joseph J. Spezeski, who took
on the entire job of preparing the finished drawings and making necessary
corrections. This enormous project was undertaken and carried through by
these two young people spontaneously. In order to free them entirely from
other distractions, their regular charting work was taken over for a period of
months by the rest of the chartroom staff, so that a great deal of credit is due
to the fine efforts of the entire chartroom group.
John Magee December 3, 1966
xli
Taylor & Francis
Taylor & Francis Group
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Preface to the fourth edition
In the several years since publication of the first edition of this work, “the
stock market goes right on repeating the same old movements in much the
same old routine.” Nearly all of the technical phenomena outlined in the
first edition have appeared many times since then, and we see no reason to
expect these habits of stocks will change materially in the years ahead,
barring revolutionary changes in the economy, such as the abolishment of
the free market entirely.
Since the basic nature of the market has not changed appreciably, it has
been unnecessary to make sweeping alterations in the text of “Part One:
Technical Theory.” The previous edition has been very carefully restudied,
and revisions have been made where they were called for to bring the
material up to date. In “Part Two: Trading Tactics,” more extensive changes
were needed, due to the more specific nature of the material and some
differences in the present margin requirements, trading rules, etc. Also,
there have been some improvements in the application of technical methods
at the tactical level, and these have been incorporated in this section.
Somewhat less emphasis has been put on the use of stop-loss orders, since
their need is not so great in the case of the experienced trader as it might be
with the novice. The principle of always following the Major Trend has
been modified to achieve better protection of capital through balance and
diversification. In line with avoiding “all-out” situations, with their
consequent dangers, the idea of using an Evaluative Index has been
introduced, and this concept has modified somewhat the tactics of following
the Major Trend. It also has a bearing on the Composite Leverage or
determination of total risk.
Type for the entire book has been reset in this edition. The illustrative charts
originally used have been, in the main, retained, since they demonstrate the
various points very well, but a new chapter includes a number of additional
charts taken from the market history of recent years, showing how the same
phenomena continue to appear again and again.
The appendix (Appendix C, 5th edition) on the Sensitivity Indexes has been
completely recomputed and extended to cover a broad list of the more
important issues. The arduous labor of determining these index figures was
undertaken by Frank J. Curto and Marcella P. Curto. Material help in
proofreading and revision for this edition was given by Beverly Magee and
Elinor T. Magee.
John Magee January 1, 1957
Taylor & Francis
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Preface to the second edition
It is, needless to say, gratifying to the authors of this treatise to report that
not only has a large first edition been exhausted (although it was originally
assumed it would suffice for many years), but also, the demand for copies
has been increasing at a rather astonishing pace during the past six months
without any “promotion” except word-of-mouth recommendation from one
investor to another.
In preparing this new edition, a careful perusal of everything that was
written in the previous printing, checked by the market events of the past 24
months and compared with all of the additional chart data accumulated
during that period, resulted in the not unexpected, but nevertheless mildly
surprising conclusion that nothing of real consequence needed to be
changed or amplified. Hence, only minor revisions of an editorial nature
have been made.
It would have been interesting to augment our already copious illustrations
with a number of charts from current months of market action, but costs of
engraving and printing have risen to such a distressingly high level that any
additions of that sort would, it was found, be prohibitively expensive. Aside
from their novelty, they would add nothing to the book; they would only be
substituted for other charts of precisely the same nature and significance,
and fully as pertinent to present-day conditions.
The stock market, as I wrote in the original Foreword, “goes right on
repeating the same old movements in much the same old routine. The
importance of a knowledge of these phenomena to the trader and investor
has been in no whit diminished.” We see the same forecasting patterns
developing on the charts today that we have seen over and over again for
the past 20 years. Neither the mechanics nor the “human element” of the
stock market has changed, and there is no reason to think they will.
Robert D. Edwards May 1, 1951
xlv
Taylor & Francis
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Foreword
This book has been written for the layman rather than for the Wall Street
professional. But, it assumes the reader is already possessed of at least an
elementary knowledge of the nature of stocks and bonds, and he has had
some dealings with a broker and some familiarity with the financial pages
of his newspapers. Hence, no attempt is made herein to define common
stock market terms and procedures. Every effort, however, has been exerted
to explain, in full, the theories and the terminology of our specific subject,
technical market analysis.
Part One is based, in large part, on the pioneer researches and writings of
the late Richard W. Schabacker. Students of his Technical Analysis and
Stock Market Profits (the latest revision of which is now out of print was
made in 1937 by the present writer and Albert L. Kimball) will find in the
pages of this section much that is familiar and, except for the illustrations,
only a little that is really novel. It has been a matter of surprise, in fact, to
the authors and other students of market technics that all the new controls
and regulations of the past several years, the new taxes which have placed a
heavy handicap on successful investors, the greatly augmented and
improved facilities for acquiring dependable information on securities, even
the quite radical changes in certain portions of our basic economy, have not
much altered the “pattern” of the stock market.
Certain of the evidences of pool manipulation that used to appear on the
charts are now seldom seen. A few of the price formations that formerly
were quite common, now appear rarely or may have lost much of their
practical utility for the trader; they have been omitted from this text. Others
have altered their habits slightly, or their consequences to a degree (but not
their fundamental nature), which has, of course, been noted herein. The
distressing thinness of the market at times—one of the undoubted effects of
regulation—has resulted in a few more “false moves,” more spells of
uninteresting (and unprofitable) inactivity. But, in the main, the market goes
right on repeating the same old movements in much the same old routine.
The importance of a knowledge of these phenomena to the trader and
investor has been in no whit diminished.
Part Two, which has to do with the practical application of these market
patterns and phenomena, with the tactics of trading, is all new. For more
than 15 years (his total market experience extends back nearly 30 years),
John Magee has invested and traded exclusively via the technical theory,
kept thousands of charts, made hundreds of actual trades, tested all sorts of
applications, audited and analyzed methods, tactics, and results from every
conceivable angle, depended on his profits for his living. His contribution is
that of one who has tried and knows.
It may well be added here—and will be often repeated in the following
pages—that the technical guides to trading in stocks are by no means
infallible. The more experience one gains in their use, the more alive one
becomes to their pitfalls and their failures. There is no such thing as a sure-
fire method of “beating the market”; the authors have no hesitancy in
saying that there never will be. Nevertheless, a knowledge and judicious
application of the
xlvii principles of technical analysis does pay dividends—is more profitable
(and far safer) for the average investor than any other of the presently
recognized and established approaches to the problems of buying and
selling securities.
Robert D. Edwards
July 1948
part one
Technical theory
Taylor & Francis
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http://taylorandfrancis.com
chapter one
The technical approach to trading and investing
Few human activities have been so exhaustively studied during the past
century, from so many angles and by so many different sorts of people, as
the buying and selling of corporate securities. The rewards the stock market
holds out to those who read it right are enormous; the penalties it exacts
from careless, dozing, or “unlucky” investors are calamitous. No wonder it
has attracted some of the world's most astute accountants, analysts, and
researchers, along with a motley crew of eccentrics, mystics, “hunch
players,” and a multitude of just ordinary hopeful citizens.
Able brains have sought, and continue constantly to seek, for safe and sure
methods of appraising the state and trend of the market, as well as
discovering the right stock to buy and the right time to buy it. This intensive
research has not been fruitless—far from it. There are a great many
successful investors and speculators (using the word in its true sense, which
is without opprobrium) who, by one road or another, have acquired the
necessary insight into the forces with which they deal and the judgment, the
forethought, and the all-important self-discipline to deal with them
profitably.
In the course of years of stock market study, two quite distinct schools of
thought have arisen, providing two radically different methods of arriving at
the answers to the trader's problem of what and when. In the parlance of
“the Street,” one of these is commonly referred to as the fundamental or
statistical, and the other as the technical. (In recent years a third approach,
the cyclical, has made rapid progress, and although still beset by a “lunatic
fringe,” it promises to contribute a great deal to our understanding of
economic trends.)
The stock market fundamentalist depends on statistics. He examines the
auditors' reports, the profit-and-loss statements, the quarterly balance
sheets, the dividend records, and the policies of the companies whose shares
he has under observation. He analyzes sales data, managerial ability, plant
capacity, and the competition. He turns to bank and treasury reports,
production indexes, price statistics, and crop forecasts, to gauge the state of
business in general, and reads the daily news carefully to arrive at an
estimate of future business conditions. Taking all these into account, he
evaluates his stock; if it is selling currently below his appraisal, he regards
it as a buy. (EN9: And, no surprise, the buyer's name is Warren Buffet, and
he buys the company, not the stock, for although this is an excellent way to
buy companies, it is not a very good way to buy stocks.) EN: Read Robert
Prechter's summation of the fundamental methodology as an amusing
endnote at the end of this chapter.
As a matter of fact, aside from the greenest of newcomers when they first
tackle the investment problem, and to whom, in their inexperience, any
other point of view is not only irrational but incomprehensible, your pure
fundamentalist is a rare bird. Even those market authorities who pretend to
scorn charts and “chartists” utterly are not oblivious to the “action”
chronicled by the ticker tape, and they do not conceal their respect for the
Dow Theory, which, whether they realize it or not, is, in its very essence,
purely technical.
Definition of technical analysis
The term “technical,” in its application to the stock market, has come to
have a special meaning, quite different from its ordinary dictionary
definition. It refers to the study of the action of the market itself as opposed
to the study of the goods in which the market deals. Technical Analysis is
the science of recording, usually in graphic form, the actual history of
trading (price changes, volume of transactions, etc.) in a certain stock or in
“the Averages” and then deducing from that pictured history the probable
future trend. EN: With the advent of the computer, many schools of
technical analysis have arisen. Number-driven technical analysis (e.g.,
moving average studies, oscillators, etc.) attempts to completely objectify
the analysis of the markets. The work of Edwards and Magee is the
embodiment and definition of “classical technical analysis.”
The technical student argues thus: it is futile to assign an intrinsic value to a
stock certificate. One share of U.S. Steel, for example, was worth $261 in
the early fall of 1929, but you could buy it for only $22 in June 1932. By
March 1937, it was selling for $126 and just one year later it was selling for
$38. In May 1946, it had climbed back up to $97, and 10 months later, in
1947, had dropped below $70, although the company's earnings on this last
date were reputed to be nearing an all-time high and interest rates in general
were still near an all-time low. The book value of this share of U.S. Steel,
according to the corporation's balance sheet, was about $204 in 1929 (end
of the year), $187 in 1932, $151 in 1937, $117 in 1938, and $142 in 1946.
This sort of wide divergence between presumed value and actual price is
not the exception—it is the rule. It is going on all the time. The fact is the
real value of a share of U.S. Steel common is determined at any given time
solely, definitely, and inexorably by supply and demand, which are
accurately reflected in the transactions consummated on the floor of the
New York Stock Exchange (see Figure 1.1).
Of course, the statistics fundamentalists study play a part in the supply-
demand equation—that is freely admitted. But many other factors are
affecting it as well. The market price reflects not only the differing value
opinions of many orthodox security appraisers, but also all the hopes and
fears and guesses and moods, rational and irrational, of hundreds of
potential buyers and sellers, as well as their needs and their resources—in
total, factors that defy analysis and for which no statistics are obtainable,
but that nevertheless are synthesized, weighed, and finally expressed in the
one precise figure at which a buyer and a seller get together and make a
deal (through their agents, their respective stock brokers). This is the only
figure that counts.
Moreover, the technician claims, with complete justification, that the bulk
of the statistics the fundamentalists study are past history, already out of
date and sterile because the market is not interested in the past or even in
the present. It is constantly looking ahead, attempting to discount future
developments, weighing and balancing all the estimates and guesses of
thousands of investors who look into the future from different points of
view and through glasses of many different hues. In brief, the going price,
as established by the market itself, comprehends all the fundamental
information the statistical analyst can hope to learn (plus some that is
perhaps secret from him or known only to a few insiders) and much else
besides of equal or even greater importance.
All of which, admitting its truth, would be of little significance were it not
for the fact, which no one of experience doubts, that prices move in trends
and trends tend to continue until something happens to change the supply-
demand balance. Such changes are usually detectable in the action of the
market. Certain patterns or formations, levels or areas, appear on the charts
that have a meaning and that can be interpreted in terms of probable future
Figure 1.1 Monthly price ranges of U.S. Steel common from January 1929
to December 1946. Compare the great swings in the market price for this
stock—from 1929 (extreme high, 261 3/4) to 1932 (extreme low, 21 1/4),
from 1932 to 1937, from 1937 to 1938, from 1942 to 1946—with its book
values for those years as cited on the previous page.
trend development. They are not infallible, it must be noted, but the odds
are definitely in their favor. Time after time, as experience has amply
proved, they are far more prescient than the best informed and most shrewd
of statisticians.
The technical analyst may go even further in his claims. He may offer to
interpret the chart of a stock whose name he does not know, so long as the
record of trading is accurate and covers a long enough term to enable him to
study its market background and habits. He may suggest he could trade with
profit in a stock knowing only its ticker symbol, completely ignorant of the
company, the industry, what it manufactures or sells, or how it is
capitalized. Needless to say, such practice is not recommended, but if your
market technician is really experienced at his business, he could, in theory,
do exactly what he claims.
Should the reader, at this point, find the technical approach to trading or
investing, as explained in the foregoing, completely abhorrent, perhaps he
had better close the book now, for it is primarily the technical approach, the
science of technical analysis, with which the remainder of the book deals.
EN: The Elliott Wave Theory: perspective and comments from a Magee
investment letter of the 80s. This week, we had the pleasure of attending the
December meeting of the Market Technicians Association of New York
(MTANY).
Long-term subscribers will remember the MTANY as the organization that
honored John Magee with its Man of the Year award in 1978. The speaker
was Robert Prechter, publisher of “The Elliott Wave Theorist,” an
investment advisory that bases its forecasts on interpretations of R. N.
Elliott's work on the stock market.
Of primary interest to subscribers are Prechter's comments on technical
analysis itself. The Elliott Wave Theory, it must be remembered, is really no
more than a “catalog” of stock market price movements, laid one on top of
the other, so to speak, until a grand, underlying, and enduring pattern is
observed; in short, pure technical analysis. Among Prechter's definitions
and observations regarding fundamental analysis are the following:
1. First, let's define "technical" versus "fundamental" data ... technical
data is that which is generated by the action of the market under study.
2. The main problem with fundamental analysis is its indicators are
removed from the market itself. The analyst assumes causality between
external events and market movements, a concept which is almost
certainly false. But, just as important (and less recognized), is that
fundamental analysis almost always requires a forecast of the
fundamental data itself before conclusions about the market are drawn.
The analyst is then forced to take a second step in coming to a
conclusion about how those forecasted events will affect the markets!
Technicians only have one step to take, which gives them an edge right
off the bat. Their main advantage is they don't have to forecast their
indicators.
3. What's worse, even the fundamentalists' second step is probably a
process built on quicksand. ... The most common application of
fundamental analysis is estimating companies' earnings for both the
current year and next year and recommending stocks on that basis. .
And the record on that basis alone is very poor, as Barron's pointed out
in a June 4 article, which showed that earnings estimates averaged
18% error in the 30 Dow Jones Industrial Average (DJIA) stocks for
any year already completed and 54% error for the year ahead. The
weakest link, however, is the assumption that correct earnings
estimates are a basis for choosing stock market winners. According to
a table in the same Barron's article, a purchase of the 10 DJIA stocks
with the best earnings estimates would have produced a 10-year
cumulative gain of 40.5%, while choosing the 10 DJIA with the worst
earnings estimates would have produced a whopping 142.5% gain.
We enjoyed Prechter's polished exposition of a technical approach, which is
different from our own. As for his observations about fundamental analysis,
we simply couldn't agree more.
chapter two
Charts
Charts are the working tools of the technical analyst. They have been
developed in a multitude of forms and styles to represent graphically almost
anything that takes place in the market as well as to plot an “index” derived
therefrom. They may be monthly charts on which an entire month's trading
record is condensed into a single entry, or they may be weekly, daily,
hourly, transaction, “point-and-figure,” and candlestick charts. They may be
constructed on arithmetic, logarithmic, or square-root scale, or they may be
projected as “oscillators.” They may delineate moving averages, proportion
of trading volume to price movement, average price of most active issues,
odd-lot transactions, the short interest, and an infinitude of other relations,
ratios, and indexes—all technical in the sense that they are derived, directly
or indirectly, from what actually has been transacted on the exchanges.
Fortunately, we shall not need to concern ourselves with most of these
charts; they are of interest only to the full-time economic analyst. Many of
these charts have derived from a completely futile (so far, at least) endeavor
to discover a “mechanical” index or combination of indexes that will
always, automatically, without ever failing or going wrong, give warning of
a change in trend; in our experience, such charts are often confusing and
sometimes downright deceptive at a most critical juncture. This book,
however, is designed for the layman, the professional who cannot spend all
of his hours on his investing or trading operations, but to whom these
operations are, nevertheless, of sufficient importance or interest to warrant
his devoting at least a few minutes a day to their study and management.
(EN9: In retrospect, this is an underestimation of the importance of the
work. In the 21st century, the best professionals are acutely aware of the
importance of trend analysis and use this work as their textbook.) The
theories and methods outlined herein will require only the simplest form of
stock chart—a record of the price range (open, high/low and close) and
volume of shares traded each day. These daily graphs will be supplemented,
for certain purposes that will be discussed later in this text, by weekly or
monthly charts, which for most stocks can be easily generated by almost all
commercially available investment software and websites.
Nearly all the illustrations throughout the following chapters are examples
of such daily charts. They are easy to make and maintain manually,
requiring only a supply of graph or cross-section paper (almost any kind
can serve), a daily newspaper that gives full and accurate reports on stock
exchange dealings, a sharp pencil, and a few minutes of time. EN:
Alternatively, numerous data services are available for use with computer
software packages, not to mention internet sites (which are mentioned in
Appendix B, Resources). The use of this technology eliminates the burden of
manual chart keeping. If there is a drawback to this technology, it might be
in the loss of the “feel” the investor gets through manual charting.
It is customary in preparing ordinary daily stock charts to let the horizontal
axis represent time, with the vertical cross-lines (or as some prefer, the
spaces between them) from left to right, thus standing for successive days.
The vertical scale is used for prices, with each horizontal cross-line then
representing a specific price level. Space is usually provided at the bottom
of the sheet to plot volume, that is, the number of shares that change hands
each day. The newspapers publishing complete stock market reports give
the day's turnover or volume (exclusive of odd-lot transactions that for our
present purpose may be disregarded), the highest and lowest price at which
each stock sold during the day, the closing price (which is the price at which
the last sale effected during the day was made), and usually the opening or
first sale price. On our charts, the daily price range is plotted by drawing a
vertical line connecting the points representing the high and the low. Then a
short horizontal “tick” is added, either crossing the vertical range line or
extending out to the right from it, at the level of the closing price.
Sometimes all transactions in a stock during a day take place at one and the
same price; the high, low, and close are thus all on level and the only mark
on our chart will be the horizontal dash representing the closing figure.
Volume is depicted by drawing a vertical line up from the baseline of the
chart.
The opening price need not be recorded. (EN10: Candlestick charts require
this piece of data.) Experience has shown that it seldom, if ever, has any
significance in estimating future developments, which is all that ordinarily
should interest us. The closing price is important, however. It is, in fact, the
only price that many casual readers of the financial pages ever look at. It
represents the final evaluation of the stock made by the market during the
day. The closing price may be registered in the first hour of trading,
provided no other sales are subsequently affected, but, it nevertheless
becomes the figure upon which a majority of prospective traders base their
plans for the following day. Hence, its technical significance is evident and
will appear in various contexts in later chapters.
Different types of scales
Many specific suggestions as to the details of charting are deferred for
discussion in Section II of this book, but there is one chart feature that may
well be considered here. Until recent years, nearly all stock price charts
were kept on the common form of graph paper ruled to what is known as
plain or arithmetic scale. But more and more chartists have now come to
use what is known as semilogarithmic paper, or sometimes as ratio or
percentage paper. Our experience indicates that the semilogarithmic scale
has definite advantages in this work, and most of the charts reproduced in
this book employ this scale. The two types of scales may be distinguished at
a glance: on arithmetic paper, equal distances on the vertical scale (i.e.,
between horizontal lines) represent equal amounts in dollars, whereas on
the semilogarithmic paper, they represent equal percentage changes. Thus,
on arithmetic paper, the distance between 10 and 20 on the vertical scale is
exactly the same as that from 20 to 30 and from 30 to 40. On the
semilogarithmic scale the difference from 10 to 20, representing an increase
of 100%, is the same as that from 20 to 40 or from 40 to 80, in each case
representing another 100% increase.
Percentage relations, it goes without saying, are important in trading in
securities. The semilogarithmic scale permits direct comparison of high-
and low-priced stocks and makes it easier to choose the one offering the
greater (percentage) profit on the funds to be invested. It facilitates the
placing of stop-loss orders. Area patterns appear much the same on either
type of paper, but certain trendlines develop more advantageously on the
ratio scale. Almost anyone can quickly become accustomed to making
entries on semilogarithmic paper. (We recommend its use.) Its advantages,
however, are not so great as to require one to change—one who, because of
long familiarity and practice, prefers an arithmetic sheet. Such percentage
calculations, as may seem to be required, can be made on another sheet or
in the head, and the results then can be entered on the arithmetic chart, if a
record is desired.
Several firms specializing in the manufacture of graph paper and other
engineers' and architects' supplies now offer sheets specifically designed for
stock charting, on which heavier lines to define the business week mark
each sixth day on the time scale, and the price scale is subdivided into
eighths to represent the standard fractions of the dollar in which stocks are
traded on all U.S. exchanges. (EN9: Eighths went the way of the New
Haven and now decimals reign.) These sheets are available in various sizes
and with either arithmetic or logarithmic price and volume scales. EN: This
paper is only of interest to the manual chartist, as modern software, as
detailed in Appendix B, Resources, enables the computer chartist to easily
switch between price scales and methods of charting. References to such
paper are also found there.
On weekly charts, each vertical line represents a week's worth of trading.
The price range for the week is plotted thereon and usually the total
volume, but the closing price may be omitted. The range extends from the
highest price at which the stock sold on any day during the week to the
lowest price at which it sold on any day; these two extremes might, and
sometimes do, occur on the same day, but the weekly chart makes no
distinction as to day. Monthly charts are prepared in the same way but do
not, as a rule, record volume. These two charts—often referred to as long-
term or major charts—are used chiefly for determining important support
and resistance levels and for marking long-term trends. Weekly charts—if
the reader prefers to keep his own—can be posted easily from the Sunday
morning editions of those daily newspapers (e.g., the New York Times or
Barron's Business and Financial Weekly) that publish a summary of the
previous week's transactions.
In concluding this chapter on the construction of the charts that we shall
study in succeeding chapters, it can well be said that there is no special
virtue, certainly no magic, in the chart itself. It is simply a pictorial record
of the trading history of the stock or stocks in which we may be interested.
To the person possessed of a photographic memory, no chart work is
necessary; his mind records all the necessary data—he carries his charts in
his head. Many of the expert “tape-readers” who have no use for charts are
gifted with that rare memory talent that renders reference to graphic records
unnecessary. But most of us are not so blessed; to use the chart is necessary
and useful because it lends itself conveniently to the type of analysis that
indicates future probabilities.
There is a saying on Wall Street to the effect that “there is nothing wrong
with charts— the trouble is with the chartists,” which is simply another way
of expressing the truth that it is not the chart but its interpretation that is
important. Chart analysis is neither easy nor foolproof. Yet, it is not at all
uncommon for some casual investor who has no idea whatever of market
technics to pick up a chart by chance and see in it something he had not
hitherto suspected, something perhaps that saves him from making an
unfavorable commitment.
If you have never used stock charts, and have never paid much attention to
them, you may be surprised at some of the significant things you will detect
as soon as you begin to study them seriously.
EN9: Surprise and astonishment are the words used to describe the
reactions of even professionals when they are fully exposed to a coherent
presentation of the methods of Edwards and Magee. I have often
commented that no understanding of other (number driven statistical)
methods of technical analysis is possible without a firm grasp of the
concepts and principles of this book.
Some other comments are worth noting relevant to Edwards' discussion.
For manual charting, semilog remains the superior scale. Given the ease of
changing scale and time frames on internet sites (e.g., prophet.net,
thinkorswim.com, tdameritrade.com, and stockcharts.com) and in the
standalone software, one may switch from a close-up of a month to a long-
range perspective of years. In this process, it is important to maintain
perspective. Multiyear log charts of large ranges lose graphic importance
at the top as chart intervals shrink. This distortion must be countered by
breaking the time frame into smaller increments. Thus, instead of five years
of a chart that spans a range of 10-200, we look at five charts of one year
each as well as the five-year chart.
In the modern era, a new graphic representation has gained enormous
popularity—candlestick charting. In this method, color is added to the chart
by coloring the body of the candlestick—white for rising prices, black for
falling prices (or colors of your choice). Thus, the direction of the trend is
dramatized. Also, candlestick patterns are said to be of value in recognizing
trend reversals and other trend states.
A host of other charting methods exists: Three Line Break, Renko, Kagi...
These may be researched in Nison's book, Beyond Candlesticks. I will not
treat these in this book, but I do include them in an appendix on
examination of Point and Figure charting.
chapter three
The Dow Theory
The Dow Theory is the granddaddy of all technical market studies.
Although it is frequently criticized for being “too late” and occasionally
derided (particularly in the early stages of a Bear Market) by those who
rebel against its verdicts, it is known by name to nearly everyone who has
had any association with the stock market, and it is respected by most.
Many who heed it in greater or lesser degrees in determining their
investment policies never realize that it is purely and simply “technical.” It
is built upon and concerned with nothing but the action of the stock market
(as expressed in certain averages), deriving nothing from the business
statistics on which the fundamentalists depend.
There is much in the writings of its original promulgator, Charles H. Dow,
to suggest he did not think of his theory as a device for forecasting the stock
market, or even as a guide for investors, but rather as a barometer of general
business trends. Dow founded the Dow-Jones Financial News Service and
is credited with the invention of stock market averages. He outlined the
basic principles of the theory, which was later named after him, in editorials
he wrote for the Wall Street Journal. Upon his death in 1902, his successor,
William P. Hamilton, as editor of the Journal, took up Dow's principles and,
in the course of 27 years of writing on the stock market, organized and
formulated them into the Dow Theory as we know it today.
Before we proceed to an explanation of the theory, it will be necessary to
examine the stock averages that it employs. Long before the time of Dow,
the fact was familiar to bankers and businessmen that the securities of most
established companies tended to go up or down in price together.
Exceptions—stocks that moved against the general financial tide—were
rare, nor did they as a rule persevere in that contrary course for more than a
few days or weeks at a time. It is true that when a boom was on, the prices
of some issues rose faster and farther than others, and when the trend was
toward depression, some stocks declined rapidly whereas others would put
up considerable resistance to the forces that were dragging down the
market. The fact remained, however, that most securities tended to swing
together. (They still do and always will.)
This fact, as we have said, has long been commonly known and accepted
(so completely taken for granted that its importance is usually overlooked),
for it is important— tremendously important—from many angles in
addition to those that come within the province of this volume. One of the
best reasons for a student of market technics to start with the Dow Theory is
because that theory stresses the general market trend.
Charles Dow is believed to have been the first to make a thorough effort to
express the general trend (or, more correctly, level) of the securities market
in terms of the average price of a selected few representative stocks. As
finally set up in January of 1897, in the form that has continued to date and
used by Dow in his studies of market trends, there were two Dow-Jones
Averages. One was composed solely of the stocks of 20 railroad companies,
for the railroads were the dominant corporate enterprises of his day. The
other, called the Industrial Average, represented all other types of
businesses and was made up, at first, of only 12 issues. This number was
increased to 20 in 1916 and to 30 on October 1, 1928.
The Dow Averages
The stocks included in these two Averages have been changed from time to
time to keep the lists up to date and as nearly representative as possible of
their respective groups. Only General Electric, of the present 30 industrial
stocks, was included in the original Industrial Average, and that was
dropped at one time (in 1898) and subsequently reinserted. In 1929, all
stocks of public utility companies were dropped from the Industrial Average
and a new Utility Average of 20 issues was set up; in 1938, its number was
reduced to 15. The 20 rail, 30 industrial, and 15 utility stocks are now
averaged together to make what is known as the Dow-Jones Stock
Composite. The history of these Averages, the various adjustments that have
been made in them and their method of computation is an interesting story
in itself, which the reader may want to look up elsewhere. EN: See
Appendix B, Resources, for references. Note also there is now a
proliferation of Dow-Jones Averages. For our present purpose, it remains
only to add that the Dow Theory pays no attention to the Utility or
Composite Averages; its interpretations are based on the Rail and Industrial
Averages only. EN: The Rails are now known as Transportations.
In recent years, the values of the Dow-Jones Averages have been computed
for the end of each hour of trading as well as the end of the day. EN: Now
computed in real time and available over the internet, these hourly figures
are published in the Wall Street Journal as well as on all market tickers. In
fact, presently, the Averages are computed in real time, a necessity for
options and futures trading that takes place on them. The Wall Street
Journal also prints in each issue a summary of the important highs and lows
of each average by date for the preceding two or three years. Their daily
closing prices are reported in many other metropolitan daily newspapers.
Basic tenets
To get back to the Dow Theory, here are its basic tenets:
1. The Averages discount everything (except “acts of God”): Since
they reflect the combined market activities of thousands of investors,
including those possessed of the greatest foresight and the best
information on trends and events, the Averages in their day-to-day
fluctuations discount everything known, everything foreseeable, and
every condition that can affect the supply of or the demand for
corporate securities. Even unpredictable natural calamities, when they
happen, are quickly appraised and their possible effects discounted.
2. The Three Trends: The “market,” meaning the price of stocks in
general, swings in trends, of which the most important are its Major or
Primary Trends. These are the extensive up or down movements that
usually last for a year or more and result in general appreciation or
depreciation in value of more than 20%. Movements in the direction of
the Primary Trend are interrupted at intervals by Secondary Swings in
the opposite direction— reactions or corrections that occur when the
Primary Move has temporarily “gotten ahead of itself.” (Both
Secondary and the intervening segments of the Primary Trend are
frequently lumped together as Intermediate Movements—a term we
shall find useful in subsequent discussions.) Finally, the Secondary
Trends are composed of Minor Trends or day-to-day fluctuations that
are unimportant to Dow Theory.
3. The Primary Trends: These, as aforesaid, are the broad, overall, up
and down movements that usually (but not invariably) last for more
than a year and may run for several years. So long as each successive
rally (price advance) reaches a higher level than the one before it, and
each Secondary Reaction stops (i.e., the price trend reverses from
down to up) at a higher level than the previous reaction, the Primary
Trend is up. This is called a Bull Market. Conversely, when each
Intermediate Decline carries prices to successively lower levels and
each intervening rally fails to bring them back up to the top level of the
preceding rally, the Primary Trend is down. This is called a Bear
Market. (The terms Bull and Bear are frequently used loosely with
reference, respectively, to any sort of up or down movements, but we
shall use them in this book only in connection with the Major or
Primary Movements of the market in the Dow sense.) Ordinarily—
theoretically, at least—the Primary Trend is the only one of the three
trends with which the true long-term investor is concerned. His aim is
to buy stocks as early as possible in a Bull Market—just as soon as he
can be sure that one has started—and then hold them until (and only
until) it becomes evident it has ended and a Bear Market has started.
He knows he can safely disregard all the intervening Secondary
Reactions and Minor Fluctuations. The trader, however, may well
concern himself also with the Secondary Swings, and it will appear
later on in this book that he can do so with profit.
4. The Secondary Trends: These are the important reactions that
interrupt the progress of prices in the Primary Direction. They are the
Intermediate Declines or corrections that occur during Bull Markets
and the Intermediate Rallies or recoveries that occur in Bear Markets.
Normally, they last for three weeks to many months, rarely longer.
Normally, they retrace from one-third to two-thirds of the gain (or loss,
as the case may be) in prices registered in the preceding swing in the
Primary Direction. Thus, in a Bull Market, prices in terms of the
Industrial Average might rise steadily, or with only brief and minor
interruptions, for a total gain of 30 points before a Secondary
Correction occurred. That correction might then be expected to
produce a decline of not less than 10 points and not more than 20
points before a new Intermediate Advance in the Primary Bull Trend
develops.
Note, however, the one-third/two-thirds rule is not an unbreakable law; it is
simply a statement of probabilities. Most Secondaries are confined within
these limits; many of them stop very close to the halfway mark, retracing
50% of the preceding Primary Swing. They seldom run less than one-third,
but some of them cancel nearly all of it.
Thus, we have two criteria by which to recognize a Secondary Trend. Any
price movement contrary in direction to the Primary Trend that lasts for at
least three weeks and retraces at least one-third of the preceding net move
in the Primary Direction (from the end of the preceding Secondary to the
beginning of this one, disregarding Minor Fluctuations) is labelled as
Intermediate Rank, that is, a true Secondary. Despite these criteria,
however, the Secondary Trend is often confusing in its recognition, and its
correct appraisal at the time it develops, and while it is in process poses the
Dow theorist's most difficult problem. We shall have more to say about this
later.
5. The Minor Trends: These are the brief (rarely as long as three
weeks—usually less than six days) fluctuations that are, so far as the
Dow Theory is concerned, meaningless in themselves, but which, in
toto, make up the Intermediate Trends. Usually, but not always, an
Intermediate Swing, whether a Secondary or the segment of a Primary
between successive Secondaries, is made up of a series of three or
more distinguishable Minor Waves. Inferences drawn from these day-
to-day fluctuations are quite apt to be misleading. The Minor Trend is
the only one of the three trends that can be “manipulated” (although it
is, in fact, doubtful if under present conditions even that can be
purposely manipulated to any important extent). Primary and
Secondary Trends cannot be manipulated; it would strain the resources
of the U.S. Treasury to do so.
Right here, before we go on to state a sixth Dow tenet, we may well take
time out for a few minutes to clarify the concept of the three trends by
drawing an analogy between the movements of the stock market and the
movements of the sea. The Major (Primary) Trends in stock prices are like
the tides. We can compare a Bull Market to an incoming or flood tide that
carries the water farther and farther up the beach until finally it reaches
high-water mark and begins to turn; it then follows the receding or ebb tide,
comparable to a Bear Market. But all the time, during both ebb and flow of
the tide, the waves are rolling in, breaking on the beach, and then receding.
Although the tide is rising, each succeeding wave pushes a little farther up
onto the shore and, as it recedes, does not carry the water quite so far back
as did its predecessor. During the tidal ebb, each advancing wave falls a
little short of the mark set by the one before it, and each receding wave
uncovers a little more of the beach. These waves are the Intermediate
Trends, Primary or Secondary, depending on whether their movement is
with or against the direction of the tide. Meanwhile, the surface of the water
is constantly agitated by wavelets, ripples, and “cat's-paws” moving with or
against or across the trend of the waves—these are analogous to the
market's Minor Trends, its unimportant day-to-day fluctuations. The tide,
the wave, and the ripple represent, respectively, the Primary or Major, the
Secondary or Intermediate, and the Minor Trends of the market.
Tide, wave, and ripple
A shore dweller who had no tide table might set about determining the
direction of the tide by driving a stake in the beach at the highest point
reached by an incoming wave. Then, if the next wave pushed the water up
beyond his stake, he would know the tide was rising. If he shifted his stake
with the peak mark of each wave, a time would come when one wave
would stop and start to recede short of his previous mark; then he would
know that the tide had turned and had started to ebb. That, in effect (and
much simplified), is what the Dow theorist does in defining the trend of the
stock market.
The comparison with tide, wave, and ripple has been used since the earliest
days of the Dow Theory. It is even possible that the movements of the sea
may have suggested the elements of the theory to Dow. But the analogy
cannot be pushed too far. The tides and waves of the stock market are not as
regular as those of the ocean. Tables can be prepared years in advance to
predict accurately the time of every ebb and flow of the waters, but no
timetables are provided by the Dow Theory for the stock market. We may
return to some points of this comparison later, but we must proceed now to
take up the remaining tenets and rules of the Theory.
Major trend phases
1. The Bull Market: Primary Uptrends are usually (but not invariably)
divisible into three phases. The first is the phase of accumulation during
which farsighted investors, sensing that business, although now depressed,
is due to turn up, are willing to pick up all the shares offered by discouraged
and distressed sellers and to raise their bids gradually as such selling
diminishes in volume. Financial reports are still bad— in fact, often at their
worst—during this phase. The public is completely disgusted with the stock
market—out of it entirely. Activity is only moderate but beginning to
increase on the rallies (Minor Advances).
The second phase is one of fairly steady advance and increasing activity as
the improved tone of business and a rising trend in corporate earnings begin
to attract attention. It is during this phase that the technical trader normally
is able to reap his best harvest of profits.
Finally comes the third phase when the market boils with activity as the
public flocks to the boardrooms. All the financial news is good, price
advances are spectacular and frequently make the front page of the daily
papers, and new issues are brought out in increasing numbers. It is during
this phase that one of your friends will call up and blithely remark, “Say, I
see the market is going up. What's a good buy?”—oblivious to the fact it
has been going up for perhaps two years, has already gone up a long way,
and is now reaching the stage at which it might be more appropriate to ask,
“What's a good thing to sell?” In the last stage of this phase, with
speculation rampant, volume continues to rise, but “air pockets” appear
with increasing frequency; the “cats and dogs” (low-priced stocks of no
investment value) are whirled up, but more and more of the top-grade issues
refuse to follow.
2. The Bear Market: Primary Downtrends are also usually (but again, not
invariably) characterized by three phases. The first is the distribution period
(which really starts in the later stages of the preceding Bull Market). During
this phase, farsighted investors sense the fact that business earnings have
reached an abnormal height and unload their holdings at an increasing pace.
Trading volume is still high, although tending to diminish on rallies, and the
public is still active but beginning to show signs of frustration, as hoped-for
profits fade away.
The second phase is the panic phase. Buyers begin to thin out and sellers
become more urgent; the downward trend of prices suddenly accelerates
into an almost vertical drop, whereas volume mounts to climactic
proportions. After the Panic Phase (which usually runs too far relative to
then-existing business conditions), there may be a fairly long Secondary
Recovery or a sideways movement, and then the third phase begins.
This is characterized by discouraged selling on the part of those investors
who held on through the Panic or, perhaps, bought during it because stocks
looked cheap in comparison with prices that had ruled a few months earlier.
The business news now begins to deteriorate. As the third phase proceeds,
the downward movement is less rapid, but it is maintained by more and
more distress selling from those who have to raise cash for other needs. The
“cats and dogs” may lose practically all their previous Bull Advance in the
first two phases. Better-grade stocks decline more gradually, as their owners
cling to them to the last. In consequence, the final stage of a Bear Market is
frequently concentrated in such issues. The Bear Market ends when
everything in the way of possible bad news, the worst to be expected, has
been discounted, and it is usually over before all the bad news is “out.”
The three Bear Market phases described in the preceding paragraph are not
the same as those named by others who have discussed this subject, but the
writers of this study feel they represent a more accurate and realistic
division of the Primary down moves of the past 30 years. The reader should
be warned, however, that no two Bear Markets are exactly alike, and neither
are any two Bull Markets. Some may lack one or another of the three
typical phases. A few Major Advances have passed from the first to the
third stage with only a brief and rapid intervening mark-up. A few short
Bear Markets have developed no marked Panic Phase and others have
ended with it, as in April 1939. No time limits can be set for any phase; the
third stage of a Bull Market, for example, the phase of excited speculation
and great public activity, may last for more than a year or run out in a
month or two. The Panic Phase of a Bear Market is usually exhausted in a
very few weeks if not in days, but the 1929 through
1932 decline was interspersed with at least five Panic Waves of major
proportions. Nevertheless, the typical characteristics of Primary Trends are
well worth keeping in mind. If you know the symptoms that normally
accompany the last stage of a Bull Market, for example, you are less likely
to be deluded by its exciting atmosphere.
Principle of confirmation
1. The two Averages must confirm: This is the most-often questioned and
the most difficult to rationalize of all the Dow principles. Yet it has stood
the test of time; the fact it has worked is not disputed by any who have
carefully examined the records. Those who have disregarded it in practice
have, more often than not, had occasion to regret their apostasy. What it
means is that no valid signal of a change in trend can be produced by the
action of one Average alone. Take, for example, the hypothetical case
shown in Diagram 3.1. In this, we assume that a Bear Market has been in
effect for several months and then, starting at a, the Industrial Average rises
(along with the Rails) in a Secondary Recovery to b. On their next decline,
however, the Industrials
Diagram 3.1 A hypothetical daily market chart to show how one average
may fail to confirm the other's Dow signal. Closing prices, indicated by
short horizontal dashes, are connected with vertical lines to make the day-
to-day trend easier to follow.
At this point, the Industrials have “signaled” a change in trend from down
to up. But note the Rails during this period: their decline from b to c carried
them lower than a, and their subsequent advance from c to d has not taken
them above b. They have (so far) refused to confirm the Industrials and,
hence, the Major Trend of the market must be regarded as still down.
Should the Rails go on to rise eventually above their b, then, and then only,
would we have a definite signal of a turn in the tide. Until such a
development, however, the chances remain that the Industrials will not be
able to continue their upward course alone, that they ultimately will be
dragged down again by the Rails. At best, the direction of the Primary
Trend is still in doubt.
This example illustrates only one of the many ways in which the principle
of confirmation applies. Note also that at c, it might have been said that the
Industrials had thus far not confirmed the Rails in continuing the
Downtrend, but this had to do only with the continuation or reaffirmation of
an existing trend. It is not necessary that the two Averages confirm on the
same day. Frequently, both will move into new high (or low) ground
together, but there are plenty of cases in which one or the other lags behind
for days, weeks, or even a month or two. One must be patient in these
doubtful cases and wait until the market declares itself in definite fashion.
2. “Volume goes with the trend”: Those words, which you may often hear
spoken with ritual solemnity but little understanding, are the colloquial
expression for the general truth that trading activity tends to expand as
prices move in the direction of the prevailing Primary Trend. Thus, in a Bull
Market, volume increases when prices rise and dwindles as prices decline;
in Bear Markets, turnover increases when prices drop and dries up as they
recover. To a lesser degree, this holds for Secondary Trends also, especially
in the early stages of an extended Secondary Recovery within a Bear
Market, when activity may show a tendency to pick up on the Minor Rallies
and diminish on the Minor Setbacks. But to this rule, again, there are
exceptions, and useful conclusions can seldom be drawn from the volume
manifestations of a few days, much less from a single trading session; it is
only the overall and relative volume trend over a period of time that may
produce helpful indications. Moreover, in Dow Theory, conclusive signals
as to the market's trend are produced in the final analysis only by price
movement. Volume simply affords collateral evidence that may aid
interpretation of otherwise doubtful situations. (We shall have much more
to say in later chapters about volume in specific relation to other technical
phenomena.)
3. “Lines” may substitute for Secondaries: A line in Dow Theory
parlance is a sideways movement (as it appears on the charts) in one or both
of the Averages, which lasts for two or three weeks or, sometimes, for as
many months, in the course of which prices fluctuate within a range of
approximately 5% or less (of their mean figure). The formation of a Line
signifies that pressure of buying and selling is more or less in balance.
Eventually, of course, either the offerings within that price range are
exhausted and those who want to buy stocks have to raise their bids to
induce owners to sell, or else those who are eager to sell at the Line price
range find that buyers have vanished and that, in consequence, they must
cut their prices to dispose of their shares. Hence, an advance in prices
through the upper limits of an established Line is a Bullish Signal and,
conversely, a breakdown through its lower limits is a Bearish Signal.
Generally speaking, the longer the Line (in duration) and the narrower or
more compact its price range, the greater the significance of its ultimate
breakout.
Lines occur often enough to make their recognition essential to followers of
Dow's principles. They may develop at important Tops or Bottoms,
signaling periods of distribution or of accumulation, respectively, but they
come more frequently as interludes of rest or Consolidation in the progress
of established Major Trends. Under those circumstances, they take the place
of normal Secondary Waves. A Line may develop in one Average while the
other is going through a typical Secondary Reaction. A price movement out
of a Line, either up or down, is usually followed by a more extensive
additional move in the same direction than can be counted on to follow the
“signal” produced when a new wave pushes beyond the limits set by a
preceding Primary Wave. The direction in which prices will break out of a
Line cannot be determined in advance of the actual movement. The 5%
limit ordinarily assigned to a Line is arbitrarily based on experience; there
have been a few slightly wider sideways movements that, by virtue of their
compactness and well-defined boundaries, could be construed as true Lines.
(Later in this book, we shall see that the Dow Line is, in many respects,
similar to the more strictly defined patterns known as rectangles that appear
on the charts of individual stocks.)
4. Only closing prices used: Dow Theory pays no attention to any extreme
highs or lows that may be registered during a day and before the market
closes, but takes into account only the closing figures, that is, the average of
the day's final sale prices for the component issues. We have discussed the
psychological importance of the end-of-day prices under the subject of
chart construction and need not deal with it further here, except to say that
this is another Dow rule that has stood the test of time. It works thus:
suppose an Intermediate Advance in a Primary Uptrend reaches its peak on
a certain day at 11:00 a.m., at which hour the Industrial Average figures at,
say, 152.45, and then falls back to close at 150.70. All that the next advance
will have to do to indicate the Primary Trend is still up is register a daily
close above 150.70. The previous intraday high of 152.45 does not count.
Conversely, using the same figures for our first advance, if the next
upswing carries prices to an intraday high at, say, 152.60, but fails to
register a closing price above 150.70, the continuation of the Primary Bull
Trend is still in doubt.
In recent years, differences of opinion have arisen among market students
as to the extent to which an Average should push beyond a previous limit
(Top or Bottom figure) to signal (or confirm or reaffirm, as the case may
be) a market trend. Dow and Hamilton evidently regarded any penetration,
even as little as 0.01, in closing price as a valid signal, but some modern
commentators have required penetration by a full point (1.00). We think the
original view has the best of the argument—that is, that the record shows
little or nothing in practical results to favor any of the proposed
modifications. One incident in June 1946, to which we shall refer in the
following chapter (EN10: Now in Appendix A), shows a decided advantage
for the orthodox “any-penetration-whatever” rule.
5. A trend should be assumed to continue in effect until such time as its
reversal has been definitely signaled: This Dow Theory tenet is one that,
perhaps more than any other, has evoked criticism. Yet, when correctly
understood, it, like all the others we have enumerated, stands up under
practical test. What it states is really a probability. It is a warning against
changing one's market position too soon, against “jumping the gun.” It does
not imply that one should delay action by one unnecessary minute once a
signal of change in trend has appeared. But it expresses the experience that
the odds are in favor of the man who waits until he is sure, and against the
other fellow who buys (or sells) prematurely. These odds cannot be stated in
mathematical language such as 2-1 or 3-1; as a matter of fact, they are
constantly changing. Bull Markets do not climb forever and Bear Markets
always reach a Bottom sooner or later. When a new Primary Trend is first
definitely signaled by the action of the two Averages, the odds that it will be
continued, despite any near-term reactions or interruptions, are at their
greatest. But as this Primary Trend carries on, the odds in favor of its
further extension grow smaller. Thus, each successive reaffirmation of a
Bull Market (new Intermediate high in one average confirmed by a new
Intermediate high in the other) carries relatively less weight. The incentive
to buy, the prospect of selling new purchases at a profit, is smaller after a
Bull Market has been in existence for several months than it was when the
Primary Uptrend was first recognized; this 12th Dow tenet says, “Hold your
position pending contrary orders.”
A corollary to this tenet, which is not so contradictory as it may at first
seem, is this: a reversal in trend can occur any time after that trend has been
confirmed. This can be taken simply as a warning that the Dow Theory
investor must watch the market constantly if he has any commitment in it.
EN: Modern market importance of Dow Theory and necessity for moving to
a new composite market theory
Dow Theory has much to recommend it. Concepts embodied within Dow
Theory retain their validity to the present day and retain their importance
as the foundation thinking for technical analysis. Concepts of waves, major,
secondary, and minor movements are absolutely descriptive of the reality of
the market. Other constructs within Dow Theory are similarly important—
that all information is discounted; that major market movements are like
the tide and, as it were, raise all boats; that trends tend to continue. These
are not just theoretical musings, but observations of reality.
In addition to its technical validity, the Dow has now taken on a mythic
dimension. It has a symbolic function that interacts with its originally
intended purpose. Dow and Hamilton saw their measurement of the market
as an economic barometer for the entire economy; its use as a tool for
investing in the market came later.
In the opinion of this editor, the Dow Theory is no longer adequate to its
original purpose—or even to its secondary purpose. It is a simple theory
propounded in a simple time. Expounders of Dow Theory have implicitly
recognized the necessity for evolutionary changes to the doctrine with the
addition of the Rails (now Transportations) and the Utilities ad infinitum.
Thirty stocks may have been sufficient originally to reflect the U.S.
economy. No one would deny that simple paradigm must be changed to
reflect an economic structure geometrically more diverse than that of Dow
and Hamilton. Entering the twenty-first century, the U.S. and global
economy require more sophisticated econometrics than the Dow alone.
For that reason, I consider that to fulfill the functions of the old Dow, we
now must consider a variety of averages and indexes to measure the state of
the market—not to mention the economy, which is another question,
although not altogether another question, but at least another question.
Magee foreshadowed some instruments of great value to this end in his
writings, specifically on the Magee Evaluative Index (Chapter 38), which
may be used for the entire market, and not just for one summary index or
average. The value and power of this tool are still little used and
understood.
In twenty-first-century markets, there are not just broad tides and markets
flowing in one direction as they might on Magee's Cape Cod. Instead, the
currents, riptide, and crosscurrents are like the economy of the country,
moved West. They are now symbolized by the Pacific Ocean roaring in and
out of San Francisco Bay. Although the Dow is in a secondary Downtrend,
the broader Standard & Poor's 500 is going to new highs, and although
they are both whipping sideways, the National Association of Securities
Dealers Automated Quotations (NASDAQ) is rocketing into space. For this
reason, I now believe that only a composite of the three indexes can express
the true state of the markets as a whole. And, in addition, to dissect the
entrails of the market, the Magee Evaluative Index should be run across the
three indexes.
The Dow Theory required the Rails and Industrial Averages move in
harmony to signal Bull or Bear Markets. In this century, there is a similar
need for harmonic convergence among the averages to indicate to us the
state of the markets as a whole.
When all three indexes agree in the direction of their trends, up or down or
sideways, Bulls may be assumed to be safe in general, and vice versa for
Bears. Failure of the three to be in harmony is a clear sign of mixed
markets and advises one to arrange his bets and portfolio to correspond
with economic uncertainty. Capital should flow naturally to the most
productive area. What reason is there to ride the Dow down when the
NASDAQ is raging up? If the investor follows the philosophy of this book,
he will never sit passively through an extended Downtrend. At the very
least, he will be hedged, if not outright short. (As Edwards and Magee
preferred and as this editor prefers.)
EN10: Notes on Edwards' description of Dow Theory
We must keep in perspective Edwards' description of Dow Theory. When he
speaks of Secondaries of 10 and 20 points, or a Primary of 30 points, we
should be reminded that the entire market could be accommodated in the
backseat of a Packard. The top in 1929 was approximately 386 and the
bottom approximately 64; hence, 10, 20, or 30 points constituted important
percentage moves.
Similarly, a primary market move of 20%, although still of importance,
hardly describes the violence and range of modern markets. From March
2009 to November 2017, the Dow moved from 6469.95 to 23,602.12—a
move of 17,132.17 or 264%.
chapter four
The Dow Theory's defects
EN10: Figures 2-9 from the ninth edition now appear in Appendix A along
with Edwards' detailed account of Dow Theory operations.
Our readers, we suspect, heaved a deep sigh of relief when they closed the
preceding chapter (EN10: Chapter 4 in the ninth edition, now Appendix A),
which covered a difficult, tedious, and, at times, confusing subject. Some
may even wish at this point that the Dow Theory had never been conceived.
Others doubtless spotted one or more of its real or supposed defects and
have questions to ask. Before we proceed to more interesting chart matters,
we had better devote a few pages to clearing up these questions.
First, let's take up the charge of “second-guessing,” which is so often flung
at writers on Dow Theory. It is a charge that will continue to crop up so
long as opinions differ among Dow theorists at critical periods (which,
unfortunately, is often the case). Even the most experienced and careful
Dow analysts find it necessary occasionally to change their interpretations
when a stand first ventured is rendered untenable by some subsequent
action of the market. They would not attempt to deny it, but, they say, in the
long run, surprisingly little is lost by such temporary misinterpretations.
Many of them publish their comments regularly and can refer you to the
printed files of opinions and advice expressed before and during the event,
as well as after it. Regarding Chapter 4 in the ninth edition (now Appendix
A), the reader, if he cares to check such records, will find that the
interpretations given therein (aside from the remarks made “in retrospect”
and so labeled) were precisely the interpretations published at the time by
the best-established Dow analysts. EN9: Although, in the modern age
Richard Russell (now deceased) (dowtheoryletters. com) was senior in
terms of reputation, a host of other Dow theorists (actually trying to round
them up is like herding cats) inhabit the scene, among them Jack Schannep
(thedowtheory.com) and Richard Moroney (dowtheory.com) who must be
taken into account when consulting the sacred-chicken bones. Robert W.
Colby (robertwcolby.com) is also currently doing authoritative work in Dow
Theory. Note that it is the chicken that is sacred, and the bones only
secondarily.
The Dow Theory is too late
The objection that the Dow Theory is too late is more valid. It is sometimes
expressed in the rather intemperate statement that “the Dow Theory is a
surefire system for depriving the investor of the first third and the last third
of every Major Move, and sometimes there isn't any middle third!” Or, to
give a specific example: A Primary Bull Market started in 1942 with the
Industrial Average at 92.92 and ended in 1946 at 212.50, for a total gain of
119.58 Average points, but the strict Dow theorists could not buy until the
Industrials were up to 125.88 and could not sell until prices had already
declined to 191.04; thus, capturing, at best, only about 65 points, or not
much more than half of the total move. This specific statement cannot be
disputed, yet the answer to the general objection is to “try to find a man
who first bought his stocks at 92.92 (or even within 5 points of that level)
and stayed 100% long throughout the intervening years, and finally sold out
at 212.50, or within 5 points thereof.” The reader is welcome to try; he will,
in fact, find it very difficult to locate even a dozen who did as well as the
Dow Theory.
A still better answer, because it comprehends all of the hazards of every
known kind of Bull and Bear Market to date, is the overall dollars and cents
record of the past 60 years. We are indebted to Richard Durant for
permission to reprint the following computation of what would, in theory,
have resulted if a fund of only $100 could have been invested in the stocks
of the Dow-Jones Industrial Average on July 12, 1897, when a Primary Bull
Market was signaled by the Dow Theory, and those stocks were thereafter
sold and repurchased when, and only when, the Dow Theory had definitely
confirmed a change in the Major Trend (see Table 4.1).
Table 4.1 The Dow Theory's 60-Year Record
SignalDate
Dow Jones
Average Price
Loss
(V)
Change
(%)
Capital
Gain
Accumulated
Profit
Bought7/12/189744.61 100
Sold 12/16/189963.84 43.11 143.11
Bought10/20/190059.44
Sold 6/1/190359.59 0.25 0.36 143.47
Bought7/12/190451.37
Sold 4/26/190692.44 79.95 114.7 258.18
Bought4/24/190870.01
Sold 5/3/191084.72 21.01 54.25 312.42
Bought10/10/191081.91
Sold 1/14/191384.96 3.72 11.63 324.05
Bought4/9/191565.02
Sold 8/28/191786.12 32.45 105.16429.22
Bought5/13/191882.16
Sold 2/3/192099.96 21.67 92.99 522.21
Bought2/6/192283.7
Sold 6/20/192390.81 8.49 44.36 566.56
Bought12/7/192393.8
Sold 10/23/1929305.85 226.071,280.811,847.38
Bought5/24/193384.29
Sold 9/7/1937164.39 95.03 1,755.543,602.92
Bought6/23/1938127.41
Sold 3/31/1939136.42 7.07 254.793,857.7
Bought7/17/1939142.58
Sold 5/13/1940137.5 V -3.56 -137.453,720.26
Bought2/1/1943125.88
Sold 8/27/1946191.04 51.76 1,925.745,646
Bought10/2/1950228.94
Sold 4/2/1953280.03 22.32 1,259.956,905.95
Bought1/19/1954288.27
Sold 10/1/1956468.7 62.59 4,322.4811,228.43
In brief, an investment of $100 in 1897 would have become $11,228.43 in
1956 simply by buying the Industrial Average stocks each time the Dow
Theory announced a Bull Market and holding them until the Dow Theory
announced a Bear Market. During this period, the investor would have
made 15 purchases and 15 sales, or about one transaction every two years
on average.
The record is not perfect. It shows one losing transaction and three
instances in which reinvestment would have been made at a higher level
than the preceding liquidation. But, at that, it hardly needs defending. Also,
it takes no account of commissions and transfer taxes, but neither does it
include the dividends the investor would have received during the time he
held his stocks; the latter would have added many more dollars to the fund.
For the enlightenment of the man who believes in “just buying good stocks
and putting them away,” compare these results with the best that could have
been done by buying shares only once at the lowest price recorded by the
Industrial Average during these entire 60 years and selling them only once
at the highest: $100 invested at the all-time low, 29.64, on August 10, 1896,
would have become only $1,757.93 at the then all-time high, 521.05, 60
years later on April 6, 1956. Compare this to the $11,228.43 gained from
the Dow Theory program.
EN: This record of the Dow Theory is updated to end of year 2017 in Table
4.2. I have left this record as is so that the reader may clearly distinguish
my work from that of Edwards.
The Dow Theory is not infallible
The Dow Theory is not infallible. It depends on interpretation and is subject
to all the hazards of human interpretive ability. But, again, the record speaks
for itself.
The Dow Theory frequently leaves the investor in doubt
The fact that the Dow Theory frequently leaves the investor in doubt is true
in one sense, yet not in another. There is never a time when the Dow Theory
does not afford a presumptive answer to the question of the direction of the
Primary Trend. That answer will be wrong for a relatively short time at the
beginning of each new Major Swing. There will also be times when a good
Dow analyst should say, “The Primary Trend is still presumably up, but it
has reached a dangerous stage, and I cannot conscientiously advise you to
buy now. It may be too late.”
Frequently, however, the above objection simply reflects the inability of the
critic mentally to accept the fundamental concept that the Averages discount
all the news and statistics. He doubts the Dow Theory because he cannot
reconcile its message with his own ideas, derived from other sources, of
what stocks should do. The theory is usually more nearly right.
This criticism in other cases reflects nothing but impatience. There may be
weeks or months (as, e.g., during the formation of a Line) when the Dow
Theory cannot “talk.” The active trader quite naturally rebels, but patience is
a virtue in the stock market as elsewhere—in fact, essential if serious
mistakes are to be avoided.
The Dow Theory does not help the Intermediate Trend investor
It is perfectly true that the Dow Theory does not help the Intermediate Trend
investor, as it gives little or no warning of changes in Intermediate Trend.
Yet, if a fair share of these can be captured, the profit amounts to more than
can be derived from the Primary Trend alone. Some traders have worked out
supplementary rules on the basis of Dow principles
SignalDate
Average
Price
Loss
(V)
Percentage
Change (%)
Capital
Gain
Accumulated
Wealth
1 Buy 7/12/189744.61 100.00
2 Sell 12/16/189963.84 43.11 143.11
3 Buy 10/20/190059.44
4 Sell 6/1/190359.59 0.25 0.36 143.47
5 Buy 7/12/190451.37
6 Sell 4/26/190692.44 79.950 114.70 258.18
7 Buy 4/24/190870.01
8 Sell 5/3/191084.72 21.01 54.25 312.42
9 Buy 10/10/191081.91
10Sell 1/14/191384.96 3.72 11.63 324.05
11Buy 4/9/191565.02
12Sell 8/28/191786.12 32.45 105.16 429.22
13Buy 5/13/191882.16
14Sell 2/3/192099.96 21.67 92.99 522.21
15Buy 2/6/192283.7
16Sell 6/20/192390.81 8.49 44.36 566.56
17Buy 12/7/192393.8
18Sell 10/23/1929305.85 226.07 1280.811,847.38
19Buy 5/24/193384.29
20Sell 9/7/1937164.39 95.03 1755.543,602.92
21Buy 6/23/1938127.41
22Sell 3/31/1939136.42 7.07 254.79 3,857.70
23Buy 7/17/1939142.58
24Sell 5/13/1940137.5 X -3.56 -137.453,720.26
25Buy 2/1/1943125.88
26Sell 8/27/1946191.04 51.76 1925.745,646.00
27Buy 10/2/1950228.94
28Sell 4/2/1953280.03 22.32 1259.956,905.95
29Buy 1/19/1954288.27
30Sell 10/1/1956468.7 62.59 4322.4811,228.43
31Buy 5/2/1958459.56
32Sell 3/3/1960612.05 33.18 3725.7914,954.22
33Buy 2/23/1961654.42
34Sell 4/26/1962678.68 3.71 554.37 15,508.59
35Buy 11/9/1962616.13
36Sell 5/5/1966899.77 46.04 7139.4922,648.08
37Buy 1/11/1967822.49
38Sell 10/24/1967888.18 7.99 1808.8424,456.92
39Buy 10/1/1968942.32
40Sell 2/25/1969899.8 X -4.51 -1103.5623,353.36
41Buy 10/27/1969860.28
42Sell 1/26/1970768.88X -10.62 -2481.1720,872.19
(Continued)
Table 4.2 (Continued) The Dow Theory's 121-Year Record
SignalDate
Average
Price
Loss
(X)
Percentage
Change
(%)
Capital
Gain
Accumulated
Wealth
43Buy 9/28/1970758.97
44Sell 7/28/1971872.01 14.89 3108.68 23,980.87
45Buy 2/10/1972921.28
46Sell 2/23/1973959.89 4.19 1005.02 24,985.88
47Buy 1/27/1975692.66
48Sell 10/24/1977802.32 15.83 3955.70 28,941.58
49Buy 6/6/1978866.51
50Sell 7/2/1981959.19 10.70 3095.53 32,037.11
51Buy 10/7/1982965.97
52Sell 1/25/19841231.89 27.53 8819.43 40,856.54
53Buy 11/6/19841244.15
54Sell 10/15/19872355.09 89.29 36482.0777,338.61
55Buy 2/29/19882071.62
56Sell 10/13/19892569.26 24.02 18578.11 95,916.72
57Buy 6/4/19902935.19
58Sell 8/3/19902809.65X -4.28 -4102.4291,814.30
59Buy 1/18/19912646.78
60Sell 10/5/19923179 20.11 18462.21110,276.51
61Buy 11/25/19923266.22
62Sell 8/4/19988487.31 159.85 176278.26286,554.76
63Buy 11/2/19988706.5
64Sell 9/23/199910318.59 18.52 53058.30339,613.06
65Buy 11/8/20019587.52
66Sell 6/25/20029126.8 X -4.81 -16319.81323,293.25
67Buy 1/6/20038773.57
68Sell 11/21/200712799.04 45.88 148332.69471,625.94
69Buy 4/18/200812849.36
70Sell 9/29/200810365.45X -19.33 -91170.02380,455.93
71Buy 4/9/20098083.38
72Sell 6/30/20109774.02 20.92 79572.41460,028.33
73Buy 9/27/201010812.04
74Sell 8/2/2011 11866.62 9.75 44870.04504,898.37
75Buy 12/23/201112294
76Sell 6/4/201212101.46 -1.57 -7907.36496,991.01
77Buy 1/18/201313649.7
78Sell 8/20/201516990.69 24.48 121646.78618,637.78
79Buy 10/19/201517084.49
80Sell 1/6/201616906.51 -1.04 -6444.74612,193.04
81Buy 4/20/201618053.6X
82Sell 6/24/201617400.75 -3.62 -15926.29596,266.75
83Buy 9/7/201618526.14
84Sell 12/29/201724719.22 33.43 199325.26795,592.01
that they apply to Intermediate Movements, but these have not proved to be
satisfactory. The remainder of our book is devoted to a better approach to
this problem.
The Dow Theory is a mechanical device designed to tell the direction of the
Primary Market Trend, which is important because, as said at the beginning
of this book, most stocks tend to go with the trend. The Dow Theory does
not and cannot tell you which individual stocks to buy, aside from those
stocks that make up the Averages. That, again, is a problem for the
remainder of this book.
EN: An old criticism, irrelevant in modern markets.
“The Dow Theory does not tell you which stocks to buy.” This was true at
the time Edwards wrote this, but in modern markets, the investor can buy
substitute instruments that almost perfectly mimic its behavior (DIA). This is
possible because the investor can trade in surrogates for the Dow Averages
in present markets (see Chapter 15).
The Dow Theory in the 20th and 21st centuries
As may be seen in Table 4.2, augmenting Table 4.1, the Dow Theory
continued to provide its user an advantage over the unaware Buy-and-Hold
Investor. From its original investment of $100 in 1897, the Dow Theory
investment would have grown to $795,592.01 by December 29, 2017, with
the long trade still open. Table 4.2 shows the details, including the post-2000
bust drawdown. To my mind, this table is a powerful demonstration of the
effectiveness of methodical technical investing, be it Dow Theory or some
other robust method—which I will discuss in Chapter 5.
By contrast, the buy-and-hold investment of $100, if bought at the low,
29.64, and sold at the close, December 29, 2017, would have grown to
$55,411.83.
I am indebted to Jack Schannep of TheDowTheory.Com
(http://www.thedowtheory. com) for the data recapitulated here. On
Schannep's website, a clear exposition of the Dow Theory and its record
may be found—much more complete than that which is found here, outside
of Edwards' magisterial presentation.
Minor discrepancies are acknowledged within these and others' data, a point
that will be raised by purists. This is occasioned by disagreements within the
priestly circles of those who keep the sacred records. That is, not all theorists
are in 100% agreement as to the exact date or nature of the signals. (Some
will say the reentry date of October 1, 1956 should have been October 7,
1957, for example.) Meaning some judgment is involved in interpretation of
the entrails. The Dow Theory is not a 100% objective algorithm, just as chart
analysis is not reducible to an objective algorithm. (I am allowed to jest at
the priesthood as I am a minor acolyte in these matters. It would not be
seemly for the uninitiated to burlesque.)
In brief, an investment of $100 in 1897 would have become $795,592.01
simply by buying the Industrial Average stocks each time the Dow Theory
announced a Bull Market and holding them until the Dow Theory
announced a Bear Market, and then selling, with the entire equity reinvested
on each trade.
The Technical Investor would have had this amount in pocket marked to
market at the end of 2017, as opposed to the $55,411.83 of his dozing
counterpart, or the Trust Department of the Rip Van Winkle Bank of Sleepy
Hollow. And, in addition, he would not have been illiquidified during Bear
Markets.
Whether the Dow Theory retains its validity over the market as a whole,
there can be no question that it still calls the turn for its sector of the market,
which as Jack Schannep correctly notes, has five times the capitalization of
the NASDAQ (see Table 4.2).
As Mark Twain observed, everybody talks about the Dow Theory, but
nobody does anything about it. Perhaps that is not precisely what Twain
said, but close enough for government work. As further inquiry into the
inner workings of the Dow Theory, I initiated a series of studies of the
record with Brian Brooker, who holds a master's of science in finance from
Golden Gate University, and Matt Mullens, and Nehemiah Brown III my
graduate students at Golden Gate University. Included here are some of the
results of our study, from the book, Sacred Chickens, the Holy Grail and
Dow Theory (Amazon).
It seems obvious that the risk characteristics of Dow Theory investing are
unique, and I will belabor the obvious. The Buy-and-Hold Investor
mentioned above for comparison with the Dow Theory Investor not only
realized less profit over the period of his investment but also experienced
greatly expanded risk over the life of the investment. At first blush, all the
profits garnered by the reversing investor in Table 4.3 represent risk actually
experienced by the Buy-and-Hold Investor—but that is only first blush. A
little deeper thought reveals the true extent of the Buy-and-Hold Investor's
risk is measured by maximum drawdowns over any given period of time. It
is not necessary to theorize about this question; the measurement is
empirical.
When viewed in perspective, these risks are startling. From the top in 2000
to the low in 2002, a 39% drawdown occurred. Is this disquieting? A 41%
drawdown occurred during the Reagan crash of 1987. A mere bagatelle. The
Hoover drawdown from 1929 to 1932 was 89%. Such things are unlikely to
happen again. The big guys would step in and support the market.
Clearly, the way to reduce market risk to zero is to be out of the market. Less
obviously, or perhaps blatantly, the second most important way to reduce
risk is to be right about the trend—or to not be wrong. Moreover, because of
the nature of the Dow Theory, much time is spent on the sidelines by the
Dow investor. This is a natural reduction of risk. In fact, of the total days
from 1897 to 2018, 44,193, the Dow Investor spent 15,492 (or about 35% of
the time) days at the beach or at the S&L. But his accumulated profits have
not been credited with interest, as this is a “pure” study.
As will be readily apparent, Table 4.3 is much richer in data than just the
duration of investments in the long side of the market. Acting on the maxim
(my own) that it is unwise to invest on only one side of the market, I have
computed the accumulated profits gained by trading the Dow long and short.
After all, the market goes down as well as up, and for a reversing system a
liquidation of longs is a signal to go short. If the record on the long side is
impressive, showing accumulated profits to 2018 of $795,592.01, how much
more impressive is the accumulated profit of $5,757,390.17 garnered from
trading both sides of the Dow, long and short?
The reader who listens carefully will hear the metamessage. For the great
majority of investors, it is the long run that is important. In the right-now
culture of the internet and computer age and the get-rich-quick mentality,
one wonders whether there are still such investors, outside of the very rich
and very intelligent. Perhaps there are still a few aging readers of early
editions of this book, and, not to despair, perhaps some new converts.
A note of caution is in order here: beware of spreadsheets run amuck. As the
spreadsheet serenely grinds through a trade it doesn't care how it may be
creating a fantasy universe. Likewise, the more transactions the greater the
eventual figure as the compounding effect of reinvesting the total bankroll
on every roll of the dice. This being said, putting the matter into
mathematical perspective and discounting inflated totals still makes the
performance impressive—much more so considering most professional fund
managers can't beat the market.
Table 4.3 Performance of Dow Theory through 2017: Longs and Shorts
Accumulated
Trade#SignalDate PricePL%Profit BullBear
1 Long7/12/189744.61 100.00
2 Short12/16/189963.8443.11 143.11 887
3 Long10/20/190059.446.89 152.97 308
4 Short6/1/190359.590.25 153.36 954
5 Long7/12/190451.3713.79174.51 407
6 Short4/26/190692.4479.95314.04 653
7 Long4/24/190870.0124.26390.24 729
8 Short5/3/191084.7221.01472.23 739
9 Long10/10/191081.913.32 487.89 160
10 Short1/14/191384.963.72 506.06 827
11 Long4/9/191565.0223.47624.83 815
12 Short8/28/191786.1232.45827.60 872
13 Long5/13/191882.164.60 865.66 258
14 Short2/3/192099.9621.671,053.20631
15 Long2/6/192283.7 16.271,224.52 734
16 Short6/20/192390.818.49 1,328.54499
17 Long12/7/192393.8 -3.29 1,284.79 170
18 Short10/23/1929305.85226.074,189.282147
19 Long5/24/193384.2972.447,224.02 1309
20 Short9/7/1937164.3995.0314,088.941567
21 Long6/23/1938127.4122.5017,258.28 289
22 Short3/31/1939136.427.07 18,478.73281
23 Long7/17/1939142.58-4.52 17,644.33 108
24 Short5/13/1940137.5-3.56 17,015.68301
25 Long2/1/1943125.888.45 18,453.66 994
26 Short8/27/1946191.0451.7628,005.931303
27 Long10/2/1950228.94-19.8422,449.90 1497
28 Short4/2/1953280.0322.3227,459.79913
29 Long1/19/1954288.27-2.94 26,651.78 292
30 Short10/1/1956468.762.5943,333.29986
31 Long5/2/1958459.561.95 44,178.32 578
32 Short3/3/1960612.0533.1858,837.46671
33 Long2/23/1961654.42-6.92 54,764.35 586
34 Short4/26/1962678.683.71 56,794.52198
35 Long11/9/1962616.139.22 62,028.94 197
36 Short5/5/1966899.7746.0490,584.421273
37 Long1/11/1967822.498.59 98,364.60 251
38 Short10/24/1967888.187.99 106,220.70286
39 Long10/1/1968942.32-6.10 99,745.90 343
40 Short2/25/1969899.8-4.51 95,245.10147
41 Long10/27/1969860.284.39 99,428.35 244
42 Short1/26/1970768.88-10.6288,864.6391
(Continued)
Table 4.3 (Continued) Performance of Dow Theory through 2017: Longs
and Shorts
Trade#SignalM/D/Y Price PL%
Accumulated
Profit BullBear
43 Long 9/28/1970758.97 1.29 90,010.00 245
44 Short 7/28/1971872.01 14.891,03,415.97303
45 Long 2/10/1972921.28 -5.65 97,572.80 197
46 Short 2/23/1973959.89 4.19 101,661.99411
47 Long 1/27/1975692.66 27.84129,964.33 588
48 Short 10/24/1977802.32 15.83150,539.921084
49 Long 6/6/1978866.51 -8.00 138,495.90 225
50 Short 7/2/1981959.19 10.70153,309.11 135
51 Long 10/7/1982965.97 -0.71 152,225.45 572
52 Short 1/25/19841231.8927.53194,131.30415
53 Long 11/6/19841244.15-1.00 192,199.27 462
54 Short 10/15/19872355.0989.29363,819.94475
55 Long 2/29/19882071.6212.04407,611.06 362
56 Short 10/13/19892569.2624.02505,526.50997
57 Long 6/4/19902935.19-14.24433,526.27 84
58 Short 8/3/19902809.65-4.28 414,984.06645
59 Long 1/18/19912646.785.80 439,039.89 234
60 Short 10/5/19923179 20.11 527,322.9460
61 Long 11/25/19923266.22-2.74 512,855.15 124
62 Short 8/4/19988487.31159.851,332,659.972799
63 Long 11/2/19988706.5 -2.58 1,298,243.21 42
64 Short 9/23/199910318.5918.521,538,625.09373
65 Long 11/8/20019587.527.08 1,647,636.37 777
66 Short 6/25/20029126.8 -4.81 1,568,460.62229
67 Long 1/6/20038773.573.87 1,629,163.97 195
68 Short 11/21/200712799.0445.882,376,653.391780
69 Long 4/18/200812849.36-0.39 2,367,309.47 149
70 Short 9/29/200810365.45-19.331,909,684.83149
71 Long 4/9/20098083.3822.022,330,123.36 192
72 Short 6/30/20109774.0220.922,817,468.97447
73 Long 9/27/201010812.04-10.622,518,248.26 89
74 Short 8/2/2011 11866.629.75 2,763,872.05309
75 Long 12/23/201112294 3.60 2,863,413.76 143
76 Short 6/4/201212101.46-1.57 2,818,568.99164
77 Long 1/18/201313649.712.793,179,171.86 228
78 Short 8/20/201516990.6924.483,957,326.79944
79 Long 10/19/201517084.490.55 3,979,173.89 60
80 Short 1/6/201616906.51-1.04 3,937,720.3079
81 Long 4/20/201618053.66.78 4,204,890.74 105
82 Short 6/24/201617400.75-3.62 4,052,834.4765
83 Long 9/7/201618526.146.47 4,314,950.73 75
84 MtoMkt12/31/201724719.2233.435,757,390.17480
85 15417
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chapter five
Replacing Dow Theory with John Magee's Basing points Procedure
I have humorously compared the interpretation of the market using Dow Theory to the ancient Romanpractice of haruspication—that is, the examination of animal or bird entrails to forecast the future. DowTheory analysts examine the market and venture their expert opinions as to whether Dow Theory saysthe market is a buy, a sell, or a hold. Sometimes it seems as if they might be sitting on a tripod at Delphiand inhaling substances legal in California but forbidden in Washington, D.C. Additionally, from thesame data they often extract different conclusions. (No disrespect of Dow theorists is intended. Some ofmy best friends are Dow analysts.) From this observation came the motivation to look for a better way.That better way is found in Chapter 28 in which Magee outlined (and I have further articulated) a methodthat is eminently adaptable to long-long term investing. We are talking about investments that might lastfor years. One reason the rich get richer is they practice this kind of investing. They correctly assessbusiness conditions and economic circumstances and take deeply entrenched positions that, in secularbull markets, return them profits beyond the hope of swing traders and midterm traders. Perhaps in somecases they even use Dow Theory. Whatever they use, they are not chased from the market, except by truechanges in the major trend.
Investing on this time scale has never been easy—except for the well-capitalized mature and patientinvestor. Using Magee's Basing Points Procedure, it is now possible for the general investor to invest onthe Dow Theory (or longer) time scale. To demonstrate the power of this procedure, I undertook anumber of studies. The first and most important of these was a study of the Dow Industrials since 1900using Dow Theory. By studying the Industrials, we have an excellent benchmark in the performance ofDow Theory over that time.
The fractal nature of the market
A fact that all traders know in their bones was enunciated by the polymath, Benoit Mandelbrot, whostated market price behavior is fractal. Fractal literally means self-similar at all scales. In other words, atwo-minute bar chart exhibits the same kind of formations and characteristics as a daily chart, and sodoes a weekly chart. If you were presented a chart and told to determine the time scale, you would beunable to answer from the data alone. When you read about moving average systems in Chapter 36, youwill see—as you probably know already—that a 10-day moving average system trades 10 times as muchas a 200-day moving average system. The closer you are to the market, the more prone you are to be ledastray by noise. This is one reason day traders are so seldom successful—noise and random price activitymake for difficult data to analyze. Important traders of my acquaintance trade on weekly data: in otherwords, they trade using one bar to represent a week of market activity. Not surprisingly, they tradeinfrequently compared with daily bar traders.
Considering these facts, I constructed a Basing Points Procedure using weekly bars to test the method.Instead of using “three-days-away” data to determine Basing Points, I used “three-bars-away” data. Itook all the Industrials data and back studied it to see what the performance would have been usingMagee's procedure. The results are impressive; not eye-popping in terms of profits but sufficient.Furthermore, when considering operating characteristics overall, especially in ease of operation, theMagee method wins hands down.
The results of using Magee's simple-as-pie method are superior to the results obtained by using thecomplex and often obtuse Dow Theory. Later in this chapter, I will summarize the results of the studyand illustrate the tables.
• Profits produced by the Magee Procedure are superior to those produced by the Dow Theory:$1,147,486.52 as opposed to $795,592.01.
• Profits produced by Variant 2 of the Magee Procedure were $2,982,577.83.
• Compound Annual Growth Rates (CAGR) were also similar: 7.9% (Variant 1) versus 7.87% and 8.37%for Variant 2.
• Risk profiles were also quite similar: average drawdown for Dow Theory was 13.78% and for theMagee Procedure was 16%. Maximum drawdown was 25.3% for Dow Theory and 30% for the MageeProcedure.
• Also pertinent to risk, considering long-side trades only, the Dow Theory was out of the market 36% ofthe time and the Magee Procedure 35%. This is a little remarked fact about Dow Theory—and unknownbefore this about Magee's Procedure. This is a radically important fact; it means each procedure is risk-free more than a third of the time. Calculating the out-of-market returns is such a hairy process, it wasnot undertaken.
• As a result of differences in drawdowns and stop methods, Magee's Procedure is operationally superiorto Dow Theory. Since 1900, the Dow Theory has made 42 trades, the Magee Procedure has made 25.Considering the similarity of risk and profit characteristics, a system that trades less is preferable—lesscost, less slippage, fewer chances to lose market position. This is to say, better control of the vigorish.
In short, the Magee Basing Points Procedure represents the best alternative to the Dow Theory for thetrue long-term investor. It can be used on weekly bars, in which case its full long-term power isevidenced. It also can be used on daily bars for a more sensitive approach.
The Basing Points Procedure may be operated in two ways, which I call Variant 1 and Variant 2. Variant1 sets stops based on wave lows. Variant 2, in addition to wave lows, uses new wave highs (see Chapter28). Table 5.1 denotes trades for the Basing Points Procedure, Variant 1. Table 5.2 denotes trades for theBasing Points Procedure, Variant 2. Keys to trades are shown in Figures 5.2 and 5.3. Readers, andinvestors in general, have every right to be skeptical of academic studies. Every morning, the mailbox isfull of “can't fail” “get-rich-quick” systems being sold by Wall Street hucksters who always showmouthwatering profits. Yet these are always paper studies. By contrast, the Magee Basing PointsProcedure has been in operation in the market for some years, and its effectiveness has beendemonstrated. It exited, and shorted, the market in January 2008 and remained short until March 2009. In2011, the Procedure exited longs and went short in late July before the Greek debt crisis. Letters writtenin real time during these events are in the http://www. edwards-magee.com archives and are available foraudit. Charts made at the time follow here. (See Figures 5.2 and 5.3. Figure 5.1 shows a detailed chart ofthe analysis of the top of the 2007 market and the short that resulted in early 2008.)
Table 5.1 Trades Made by the Magee Basing Points Procedure, Variant 1
Date Signal
Wave
High
Wave
Low
Stop
Price
P/L
Long%
Accum
Lng Riskpts Risk%
DurationDuration
LongShort
9/24/1900Long 53.0050.35 143.1
6/17/1901 78.30 371
9/30/1901Short 64.0311.0320.81172.8814.2718.22
11/2/1903 42.20
7/11/1904Long 52.02 1015
1/15/1906 103.00
8/5/1907Short 76.7624.7547.57255.1326.2425.481120
1/11/1907 53.00
3/23/1908Long 67.77 231
9/27/1909 100.50
1/31/2010Short 91.11 23.3434.43342.979.39 9.34 679
9/25/1911 72.90
4/22/1912Long 88.58 812
9/30/1912 94.20
12/9/1912Short 85.88-2.70-3.05332.528.32 8.83 231
12/21/1914 53.20
3/29/1915Long 60.26 840
11/13/1916110.13
8/27/1917Short 84.6524.4040.49467.1425.4823.14882
12/17/1917 65.90
8/19/1918Long 84.56 357
11/3/1919 119.60
8/9/1920Short 83.72-0.84-0.99462.5035.8830.00721
8/22/1921 63.90
10/24/1921 Long 72.10 441
3/19/1923 105.40
7/23/1923Short 87.4015.3021.22560.6518.0017.08637
10/22/1923 85.76
1/21/1924Long 96.51 182
9/2/1929 386.10
10/21/1929Short 319.30222.79230.841854.8666.8017.302100
7/4/1932 40.60
4/24/1933Long 70.97 1281
3/8/1937 195.60
9/6/1937Short 166.5495.57134.674352.8529.0614.861596
3/28/1938 97.50
7/18/1938Long 136.89 315
9/11/1939 157.80
5/13/1940Short 135.95-0.94-0.684323.0621.8513.85665
4/27/1942 92.70
7/6/1942Long 105.99 784
5/27/1946 213.4
9/16/1946Short 172.4366.4462.697033.1740.9719.201533
6/13/1949 160.6
10/24/1949 Long 184.27 1134
4/9/1956 524.4
9/23/1957Short 468.26283.99154.1217872.7356.1410.712891
10/21/1957 416.2
Table 5.1 (Continued) Trades Made by the Magee Basing Points Procedure, Variant 1
Date SignalWave
High
Wave
Low
Stop
Price
P/L
Long
% Accum
Lng
Risk ptsRisk% DurationDuration
LongShort
6/23/1958Long 465.77 273
1/4/1960 688.2
9/26/1960Short 582.64116.8725.0922357.51105.5615.34826
10/24/1960 564.2
4/3/1961Long 664.66 189
11/13/1961741.3
5/7/1962Short 654.46-10.20-1.5322014.4486.8411.71399
6/25/1962 524.6
12/31/1962 Long 640.66
1/17/1966 1000.6 238
5/9/1966Short 878.18237.5237.0730176.13122.4212.231225
10/10/1966 735.7
10/14/1968 Long 937.71 889
12/2/1968 994.7
6/9/1969Short 895.4-42.31-4.5128814.5199.309.98238
5/25/1970 627.5
1/11/1971Long 827.40 581
1/8/1973 1067.2
5/14/1973Short 871.2543.855.3030341.63195.9518.36854
12/2/1974 572.1
12/10/1975 Long 713.58 940
9/20/1976 1026.3
5/23/1977Short 904.12190.5426.7038443.24122.1811.90530
2/27/1978 742.13
8/14/1978Long 875.60 448
9/4/1978 907.73
3/24/1980Short 780.15-95.45-10.9034252.39127.5814.05588
4/21/1980 759.13
8/4/1980Long 930.96 133
3/30/1981 1030.98
8/3/1981Short 877.8-53.16-5.7132296.66153.1814.86364
8/9/1982 769.98
10/4/1982Long 902.82 427
8/24/1987 2746.7
10/19/1987 Short 2071.511,168.69129.4574104.67675.1924.581841
8/24/1987 1616.2
1/23/1989Long 2234.53
7/20/1998 9367.94 462
8/24/1998Short 8141.865,907.33264.37270011.561,226.0813.093500
7/20/1998 7402.61
3/8/1999Long 9015.28 196
1/10/2000 11750.28
2/21/2000Short 9889.28874.009.69296188.211,861.0015.84350
10/7/2002 7197.49
9/1/2003Long 9314.67 1288
10/8/2007 14198.1
1/7/2008Short 12503.043,188.3734.23397572.061,695.0611.941589
3/2/2009 6469.95
Table 5.1 (Continued) Trades Made by the Magee Basing Points Procedure, Variant 1
Wave Wave Stop P/L Accum Risk Duration Duration
Date Signal High Low Price Long % Lng pts Risk % Long Short
5/4/2009 Long 8564.52 484
12/31/200910428.05
12/29/2017 Markto 16928.03 24719.22 16154.70 749914.46 188.62 1147486.52 14291.17137.05% 3161
market
12/29/17
Table 5.2 Trades Made by the Magee Basing Points Procedure, Variant 2
Date SignalStopProfit%
Accumulated
Profit
Duration
Long
Duration
Short
9/25/1900Buy 143.10
6/18/1901 371
10/1/1901Sell64.0311.0320.81172.88
11/3/1903
7/12/1904Buy52.02 1015
1/16/1906
8/6/1907Sell76.7624.7547.57255.13 1120
1/12/1907
3/24/1908Buy67.77 231
9/28/1909
2/1/1910Sell91.11 23.3434.43342.97 679
9/26/1911
4/23/1912Buy88.58 812
10/1/1912
12/10/1912Sell85.88-2.70-3.05332.52 231
12/22/1914
3/30/1915Buy60.26 840
11/14/1916
8/28/1917Sell84.6524.4040.49467.14 882
12/18/1917
8/20/1918Buy84.56 357
11/4/1919
8/10/1920Sell83.72-0.84-0.99462.50 721
8/23/1921
10/25/1921Buy72.10 441
3/20/1923
7/24/1923Sell87.4015.3021.22560.65 637
10/23/1923
1/22/1924Buy96.51 182
9/3/1929
10/22/1929Sell337.92241.41250.141963.032100
7/5/1932
Date SignalStopProfit%
Accumulated
Profit
Duration
Long
Duration
Short
4/25/1933Buy70.97 1281
3/9/1937
9/7/1937Sell166.5495.57134.674606.691596
3/29/1938
7/19/1938Buy136.89 315
9/12/1939
5/14/1940Sell135.95-0.94-0.684575.16665
4/28/1942
7/7/1942Buy105.99 784
5/28/1946
9/17/1946Sell172.4366.4462.697443.311533
6/14/1949
10/25/1949Buy184.27 1134
4/10/1956
9/24/1957Sell468.26283.99154.1218914.982891
10/21/1957
6/24/1958Buy465.77 273
1/5/1960
9/27/1960Sell582.64116.8725.0923661.29826
10/25/1960
4/4/1961Buy664.66 189
11/14/1961
5/8/1962Sell654.46-10.20-1.5323298.21399
6/26/1962
1/1/1962Buy640.66
1/18/1966 238
5/10/1966Sell878.18237.5237.0731935.851225
10/11/1966
10/15/1968Buy937.71 889
12/3/1968
6/9/1969Sell895.40-42.31-4.5130494.83238
5/26/1970
1/12/1971Buy827.40 581
1/9/1973
5/15/1973Sell871.2543.855.3032111.01 854
12/3/1974
12/11/1975Buy713.58 940
9/21/1976
5/24/1977Sell904.12190.5426.7040685.06530
2/28/1978
8/15/1978Buy875.60 448
9/5/1978
3/25/1980Sell780.15-95.45-10.9036249.82588
4/22/1980
Table 5.2 (Continued) Trades Made by the Magee Basing Points Procedure, Variant 2
Date SignalStop Profit %
Accumulated
Profit
Duration
Long
Duration
Short
8/5/1980Buy 930.96 133
3/31/1981
8/4/1981Sell 877.80-53.16-5.7134180.04364
8/10/1982
10/5/1982Buy 902.82 427
8/25/1987
10/20/1987Sell 2458.461555.64172.3193075.781841
8/25/1987
1/24/1989Buy 2234.53
7/21/1998 462
8/25/1998Sell 8141.865907.33264.37339135.653500
7/21/1998
3/9/1999Buy 9015.28 196
9/21/1999
9/21/1999Sell 10470.081454.8016.14393862.09196
1/3/2000
10/15/2002Buy 8138.30 1120
10/1/2002
1/28/2003Sell 7984.95-153.35-1.88386440.54105
10/8/2006
3/18/2003Buy 8220.90 49
5/11/2004Sell 9966.411745.5121.23468491.88420
2/28/2005Buy 10887.90
7/30/2007Sell 13110.422222.5220.41564123.97882
10/1/2007
3/23/2009Buy 7411.89
3/2//2009 602
12/29/2017Mark to24719.2217307.33233.511881396.573262
Market
This study and the use of Magee's Basing Points Procedure to replace Dow Theory is explained inexquisite detail in the book Sacred Chickens, the Holy Grail and Dow Theory (available athttp://www.amazon.com).
Figure 5.1 How the 2008 top in the Industrials was managed with Basing Points.
Certainly, one of the most interesting charts of the last 20 years. Here we can see the stairstops rising ashigher wave lows are made. Moreover, one—or two—of those instances of surprising serendipity occurs.The Basing Point stop is quite close to a stop that would have been calculated from the neckline of thehead-and-shoulders formation. The very long-term trendline from 2003 intersects prices very near theBasing Point calculated stop, calling to mind the “rule of multiple techniques,” which states anyconclusion arrived at by multiple techniques is much more probable than that using only one method.This Basing Points system—or method, or what-have-you— remained short until March 2009.
116.47
Chapter five: Replacing Dow Theory with John Magee's Basing points Procedure
Figure 5.2 The Dow-Jones Industrials 1924-1934. This is a period of the chart covered in Figure 5.3.
Figure 5.3 This is one of the most interesting charts ever made of the Dow-Jones Industrials. It showsevery trade made by Dow Theory since the beginning and also shows trades made by Magee's BasingPoints Procedure.
Technical Analysis of Stock Trends
chapter six
Important Reversal Patterns
In our discussion of certain deficiencies in the Dow Theory from the point of view of the practical trader, wementioned the fact that it did not tell us what specific stocks to trade in. (EN9: Obviously, no longer aproblem as the investor may buy the DIA and trade the Average like a stock.) A conservative and wealthyinvestor, more interested in safety than maximum profit, can solve this problem by making up acomprehensive and thoroughly diversified list of sound, well-seasoned “blue chip” issues and handing hisbroker an order to buy the lot when the Dow Theory signals a Bull Trend. Some of his selections will dobetter than others; some may “go sour,” but wide diversification will ensure he gets a fair Average result.Better results should be obtained if we can find a way to select for purchase the most favorably situated issuesat any given time and can manage to sell them promptly and switch to others whenever the prospects for thefirst have been fully discounted.
There is the possibility, too, of increasing our gains if we can, at times, buy with safety earlier in an uptrendthan the Dow theorist does, and sell before the market has reacted far enough to give a Dow Bear Signal.
We mentioned also the fact that the Dow Theory is of little or no assistance in trading on the IntermediateTrends. There is obviously more money to be made if we can get the benefit of each up move without havingto write off some of our profits in each reaction. Or, if we can profit both ways by trading on both the “longside” and “short side” of the market.
Finally, although all stocks tend to move with “the market” as typified in the Averages, there are, in fact, widevariations in the price paths of individual issues. An average, after all, is just that, a device for expressing inone figure a diversity of other figures. A Primary Bull Market ended in the Dow-Jones Industrial Average onMay 29, 1946, but United Airlines registered its highest price in December 1945; General Motors saw its peakin January 1946; Goodyear in April, DuPont in June, and Schenley in August. Is there a way of capitalizingon these divergences?
Technical analysis of the charts of individual stocks definitely answers the first and most important of thesefour problems: the matter of selection. It frequently, but not always, gives us a running start on the DowTheory; it also, in large part, takes care of the question of the Intermediate Trend, although there are certainreservations as to policy and risk in connection with both these points that will be taken up in due course.Finally, careful technical analysis should, in nearly every case, get us out of a stock that “tops out” ahead ofthe Averages long before it has suffered any considerable decline, often in time to transfer funds to otherissues that have yet to complete their advances.
Just as the Averages constantly discount all known and foreseeable factors affecting the future of securityprices in general, the market action of an individual issue reflects all the factors affecting its individual future.Among these factors, and expressed in its chart, are the general market conditions that influence all stocks toa greater or lesser degree, as well as the particular conditions applying to the particular stock, including theoperations of “insiders.”
Let us assume right from the start that you, the reader, are not a member of that mysterious inner circle knownto the boardrooms as “the insiders.” Such a group—genuinely entitled to be called insiders, thoroughlyinformed on every fact, figure, and development that might determine the fortunes of a certain corporation—may exist from time to time and may influence the market price of its stock (EN9: and wind up in prison).But it is fairly certain that there are not nearly so many “insiders” as the amateur trader supposes and that theydo not cause one-tenth of the market movements for which the public blames them. It is even more certainthat insiders can be wrong; they would, in fact, be the first to admit it. Frequently, their plans are upset bysome development that they could not foresee or by some blind force that puts to scorn all expert estimates ofvalue. Any success they have, however, can be accomplished only by buying and selling on the floor of theExchange. [EN9: No longer strictly true. Insiders sold stock to their companies in the tulip (dot.com) bubble,which went unreported publicly for up to a year. Still, only an isolated problem.] They can do neither without
altering the delicate poise of supply and demand that governs prices. Whatever they do is sooner or laterreflected on the charts where you, the “outsider,” can detect it, or at least detect the way in which the supply-demand equation is being affected by insiders' operations, plus all other prevailing market factors. So, you donot need to be an insider to ride with them frequently.
Important Reversal Patterns
Stock prices move in trends. Some of those trends are straight, some are curved; some are brief and some arelong-continued; some are irregular or poorly defined and others are amazingly regular or “normal,” producedin a series of action and reaction waves of great uniformity. Sooner or later, these trends change direction;they may reverse (as from up to down), or they may be interrupted by some sort of sideways movement andthen, after a time, proceed again in their former direction.
In most cases, when a price trend is in the process of reversal, either from up to down or from down to up, acharacteristic area or pattern takes shape on the chart, which becomes recognizable as a Reversal Formation.Some of these chart pictures are built and completed quickly, whereas others may require several weeks toreach a stage at which one can surely say a Reversal of Trend is definitely indicated. Speaking in broadgeneralities, the greater the Reversal Area—the wider the price fluctuations within it, the longer it takes tobuild, and the more shares transferred during its construction—the more important its implications. Thus,roughly speaking, a big Reversal Formation suggests a big move to follow and a small pattern, a small move.Needless to say, the first and most important task of the technical chart analyst is to learn to know theimportant Reversal Formations and to judge what they may signify in terms of trading opportunities.
There is one recognized Reversal Pattern that appears and is completed within a single day's trading, and is, inconsequence, named the “One-Day Reversal.” At times, it has great significance—such as calling a halt, atleast temporarily, to any up or down move—but in its ordinary manifestations, it does not imply much of animmediate move in the opposite direction. It is a useful pattern, and we shall have more to say about it later,but the price formations from which extensive new trends proceed take time to build. One does not bringinstantly to a stop a heavy car moving at 70 miles an hour and, all within the same split second, turn it aroundand get it moving back down the road in the opposite direction at 70 miles an hour.
Time required to reverse a trend
We do not need to lean on a racing automobile analogy to explain why it takes time (and volume and priceaction) to produce an important Trend Reversal. The logic of it is plain enough if we take but a moment toexamine it. We can do so most easily by describing what might have (and, doubtless, many times has)happened in specific terms. Suppose a certain well-informed and well-financed coterie (EN9: A congerie ofmutual funds, for example) decides the shares of a certain company, now selling around 40, are cheap; thatthis company's affairs are progressing so satisfactorily that, before long, it will attract the attention of manyinvestors; and that its stock will be in demand at much higher levels, perhaps at 60 or 65. Our group realizes ifthey manage their market operations skillfully, if nothing unforeseen intervenes to upset their calculations,they can “take” 20 points out of the situation. So they proceed to buy in all offerings, going about thisbusiness as quietly as possible, until they have accumulated their line, which may run to several thousandshares and represent practically all of the current floating supply of the issue. Then they wait. Professionalsbecome suspicious and the rumor circulates that there is “something doing in PDQ,” or other canny bargainhunters discover the company's bright prospects, or chart analysts detect the signs of accumulation in thestock's action. Buyers now find the stock is scarce; there are few offerings on the books, and they have toraise their bids to get it—an advance starts.
The up-move gathers momentum as more and more traders are attracted by rising prices. It is helped along bythe good reports (higher earnings, increased dividend, etc.), which our group knew were to be expected.Eventually, prices approach the level at which they had planned to take profits. But this operation, thedistribution of their holdings may require even more patient and skillful handling than did the accumulation.Suppose they have 20,000 shares to unload; they cannot throw all of the shares on the market at once— doing
so would defeat their own ends immediately and, perhaps, permanently. They must feed their line out little bylittle, trying to avoid attention, feeling their way along and never permitting a surplus of offerings to kill thedemand. If activity in their stock has reached a level of, say, 2000 shares transferred daily, they may be able todispose of 500 shares a day from their holdings without bringing the price down. (They will be competing,sooner or later, with others who have followed their play, bought lower down, and will be ready to take profitsas soon as the advance shows signs of weakening.) So they start to sell when the rising trend appears to haveattained maximum momentum, or as it nears their price objective, but well before it has reached its probablelimit, and they push out their shares as rapidly as buyers will take them.
Before long—as a rule, before they have distributed their entire line—a lull in demand will occur. Perhapsprospective buyers sense the increase in supply. A reaction develops. Our group quickly ceases selling,withdraws its offers, and perhaps even buys back a few shares to support prices if they threaten to drop toofar. With supply temporarily held off the market, the decline halts and the advance resumes. Our group lets itproceed this time until it carries prices into new high ground; this reassures other holders and brings in morebuyers. As soon as the pot is once again merrily boiling, distribution is started anew and, if the maneuver hasbeen well directed, completed in perhaps two or three weeks, before the second wave of demand has beenexhausted.
Our group is now out of its stock with a nice profit; its 20,000 shares have passed into other hands. If theygauged the market correctly and distributed their line at a price about as high as the situation would bear,demand will have been satiated for a long time to come. Prices will probably first drift back to somewherenear the level at which they were supported on the previous dip and then rally feebly on the strength of a littlenew buying from traders who were waiting for just such a minor reaction, meet sales from other traders whofailed to seize the opportunity to take their profits on the preceding volume Top and are now anxious to getout, and then break down into a decline of Intermediate or Major proportions.
You can see now why, under one specific set of circumstances, a Top area (a chart pattern of distribution)takes time and volume to complete. Nevertheless, it does not matter whether we have to deal with the highlyorganized operations of a single group of insiders or of an investment syndicate or, as is more often the case,the quite unorganized activities of all the investors variously interested in an issue—the result is pretty muchthe same. Distribution, which is simply Wall Street's way of expressing the process of supply overcomingdemand, takes time and a change in ownership (turnover) of a large number of shares. And it is amazing tosee how these patterns of distribution, which hereafter we shall find it simpler to refer to as “Tops,” tend toassume certain well-defined forms. Most of the same pattern forms appear also as “Bottoms,” in whichmanifestation they signify accumulation instead of distribution.
The Head-and-Shoulders Top Formation
If you followed closely and were able successfully to visualize how the foregoing example of distributionwould appear on a chart, you saw a Head-and-Shoulders Top Formation. This is one of the more commonand, by all odds, the most reliable of the Major Reversal Patterns. You probably have heard this patternmentioned, as many traders are familiar with its name, but not so many really know it and can distinguish itfrom somewhat similar price developments that do not portend a real Reversal of Trend.
The typical or, if you will, the ideal, Head-and-Shoulders Top is illustrated in Diagram 6.1. You can easily seehow this formation got its name. It consists of the following:
A. A strong rally, climaxing a more or less extensive advance, on which trading volume becomes veryheavy, followed by a Minor Recession on which volume runs considerably lower than it did during thedays of rise and at the Top. This is the “left shoulder.”
B. Another high-volume advance that reaches a higher level than the top of the left shoulder, and thenanother reaction on less volume that takes prices down to somewhere near the bottom level of the
preceding recession, somewhat lower perhaps or somewhat higher, but, in any case, below the top of theleft shoulder. This is the “Head.”
C. A third rally, but this time on decidedly less volume than accompanied the formation of either the leftshoulder or the head, which fails to reach the height of the head before another decline sets in. This is the“right shoulder.”
D. Finally, decline of prices in this third recession down through a line (the “neckline”) drawn across theBottoms of the reactions between the left shoulder and head, and the head and right shoulder,respectively, and a close below that line by an amount approximately equivalent to 3% of the stock'smarket price. This is the “confirmation” or “breakout.”
Note that each and every item cited in A, B, C, and D of Diagram 6.1 is essential to a valid Head-and-Shoulders Top Formation. The lack of any one of them casts in doubt the forecasting value of the pattern. Innaming them, we have left the way clear for the many variations that occur (for no two Head-and-Shouldersare exactly alike) and have included only the features that must be present if we are to depend on the patternas signaling an important Reversal of Trend. Let us examine them in greater detail (see Figures 6.1 through6.12).
Volume is important
First, let us consider the matter of volume. It is always to be watched as a vital part of the total picture. Thechart of trading activity makes a pattern just as does the chart of price
Diagram 6.1 A hypothetical daily stock chart. Price in the upper part and volume at bottom—drawn to showhow an ideal Head-and-Shoulders Top Reversal Formation would develop. A, B, C, and D refer to essentialfeatures listed on the previous page.
ranges. The two go together and each must conform to the requirements of the case. But note also that volumeis relative. When we speak of high volume, we mean a rate of trading notably greater than has beencustomary in that particular stock during that particular period under examination. The exact number of sharestraded is not important, and it will not ordinarily signify anything for our purposes to compare a daily volumeof, say, 6500 shares in Radio Corporation with 500 in Bohn Aluminum and Brass. The former may be verylow and the latter very high as judged by the proper technical criterion, which is, in each case, the averagerecent activity in the same issue. In the case of a Head-and-Shoulders Top, as mentioned, high volume attendsthe making of the left shoulder; this means that activity on the rise to and at the top of the left shoulder shouldbe greater than on the preceding rally waves in the same issue, followed by a Minor Recession on dwindlingactivity, and then a new advance on high volume. The action thus far does not differ from what we shouldexpect of normal wave development within a continuing uptrend. In these respects, any two typical,successively higher waves in an advance may, as you can see, become the left shoulder and head,respectively, of a Head-and-Shoulders Reversal.
Figure 6.1 Starting in March, “HUM” formed a broad Head-and-Shoulders Top pattern on the daily chart.August's decline penetrated the neckline by 3%, confirming the Reversal Pattern. The minimum objective forthe Head-and-Shoulders Top would be 18.
Figure 6.2 Daily chart of Chicago, Milwaukee, St. Paul, & Pacific common from January 1 to June 29, 1946.Head-and-Shoulders that topped this issue's Primary Advance in February was unmistakable, despite thesmall size of shoulders (SS). Note the volume pattern. Measuring implication (see following pages) of thisformation was carried out by April. Rectangular price congestion of March 30 to May 4 is a subject ofChapter 9. “ST” fell to 11 1/2 in October.
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Figure 6.3 Bull market top of Westinghouse Electric in 1946 was the “wide-swinging,” powerful type ofHead-and-Shoulders Pattern (S-H-S). Decline that broke neckline (NL) on February 13 produced a breakawaygap (G) discussed in Chapter 12. Measuring formula (see following pages) called for initial decline to 33. Thepossible Bottom Head-and-Shoulders Pattern (S?-H?-S?) formed in March was never completed (see Chapter7). Note the failure of prices to push up through the neckline of the latter at any time, despite several rallyefforts in late spring while general market Averages were actually reaching new high levels. By the following
November, “WX” had broken on down to 21 1/2. Study in detail the change in volume pattern after the end ofJanuary.
The first suggestion a Head-and-Shoulders is really developing may come when the volume record shows thatactivity accompanying the most recent Top was somewhat less than the one preceding it. If this volumedisparity is conspicuous, and if it becomes evident from the way prices are receding that the second andhigher rally has ended, then the chart should be tabbed with a “red” signal and further developments shouldbe scrutinized. But such a preliminary warning does not always appear and should not be taken as conclusivewhen it does. Roughly estimated, about one-third of all confirmed Head-and-Shoulders Formations showmore volume on the left shoulder than on the head, another third show about equal volume, and the final thirdshow greater volume on the head than on the left shoulder.
Another warning—or, more often, the first—comes when prices drop in the course of the second reaction(i.e., from the head) below the level of the Top of the left shoulder. Such action, as we shall see later on in ourspecific study of Support and Resistance levels, is significant of weakness in the price structure. So far it isMinor, it may be only temporary, and it is certainly not conclusive. Nevertheless, when this occurs, put adouble red tab on your chart.
Breaking the neckline
The real tip-off appears when activity fails to pick up appreciably on the third rally, the right shoulder. If themarket remains dull as prices recover (at which stage you can draw a tentative “neckline” on your chart) andif, as they approach the approximate level of the left shoulder
Figure 6.4 A large Head-and-Shoulders Topping Pattern evolved in “TDY” over five months, withDecember's high-volume plunge through the neckline confirming the Trend Reversal. Because this was a veryexpensive stock, you might have considered buying the April 260 puts instead of selling “TDY” sharesoutright. Our measured objective in this issue was 44 points from penetration of the 264 neckline, or 220.
Top and begin to round over (volume is still relatively small), your Head-and-Shoulders Top is at least 75%completed. Although the specific application of these pattern studies in trading tactics is the province of thesecond part of this book, we note here that many stock traders sell or switch just as soon as they are sure alow-volume right shoulder has been completed, without waiting for the final confirmation named under D asthe breaking of the neckline.
Nevertheless, the Head-and-Shoulders is not complete, and an important Reversal of Trend is notconclusively signaled until the neckline has been penetrated downside by a decisive margin. Until theneckline is broken, a certain percentage of Head-and-Shoulders developments, perhaps 20%, are “saved”—that is, prices do not go lower, but simply flounder listlessly for a period of time in the general range of theright shoulder, then eventually firm up and renew their advance.
Finally, in rare cases, a Head-and-Shoulders Top is confirmed by a decisive neckline penetration and stillprices do not go down much farther. “False moves” such as this are the most difficult phenomena with whichthe technical analyst has to cope. Fortunately, in the case of the Head-and-Shoulders, they are extremely rare.The odds are so overwhelmingly in favor of the downtrend continuing once a Head-and-Shoulders Formationhas been confirmed, it pays to believe the evidence of the chart no matter how much it may appear to be outof accord with the prevailing news or market psychology.
One thing is worth noting about Head-and-Shoulders Formations that fail completion or produce falseconfirmations—that is, such developments almost never occur in the early stages of a Primary Advance. AHead-and-Shoulders Formation that does not work is a warning that even though there is still some life in thesituation, a genuine turn is near. The next time something in the nature of a Reversal Pattern begins to appearon the charts, it is apt to be final.
Figure 6.5 “ICX” was in a powerful uptrend for more than a decade and gains were spectacular. But theupward momentum began to fade and topping indications were evident. The August peak fulfilled theobjective of the measuring flag formed during 1985. The August gap to new highs was quickly filled,indicating it was an Exhaustion Gap. The reaction back to Support, followed by a slow, relatively low-volumerally to the July high, formed a credible right shoulder. The final week's high-volume plunge through theneckline confirmed the Reversal. The minimum objective for the Head-and-Shoulders Pattern was 19 1/4, thetop of the 1985 Flag. A possible alternative cover point was the Bottom of the Flag at 14 1/4.
Variations in Head-and-Shoulders Tops
There is a tendency, surprising when one thinks of all the vagaries of news and crosscurrents that mayinfluence day-to-day trading, for Head-and-Shoulders Patterns to develop a high degree of symmetry. Theneckline tends to be horizontal and the right shoulder tends to resemble the left in price confirmation(although not, of course, in volume); there is a sort of satisfying balance to the overall picture. But symmetryis not essential to a significant Head-and-Shoulders development. The neckline may slope up (from left toright) or down. The only qualification on an up-sloping neckline is that the Bottom of the recession betweenthe head and right shoulder must form appreciably below the general level of the Top of the left shoulder. It issometimes said that a down-sloping neckline indicates an unusually weak situation. This is so obvious that itis apt to be given even more weight than it deserves. A share of that excessive weakness, it should be noted,will have already been discharged by the time the down-sloping pattern is formed and prices have broken theneckline. The measuring formula, which we shall discuss later, applies to such situations.
Due to the tendency toward symmetry in shoulder development, some traders, as soon as the neckline hasformed, will draw on their charts a line parallel to the neckline, extending from the top of the left shoulderthrough the head and on to the right. This furnishes a guide as to the approximate height the right shoulderrally should attain and,
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Figure 6.6 Reversal Formations, which develop in important stocks while the general market is stillapparently in a strong trend, are often difficult to believe, much less act on. But they may be highlysignificant. DuPont topped out in 1936, four months ahead of the Averages. Despite its extended rightshoulder (but note volume), Reversal implications were clear on December 19. The Pullback of January,meeting supply at the old neckline level, and the second try in March were interesting and typical of such ageneral market situation. Compare with Figure 6.11.
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Figure 6.7 Another 1937 Bull Market Top of Head-and-Shoulders Form, with only one quick Pullback(February 10). In this case, volume increased sharply on February 5 with the initial break through the neckline(NL). Measuring formula was satisfied in March. Study this picture in connection with “ED's” long-rangechart (Figure 10.4) in Chapter 10; turn back to it later when you come to the Support-Resistance study inChapter 13.
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Figure 6.8 The six-month-long Head-and-Shoulders Top of Republic Aviation in 1946. Such a patternbecame a possibility to be watched for when prices broke down in May below the level of the February high(first S). Refer to requirement B. Note also how the Head-and-Shoulders Measuring Formula (Chapter 7) isapplied to patterns with up-slanting necklines. Minimum downside requirement here was 12 1/2, reached inNovember. The quick Pullback on July 27 gave a last good selling opportunity.
Figure 6.9 After a sharp reaction from its 1983 high, which lasted a year and pushed “DIS” back to long-termSupport, the Bulls took over and sent Walt and friends on a trip to the moon. But beginning in April, the
rocket began to lose power, and it looked like reentry had begun. Since the big-volume days of spring, thisissue etched out a large Head-and-Shoulders Top. High-volume penetration of the neckline by 3% confirmedthe Reversal.
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Figure 6.10 New York Central made a Head-and-Shoulders Top in June 1945. Intermediate Up Trendline(IUT) was broken by drop from head on July 5. Minimum measuring implication was carried out at 24 onAugust 18. Reaction ended a few days later at 22 3/4. Prices recovered to projected neckline (see September25), dropped again to 26 7/8 in October, and then pushed up, giving “rebuy” signal (on Fan Line construction)at 30 in the first week of November. Final Bull Market High was made in January at 35 1/2. The period fromAugust 1945 to February 1946 was difficult for technical traders in this stock. Those who sold at 26-27 inJuly 1945 could, however, congratulate themselves in May 1947 when “CN” hit 12.
consequently, a selling level. But you will not see very many formations as perfect and symmetrical as ourideal picture, a fact the several actual examples accompanying this chapter amply illustrate. Either shouldermay, in fact, go higher or take more time than the other. Either or both may come up nearly to the level of thehead (but not equal it, or else no Head-and-Shoulders exists) or both may fall considerably short of it. Ifactivity attending the right shoulder is abnormally dull, that shoulder is apt to be low but protracted in time. Ingeneral, there seems to be a balanced relation between the three elements of price pattern, time, and volumethat is practically impossible to express in words or figures, but comes with experience to sense in itsdevelopment. However, there are no laws beyond those stated in our A, B, C, and D of Diagram 6.1; withinthose limits, look for an infinity of minor variations.
Price action following confirmation: the measuring formula
The final step, the downside penetration of the neckline, may be attended by some increase in activity, but itusually is not at first. If volume remains small for a few days as prices drift lower, a “Pullback” movefrequently ensues that brings quotations up again to the neckline level (rarely through it). Normally, this is the“last gasp”; prices then turn down quickly, as a rule, and break away on a sharply augmented turnover.Whether or not a Pullback Rally will occur after the initial penetration seems often to depend on the conditionof the market in general. If the whole market trend is turning down at the same time as our individual issue,which has just completed its Head-and-Shoulders, there will probably be no Pullback;
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6 13 20 27 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 7 1421 28'
Figure 6.11 The great 1929 Bull Market Top was characterized by many impressive Head-and-ShouldersFormations, of which this is an interesting example. Note the small Head-and-Shoulders Pattern ofSeptember, which became the head of a much larger formation of the same character. The Pullback of
October 9 to the upper neckline afforded a second chance to get out at 128 to those who did not sellimmediately when this first line was decisively penetrated on September 28. The larger pattern “broke” onOctober 19, with a quick pullback on October 22. Less than a month later “UUK” had lost half its peak value.By 1932 it had fallen to 15 1/2. Although such a catastrophic decline as 1929-1932 may never come again, themoral is, nonetheless, plain: never scorn a Head-and-Shoulders Formation. Patterns such as this merge intothe “multiple” types discussed in Chapter 7. Although this example is selected from the 1929 portfolio, theywere not at all uncommon in the mid-20th century. Several modern examples appear in our later pages.
prices instead will tend to accelerate their decline, with activity increasing as they leave the vicinity of theTop. If, on the other hand, the general market is still firm, then an attempt at a Pullback is likely. Also, theodds seem slightly to favor a Pullback if the neckline has been broken before much of a right shoulderdeveloped, but certainly no sure rules can be laid down. In any event, the Pullback Rally is of practicalinterest chiefly to the trader who wants to sell the stock short, or who has sold it short and has then to decidewhere he should place a stop-loss order.
Now we come to one of the most interesting features of this basic Reversal Formation— the indication that itgives as to the extent (in points) of the move that is likely to follow the completion of a Head-and-Shoulders.Measure the number of points down vertically
Figure 6.12 Dow Jones Industrials, Head-and-Shoulders Top 2007-2008; edwards-magee.com identified thismassive Head-and-Shoulders Formation in early 2008, after having already exited the market in January 2008and wrote the following letter. Note "A low" and "B low"; if this yearlong formation is a massive Top(perhaps a double-headed Head-and-Shoulders) and A low is its lower boundary, then a low of 9680 ispredicted. If B low is the defining point, the predicted low is 10836. Remember Niels Bohr and the difficultyof forecasting? Again, it is not necessary to believe this scenario to know how to bet. The Dow is in a six-month downtrend, the last 21/2 months of which are sideways, with lower highs in the sidetrend. The low of9680 is a probable minimum. Mark Hulbert says Richard Band is predicting a 16000 Dow. Watch out for lowflying eggs (as in getting egg on your face). Then the Dow went to 6469.95 in the great Bush Bear Market.
Technical Analysis of Stock Trends
from the Top of the head to the neckline as drawn in Figure 6.4. Then measure the same distance down fromthe neckline at the point at which prices finally penetrated it following the completion of the right shoulder.The price level thus marked is the minimum probable objective of the decline.
Let us hasten to state one important qualification to the Head-and-Shoulders Measuring Formula. Refer backto our original set of specifications for a Head-and-Shoulders. Under A, we required “strong rally climaxing amore or less extensive advance.” If the up-move preceding the formation of a Reversal Area has been small,the down-move following it may—in fact, probably will—be equally small. In brief, a Reversal Pattern has tohave something to reverse. So, we really have two minimums: one being the extent of the advance precedingthe formation of the Head-and-Shoulders and the other derived from our measuring formula, whichever is thesmaller will apply. The measuring rule is indicated on several of the examples that illustrate this chapter. Youcan see now why a down-sloping neckline indicates a “weaker” situation than an up-sloping neckline, and justhow much weaker, as well as the fact that more than half of the minimum expected weakness has alreadybeen expended in the decline from the top of the head to the penetration of the neckline.
The maximum indications are quite another matter, for which no simple rules can be laid down. Factors thatenter into this are the extent of the previous rise, the size, volume, and duration of the Head-and-ShouldersFormation, the general market Primary Trend (very important), and the distance that prices can fall beforethey come to an established Support Zone. Some of these are topics for later discussion.
Relation of Head-and-Shoulders to Dow Theory
Without doubt, some readers have already suspected the Head-and-Shoulders Pattern is, in a sense, just anadaptation of the principles of Dow Theory to the action of an individual stock. So it is. The decline of pricesfrom the head to the neckline, the rally to the right shoulder, and then the ensuing decline that breaks theneckline set up a sequence of lower Tops and Bottoms analogous to those that signal a downtrend in DowTheory. This logical relation of the Head-and-Shoulders to Dow Theory is another reason, in addition to itsbasic importance, frequency, and dependability, why we have placed it first in our study of ReversalFormations. But it also is more definite, gives advance warnings that are relatively easier to detect, and isquicker with its signals in the case of up-sloping necklines. Moreover, it requires no specified minimum timefor any of its component moves, and no confirmation by another stock or Average.
There are Head-and-Shoulders Bottoms (EN: An undescriptive term for a bottom formation that I wouldprefer to call the “Kilroy Bottom.” See Figure 7.4.) as well as Tops, with equally important implications. TheBottom Formations will be taken up in our next chapter.
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chapter seven
Important Reversal Patterns: continued
Head-and-Shoulders (EN: or Kilroy) Bottoms
A formation of the Head-and-Shoulders type may develop at an important Reversal ofTrend from down to up. In that case, it is called a Head-and-Shoulders Bottom, and itsprice pattern (as compared with a Top) is turned upside down, that is, it stands on itshead. EN: The present Editor has always been impatient with the undescriptive natureof the term “Head-and-Shoulders Bottom,” and so he has renamed it the “KilroyBottom.” See Figure 7.4. The volume pattern is somewhat the same (not turned upsidedown) as at a Top but with some important changes in the latter half of the formation,which we shall discuss in detail. We can lay down specifications for it in much thesame words as we used for the Head-and-Shoulders Top. Here they are, with theportions that differ in principle from the Top printed in italics (see Figures 7.1 through7.25):
A. A decline, climaxing a more or less extensive downtrend, on which tradingvolume increases notably, followed by a Minor Recovery, on which volume runsless than it did during the days of final decline and at the Bottom. This is the “leftshoulder.” EN9: Or left hand.
B. Another decline that carries prices below the Bottom of the left shoulder, onwhich activity shows some increase (as compared with the preceding recovery)but usually does not equal the rate attained on the left-shoulder decline, followedby another recovery that carries above the Bottom level of the left shoulder and onwhich activity may pick up, or at any rate exceed that on the recovery from the leftshoulder. This is the “head.” EN9: Or nose.
C. A third decline on decidedly less volume than accompanied the making ofeither the left shoulder or head, which fails to reach the low level of the headbefore another rally starts. This is the “right shoulder.” EN9: Or right hand.
D. Finally, an advance on which activity increases notably, which pushes upthrough the neckline (EN9: Or fenceline) and closes above by an amountapproximately equivalent to 3% of the stock's market price, with a conspicuousburst of activity attending this penetration. This is the “confirmation” or“breakout.”
The essential difference between Top and Bottom Patterns, you can see, lies in theirvolume charts. Activity in Head-and-Shoulders Bottom Formation usually begins toshow uptrend characteristics at the start of the head and always to a detectable degreeon the rally from the head. It is even more marked on the rally from the right shoulder.
It must be present on the penetration of the neckline, or else the breakout is not to berelied on as a decisive confirmation.
An important basic principle of techniques that is involved here merits furtherdiscussion. Wall Street has an old saying that expresses it: “It takes buying to put stocksup, but they can fall of their own weight.” Thus, we trust, and regard as conclusive, anyprice break (by a decisive margin) down through the neckline of a Head-and-ShouldersTop
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I 2 9 16 23 30.6 .13.20-27 4 -11-18 25 1'8 '15 22 29 5 12 19 26: 4 11-18 25
Figure 7.1 After “rounding over” in October 1943 in the last phase of a long declinefrom 41 in 1940, Lockheed made a conspicuous two-month Head-and-ShouldersBottom. Note especially, on the above chart, the volume on the rally in early Decemberand in the first week of January with reference to points B and D on the precedingpages. “LK” dropped back to 15 again in June 1944, and then ran up quickly to 23 byNovember, finally reaching 45 in January 1946. One advantage of logarithmicallyscaled charts is they expand, and thus call attention to important formations thatdevelop at low price levels, and that would be obscured on an arithmetic scale.
even though it occurs on a light turnover, but we do not trust a breakout from a Head-and-Shoulders Bottom unless it is definitely attended by high volume. A low-volumebreakout from a Bottom Pattern may only be premature, to be followed after more“work” around the Bottom levels by a genuine advance, or it may be a “false” moveentirely. It pays generally to wait and see. This same distinction in volume developmentapplies to some of the other Reversal Patterns we shall take up later in this chapter.
Other differences between Top and Bottom Head-and-Shoulders do not involve anynew principles. It can be said that Bottoms are generally longer and flatter, that is, theytake more time in relation to depth of pattern in points than do Tops. This is particularlytrue when they occur at Reversals in the Primary Trend. The overall volume at Bottomstends to be less than at Tops, and the turns tend to be more “rounded.” In theconstruction of a Head-and-Shoulders Top, the activity that goes into the left shoulderusually exceeds that on any preceding rally in the entire uptrend. In a downtrend, on theother hand, there may be Panic Selling in some of the earlier phases of decline, whichruns the volume chart up to a mark higher than any that is subsequently registered inthe final Bottom Formation. None of these differences, however, affects our essentialHead-and-Shoulders specifications.
The measuring implications of the Head-and-Shoulders Bottom are the same in allrespects and are applied in the same way as with Tops. Tendency toward symmetry isagain the rule, with variations as to slope of neckline, relative size of shoulders aboutthe same as in Tops. Reactions to the neckline following the initial breakout from theBottom type appear in about the same frequency and proportions as do the PullbackRallies, which follow the initial breakdown from the Top type.
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Figure 7.2 Weekly charts are particularly useful for detecting Major Bottom Reversalsbecause Bottom Formations characteristically take longer to build than Tops. DomeMines made a typical Head-and-Shoulders base, 13 months' long, at its Primary TrendReversal in 1942. Note the volume pattern. (Volume detail, however, is better studiedon daily charts.) Dome's powerful Head-and-Shoulders Bottom was “high” enough tobe conspicuous on an arithmetic monthly chart. It reached 25 in 1944.
Multiple Head-and-Shoulders Patterns
The Head-and-Shoulders Formations we have examined up to this point have been,despite minor variations, relatively simple and clear-cut, consisting of three well-defined elements. We come now to a group of related patterns that carry much the sametechnical significance but have more elements and are much less clearly defined. Theseare the Multiple Head-and-Shoulders Tops and Bottoms, also known as ComplexFormations. We need not take much of our space to define or lay down specificationsfor them, as they may be described quite sufficiently as Head-and-Shoulders Reversalsin which either the shoulders or the head, or both, has been doubled or proliferated intoseveral distinct waves.
Almost any combination is possible, of which only a few can be illustrated in the actualchart examples reproduced in this chapter. Formations of this type appear with fairfrequency at Primary Bottoms and Tops, but more often at Bottoms than at Tops. They
Figure 7.3 With a strong movement toward lower interest rates evident since June, thetiming of the low in “FNM” is not surprising. Neither is the massive width (fromMarch through October) of its evolving pattern, which closely matches that of the huge,complex Inverse Head-and-Shoulders Bottom in Treasury Bills (December 1984),September 25, 1984. Even the slight timing lag is appropriate.
Figure 7.4 EN: At the risk of being considered a comic (actually, a satirist), I suggestthat, although the image is comical, the pattern is more descriptive of theincongruously named “Head-and-Shoulders Bottom” than the present terminology.
Left hand equals left shoulder, right hand equals right shoulder, nose equals head, andneckline equals fence line, or, as easily, neckline. I am teaching all of my students tothink and use these terms, which makes much more sense than the absurd “upside downHead-and-Shoulders Bottom standing on its head.” One hundred years from now, thiscontribution to the nomenclature will be accepted as totally descriptive andappropriate, and the term “Head-and-Shoulders Bottom” will have disappeared fromthe lexicon.
A common form consists of two left shoulders of approximately equal size, a singlehead, and then two right shoulders, again, of approximately even size and balancing thetwo on the left. Another is made up of two heads with two or more shoulders on eitherside. Still another form, of which you will usually find several good examples at anyMajor Market Turn, consists of double shoulders on either side of a head, which isitself composed of a small but quite distinguishable Head-and-Shoulders development.
Figure 7.5 A ragged Kilroy (or, if from the old school, a Head-and-Shoulders) Bottomthat ended the Bear Market (or first phase thereof) of 2001-2002. Some seven and ahalf months in formation it threw a few knuckle balls and curves and looked right up toMarch 2003 as though it were a Bear Market rally. Once the neckline was taken out,there was no arguing with it—it was a real Bottom. It balked at the neckline for acouple of months before becoming a full Bull. Complex economic and political realities
affected the markets: the terrorist attacks of September 11, 2001, which put paid to thetulipomania of the roaring 1990s and the ill-advised tax cuts of the Bush Jr.administration. Using the formula of cut taxes and increase spending to start a war, themarket was sufficiently stimulated to rally exuberantly. The downtrend line is drawnhere and the reader should have no trouble seeing the break of the long-term downtrendas well as the Kilroy Bottom demanded a shifting of gears from Bear to Bull.
Tendency to symmetry
We have mentioned the tendency toward symmetry in the simple Head-and-ShouldersFormation. Patterns of the Multiple or Complex type show an even stronger urgetoward symmetry—so strong, in fact, that it may be counted on in determining tradingpolicy. If there are two shoulders on the left, there are almost always two on the right ofnearly the same size and duration. (One does not know that a Multiple is in the processof formation until its right shoulder becomes evident.) Except in volume, the right-handhalf of the pattern is, in the great majority of cases, an approximate mirror image of theleft.
Necklines on Multiple Head-and-Shoulders Formations are not always easy to drawbecause the reactions between the shoulders and heads may not stop at levels that allfall on a single line. Up-sloping and down-sloping variants seldom appear in this classof patterns; necklines are almost always very close to the horizontal. Sometimes, it ispossible to estimate by simple inspection where the critical line really lies. More often,there are two necklines, an inner and an outer, and no price movement of consequenceis to be expected until the outer has been penetrated (which is simply anotherexpression of that tendency toward symmetry referred to above).
Curiously enough, the “power” of a Multiple Head-and-Shoulders Pattern is more aptto be over rather than underestimated. One might think, in view of the length of timeand

Figure 7.6 “MCA” enjoyed an excellent advance from 1980 to 1986, but the goingbecame increasingly difficult after the turn of the year, when this issue began tochallenge its 1985 high. Although the Bulls did manage to set a new high-water mark inApril, a series of Pullbacks kept this issue well away from any further tests. Indeed, alarge Complex Head-and-Shoulders Top appeared to be unfolding with the MajorNeckline penetrated slightly on the sell-off.
26
24
22
20
19
Sales
100's
125
100
75
50
25
DECEMBER JANUARY FEBRUARY MARCH APRIL MAY
: 1 8 15 22 29 5 12 19 26 2 9 16 23 2 9 16 23 30 6 13 20 27 4 11 18 25’
Figure 7.7 An “ideal” Multiple Top made by Budd in 1946, with two heads. Observeaccompanying volume. Prices often break away from Complex Formations morereluctantly than from the simple Head-and-Shoulders type. The late-March rally, whichwent back through the old neckline, was greater than normal in that respect, but thegeneral market Averages were pushing to new highs at this time. Repenetration of aneckline does not, of itself, cancel the implications of a Reversal Formation.
Sales
100's
125
100
75
50
25
SIL
RL
G
G
AMERICAN LOCOMOTIVE
LA
1946
APRIL MAY JUNE
AUGUST SEPTEMBER
6 13 20 27 3 10 17 24 31 7 14 21 28
6 13 20 27 4
Figure 7.8 The long Multiple Head-and-Shoulders Top made by American Locomotivein 1946 displays very well the sort of volume pattern—irregular but taking on
definitely Bearish character in its latter half—that is normal to this formation. Therounded Bear Market Rally of August (compare price and volume trends) was unable toattain the old neckline and was stopped at a Resistance (RL) created by earlier Bottomlevels (see Chapter 13). G and G mark Breakaway Gaps that were not “covered” (seeChapter 12).
Figure 7.9 From a Head-and-Shoulders Top in February, Digital plunged sharply lowerinto midJune, retracting roughly two-thirds of the 1983-1985 advance. The summer lowwas the head of a Broad, Complex Head-and-Shoulders (EN: Or Kilroy) Bottom.“DEC,” however, had already enjoyed a high-volume penetration of the neckline andwas, therefore, in a buying position.
ARCHER DANIILS MIDLAND
300
32
30
20
15
28
26
24
800
81
82l
83
22
16
15
Sales a
100's I
MARCH APRIL
MAY
JUNE
~ACGU
T SEPTEMBER
OCTOBER NOVEMBER DECEMBER
XD.035
XD.035 5 % STK.
XD.035
Figure 7.10 After testing its 1980 high in mid-1983, “ADM” turned sharply lower,retracing roughly 40% of the 1982-1983 advance by mid-1984. The summer low,however, appeared to be a Bottom. Indeed, if one looked at the volume pattern from
April to November and correlated it with price activity, it was not difficult to make agood case for a Complex Head-and-Shoulders Bottom. A neckline through the closesgave us a go signal on a penetration of 20 5/8.
Figure 7.11 An Intermediate Bottom of the Complex class, abnormal in its lack ofsymmetry but, nonetheless, easy to recognize. Low volume on reactions after the Headwas completed gave the usual (and essential) Bullish Confirmation. The sluggish startof the new trend was a common feature of Multiple Head-and-Shoulder Reversals.
Figure 7.12 The slide in Amdahl occupied the Bears from March to June before a sharprally gave notice that the Bulls were still alive. After that, a choppy sideways tradingrange evolved with Support near the Pullback lows established earlier in the year.Overall, there was a fine symmetry to this chart, including volume, which indicated theprice action from March to September was actually a Broad Head-and-ShouldersBottom. Entry was on a 3% breakout of the neckline with a minimum objective of 193/4.
amount of trading entering into its construction, that it would signal a move (in reversedirection to the trend preceding it) of greater extent than the simple Head-and-Shoulders. Yet, in its immediate consequences, at least, the Complex showsconsistently less power. Minimum measuring rules for the two types of formations arethe same and are applied in the same manner. The difference between the patternsappears in the price action after the minimum has been reached. The first downswingout of a plain Head-and-Shoulders Top, not counting any early Pullback Rally, willfrequently carry out the minimum measuring implications of that pattern quickly andrun well beyond it. From a Multiple Top, the first downswing is often more leisurely,and very seldom does it exceed the bare minimum—a probability well worthremembering when you are dealing with an Intermediate rather than a Primary Top. Ifthe Complex does develop at a turn in the Primary Trend, prices will eventually gomuch farther; however, even then, there is usually a strong recovery (or reaction, in thecase of a Bottom) from the “minimum rule” level.
A leisurely pattern
The volume attending the construction of Multiple Head-and-Shoulders conforms ingeneral to the “laws” we have previously stated and explained for simple Head-and-Shoulders Reversals. During the earlier stages of Multiple Formation development, thevolume chart may show much irregularity with little recognizable pattern, but in thelatter stages, its correspondence with the Head-and-Shoulders Trend should be plainlyseen.
There is something about Multiple Head-and-Shoulders Patterns that is especiallypleasing to technical chart followers. Due to their symmetrical tendencies, it isfascinating to watch them evolve to completion. Once completed, however, they maytry your patience by their seeming reluctance to “get going” with a new trend. On thataccount, it becomes
10
Sales
100's
1000
800
600
400
200
P J
S
S
PUBLIC SERVICE CORP.
OF N. J.
A ’ M :
Li
■J'A'S'O'N'D'J' I'M
Figure 7.13 Another variant of the Head-and-Shoulders within a Major ReversalFormation. The smaller Head-and-Shoulders Pattern was easily overlooked on the dailychart. Moreover, although it was six months long, this pattern in itself did notnecessarily imply Primary Reversal. Although, when it pushed "PJ's" prices up inOctober through the great supply that had been lodged at 12-13 the previous December,something more than a Secondary Advance could obviously be in prospect. An up-move of consequence was not finally signaled, though, until February 1943 when theupper neckline was penetrated and prices closed at 14. Public Service “threw back” to12 in November 1943 (to the old neckline exactly), but then advanced steadily to 30.Study this again when you take up Support and Resistance in Chapter 13. This chartreiterates the point that, whereas Top Formations are often completed in a relativelyshort time, Major Bottoms usually require many months, and call for a great deal ofpatience. Allowing for the greater time needed, however, most Top Patterns have theircounterparts in Bottom Formations.
easy at times to jump to the conclusion that they have “blown out,” that is, produced afalse signal. Actually, except in the matter of extent of move, which we have alreadydiscussed, they are fully as reliable as the plain Head and Shoulders. False moves arerelatively rare with both. And in those extraordinary cases when a Complex Formationdoes go wrong, it still stands, like the plain Head-and-Shoulders, as a warning that thefinal Reversal is near.
Rounding Tops and Bottoms
The Multiple Formations we have just examined are produced by a sort of extension orproliferation of the ordinary Head-and-Shoulders Pattern. Carry this process still furtherand the Complexes merge into our next class of Reversals, known as Rounding Turns.
24
22
20
19
18
17
16
15
14 Sales 100's 125 100
75
50
25
L-ii-’-L
■ ■,
NATIONAL SUPPLY
NS
1946
Uuuilyiil
APRIL
6 13 20 27 4 11 18 25 1 8 15 22 29 6 ' 13 20 27 ' 3 10 17 24 31 7 14 21 28’
Figure 7.14 Still another form the Complex Reversal may take. This can be describedas a Head-and-Shoulders Pattern with two widely separated heads. Study its volumepattern, noting the breakout on June 20 and the subsequent Pullback. Compare it withBethlehem Steel's Bottom Reversal shown in Chapter 12, Figure 12.12.
72
68
64
60
56
Sales 100's
125
100
75
50
25
• il. -fL ..
S " 4 T—• $3
...............
SUM mt? % ■ $|l
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APRIL MAY JUNE ’ JULY * AUGUST SEPTEMBER
■ 6 13 20 27 4 11 18 25’1’8 15’22’29 6 13 20 27 3 10 17 24 31 7 14 21 28
Figure 7.15 Major Top Reversal Patterns in high-priced investment issues arefrequently long and “flat.” The 1946 Top of Phillips Petroleum could be classified aseither a Multiple Head-and-Shoulders or an irregular Rounding Top. An importanttrendline (see Chapter 14) was broken downside in July.
In our first approach to the theory of chart Reversal Patterns, we saw why it takes timeand a considerable volume of trading to swing an established trend in prices from up todown or down to up. In the Head-and-Shoulders type of Reversal, the trend surges,struggles, and attacks again and again before it finally gives up and retreats. During thisstruggle, the balance between the forces of supply and demand fluctuates, often wildly,
AMERICAN & FOREIGN POWER 2d PFD. A
FPD Pr
1945
26
Sales
100's
125
100
75
50
25
JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBE
7 14 21 28 4 11 18
Figure 7.16 The war-end reaction of 1945 in American & Foreign Power 2d Preferred,as well as in many other issues, took the form of a Rounding Bottom. Compare theprice and volume trends. By October 4, the implications were plain to see.
until finally the one overcomes the other. In the Multiple Formations, a similar processgoes on but rather less violently and, over a period of time, the progressive change fromone force to the other becomes clearly apparent.
The Rounding Turn is a much simpler and more logical manifestation of this technicalphenomenon. It pictures simply and plainly a gradual, progressive, and fairlysymmetrical change in the trend direction, produced by a gradual shift in the balance ofpower between buying and selling.
If, for example, the buying has been stronger than the selling for some time past, weknow the result will have been a general upward trend in the price of our stock, asindicated by our pictorial chart record of its trading history. So long as the buyers of thestock remain more anxious, more numerous, more aggressive, and more powerful thanthe sellers, that preceding upward trend will continue. Now, suppose the selling grows alittle stronger while the buying either weakens slightly or remains stationary at itsprevious strength; this slight change in the technical balance will be indicated by aslowing up of the previous advance. As the selling increases in relative power, it willfinally become equal to the buying power, with the result of the market level neithermoving up nor down but remaining, for a time, quite stationary (except for Minor andinsignificant fluctuations).
Assume the new development continues and the selling pressure grows until it is finallystronger than buying power. Now the balance is moving the other way. There are nowmore sellers than buyers, and the result will be a gradual decline in the marketquotations for the stock. If this change in the balance of power is fairly steady andcontinues to its logical conclusion, we can see, even without the aid of a chart, that ourpicture of the price movement for that stock would be one of a long advancing trendslowly beginning to round off, holding in stationary suspense for a time, and thencommencing a retreat, reversing the previous upward movement into a new andAccelerating Downward Trend.
20
15
10
5
AMERICAN SAFETY RAZOR ARZ I
IMSgggiiHi
........
1931 ! 1932 1933 11934 .1935 ■'"1936 0937 0938 0939 0 940 [1941 0942 [1943T1944 ,1945 j 1946.
Figure 7.17 Monthly chart on an arithmetic scale. American Safety Razor's 1932 MajorBottom was a Head-and-Shoulders and also its 1936 Bull Top. Its 1942 to 1946 Bull
Market started from a Rounding Bottom nearly two and a half years long. Monthlychart study pays.
Rounding Bottoms are commonly referred to as Bowl or Saucer Patterns. RoundingTops are sometimes called Inverted Bowls. Despite the logic of their construction,neither type appears as frequently as Head-and-Shoulders Formations. RoundingBottoms occur most often in low-priced stocks, in an extended, flat-bottomed form thatusually takes many months to complete. There was a host of such developments during1942 and 1943 among issues selling under $10.00 a share. (It should be noted here that“Saucer” Bottoms of two or three months' duration also appear frequently, one rightafter another, in the charts of low-priced issues during an extended up-movement. Theircharacteristics and denotations will be discussed in the section “Consolidation.”)
Tops of the Rounding type are rare among stocks in the lower and medium-priceranges, but they are found occasionally in the charts of those high-priced commonstocks that command an AA rating among wealthy investors and do not ordinarilyinterest the general public. They also appear frequently in the charts of high-gradepreferred stocks, quite naturally because the demand for their shares reflects chieflytwo factors—supply of funds seeking conservative investment and interest rates—bothof which tend to change very slowly. The speculative appeal that produces wide-swinging price fluctuations is absent in such issues. The same line of reasoningexplains why Rounding Tops almost never develop
30
20
10
Sales 100's
200
100
1939
Figure 7.18 Monthly chart of Budd Company. Note that 1942 was the first year toproduce a dull Saucer-Shaped Pattern, a Rounding Bottom of Major import. “BF”climbed from below 3 in 1942 to above 26 in 1946.
am
:dH
igl
J
il /
1 !l,li„! iie; X
Zu
Bi liihlll,liili;
30
20
10
Sales
100's
100
50
Figure 7.19 Similar formation in CertainTeed Products, which rose from below 2 in1942 to above 25 in 1946. Study volume, 1940 to 1945. The up-curving type of MajorBull Trend shown on these charts will be discussed in Chapter 15.
in lower priced, speculative common stocks; Bull Markets in those stocks are toppedoff by excited public buying that pays little or no heed to long-range investmentconsiderations.
How Rounding Turns affect trading activity
We have not yet mentioned the volume half of the Rounding Turn picture, which isinteresting, as well as meaningful. In the case of Rounding Bottoms, its pattern isusually as clean-cut and decisive as the price pattern. The first step in the gradualconquest of supply by demand, which produces a Rounding Bottom, appears as alessening in selling pressure. Volume, which has been running high, graduallydecreases. Demand is still timid, but the pressure on it is less; so, while prices still
decline, the pace is slower and the trend curves more and more to the horizontal. At theBottom, with the two forces technically in balance, relatively few transactions arerecorded. Then demand begins to increase, and as the price curve turns up, tradingbecomes more active. Volume accelerates with the trend until often it reaches a sort ofclimactic peak in a few days of almost “vertical” price movement on the chart.
In such formations, the tips of the volume lines at the bottom of the chart, whenconnected, will describe an arc that often roughly parallels the arc formed by the price
20 27 5
J. I. CASE
1932
nninniiiiinunnniiiiiinniiinui.nniuiiiii.iiiiii,,iii.li.^iiihiiniTnin.Hiiiiiiiiit
MARCH APRIL MAY JUNE
12 1 9 26 ' 2 ■ 9 : 1 6 23 30 7 14r21 :2.8'4 31 '18 25 T 2 '
12 19 26: 2
Figure 7.20 A classic example of Rounding Bottom at the Major Trend Reversal of1932. The jump out of line on June 10 and subsequent return to the Saucer Pattern is acommon development in Rounding Bottoms.
“Bowl” above. These patterns, when they occur after an extensive decline, are ofoutstanding importance, for they nearly always denote a change in Primary Trend andan extensive advance yet to come. That advance, however, seldom carries in a“skyrocket” effect, which completes the entire Major Move in a few weeks. On thecontrary, the uptrend that follows the completion of the pattern itself is apt to be slowand subject to frequent interruptions, tiring out the impatient trader, but yieldingeventually a substantial profit.
Let us repeat that trading volume should ebb to an extreme low at the Bottom of aBowl Pattern if its implications are to be trusted. After prices have passed dead center,however, and have begun their first gradual climb with as yet only a slight pickup inactivity, something in the nature of a premature breakout may occur. Without warning,a burst of buying may shoot quotations straight up for a day or two. These incidents areby no means rare, but, almost invariably, prices will quickly drop back again into theirformer channel, and the gradual rounding movement is resumed. There is no particulardanger for the trader in these premature bursts, but if he is tempted to jump in on such a
sudden showing of strength, he should realize there probably will still be need forpatience. A classic example of this type of premature break is shown in Figure 7.20.
See Chapter 16 for some very important 2005 rounding bottoms and their consequencesup to 2011.
42
40
38
36
34
32
30
28
26 Sales 100's
25
20
15
10
5
GAMEWELL GO.
JANUARY FEBRUARY
MARCH
JUNE
; 8 15 22 29 5 12 19 26 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1
Figure 7.21 An extreme case of Dormant Bottom. There were many days in the firstfour months during which no shares were traded. A “buy” signal appeared on April 26.Note the volume.
Figure 7.22 The March 1935 reaction produced many Rounding Bottoms. This oneverges on the dormant type. The gap (G), a Breakaway through a Resistance Level, wasnot closed until late 1937 (see Chapter 12).
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14
13
12
:-:i :t
1988
APPLIED MAGNETICS CORP
APM :| C I
Sales
100's
JUNE
1000
800
600
400
200
Figure 7.23 In a broad trading range (11—17 1/2) during 1988, "APM" turned downfrom Resistance in the summer. The reaction, however, was slow, forming a Saucer-likePattern from July through November on generally Bullish price-volume correlation. Ofparticular note was the fact the low point of the Saucer was above the February low,that is, higher lows were beginning to emerge. The High-Volume Rally through theShort-Term Downtrend Line signaled the start of the next up-leg.
O1 ... .
I1RU
JUNE "JOEY— AUGUST—SEPTEMBER OCTOBER ' NOVEMBER DECEMBER
18 25 2 19 16 23 30 6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 3 10 17 24 31
The Dormant Bottom variation
One sort of Major Bottom chart picture has been called a Dormant Bottom. Thisvariation relates logically to our Bowl Pattern, being, in effect, an extreme developmentof the "extended, flat-bottomed form" to which we have alluded above. It appearscharacteristically in "thin" stocks, that is, those in which the total number of shares
outstanding or, more particularly, the floating supply of shares is very small. In suchissues, a normal day's turnover may be only two or three hundred shares in an activerising market. Finally, weeks and sometimes months will pass during which no saleswill be registered for days at a time, or only an occasional lot at a figure that fluctuateswithin a fractional range, making the chart appear "flyspecked."
Eventually, there may appear a sudden and usually quite inexplicable flurry of activity.Several hundred shares appear on the tape and prices advance sharply. This "breakoutof dormancy" can be a premature move, such as we have noted in connection withtypical Rounding Bottoms, to be followed by several more weeks of inactivity, or it canbe the first lift in a sort of step-up process with shorter and shorter intervals betweeneach step, until a consistent uptrend finally develops. In any event, it is a signal that weare dealing with an important Accumulation Pattern.
What has happened to form these Dormant Bottoms is easy to guess. With relativelyfew shares outstanding, and only an occasional lot put up for sale "at the market,"investors (perhaps insiders connected with the company) would succeed only inrunning the price up out of reach if they started to bid for the stock. So they simply"hold a basket under it," as the saying goes, quickly picking up anything that is offeredbut never reaching for it,

Figure 7.24 Cray Research, a powerhouse stock for over a decade. Trading at under$1.00 in 1976, it reached 135 3/4 before the late April gap, through the Bottom of aseven-week Diamond, started the decline. However, after the High-Volume Rally inmid-January, “CYR” also managed to form an impressive Rounding Top. The concavevolume pattern, clearly evident after the high-volume decline to Support that followedthe Diamond breakdown, was particularly significant in illuminating this ToppingPattern.
until eventually the tree is shaken clean. Then they may raise their bids a point or so; ifthat seems to bring out a lot of stock for sale, they go back to their waiting tactics.
Volume pattern at Tops
The volume pattern on Rounding Tops is seldom as clearly defined as at Bottoms.Indeed, it is apt to be rather high and irregular throughout the entire rounding-overmovement in prices. Under scrutiny, one can usually see some signs of a change fromBullish to Bearish activity in the Minor Fluctuations after the peak has been passed, butthe volume warnings do not become conspicuous in most cases until the downtrend hasbegun to accelerate toward the vertical.
We know of no measuring formula that can be applied to Rounding Turns (except forthe minimum qualifications we mentioned in connection with Head-and-Shoulders, thatis, they cannot be counted on to produce a greater move than the preceding price swingin the opposite direction), but they almost never deceive. Their implications can beroughly estimated from the magnitude of the trends that led to them and the length oftime they take in the rounding-over process. The Rounding Turns that often appear onweekly and monthly charts, thus, have major import.
This leads us to the general consideration of weekly and monthly chart patterns. Thusfar, we have been speaking in detail of only daily chart developments, but all of theformations we have taken up appear, as well, in the much larger swings into whichdaily movements
30
28
26
24
22
NORTHERN INDIANA PUBLIC' SERVICE NI 1984
14
13
11
Sales
100's
ill
^ L  , P „ AY  JUNE . J ULY
■7 14 21 28 4 11 18 25 3 1017 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 7 14 21 28 411 18 25 1 8 15 22 29 6 13 XD. 375 XD. 39 XD .39
Figure 7.25 1984. We love the Scalloping tendency of Northern Indiana PublicService. Although it is obviously not a pattern portending rocket-like advance, thetechnical picture brightens with the high-volume breakout through Resistance at chartend.
are condensed on weekly and monthly charts, and with identical significance. Thus,volume record may not be quite so easy to read (climactic activity may occur on oneday of a week and the other days run dull, which would not show at all in the week'stotal figure), but it is less critical and may almost be disregarded. Head-and-ShouldersTops are particularly plentiful on monthly charts and should be accorded due respect. Infact, any clearly defined pattern, which is built to completion on a weekly or monthlychart, is proportionately significant (bearing in mind that “a Reversal must havesomething to reverse”).
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter eight
Important Reversal Patterns: the Triangles
We come next to an entirely different family of technical patterns, the
Triangles, a group that has not been as well represented on the charts of the
decade of the 1940s as it was during the 1920s and 1930s (EN10: In
plentiful supply in modern markets of the 2000s). Their scarcity in that
decade is regrettable because they are an intriguing lot with excellent profit
potential. Before we examine them in detail, however, a quick review of the
basic theory, which gives meaning and value to technical analysis, may be
appropriate. That theory can be summarized in the following brief
statements (see Figures 8.1 through 8.25).
1. The market value of a security is determined solely by the
interaction of supply and demand.
2. Supply and demand are governed at any given moment by many
hundreds of factors, some rational and some irrational. Information,
opinions, moods, and guesses (shrewd or otherwise) as to the future
combine with blind necessities in this equation. No ordinary man can
hope to grasp and weigh them all, but the market does this
automatically.
3. Disregarding Minor Fluctuations, prices move in trends that persist
for an appreciable length of time.
4. Changes in trend, which represent an important shift in the balance
between supply and demand, however caused, are detectable sooner or
later in the action of the market itself.
By this time, the fact expressed in the italicized words of the last statement
may have begun to raise some misgivings in your mind. The complaint that
the Dow Theory is often “late” has already been discussed. The Reversal
Patterns studied in the two preceding chapters give no certain signal until
after the trend has changed, usually “sooner” as compared with Dow
Theory, but never at the absolute top or bottom price. The man who sells a
stock as soon as, but not until, a Head-and-Shoulders Top has been
completed on its chart may cash in on no more than half of the total decline
from its extreme high to extreme bottom; this is due to the very terms of our
measuring formula, the first half of the decline can have taken place before
the Top Reversal Formation was finally confirmed.
Make up your mind that there is no help for it. Somebody managed to sell
his shares at the very top eighth of a point on the peak of the Head (and
some poor devil bought them). The seller was just plain lucky. His exploit
can be truly compared with a hole-in-one in golf; even a complete duffer
occasionally enjoys that thrill. But the more experienced a player, the better
satisfied he is to land safely on the green and not too far from the cup. The
more experienced an investor, the less concerned he is with getting the last
point, or even the last 10 points, out of his market commitments.
No one can ever be sure at the time that he is selling at the final high. No
rules or methods have ever been devised—or ever will be—to ensure
buying within fractions of the Bottom or selling within fractions of the Top.
Of course, a man can make certain of buying a stock at its absolute low
provided he is prepared to take at that figure every last
26
24
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20
19
18
17 Sales 100's
50
40
30
20
10
HUDSON BAY MINING & SMELTING
HD
111
S O N D '
r F ’M
i
T F ‘ M^A—M: II : A--S 1 O~’~N ; D '
Figure 8.1 A fine Symmetrical Triangle Reversal Formation on a weekly
chart. Upper boundary sloping down from February 1942 recovery high at
21 and lower boundary sloping up from “Pearl Harbor” Bottom at 16 3/8
converge to an apex of about 18 5/8. From this Major Bottom Pattern,
“HD” advanced to 45 in 1946. Note the shrinkage in volume as a pattern
formed and the increase as the price broke out through the Top in October
1942. Breakout came not quite three-quarters of the way over from the first
Top to the apex.
48
44
40
38 Sales 100's 250 200 150 100
50
1946
SEARS, ROEBUCK
_ APRIL MAY JUNE JULY AUGUST SEPTEMBER
6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 31 7 14 21 28’
Figure 8.2 Sears Roebuck made a Symmetrical Triangle Reversal at its Bull
Market Top in 1946, and then it went into another long Triangle that turned
out to be a Consolidation rather than Reversal Formation. (Logarithmic
volume scaling minimizes volume variations.) Sell signal was given at 44
1/2 and again at 41. Decline continued to 30 1/2.
80
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64
60
56
52 Sales 100's
50
40
30
20
10
S' O 'N ' D 1 J ' F ' M ' A 1 M J 'J 'A » S ' O ' N ' D ' J ' F 'M
Figure 8.3 Johns-Manville's Primary Trend Reversal in 1942 developed out
of a Symmetrical Triangle that also had some aspects of a Head-and-
Shoulders Pattern with a long right shoulder. Although this is a weekly
chart, the volume here is worthy of detailed study in connection with the
price action. “JM” (old stock) advanced more than 100 points in the next
four years.
share offered, even to the entire outstanding issue if necessary. It might, in
theory, require as much as $3.7 billion to “put a bottom” under U.S. Steel at
70 (EN9: ca. 1950s) in case you are tempted.
The reader, who at this point may think we “protest too much,” will see
more excuses for the foregoing remarks when we take up the habits of
Triangles, for these formations are not always indicative of Trend Reversal.
On the contrary, except in certain rather uncommon varieties, they are more
apt to signal what may most conveniently be termed Consolidation,
terminating an up or down move only temporarily and setting the stage for
another strong move in the same direction later on. (Schabacker called such
chart formations “Continuation Patterns.”) The reason for including
Triangles in this section of our studies under the general heading of
Reversal Formations is that they do, at times, develop at periods of Major
Trend change, and those are, by all odds, the periods that are the most
essential for the investor to recognize.
Symmetrical Triangles
The most common form of a Triangle is composed of a series of price
fluctuations, each of which is smaller than its predecessor, each Minor Top
failing to attain the height of the preceding rally, and each Minor Recession
stopping above the level of the preceding Bottom. The result is a sort of
contracting “Dow Line” on the chart—a sideways price area or trading
range whose Top can be more or less accurately defined by a down-slanting
boundary line and whose Bottom can be similarly bounded by an up-
slanting line. This type of Triangle is called a Symmetrical Triangle. If we
wanted to make a more accurate application of the language of geometry,
we might better call it an Acute Triangle because it is not at
Figure 8.4 Logarithmic price scaling on weekly chart emphasizes important
technical developments at low price levels. “DH's” Symmetrical Triangle
Bottom started a Bull Market that reached 57 in 1945. Note the Throwback
to apex of Triangle, not an uncommon development. The apex itself is a
strong Support (see Chapter 13).
all necessary that its Top and Bottom boundaries be of equal length or, in
other words, that they make the same angle with the horizontal axis.
However, there is a very strong tendency in these formations to
approximate the symmetrical form; so, the established name will do well
enough. This pattern is also sometimes referred to as a “Coil.”
While the process of contraction or coiling, which makes up the price action
of the Symmetrical Triangle Pattern, is going on, trading activity exhibits a
diminishing trend, irregularly perhaps, but nevertheless quite noticeably as
time goes on. The converging upper and lower boundary lines of the price
formation come together somewhere out to the right (the future in the time
sense) of the chart, at the apex of our Triangle. As prices work their way
along in narrower and narrower fluctuations toward the apex, volume ebbs
to an abnormally low daily turnover and, if we are dealing with a typical
example, comes the action that first suggested the name “Coil.” Suddenly
and without warning, as though a coil spring had been wound tighter and
tighter and then snapped free, prices break out of their Triangle with a
notable pickup in volume, and leap away in a strong move that tends to
approximate in extent the up or down move that preceded its formation.
There is seldom any clue given on the one chart containing the Triangle to
tell in which direction prices are going to break out of the pattern until that
action finally occurs. Sometimes you can get a pretty good idea of what is
likely to happen by observing what is going on at the same time in the
charts of other stocks (which is an important topic for
28
CUBAN - AMERICAN SUGAR
26
24
1945
22
20
19
18 Sales 100's 125 100
75
50
25
AUGUST
SEPTEMBER OCTOBER NOVEMBER DECEMBER"
7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27'3 10 17 24 1 8 15 22 29 ’
Figure 8.5 Triangles often form as a part of a larger and more important
pattern of some other type. Here a symmetrical figure constitutes the latter
half of a Rounding Turn. Note the premature breakout on October 17, return
to pattern, and then final breakaway on November 8.
24
22
20
19
18
17
16
15
14 Sales 100's 125 100
75
50
25
NATIONAL GYPSUM NG
RY
JUNE
“ FEBRUARY MARCH “ APRIL-----MAY------JUNE--------JULY
i 3 1017 24 3 4047 24 31 7 44 21 28 5~12 1926- 2 : <462338 7 i 14 >2128’
Figure 8.6 Prices in this Symmetrical Triangle squeezed way out into the
apex before erupting. Breakout at that stage is unreliable; above is a fair
sample of the false moves that occur there. Real move was down.
16
15
14
24
22
20
19
18
17
Figure 8.7 Recovery rallies from “Panic” Bottoms are often capped by
Triangles, for those are periods in which doubt and indecision are prevalent.
The doubt in such cases, however, is usually resolved in favor of renewed
decline. “Panic” Bottoms seldom hold. This chart shows a typical
Symmetrical Pattern topping the recovery from the famous Selling Climax
of October 19, 1937. Note Pullback to apex. later discussion). Often,
however, there is nothing to do but wait until the market makes up its mind
which way to go. And “making up its mind” is just what the market seems
to be doing when it builds a Triangle; everything about this pattern appears
to exemplify doubt, vacillation, and stalling until finally a decision is
reached.

Some cautions about Symmetrical Triangles
A compact, clean-cut Triangle is a fascinating picture, but it has its tricky
features. The beginner in technical chart analysis is quite naturally prone to
look for Triangles constantly, and will often think he has detected them
when, in fact, something entirely different is in the process of development.
Remember, it takes 2 points to determine a line. The top boundary line of a
price area cannot be drawn until two Minor Trend Tops have been definitely
established, which means prices must have moved up to and then down
away from both far enough to leave the two peaks standing out clear and
clean on the chart. A bottom boundary line, by the same token, cannot be
drawn until two Minor Trend Bottoms have been definitely established.
Therefore, before you can conclude that a Symmetrical Triangle is building,
you must be able to see four Reversals of Minor Trend. If it comes after an
advance in prices, you must first have a Top, next a Bottom, then a second
Top lower than the first, and finally a second Bottom higher than the first
Bottom (and prices must move up away from the second Bottom before you
can be sure it is a Bottom). Then, and only then, can you draw your
boundary lines and proceed on the assumption you have a Symmetrical
Triangle.
26
24
22
20
19
18
17
16 Sales 100's 125 100
75
50
25
VERTIENTES - CAMAGUEY SUGAR
1946
’ 6 13 20 27 4 11 18 25 18 15 22 29 6 13 20 27 3 10 17 24 31 7 14 21 28
Figure 8.9 The other side of the story—an imposing Symmetrical Triangle
which failed badly, although for the alert and experienced technician, there
were warnings of something amiss in March and April. Eastern Airlines
built, in late 1946 and early 1947, a formation which, so far as price pattern
was concerned, left little to be desired. Prices broke out topside decisively
in late March. A Throwback in April met normal Support at the upper
Triangle boundary, but the subsequent advance fell short, weakened, and
finally broke down, producing an “end run” around the apex. Warnings
referred to were high and irregular volume, particularly on reactions, in
February and March—not characteristic of valid Triangle development—
and failure of prices to push up rapidly and vigorously after the April 14
Throwback.
Figure 8.8 A Major Symmetrical Triangle Top in which prices squeezed out
into the apex and then produced a false move upside (see Figure 8.6).
“VEC,” as a matter of fact, was a bad actor technically, but this particular
breakout would be suspect anyway.
APRIL
EASTERN AIRLINES EAL
24
22
20
19
18
17
16 Sales 100's
J
'■I
4
...A..
NOVEMBERDECEMBER JANUARY
i 9 16 23 30 7 14 21 28 4 11 18 25 1
;EBRUARY MARCH
8 15 22 1 U 8 15 22 2
AUGUST SEPTEMBER
9 16 23 30 6 13 20 27 4
19
18
17
16
15
14
13
12
11
10
9 Sales 100's
50
40
30
20
10
Figure 8.10 A weekly chart. The seventh-month Consolidation area of 1944
—in “NG,” undefinable at first, developed eventually into a typical
Symmetrical Triangle. Two months after the high-volume breakout in
January 1945, prices reacted nearly to apex level and then pushed away
rapidly. Minimum measuring implications of this Triangle were satisfied at
16.
Figure 8.11 A small Symmetrical Triangle that tended toward the
“Ascending” type. Note that the higher volume that developed within this
pattern in early January came on a rally. This sort of action is fairly typical
of very “thin” stocks.
AMERICAN BANK NOTE
ABN
Figure 8.12 An Ascending Triangle 10 months long, which was the start of
a Major Bull Trend, carrying “ABN” to 45. Refusal of prices to react to the
lower pattern boundary, as here in August 1942, is a frequent development
in strong formations, a warning of near completion and breakout.
38
Sales
100's
1946
CELANESE CORPORATION CZ
Jlll.iliiiliilLilnliillil.llil. lllliyihiliiillLliUliii
JANUARY FEBRUARY^ MARCH ~ APRIL _ MAY JUNE
6 13 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28’ 5 12 19 26 2 9 16 23 30'
Figure 8.13 Premature breakouts from Right-Angle Triangles, such as
appeared in Celanese in March 1946, are temporarily disappointing to the
trader who buys on them, but they eventually work out all right. Celanese,
before its 1946 split, was subject to frequent and peculiar shakeouts, as here
on March 9 and 26.
26
24
22
20
19
18
17
16
15
Sales 100's
50
40
30
20
10
BRIGGS MANUFACTURING CO.
ik
M2 J ' J A sjo'nj d;j’ F ’M
Life.
S' O ' N ' D~'~J
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Figure 8.14 A steep recovery from a Panic Bottom (the “Pearl Harbor”
selling) flattened out into a fine Ascending Triangle. Note the horizontal
Supply Line at 19, above a gradually rising Demand Line. The breakout at
the end of September signaled initiation of an advance of some
consequence. It turned out to be a Primary Bull Market, which took Briggs
up to 53.
112
SEARS ROEBUCK
104
96
88
80
76 Sales 100's 125 150
25
50
25
OCTOBER NOVEMBER DECEMBER 'JANUARY FEBRUARY
MARCH
Figure 8.15 Sears' 1936 Bull Market Top was a Symmetrical Triangle, out
of which it declined 15 points. An Ascending Triangle then produced an
Intermediate Recovery to the Supply Zone (see Chapter 13) at the lower
side of the top Triangle. Compare this chart with the 1946 Top in Figure
8.2.
40
38
36
34
32
30
28
26
24
22
20 Sales 100's
50
40
30
20
10
SOUTHERN RAILWAY PFD.
APRIL MAY JUNE JULY AUGUST
: 4 :11 18 25 2 9 16 23 30 6 13 20 27 4 11 18 2^ 1 ' 8 15'23 29 '
1936
Figure 8.16 An Ascending Triangle at an Intermediate Bottom. This chart
runs from April through August 1936. Extreme shrinkage in trading volume
during this formation indicated a very strong technical situation.
Another point to remember—and one that does not conform at all to the
“Coil” simile— is the farther out into the apex of the Triangle prices push
without bursting its boundaries, the less force or power the pattern seems to
have. Instead of building up more pressure, it begins to lose its efficacy
after a certain stage. The best moves (up or down) seem to ensue when
prices break out decisively at a point somewhere between half and three-
quarters of the horizontal distance from the base (left-hand end) to the apex.
If prices continue to move “sideways” in narrower and narrower
fluctuations from day to day after the three-quarter mark is passed, they are
quite apt to keep right on to the apex and beyond in a dull drift or ripple that
leaves the chart analyst completely at sea. The best thing to do in such cases
is go away and look for something more promising elsewhere in your chart
book.
A third tricky point is that it becomes necessary sometimes to redraw one or
both boundaries of a Triangle before it is finally completed (i.e., before
prices break out and move away from it in a decisive fashion). This can
happen, for example, when, after the first two Rally Tops have established a
down-slanting upper boundary line, the third rally starting from the lower
boundary pushes up and through the original Top line by a moderate
19
18
17
16
15
14
13
12
11 Sales 100's
ARMOUR & COMPANY
MARCH
AUGUST SEPTEMBEROCTOBER
NOVEMBER DEC'E.mBeRJANI ARY FEBRUAR
Figure 8.17 One of the early 1947 disappointments (to the Bulls) was the
failure of “AM” to break out topside from the long Ascending Triangle
depicted above. Here is a case where supply at 15 finally overwhelmed
demand. A pattern such as this indicates a potentially strong underlying
situation for the long pull. Ordinarily, the consequence of an Ascending
Triangle's “failure” of this sort is the development either of an extended
Rectangular base within the general range of the Triangle (in this case, 10 to
15), or formation of a Double Bottom at or near the earlier low (in this case
near 10). However, “AM” dropped lower after several more attempts to
overcome the Major Supply at the 15 level, which was not substantially
penetrated until 1955.
margin and then, without developing a recognizable breakout volume on
this move, stops short of surpassing the highest level of the preceding
(second) pattern Top. When prices subsequently drop back again into
pattern, it is necessary to abandon the original upper boundary line and
draw a new one across the highs of the first and third rally tops.
How prices break out of a Symmetrical Triangle
Prices may move out of a Symmetrical Triangle either up or down. There is
seldom, if ever, as said above, any clue as to direction until the move has
actually started, that is, until prices have broken out of their triangular “area
of doubt” in decisive fashion. In a very general way, the precepts laid down
for breakouts from Head-and-Shoulders Formations apply here as well. For
example, the margin by which prices should close beyond the pattern lines
is the same, roughly 3%. It is equally essential that an upside break in prices
be confirmed by a marked increase in trading volume; lacking volume, do
not trust the price achievement. But a downside breakout, again as in the
case of the Head-and-Shoulders, does not require confirmation by a pickup
in activity. As a matter of record, volume does visibly increase in most
cases, but in a majority of down breaks, it does not do so to any notable
extent until after prices have fallen below the level of the last preceding
Minor Bottom within the Triangle, which, as you can see, may be several
points lower than the boundary line at the place (date) of the actual
breakout.
The curious fact is a downside breakout from a Symmetrical Triangle
attended to right from the start by conspicuously heavy volume is much
more apt to be a false signal rather than the start of a genuine downtrend
that will be worth following. This is particularly true if the break occurs
after prices have worked their way well out into the apex of the Triangle; a
high volume crack then frequently—we might even say usually—develops
into
12
11
10
9
8
7
6 Sales 100's 125 100
75
50
25
SOCONY-VACUUM OIL
i
' J ' A ' S ■ O ' N ' •D'1 T IM
1
S : O ' N 1 D ' J ‘M 1 M ’ A r M ; J
Figure 8.18 The 1942 Bear Market Bottom in Socony-Vacuum was an
unusual Head-and-Shoulders Formation, with the head consisting of an
Ascending Triangle. Note the increase in volume on the breakout from the
Triangle in July and again on the break through Head-and-Shoulders
neckline in October.
a two- or three-day “shakeout,” which quickly reverses itself and is
followed by a genuine move in the up direction.
All of the above the reader will have undoubtedly found most
disconcerting. Here is a pretty technical pattern, and it cannot always be
trusted. Unfortunately, Symmetrical Triangles are subject to false moves to
a far greater extent than the Head-and-Shoulders Formation or any of the
other formations we have discussed or will discuss later. Unfortunately,
some of these false moves cannot be identified as such until after a
commitment has been risked (although good trading tactics should prevent
their occasioning much more than a trivial loss). Unfortunately again, even
a typical shakeout, such described in the preceding paragraph, may produce
a double cross, proceeding right on down in a genuine decline. No technical
chart formation is 100% reliable and, of all our present subject, is the worst
offender.
But most Symmetrical Triangles—lacking an actual statistical count, our
experience would suggest more than two-thirds of them—behave
themselves properly, produce no false signals that cannot be spotted before
any damage is done. Upside breakouts on high volume may be premature in
the sense that prices return to pattern and do some more “work” there
before the genuine uptrend gets under way, but they seldom are false. We
shall have a little more to say about false signals in this chapter and more
later on that we trust will be helpful in developing the experience a trader
needs to defend himself against them.
125
100
75
50
25
Sales
100's
BATH IRON WORKS
ilk
JUNE
: I
JANUARY FEBRUARY MARCH APRIL MAY " JUNE
5 12 19 26 2 9 16 23 2 9 16 23 30 6 13 20 2^ '4 11 18 25 1 8 15 22 29
Figure 8.19 Due to a dividend of $1.00 went ex on March 14, the lower
boundary of this Descending Triangle Top in “BIW” had to be dropped 1
point from 33 and redrawn at 32. Despite the added leeway thus afforded,
however, the original pattern implications were quickly carried out. Prices
pulled back three times to the new lower boundary line of this Triangle on
April 4, April 16, and May 31—unusual, but explained by the existence of a
strong general market uptrend during this period. Whenever a stock goes
ex-dividend during the formation of an Area Pattern of any type, the lines
bounding that pattern should immediately be adjusted to the new value by
lowering them a distance corresponding to the amount of the dividend.
A typical Triangle development
The several actual chart examples of Symmetrical Triangles that illustrate
this chapter will serve, we trust, to give the reader a working acquaintance
with their appearance in various manifestations. Yet it may help to clear up
some of the more important points if we describe in detail just how a typical
pattern develops step by step. Let us suppose you are watching a stock on
your charts that has climbed, with only the normal, brief hesitations and
inconsequential reactions, from around 20 to 30, 32, 35, and is still moving
up. (Let's hope you bought it at 20!) Lower down, its turnover ran between
300 and 600 shares daily, but now, above 30, it has attracted quite a
following, and daily volume has increased to around 1,000. As it
approaches 40, activity shoots up to nearly 2,000 shares, the market
“churns” between 39 and 40, and then prices begin to drop. As they fall
back, you (especially if you own the stock) watch it with some concern, but
you know it is hardly likely that it is going to go straight down again to 20;
stocks do not act that way. (EN9: Sometimes they do now, in the twenty-first
century.) If the trend of this issue has actually been reversed, it should,
nevertheless, spend some more time and effort around its top levels and
make some sort of a Distribution Pattern.
REVERE COPPER & BRASS
1946
20
19
18
Sales 100's 125 100
75
50
25
....... APR I L .......... M AY " * J UNE  H J ULY AUGUST  "S EPTEMBER
6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 31 7 14 21 28’
Figure 8.20 On the basis of “fundamentals,” Revere was an attractive
holding in 1946, which may account for its reluctance to “give up” when
the market generally started downhill in earnest in June of that year. Its
fluctuations from mid-May to late August constructed a fine, large
Descending Triangle, in which, however, Bearish Volume Signals had
already appeared in late June and on July 23. The breakout came (with a
wide Breakaway Gap) on August 27. Prices clung to the edge of the pattern
for four days and then collapsed. The small formations outlined in April and
May are Flags, to be discussed in Chapter 11.
The decline continues for 10 days with the turnover also declining quite
appreciably. By the time prices have worked back to 33, volume is running
at about 700 shares daily. At 33, it may pick up again for a single day to 800
or 900 shares, but the reaction stops there, and after a day or two, prices
begin to climb again with little change in their turnover rate. In eight or nine
days, quotations have gotten back into the upper 30s and activity increases
and reaches, say, 1,200 shares on the day 39 is reached. Instead of going on
to 40 or beyond, however, a new reaction sets in and prices drift back to 37.
(Perhaps you will find this growing picture easier to visualize if you pencil
its development on a scrap of chart paper.) Now it is evident that a second
Top has formed at 39; you can now draw a tentative pattern line (there are
other names for this, as we shall see later) on your chart across the two
extreme high ranges (not closing prices), which will slant downward from
left to right. So far you have only one Bottom point, so you cannot draw
lines from that, but this second decline brings out even less trading activity
than the first. Volume ebbs to 400 shares and the down move halts at 34; the
price track “rounds out” and turns up again; trading is very dull, but it
begins to pick up as 36 is reached.
This action defines a second Minor Bottom and now you can draw a
Bottom “tangent,” an up-slanting line across the extreme low prices
registered on the two reactions, the first at 33 and the second at 34. Your
two pattern lines will converge, meeting near the 36H
Figure 8.21 The 1937 Bull Market Top in Westinghouse was this
Descending Triangle, which started in January and broke on February 15.
Prices hung at the lower edge of the Triangle for four days, fell away, and
then pulled back to its lower line on March 4 at the time when the general
market Averages were making their final Bull highs.
level about four weeks ahead (i.e., to the right) on your chart. You have a
Symmetrical Triangle—but you do not know whether prices are going to
fall out of it eventually or shake off present doubts and push up in a new
advance worth following. You can only watch further developments very
closely and be prepared to take whatever action is, in due time, indicated.
The second rally picks up a little in activity, attains a daily turnover of about
700 shares, and pushes up to 38 and on for part of a day to 38 3/4. This
nudges through the previously drawn pattern line by perhaps a quarter of a
point (because each swing is shorter in points traveled and, accordingly, in
duration). But the volume on this Minor Penetration is less than on the
preceding Top (at 39) and buying again ebbs. As the price range line falls
back to 37 and 36, draw a new upper tangent across the first Top at 40 and
the last Top at 38%. There is the suggestion here in this slight “lift” that the
balance may be swinging slightly to the demand side, but do not count on it.
Pinpoint accuracy is not to be expected; Triangles must be allowed some
leeway.
On the third reaction, activity dwindles away to the lowest yet. The up-
slanting Bottom boundary will be reached at about the 35 level, if prices
continue their present course. It is worth noting now whether they will
come all the way down to it this time because if they do not—if their
recession is halted half a point or so above it—that action would give some
significance to the previous bulge through the upper boundary. But this
does not happen; the drift continues right on down to 35, and now volume is
running at the rate of only 200 shares daily, less than it ran in the early
stages of the original advance above 20. This is a critical spot. The price
track flattens out momentarily, turns up feebly, yet keeps hitching
Figure 8.22 A series of Triangles, Symmetrical and Descending, which
evolved during the 1929-1932 Bear Market in Hudson Motors. Note that at
no time during this decline did anything resembling a Major Bottom appear.
Note also how each Triangle's measuring implications were carried out
before any temporary halt or consequential rally developed. Follow your
daily charts for the proper timing of your trading operations but keep an eye
always on the long-range pictures that evolve on weekly and monthly
projections, so as to maintain your perspective on the Major Trend.
up, crosses 36%, picks up activity, reaches the (new) upper Triangle
boundary at 37% and, on the next day, punches through on a turnover of
1,500 shares to close at 39%. This is a breakout; the doubt is resolved and
(barring a false move, unlikely at this point) the trend is once again up.
Note that it was not necessary for prices to surpass the previous high at 40
to produce this signal—that is one of the interesting things about
Symmetrical Triangles.

Figure 8.23 The curious, and in its early stages confusing, Major Bottom
Formation that American Rolling Mills constructed in 1941-1943. The
recovery from the “Pearl Harbor Panic” of 1941 ran into a large
Symmetrical Triangle that broke out on the downside in April 1942. The
subsequent decline satisfied the measuring requirements of that Triangle,
but it did not carry below the December low. The rally of June and reaction
of August-September built the whole area out into another and larger
Symmetrical Triangle, out of which prices broke on the upside in
September. Then the reaction to the apex of the latter, in December 1942,
and the following advance built up into a 15-month Ascending Triangle,
which constituted the final Major Bottom for a trend that carried prices up
eventually to 42 in 1946. The low volume on the June and August-
September reactions, the increase on the October markup, and, even more,
the January 1943 rise and breakout in February were unmistakably of Major
Bullish implications. It takes time, remember, to build a foundation for a
Bull Market.
Reversal or Consolidation
We started to discuss Symmetrical Triangles as Reversal Patterns, yet our
example has turned out to be, instead, a Consolidation Pattern, that is, only
a sort of resting stage in a continued uptrend. Well, three out of four of these
formations will turn out to be just that; the fourth is the dangerous one (if
you own the stock). How would it differ?
The example described might have been a Reversal instead of a
Consolidation Formation any time up to the point of the decisive
breakthrough to 39. If it had been a typical Reversal, the first change
probably would have appeared shortly after the final rally started up from
the third Bottom at 35. That rally would have petered out at about 36%, and
prices would have started to drift back again. Then, with the activity
increasing slightly, the Bottom boundary would be penetrated. As
quotations dropped to 34, daily volume might mount to 600 or 700 shares.
Any further decline would constitute a down signal, resulting in a further
pickup in turnover and an acceleration in the price decline as the stop-loss
orders (to be discussed later) spotted under 34 were “touched off.”
Before we leave our typical example, we might make some mention of the
post-breakout reactions or Pullbacks that sometimes occur. As in the case of
the Head-and-Shoulders
36
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Sales 100's 250 200 150 100
50
GOODRICH ( B. F. ) COMPANY
lull
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Figure 8.24 A beautifully compact Ascending Triangle that turned out to be
the Major Bear-to-Bull Reversal in Goodrich in 1942. The breakout from
this pattern (in April) was not signaled by any extraordinary pickup in
activity so far as this weekly record shows (but remember significant
volume detail is often hard to see in a weekly plotting). The Triangle's
measuring implications were carried out by the first upswing, which
reached 18)4 at the end of May. Supply had to be absorbed in the 18 to 21
range (refer to this chart when you study Support and Resistance in Chapter
13), but a Major Up Signal was given in September when prices erupted
through that zone with a conspicuous increase in trading volume.
Formation, the initial breakout move from a Symmetrical Triangle may halt
before prices are carried very far away from the pattern and be followed by
a Minor Reaction, usually lasting only two or three days, which will carry
quotations back to the nearest pattern boundary. Thus, in our first example
in which the break, when it came, took our stock up through the top side to
39/, the next day might have seen a push on to 40, and then prices might
have backed off again in a couple of days of decreased activity to 37% or
38. The up-move would then normally be resumed with greater vigor.
Downside breakouts are sometimes followed in much the same manner by
pullbacks to the lower boundary
ebay Inc-(Nasdaq NM) 57.75 0.240 0.417%
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25
0
Figure 8.25 A real-time chart from prophet.net. The volume blowout in July
2002 drew attention to eBay and the sloping line was drawn at that time.
Although the lines are sloppy and the pattern is ragged, it looked at the time
like a Descending Triangle with all its implications. Nevertheless, when it
broke out of the pattern on emphatic volume in October 2003 the
handwriting was on the wall. eBay was for real. So, what's for real? It could
really make money, not just capture free eyeballs, like its internet brethren
and sistern. It actually performed a service of economic benefit to many
people, unlike the internet fantasy follies. See Figure 10.26 for a longer
perspective on eBay. Lessons for the attentive: power of trendlines; alarm-
clock nature of unusual volume; not believing any forecast. Forecast in this
case would have been for a downtrend if, as it seemed, the pattern was a
descending triangle.
of the pattern, after which the decline is resumed with an increase in
volume. However, these post-breakout reactions occur less often with
Triangles than they do with Head-and-Shoulders Patterns.
Another matter we might take up before going on to study the next
formation is the rationale of the Symmetrical Triangle. It may help to fix its
characteristics in mind if we try to deduce what sequence of events might
typically produce it. Of course, any effort of this sort can result only in a
gross oversimplification, which will not fit all of the Triangle's various
manifestations, but it is an interesting mental speculation—and one not
without benefit to our understanding of the general theory of chart
formations. Let us turn back again to our typical example. We started with a
stock that ran up rather steadily from around 20 to 40 and then reacted. It is
fairly obvious what happened at 40: many investors had substantial paper
profits, approaching 100% at that price. (A “round figure” such as 40, 50,
75, or 100 is apt to become a sort of mental profit objective and, hence,
bring in increased selling.) Some of them were ready to cash in and did so,
temporarily swinging the technical balance from demand to supply; they
sold less freely, of course, as prices receded. Other would-be investors had
been attracted to the stock, but too late to “get aboard” below 30. Unwilling
to “chase” it up to 40, they welcomed the reaction and, by the time prices
had dropped back to 33, enough of them were ready to buy to swing the
balance back again to the demand side of the equation.
Watching the ensuing rally, however, were the owners of the stock who had
failed to grab their profits near 40 on the previous advance and had made up
their minds to be a little less greedy if given a second opportunity. Their
offerings began to come in above 37, say, and were sufficiently copious at
39 to stem the advance at that level. Behind the scenes, we can imagine this
process repeated again and again, with new money constantly coming in
and meeting supply from owners increasingly anxious to cinch their profits.
Eventually, the offerings of the latter are all absorbed, or perhaps
withdrawn, and then professionals, as well as hopeful investors, suddenly
discover there is no stock ahead on the books and rush to buy results.
Since the advance (or decline) that follows the completion of a Symmetrical
Triangle usually runs to worthwhile trading proportions (we shall discuss
measuring implications later), there would be an evident advantage to the
trader who could tell in advance of the breakout which way prices were
going to move. The odds are, as already stated, the new move will proceed
in the same direction as the one before the Triangle's formation. These odds
are greatest, of course, in the early stages of either a Primary Bull or Bear
Market with the chances of Reversal increasing as those Major Trends
mature. Nevertheless, the charts of other stocks often furnish valuable
collateral evidence; thus, if at the same time you detect a Symmetrical
Triangle in the process of formation in “PDQ,” a majority of your charts are
showing Saucers or Head-and-Shoulders Bottoms or Ascending Triangles
or some other pattern of typically Bullish import, it is a fair assumption that
your Symmetrical Triangle will break out topside. There are times when
advance indications of this sort are strong enough to justify taking a
position on it.
The Right-Angle Triangles
We mentioned Ascending Triangles in the preceding paragraph. The
Ascending and Descending are the Bullish and Bearish manifestations,
respectively, of our next class of patterns, the Right-Angle Triangles. In
many respects, in most in fact, they perform like their Symmetrical cousins,
but with this very gratifying difference: they give advance notice of their
intentions. Hence, their names, for the supposition always is that prices will
ascend out of the Ascending form and descend from the Descending form.
The Symmetrical Triangles, as we have seen, are constructed of a series of
successively narrower price fluctuations that can be approximately bounded
across their Tops by a down-sloping line and across their Bottoms by an up-
sloping line. Right-Angle Triangles are distinguished by the fact that one of
their boundaries is practically horizontal, whereas the other slants toward it.
If the top line is horizontal and the bottom line slopes up to meet it
somewhere out to the right of the chart (at the apex), the Triangle is of the
Ascending persuasion. If the bottom line is horizontal and the top line
slopes down, the Triangle is Descending.
These formations are perfectly logical and easy to explain. The Ascending
Triangle, for instance, pictures in the simplest and most normal form what
happens when a growing demand for a certain stock meets a large block of
shares for sale at a fixed price. If the demand continues, the supply being
distributed at that price will eventually be entirely absorbed by new owners
looking for still higher levels, and prices will then advance rapidly. A
typical Ascending Pattern starts to develop in much the same way as the
“ideal” Symmetrical Triangle previously described, with an advance in our
certain stock from 20 to 40 at which point sufficient supply suddenly
appears on the market to fill the orders of all buyers and produce a reaction.
Sensing the temporary satiation of demand, some owners may dump their
holdings on the decline, but offerings are soon exhausted as prices drop
back to, say, 34, and renewed demand then stimulates a new rally. This runs
into supply again at 40, and again, all buyers are accommodated at that
level. The second recession, however, carries quotation down only to 36
before another up-move develops. But the pool or inside group that is
distributing at 40 still has some of its holdings left to sell, so it may take
more time, another backing away and another attack at the 40 line before
the supply there is exhausted and the trend can push along up.
A planned distribution
This type of market action evidences a planned campaign by owners of a
fairly large quantity of shares to liquidate at a predetermined price. It
contains little of the element of doubt that we mentioned as characterizing
the Symmetrical Pattern. So long as demand persists, the distributing pool
knows it can ultimately cash in its entire line at 40 and need not sell for less.
It is equally apparent, so long as demand keeps coming in at higher and
higher levels that, once the supply at 40 has all been absorbed, the market
will advance rapidly and easily. As soon as prices break out above 40, those
who took over the supply at that figure will feel their judgment has been
vindicated and will not be disposed to sell until they, in turn, can register a
good profit.
The crux of the matter is contained in the two preceding sentences. Demand
must continue to come in at higher and higher levels, otherwise, our
formation will cease to be an Ascending Triangle. Plus, the overhead supply
must eventually be absorbed, permitting an upside breakout. If demand
begins to falter any time before the Supply Line (horizontal Top boundary)
has been broken through, the ensuing reaction may drop prices down “out
of pattern,” and then the chart technician is faced with the necessity of
revising his chart picture. One might think that such a development,
blasting the earlier promise of the chart, would occur fairly often, but, as a
matter of experience, it is surprisingly rare. We say “surprisingly” because it
is obvious that in many cases of Ascending Triangle development, the
group selling creates its Top boundary or Supply Line must believe that
level to be just about as high as the stock has any right to go. As holders of
a large enough block to influence the market for several weeks, sometimes
months, their judgment is hardly to be scorned. Yet, once it becomes
evident the lower boundary or Demand Line is slanting up, the odds are
certainly somewhere in the neighborhood of 9-1 that the new buyers will
eventually have the best of it.
On occasion, the third reaction or fourth reaction within an Ascending
Triangle Formation will break down through the previously established up-
slanting Demand Line (lower boundary), but it will be halted at the same
level as the previous reaction. The pattern from there on is apt to develop as
a Rectangle, a formation to be discussed in our next chapter, and should be
treated as such. (The tactics of trading on Ascending and Descending
Triangles, including protection against the rare cases of collapse, will be
taken up in Section II.)
Descending Triangles
Descending Triangles have a horizontal lower boundary or Demand Line
and a downsloping upper boundary or Supply Line. It is evident they are
created by reverse market conditions than those of the Ascending Pattern;
however, their implications are equally strong and their failures equally
rare. Development of a Descending Formation hinges on a campaign by a
group or syndicate (often an investment trust) (EN9: or Mutual Fund or a
takeover group) to acquire a large block of shares in a certain company at a
predetermined price below the market. Their orders are placed and allowed
to stand until executed at that level. If the successive rallies therefrom,
which their buying generates, are stifled by new supplies of stock for sale at
lower and lower levels (thus creating the typical Descending picture on the
chart), orders to buy are eventually all filled and quotations break through
and on down. The mere breaking of the critical line, which many traders
have seen function as a support under the market for a more or less
extended period, often shakes the confidence of holders who had not
previously considered selling. Their offerings now come on the market and
accelerate the decline.
Volume characteristics same as the Symmetrical type
The volume section of the Right-Angle Triangle's chart requires little
comment. It will ordinarily present a picture practically identical with that
accompanying the development of a Symmetrical Triangle. Activity tends
to lessen as prices move out toward the apex. In the Ascending Formation,
there will usually be a pickup on each rally and an ebb in turnover on each
decline within the pattern; in the Descending Formation, the opposite is
true, but sometimes it is not quite so evident. These Minor fluctuations do
not affect the overall diminishing trend of volume until the breakout point is
reached.
As to breakouts, practically everything discussed about the Symmetrical
Triangle will apply as well to the Right-Angle type. Upside breakouts (from
an Ascending Pattern, of course) are attended by a conspicuous increase in
trading volume; if not, they should be treated as suspect. Downside
breakouts (from Descending Patterns) may not evince much of a pickup in
activity, but turnover usually speeds up the second or third day out of
pattern. Throwback reactions to the pattern's boundary line after a breakout
are fairly common; their occurrence seems to depend largely on general
market conditions. Thus, if prices break down out of a Descending Triangle
in an individual stock at a time when the rest of the market is firm, a
Pullback Rally is fairly certain to intervene before any extensive further
decline takes place.
This chart, and a number that have preceded it, illustrate an important point
for the market technician that may well be restated here: When a large
number of individual issues, after an extensive advance, make well-defined
Reversal Patterns of plainly Bearish import, break down out of them, and
then succeed only in pulling back no farther than their lower boundaries or
“Resistance Lines” at a time when the Averages are going on up to new
highs, the whole market is in a dangerous condition and a Major Downturn
is imminent. Divergences of this particular sort between many important
issues and the Averages seldom develop at Intermediate Turns. The warning
is particularly pointed when stocks of the caliber of Westinghouse, DuPont,
General Motors, and others fail to “confirm” new highs in the Averages.
Refer back to Figures 6.3, 6.6, 6.9, and 8.15, for example, and compare the
“timing” in those with the trend of the Averages for the same periods. The
Saucer-Like Reaction Pattern of October to January in the above chart
analyzes into a Complex Head-and-Shoulders Consolidation, a formation
that will be taken up in Chapter 11.
Incidentally, “WX” continued on down to 130 in April 1937, made a
Rectangle base there, and recovered to 158 (see above Descending
Triangle) in August and then fell to 88 in November. Compare this daily
chart with the monthly chart of “WX” for 1935 to 1938 in Figure 15.15.
Good, reliable breakouts from Right-Angle Triangles usually occur at about
the same stage of pattern completion as they do in Symmetrical Triangles.
The earlier the breakout, the less apt it is to be a false move (although false
moves from Right-Angle Formations are considerably rarer, it should be
noted, than from Symmetrical). In those infrequent cases when prices
“squeeze” right on out of the apex without producing a definite breakout,
the pattern seems to lose much of its power.
Measuring implications of Triangles
In Chapter 6, we stated a minimum measuring rule to apply to price
movements developing from a Head-and-Shoulders Formation, and we can
lay down a somewhat similar rule for Triangles—one that applies to both
the Symmetrical and the Right-Angle species. The method of deriving the
Triangle formula is not easy to explain in words, but the reader can
familiarize himself with it quickly by studying its application on several of
the actual examples that illustrate this chapter. Assuming we are dealing
with an up-movement (upside breakout), draw from the Top of the first rally
that initiated the pattern (in other words, from its upper left-hand corner) a
line parallel to the Bottom boundary. This line will slope up away from the
pattern to the right. Prices may be expected to climb until they reach this
line. Also, as a rule, they will climb, following their breakout from the
pattern, at about the same angle or rate as characterized their trend before
entering the pattern. This principle permits us to arrive at an approximate
time and level for them to attain the measuring line. The same rules apply
(but measuring down, of course, from the lower left corner) to a descending
move.
Although application of the above formula does afford a fair estimate of the
extent of move to be expected from a Triangle, it is neither as definite nor
as reliable as the Head-and-Shoulders formula. Do not forget the important
qualification that the Triangle has somehow lost a part of its potential
strength if the breakout is delayed until prices are crowded into the apex.
Triangles on weekly and monthly charts
We have seen in preceding studies how Head-and-Shoulders Formations
may appear on the long-range (weekly or monthly) charts and will have
importance commensurate with their size. Triangles also may develop on
weekly charts with their implications usually clear and dependable, but the
coarse Triangular Patterns—which can be found on graphs of monthly price
ranges, especially the great, loose convergences that take years to complete
— had better be dismissed as without useful significance.
Other Triangular formations
There are other patterns of price consolidation or congestion that can be
bounded by converging lines and might, therefore, be classified as
Triangles. However, they deviate from the true Triangles of this chapter so
markedly in one or more important respects that they are best treated under
other headings elsewhere, such as Flags, Pennants, and Wedges. Still
another group of chart patterns develops between diverging boundary lines,
on which account they have sometimes been called Inverted Triangles. But
their causes, characteristics, and forecasting implications are so radically
different that we have chosen to rename them Broadening Formations and
discuss them in a later chapter.
The reader may have become dismayed at this point by our frequent
recourse to such qualifying adverbs as usually, ordinarily, and the like. It
cannot be avoided if one wishes to present a true picture of what actually
happens. No two chart patterns are ever precisely alike; no two market
trends develop in quite the same way. History repeats itself in the stock
market, but never exactly. Nevertheless, the investor who familiarizes
himself with the historical pattern, with the normal market action, and
refuses to be tempted into a commitment in the belief that “this time will be
different,” will be far and away ahead of the fellow who looks for the
exception rather than the rule.
The beginner is proverbially lucky. He will find Triangles, Head-and-
Shoulders, or other significant patterns, one after the other, on his charts,
watch them develop, and see them carry through with profitable moves
according to rule, until the exception comes along—or he will overlook the
larger picture while concentrating on some Minor Pattern development—
and suddenly awake to the fact he is caught in a very bad play. Hence, we
constantly emphasize the nonconforming movements. Our words of
qualification are necessary because technical analysis of market action is
not an exact science and never will be.
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter nine
More important Reversal Patterns
The Rectangles, Double and Triple Tops
The Triangular Price Formations, which we examined in Chapter 8, can be either Reversal or ConsolidationPatterns. In the case of the Right-Angle Triangles, we know as soon as they have attained recognizable form inwhich direction the trend will (or should) proceed. With the Symmetrical Triangles, we have no way of knowingwhether they point up or down until prices finally break away from them, although the odds are, as we have seen,the previous trend will be continued rather than reversed. In this respect, and in many others, our next class oftechnical formations, the Rectangles, resemble the Symmetrical Triangles. There are, in fact, so many points ofsimilarity between them that we can forego any long and detailed discussion. (For illustrations in this chapter, seeFigures 9.1 through 9.18.)
A Rectangle consists of a series of sideways price fluctuations, a “trading area,” as it is sometimes called, whichcan be bounded both top and bottom by horizontal lines. A glance at any one of the examples that illustrate thesepages will show how it got its name. On rare occasions, you may discover a chart pattern whose upper and lowerboundary lines are parallel but either slightly down-sloping or up-sloping. So long as their departure from thehorizontal is trivial, they may be treated as Rectangles. You will also find, on occasion, patterns whose boundaries,while nearly horizontal, tend somewhat to converge. These may be considered Rectangles or SymmetricalTriangles; it does not matter which because the “prognosis” will be the same in either case.
If you will give a quick mental review also to the Head-and-Shoulders, the Complex, and the Rounding types offormations, you will see how, if you disregard the volume part of their charts, any one of these patterns mightmerge or grade into a Rectangle. As a matter of fact, however, you will seldom be left in doubt as to properclassification because the circumstances of trading, the type of buying and selling, which produce Rectangles aredifferent, which is usually apparent.
We characterized the Symmetrical Triangle as a “picture of doubt.” The Rectangle might, with even greaterpropriety, be called a picture of conflict. Of course, any fairly compact price formation represents conflict in thesupply-demand sense. A Head-and-Shoulders Top, for example, portrays a conflict between “strong” sellers and“weak” buyers with the outcome already clearly seen before the combat has ended. But a Rectangle defines acontest between two groups of approximately equal strength—between owners of the stock who wish to dispose oftheir shares at a certain price and others who wish to accumulate the stock at a certain lower figure. They bat theball back and forth (up and down, that is) between them until ultimately, and usually quite suddenly, one team isexhausted (or changes its mind) and the other proceeds to knock the ball out of the lot. Nobody (often, not even thecontestants themselves) can tell who is going to win until one line or the other is decisively broken.
We speak of two groups operating in the development of a rectangular trading area because, under present-dayconditions, that is what is usually the fact behind the scenes. This, it should be noted, does not imply“manipulation” in any invidious sense. An investment trust or an estate or, in some cases, an individual heavystockholder has good
26
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NASH - KELVINATOR
NK
Sales
100's
250
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100
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OCTOBER NOVEMBER DECEMBER JANUARY FEBRUARY MARCH
6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 2 9 16 23 2 9 16 23 30'
Figure 9.1 Although its Bottom boundary had a slight tendency to “lift,” the formation that put a Top on Nash-Kelvinator in 1946 was an unmistakable four-month distribution Rectangle. Long and rather loose RectangularPatterns of the type shown here may not evince constantly and noticeably diminishing volume, but note,nevertheless, the general, although irregular, downtrend in volume from mid-October to mid-February.
56
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LIMA LOCOMOTIVE WORKS
LMW
Sales
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50
40
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OCTOBER NOVEMBER DECEMBER JANUARY FEBRUARY MARCH
7 14 21 28 4 11 18 25 2 9 16 23 30 6 13 20 27 3 10 17 24 3 10 17 24'31
Figure 9.2 Consolidation Rectangles in uptrends have been less common in recent years than during the 1920s andearly 1930s. The large price gap (G) in this example is of the “last in pattern” type, which we shall come to inChapter 12. When a gap within a pattern area is followed by breakout from that pattern, as in this case, the gap isinfrequently closed quickly.
and sufficient reasons for selling at the top price (the “Supply Line” of the Rectangle) with no intent to mislead thepublic. Another investment trust or a group of insiders interested in the company may have equally good and, fromtheir point of view, wise reasons for buying at the bottom price (“Demand Line”). Such are the forces at work inthe market at the start of most Rectangular Chart Patterns, but if the “spread” between top and bottom
96
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JANUARY
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Figure 9.3 A perfect example of Consolidation Rectangle that formed in Loew's near the end of the 1932-1937Bull Market. In this case, a large block of “inside” stock was distributed at 64 to 65 but taken over around 62 byother investors who had the satisfaction of seeing it go on up to 87 the following August. Note the Throwbackfollowing breakout in January.
lines is wide enough (say 8%-10% of the market value of the stock), the situation may quickly attract a followingfrom quick-turn scalpers and the professional element. Thus, a syndicate holding a large block of U.S. Steel maydecide to liquidate at 76, whereas another group decides to invest heavily in “Steel” at 69. The price of X willnaturally fluctuate for a time between those two levels. Traders, seeing this, will try to ride the play, buying at 69and selling at 76 (perhaps also selling short at 76 and covering at 69). Their operations will tend to accentuate orextend the Rectangle, although the number of shares involved in such parasitic trading is seldom great enough toaffect the final outcome. As a matter of fact, this type of trading inside a Rectangle can be quite profitable at times,especially if protected by judicious stops (see Section II).
Pool operations
In times past, before the U.S. Securities and Exchange Commission (SEC) outlawed the practice, Rectangles werefrequently created by the well-organized operations of a single “pool” or syndicate. Such a pool might undertake toaccumulate a large block of
13
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Figure 9.4 Here is a Rectangle in Socony-Vacuum, a low-priced stock characterized by fluctuations within anarrow range. After reaching a high of 18 in December 1945, it fell back to 15 and then rallied in mid-1946 asshown above. In late August, prices broke down through an Intermediate Trendline (see Chapter 14) and four dayslater fell out of the Rectangle. This formation, in conjunction with the earlier and higher Top, implied lower levelsfor “SOV” for some time to come. See also comment under Figure 9.5.
1946
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Figure 9.5 Another long, loose Rectangle of Major Reversal implications, somewhat similar to that pictured inFigure 9.1. Both an Intermediate and Major Up Trendline (to be discussed later) were decisively punctured by“YB” in August, just before its Rectangle broke down. Under Figure 8.21, we discussed one sort of warning of aPrimary Downturn that may be derived from the comparison of individual stock charts with the Averages. Here isanother hint: the better-grade steels and oils (see “SOV,” Figure 9.4) frequently hold up, or make strongerSecondary Recoveries, after the Averages have turned down at Major Tops. The Street sometimes speaks of“distribution under cover of strength in the steels.”
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Figure 9.6 The Rectangle in early 1945 in “EAL” was actually the final stage of a nearly two-year Consolidationin the rise, which started around 17 in 1942 and ended above 125 in December 1945. G, G mark gaps (see Chapter12), the first a Breakaway and the second a Measuring Gap, which marked the probable objective of the move as55. When prices reached that level, another Consolidation developed, a Symmetrical Triangle. Neither of thesegaps was “closed” during the following two years.
stock in a certain company with a view to marking it up and taking profits when some piece of good news, ofwhich they had inside knowledge, eventually became public. To acquire the desired “line,” they would find itnecessary first to shake out shares held by other traders and uninformed investors. They might start their campaignby suddenly selling short a few hundred shares to quench any current demand and start a reaction. Then, on thatreaction to the previously determined accumulation level, they would start to buy, scattering their orders carefullyand avoiding any publicity. Their buying would, sooner or later, engender a rally, but then they would “plant”rumors around the boardrooms to the effect that such-and-such insiders were selling, or that a projected mergerwas being called off, or a dividend would have to be passed, and, if necessary, they would ostentatiously let out afew of their own recently purchased shares to give color to the rumor. The process might be repeated several timeswith the “pool” gradually securing more and more shares on balance until, finally, its intended line is completed orcould not shake out more of the floating supply. Often, what was going on was fairly evident to the alert chartistback in the 1920s even before the operation was concluded, and perfectly evident, of course, as soon as pricesbroke out topside from their Rectangle.
But such tactics are no longer permitted. “Wash sales” are strictly condemned; the constant policing of allexchange transactions and prompt investigation by the SEC of any suspicious news or activity in a stockeffectually deters the blatant “pool” manipulations of previous years. This probably is the chief reason whyRectangles are nowhere near so common on the charts of the 1950s as they were in the 1920s. (EN: Not uncommonin the 2000s.)
Sales
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Figure 9.7 An extraordinary, fine, long Rectangle that developed after “ZA” had broken down out of a Head-and-Shoulders Top in February 1946. A perfect opportunity to sell this stock short was given by its Pullback of July 17-18 after prices had broken out of the Rectangle on the 15th. The Multiple Head-and-Shoulders Bottom that itsubsequently made from September to November produced a recovery to 11, but prices later fell to 6 in early 1947.
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Perhaps we can clear up various details of the Rectangle formation most quickly and easily by comparison withthat most nearly related chart pattern, the Symmetrical Triangle, as follows:
• Volume—Follows the same rules as in the Triangles, gradually diminishing as the Rectangle lengthens. Anycontrary development, unless it be a momentary news flurry, is suspect.
• Breakouts—Here also the same rules apply as with Triangles. Review volume requirements, margin ofpenetration, and so on thereunder.
• False moves—Much less frequent from Rectangles than from Symmetrical Triangles. A clearly definedRectangle is, in fact, almost as reliable as a Head-and-Shoulders, although not as powerful in its implications.
• Premature breakouts—Slightly more frequent, perhaps, from Rectangles than from Triangles.
(Note: Both false moves and premature breakouts, in the sense in which we employ these terms, areindistinguishable at the time they occur from genuine breakouts. Following both false and premature breaks, pricesreturn inside the pattern. But, in the case of a false move, the trend ultimately proceeds out of pattern in theopposite direction, while in the case of the premature move, the trend finally breaks out again and proceeds in thesame direction.)

Figure 9.8 In this weekly chart showing Sears Roebuck's 1942 Bear Market Bottom, a Consolidation Rectangle(June to November) forms the right shoulder of a large “unbalanced” Double Head-and-Shoulders Pattern.
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Figure 9.9 After advancing to 16 in January 1945, “BLL” dropped back to 13 and then constructed a 15-weekRectangle. Note that the down gap (G) on April 30 was caused by a $1.00 dividend going off. The revised bottomline of the pattern, drawn $1.00 lower, was not violated.
Figure 9.10 A brief and very “high” Rectangle formed in September 1937 in the rapid Bear Market Decline of“KN,” followed by a Descending and then a Symmetrical Triangle Consolidation.
• Pullbacks—Return of prices to the boundary of the pattern, subsequent to its initial penetration (breakout), takesplace more frequently with Rectangles than with Symmetrical Triangles. Our estimate would be that a Pullback orThrowback (the first is the common term for a rally after a downside breakout, and the second for a reactionfollowing an upside breakout) occurs within three days to three weeks in about 40% of all cases.
• Directional tendency—The Rectangle is more often a Consolidation Formation than a Reversal Formation, theratio being about the same as with Symmetrical Triangles. As Reversal Patterns, Rectangles appear morefrequently at Bottoms (either Major or Intermediate) than at Tops. Long, thin, dull Rectangles are not uncommonat Primary Bottoms, sometimes grading into the type of Flat-Bottomed Saucer or Dormancy described in Chapter7.
• Measuring implications—A safe minimum measuring formula for the Rectangle is given by its width. Pricesshould go at least as far in points beyond the pattern as the difference in points between the top and bottom lines ofthe pattern itself, though they may go much farther. Generally speaking, the brief, wide-swinging forms, whichappear nearly square in shape on the chart and in which turnover is active, are more dynamic than the longer andnarrower manifestations. Moves out of the latter almost always hesitate or react at the “minimum” point beforecarrying on.
Figure 9.11 This formation, constructed by United Aircraft in 1942, was not completed and could not be called aDouble Bottom until prices rose above 31 in February 1943. (See following pages.)
Figure 9.12 INCO quickly recovered from the Reagan Crash of 1987 and by year's end, it was nearly back to its1987 high; the latter was decisively broken in April 1988. The powerful rally continued to carry “N” higher. Butthe August reaction, followed by a poor rally in September, created a large Head-and-Shoulders Top. The earlySeptember decline broke the neckline to confirm the Reversal and the subsequent Throwback, to NecklineResistance, was an excellent selling point.
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Figure 9.13 Owing to the long-time-between-Tops requirement for true Double Top Reversals, these formationscan seldom be seen to advantage on a daily chart, but here is a good 1946 example in Republic Steel. Note the fivemonths and 20% decline between Tops. This chart contains many interesting lesser technical formations also. The“Broadening” Swings (see Chapter 10) in June and July, as the second Top was made, and the rounding rally inAugust were extremely Bearish in their implications.
Relation of rectangle to Dow Line
The resemblance of this individual stock chart formation, which we have discussed under the name of Rectangle,to the Average formation known to Dow theorists as a “Line” has doubtless occurred to you. Obviously, theirrationale and forecasting implications are much the same, but true Rectangles with sharply delimited Top (Supply)and Bottom (Demand) boundaries are truly characteristic only of trading in individual issues. Line formations inthe Averages are seldom rigorously defined, with successive Minor Heights forming quite precisely at a certainhorizontal tangent and successive Bottoms at a similarly precise horizontal level. If you will examine the separatecharts of the issues composing an Average at a time when the Average is “making a Line,” you will surely findsome of them showing an irregular uptrend, others showing an irregular downtrend, still others may be formingTriangles, and a few may be constructing Rectangles, or what not, but it is the algebraic sum of all these more orless divergent pictures that makes up the Average “Line.”
To be sure, there is some tendency on the part of active traders to sell (or buy) stocks when a certain Averagereaches a certain figure, regardless of the status of individual issues involved. An investment counsel willoccasionally advise his clients, for example, to “sell all speculative holdings when the Dow Industrials reach 500”(EN: or 5,000 or 15,000). But trading commitments based solely on general Average levels are so seldom followedconsistently that they have little effect. (EN10: In the modern era, with the availability of index exchange-tradedfunds, this is no longer true.)
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Figure 9.14 Shares of “AMR,” then selling for around 90, were split 5-for-1 in April 1946, resulting in a quickrally to a new high. But the overall aspect of a Double Top with the high made the previous December wasnevertheless apparent and confirmed when prices broke down through the “valley” level on August 28. Popularbuying brought in by “splits” is usually short-lived and only temporarily distorts the broad picture.
Rectangles from Right-Angle Triangles
In the preceding chapter, we referred to a type of partial “failure” in the development of a Right-Angle Trianglethat necessitates reclassifying the Triangle as a Rectangle. Now that we have examined the latter pattern in detail,we need say little more about this phenomenon, except to note the odds still appear to be somewhat in favor ofultimate breakout in the direction originally implied by the incipient Triangle. The fact there is this slightpresumption, however, certainly does not warrant disregard of an opposite breakout from the rectangularreconstruction.
Double and Triple Tops and Bottoms
To some of the old hands in the Street, our relegation of that good old byword, the Double Top, to a Minor Positionin our array of Reversal Formations may seem almost sacrilegious. It is referred to by name perhaps more oftenthan any other chart pattern by traders who possess a smattering of technical “lingo” but little organizedknowledge of technical facts. True Double Tops and Double Bottoms are exceedingly rare; Triple Forms are evenrarer. Additionally, the true patterns (as distinguished from chart pictures that might mistakenly
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CONTAINER CORPORATION
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Figure 9.15 The Major Reversal Formation in “CNR” at the start of a Primary Advance that reached 54. Note howan attempt at an Ascending Triangle turned into a Double Bottom.
be called such but are really assignable to some one of our other Reversal Formations) can seldom be positivelydetected until prices have gone quite a long way away from them, and can never be foretold or identified as soonas they occur from chart data alone.
But we are getting ahead of our story; we should first define what we are talking about. A Double Top is formedwhen a stock advances to a certain level with, usually, high volume at and approaching the Top figure, then retreatswith diminishing activity, then comes up again to the same (or practically the same) top price as before with somepickup in turnover, but not as much as on the first peak, and then finally turns down a second time for a Major orConsequential Intermediate Decline. A Double Bottom is the same picture upside down; the Triple types makethree Tops (or Bottoms) instead of two.
It is not difficult to skim through a book of several hundred monthly charts and pick out two or three examples ofMajor Double Tops and, perhaps, one or two Double Bottoms. One will find cases in which stocks made twosuccessive Bull Market Peaks several years apart at almost identical levels. Such phenomena stand out, in distantretrospect, like the proverbial sore thumb, which undoubtedly accounts for the undue awe with which the amateurchartist regards them. He neglects, for the moment, to consider the fact a thousand other issues might have donethe same thing but did not—that some of these even acted, for a time, as though they were going to Double Top,but then went on through and higher.
Is there any practical utility for the trader or investor in the Double Top concept? Yes, there is, but it will be easierfor us to formulate it if we first consider what is not a Double Top. Refer back for a moment to the AscendingTriangles and the Rectangles previously studied;
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TRINITY INDUSTRIES INC.
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Figure 9.16 Although Trinity Industries did not have the well-formed pattern exhibited by our otherrecommendations, we found the high-volume plunge, with the low of the day the third test of the year's low, a verybeguiling technical situation. Basically, it was a Triple Bottom with a One-Day Reversal to get the uptrend started.
when these start to evolve, the majority of the time their first step is the construction of two Tops at an identicallevel with an intervening recession, and with less volume on the second Top than on the first. In the ordinarycourse of events, a third Top will develop there, and ultimately, prices will break through and move on up to stillhigher levels. Thus, we see we must have some rule or criterion to distinguish a true Double Top Reversal Patternfrom the Double Tops that do not imply Reversal when they appear as a part of a Consolidation Area in an uptrend.
Distinguishing characteristics
No absolute and unqualified rule can be laid down to fit all cases involving stocks of different values and markethabits, but one relative distinction quickly suggests itself when we study these different kinds of chart formations:if two Tops appear at the same level but quite close together in time and with only a Minor Reaction between them,chances are they are part of a Consolidation Area; or, if a Reversal of Trend is to ensue, there will first be morepattern development—more “work” done—around those top ranges. If, on the other hand, there is a long, dull,deep, and more or less rounding reaction after the initial peak has appeared, and then an evident lack of vitalitywhen prices come up again to the previous high, we can at least be suspicious of a Double Top.
How deep is deep, and how long is long? Fair questions, to which, unfortunately, it is impossible to give simple,definite answers, but we can attempt approximations. Thus, if the two Tops are more than a month apart, they arenot likely to belong to the same Consolidation or Congestion Formation. If, in addition, the reaction between thefirst and second high reduces prices by 20% of their top value, the odds swing toward a Double Top
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Figure 9.17 Publicker made its Bull Market high only a few weeks after it was listed on the “big board.” Then itstarted to build a Descending Triangle but pulled up out of it. The final outcome was a Triple Top, completed inAugust (see Figures 8.17 and 9.15).
interpretation. But both of these criteria are arbitrary, and not without exception. There are cases in which the twopeaks have occurred only two or three weeks apart, and others in which the “valley” between them descended onlyabout 15%. Most true Double Tops, however, develop two or three months or more apart. Generally speaking, thetime element is more critical than the depth of the reaction. The greater the time between the two highs, the less theneed of any extensive decline of prices in the interim.
Given the conditions we have specified, namely, two Tops at approximately the same level but more than a monthapart on the chart, with somewhat less activity on the second advance than on the first, and a rather dull orirregular and rounding type of recession between them, we can then be suspicious that a Double Top Reversal hasactually evolved. Should a small Head-and-Shoulders or Descending Triangle start to develop at the second Top, asis frequently the case, we can be on guard, to the extent of protecting long commitments at once with a close stopor by switching to something else with a more promising chart picture.
Yet, even all these signs together are not final and conclusive. The situation can still be saved, and often is. Let ustake a look at what is, presumably, going on behind the scenes to create our chart picture up to this point. The firstTop on relatively high volume was a normal incident and tells us little except that here, for the moment, demandmet with sufficient supply to stop the advance and produce a reaction. That supply may have represented onlytraders' profit-taking, in which event the trend is likely to push on up after a brief setback. But, when the reaction
drifts off lower and lower until it has given up 15% and more of the stock's peak market value, and flattens outwithout any prompt and
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Figure 9.18 In the ordinary course of events, at the time this Bottom Pattern developed in “NG,” consisting, as itdid, of fluctuations for 10 long months within a range of only 1 full point, most traders would pay no attention toit. Certainly, it suggested very little opportunity for short-term profits. On an arithmetically scaled chart, thepattern could hardly be seen. Logarithmic price scaling, however, as we have remarked in an earlier chapter, hasthe great advantage of bringing to light the percentage importance of significant market action at very low pricelevels.
vigorous rebound, it becomes evident that either the demand was pretty well played out on the last advance or theselling represented something more than short-term profit cashing. The questions then are these: did the first highgive evidence of important distribution, and is there much more to meet at the same price range?
Nevertheless, as our chart picture shows, demand did finally come in and absorb enough of the floating supply toturn the trend around. When prices pushed up and began to run into selling again near the level of the first Top,that was to be expected on “psychological” grounds; many quick-turn operators naturally would take profits at theold high (perhaps with the intention of jumping right back in at a still higher price if the old high should beexceeded). Hence, a Minor Hesitation there was quite in order. But selling in sufficient quantity to produce anotherextensive reaction would be quite another matter. We have, by now, established a zone of Supply or Resistance atthe peak levels and a zone of Support or Demand at the Bottom of the valley between. The final and decisivequestion now is this: will the “valley” Support reappear and stop the second decline?
The conclusive definition of a Double Top is given by a negative answer to that last question. If prices, on theirrecession from the second peak, drop through the Bottom level of the valley, a Reversal of Trend from up to downis signaled, which is usually a signal of major importance. Fully confirmed Double Tops seldom appear at turns inthe Intermediate Trend; they are characteristically a Primary Reversal phenomenon. Hence, when you are sure youhave one, do not scorn it. Even though prices may have already receded 20%, the chances are they have very muchfarther to go before they reach bottom.
As to measuring implications, the Double Top affords no formula comparable with what we have attributed toHead-and-Shoulders and Triangle Formations, but it is safe to assume the decline will continue at least as farbelow the valley level as the distance from peak to valley. It may not be so in one interrupted slide; on the contrary,considerable time may be required to carry out the full descent in a series of waves. Pullbacks to the “valley” pricerange, following the first breakthrough, are not uncommon. (Take into account the general rule that a ReversalFormation can be expected to produce no more than a retracement of the trend that preceded it.)
One more point: we have said the Tops need not form at precisely the same level. Use here the 3% rule we havepreviously laid down as a measuring stick for breakouts. A first Top at 50, for example, and a second at 51 1/2would come within this limit. Curiously enough, the second peak often does exceed the first by a fraction. Theimportant points are (1) that buying cannot push prices up into the clear by a decisive margin, and (2) the Supportbelow is subsequently broken.
Double Bottoms
In identifying a Double Bottom, we can apply all of the precepts we have formulated for the Double Top Pattern,but upside down. The differences between the two pictures are just what you might expect them to be, having inmind the characteristic differences between Head-and-Shoulders Tops and Bottoms, for example. Thus, the secondBottom is usually conspicuously dull (little trading volume) and is apt to be quite rounded, whereas the second Topin a Double Top is moderately active and nearly as sharp and “spiky” in contour as the first. The rally up from thesecond Bottom shows an increase in turnover, and volume should pick up to a marked degree as the valley level, ormore properly, in this case, the height between the two Bottoms, is surpassed. Double Bottoms appear just about asfrequently as do Double Tops at Primary Trend Reversals, and Double Bottoms also occur sometimes at the end ofIntermediate Corrections in a Major Uptrend.
If you are familiar with some of the jargon of the Street, it has probably occurred to you that the second low of aDouble Bottom is an example of the market action so often referred to as a “test.” In a sense, that is just what it is—a test or corroboration of the Support (i.e., demand) that stemmed the first decline at the same level. The successof that test is not proved, however—and this is a point to remember—until prices have demonstrated their abilityto rise on increasing volume above the preceding high (the height of the rally between the two Bottoms). Until
such time, there is always the possibility a second test (third bottom) may be necessary, or even a third, and thatone of these will fail with prices then breaking on down into further decline. This thought leads us to our next typeof Reversal Formation.
Triple Tops and Bottoms
Logically, if there are Double Tops, then we might expect that there will also be Triple Tops, which will develop insomewhat similar fashion. The fact is that Reversal Formations, which can only be classed as Triple Tops, dooccur, but they are few and far between. Many patterns evolve at an important turn from up to down in the trendthat contains three Top points, but most fall more readily into the category of Rectangles. For that matter, anyHead-and-Shoulders Formation, particularly if it be rather “flat” with the head not extending much above the levelof the two shoulders, might be called a sort of Triple Top.
The true Triple Top (as distinct, that is, from other types of three-peak formations) carries a recognizable familyresemblance to the Double Top. Its Tops are widely spaced and with quite depth and usually rounding reactionsbetween them. Volume is characteristically less on the second advance than on the first, and still less on the third,which often peters out with no appreciable pickup in activity. The three highs need not be spaced quite so far apartas the two that constitute a Double Top, and they need not be equally spaced. Thus, the second Top may occur onlyabout three weeks after the first and the third six weeks or more after the second. Also, the intervening valleysneed not bottom out at exactly the same level; the first may be shallower than the second and vice versa. Also, thethree highs may not come at precisely the same price; our 3% tolerance rule is again useful here. Yet, despite allthese permissible variations, there should be, and generally is, something suspiciously familiar about the overallpicture, something that immediately suggests the possibility of a Triple Top to the experienced chartist.
The conclusive test, however, is a decline from the third Top that breaks prices down through the level of the valleyfloor (the lower one, if the two valleys form at different levels). Not until that has occurred can a Triple Top beregarded as confirmed and actually in effect; so long as demand persists at the valley price range, the trend can beturned up again. Only in those cases in which activity is conspicuously lacking on the third peak and then begins toshow Bearish characteristics by accelerating on the ensuing decline is one justified in “jumping the gun.”
Note this formation qualifies as a Triple Bottom in every detail—spacing between Bottoms, extent in percent ofintervening rallies, volume. Of course, its completion in October 1942 did not necessarily forecast that “NG”would climb to 33, as it ultimately did. But the fact that many other stocks were making sound Major BottomFormations at higher price levels at the same time certainly warranted the conclusion that “NG” was on its way up,and that it was a bargain at 5.
Triple Bottoms are simply Triple Tops turned upside down, with the same qualifications noted when discussingDouble Bottoms. The third low should always be attended by small volume, and the rise therefrom must show adecided increase in turnover and carry prices decisively above the Tops of the rallies that formed between theBottoms. One is never justified in “jumping the gun” on a presumed Triple Bottom Formation unless nearly everyother chart in the book is in an unmistakably Bullish position. The risk of premature buying is expressed in asaying one sometimes hears in the boardrooms to the effect of “a Triple Bottom is always broken.” This is not atrue saying. Once a Triple Bottom has been established and confirmed by the necessary up-side breakout, itseldomly fails—it almost always produces an advance of distinctly worthwhile proportions. But an uncompleted“possible” Triple Bottom chart picture must be regarded as treacherous. Stick to the breakout rule and you will besafe.
Triple Tops are sometimes referred to as “W” Patterns because of their occasional resemblance to that capital letteron the chart. There is a sort of hybrid between the Double and Triple Top, in which the middle one of the threeTops does not attain the height of the first and third, and thus, even more strikingly resembles a “W.” For the samereason, Double Tops are sometimes called “M” Formations.
Because the elements in Double and Triple patterns are normally spaced well apart in time, they are often easier todetect and appreciate on a weekly chart than on a daily. Monthly graphs disclose numbers of widely spread Doubleand Triple Bottoms but, on the other hand, are too coarse to reveal many good Double and Triple Top Patterns.
In our foregoing discussion of the Triple Top, we referred to a sort of intuition that comes with experience andenables a technical analyst to recognize the potentialities for Reversal of a certain chart development, sometimeslong before it has reached a conclusive stage. This is a not uncommon talent, but it is one that is seldom attainedexcept through searching study and long experience (in which the latter usually involves a few expensivemistakes). The reader of this book need not despair of acquiring “chart sense” and without undue cost—if he willconcentrate on his study, watch, check, and double-check every new development on his charts, and “keep score”on himself.
It has been said that chart interpretation is not a science but an art. It is not an exact science, to be sure, because ithas no rules to which there are not exceptions. Its finer points defy expression in rule or precept. It requiresjudgment in appraisal of many factors, some of which may seem, at times, to conflict radically with others. But tocall it an art, which implies the need for genius, or at least for a high degree of native talent, is certainly improper.Say, rather, that it demands skill, but a skill that can be acquired by anyone of ordinary intelligence.
chapter ten
Other Reversal phenomena
We have considered so far eight classes of chart patterns that appear at more or less important Reversals ofdirection in the trend of prices. They are as follows:
1. The Head-and-Shoulders
2. Multiple or Complex Head-and-Shoulders
3. Rounding Turns
4. Symmetrical Triangles
5. Right-Angle Triangles
6. Rectangles
7. Double and Triple Tops and Bottoms
8. One-Day Reversal
Of these, numbers 1, 2, 3, and 7 develop most often at Major Turns, whereas numbers 4, 5, and 6 occurmore frequently at Intermediate Stages. Numbers 1, 2, 3, and 5 give indication before they are completedas to which way the price trend is likely to proceed from them. Numbers 4 and 6 give no such indicationand, as we have seen, are rather more apt to signal Consolidation or Continuation than Reversal. But all ofthem can, and on occasion do, appear at both Major Tops or Bottoms. EN: Number 8 appears typicallyafter uncontrollable moves, up and down.
We have yet to take up a few other technical patterns that, because of their limited significance, rarity, ordoubtful utility to long-term traders, have been relegated to the end of our Reversal studies (see Figures10.1 through 10.28).
The Broadening Formations
In concluding our discussion of Triangles in Chapter 8, we mentioned certain types of price congestion ortrading areas that have sometimes been called “Inverted Triangles” because, starting with very narrowfluctuations, they widen out between diverging rather than converging boundary lines. Herein, we havechosen to classify them instead as Broadening Patterns since, except for that inverted resemblance insuperficial appearance, they are quite different in nature and trend implications.
If the Symmetrical Triangle presents a picture of “doubt” awaiting clarification and the Rectangle apicture of controlled “conflict,” the Broadening Formation may be said to suggest a market lackingintelligent sponsorship that is out of control—a situation, usually, in which the “public” is excitedlycommitted and is being whipped around by wild rumors. Note though we say it only suggests such amarket; there are times when it is obvious those are precisely the conditions that create a BroadeningPattern in prices, yet other times when the reasons for it are obscure or undiscoverable. Nevertheless, thevery fact that chart pictures of this type make their appearance, as a rule, only at the end or in the finalphases of a long Bull Market lends credence to our characterization of them.
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Figure 10.1 The Symmetrical type of Broadening Formation, which develops most frequently in the laterand more “excited” stages of a Primary Bull Market, is perfectly exemplified in this Crane Companychart. Note that the Broadening Pattern here started to form in December 1945 after a 10% reaction; if ithad formed on Top of a rally, it would have been suspected as a possible Broadening Top. Nevertheless, itcarried the usual Bearish implications. "CR" topped out at 49% in June.
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Hence, after studying the charts for some 20 years and watching what market action has followed theappearance of Broadening Price Patterns, we have come to the conclusion they are definitely Bearish inpurport—that, while further advance in price is not ruled out, the situation is, nevertheless, approaching adangerous stage. New commitments (purchases) should not be made in a stock that produces a chart of
this type, and any previous commitments should be switched at once or cashed in at the first goodopportunity.
The Broadening Formation may evolve in any one of three forms, comparable, respectively, to invertedSymmetrical, Ascending, or Descending Triangles. The "Symmetrical" type, for example, consists of aseries of price fluctuations across a horizontal axis, with each Minor Top higher and each Minor Bottomlower than its predecessor. The pattern may thus be roughly marked off by two diverging lines, the uppersloping up (from left to right) and the lower sloping down. But these Broadening Patterns arecharacteristically loose and irregular, whereas Symmetrical Triangles are normally regular and compact.The converging boundary lines of a Symmetrical Triangle are clearly defined as a rule, and the Tops andBottoms within the formation tend to fall with fair precision on those boundary lines. In a BroadeningFormation, the rallies and declines usually do not all stop at clearly marked boundary lines.
Volume during Broadening Formations
Another distinction between Triangle and Broadening Formation is in the volume chart. The constructionof a true Triangle is attended, as we have seen, by diminishing activity, starting with high volume on thefirst Minor Reversal that initiates the pattern, but growing less and less as prices fluctuate in ever-smallerwaves out toward the apex. Then activity picks up again after prices have broken out of the Triangle,immediately and sharply if the breakout is through the topside. With the Broadening Formation, on theother hand, trading activity usually remains high and irregular throughout its construction. If it developsafter
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Figure 10.2 Although this particular Major Reversal Formation appeared on the charts more than 35 yearsago, it is so perfectly developed and on such a large scale that it may well stand as our elementary modelfor an Orthodox Broadening Top. This pattern in Air Reduction is discussed in detail on previous pages.Note also the Symmetrical Triangle Consolidation of July-August, and the examples of Runaway,Breakout, and Exhaustion Gaps (RG, BG, and EG), which will be taken up in Chapter 12.
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an advance, as is almost always the case, the first Minor Reversal that starts the pattern will occur on alarge turnover, but so will the second rally in the pattern, and the third, and high
both price and volume—is, thus, one of wild and apparently “unintelligent” swings.
As can easily be seen, under such circumstances, a true breakout from the area may be difficult, if notimpossible, to detect at the time it eventuates. The volume part of the chart
1946
AMERICAN ROLLING MILLS
28
Sales
100's
125
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APRIL
MAY
JUNE
JULY
AUGUST
13 20 27 3 10 17 24 31 7 14 21 28
Figure 10.3 A small, but perfect, 1946 Broadening Top that formed at the end of a three-month chartpattern, which also had overall Broadening (and, hence, Bearish) aspects. The five critical points ofReversal are numbered on the chart. The “breakout” was registered on August 27. The Pullback Rally thatfollowed immediately was strong, but it still held within normal bounds. Another interesting BroadeningTop of 1946 appears in Figure 33.7.
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CONSOLIDATED EDISON ED
1935
1936
1937
1938
Figure 10.4 When they appear as plain and as compact as this example, Broadening Tops on weeklycharts carry very powerful Reversal indications. The Top of the fifth turn in this formation was capped onthe daily chart by a Head and Shoulders, which was pictured in Figure 6.7. The dashed lines on the abovechart are trendlines—to be discussed in Chapter 14.
kN
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Figure 10.5 Broadening tendencies that appear on monthly charts, or very wide spread (with Tops five orsix months apart) like the above on weekly charts, should not be regarded as significant technical
formations. Reversal points in a true Broadening Top should not be more than two months apart, as inFigure 10.4.
ASSOCIATED DRY GOODS DG
1945
JA N UARY FEBRUARY MARCH..............APRIL.............MAY.........* JUNE..........
■ 6 13 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28 5 12 1926 2~9 16 23 30
Figure 10.6 Three successive reactions in "DG" in February-March 1945 made successively lowerBottoms, but the intervening rallies came up to the same high (about 21%), thus forming a RightAngledBroadening Formation with a horizontal Top (Supply) Line. Penetration of this technically important topline on April 16 was a Bullish signal. The flat-topped type of pattern does not necessarily portray aBearish situation.
88
1946
80
76
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68
64
60
PARAMOUNT PICTURES
PX
56 Sales 100's 125 100
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50
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I...........................mill iiiiini
JANUARY~FEBRUAR
5 12 19 26 2 9 16 23
MARCH
2 9 16'23 30 6 13 20 27 4 11 18 25 1 8 15 22 29
Figure 10.7 The 1946 Top in Paramount Pictures, from which it fell to 46 a year later, was a RightAngledBroadening Formation with a horizontal bottom line that was “cracked” the first week of June, but notdecisively broken until June 20. (This stock was later split 2-for-1.)
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Figure 10.8 Another example of the Flat-Topped type of Broadening Price Pattern that appeared near theend of 1945. “LS” went on up to 63 in 1946. Prices broke out of this formation with a Breakout Gap (G)and another Breakout Gap appeared on December 3. G-G marks an “Island.” See Chapter 12 for Gaps.
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Sales 100's 250
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U. S. STEEL X
1946
AUGUST
4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24' 31 7 14 21 28
Figure 10.9 The 1946 Bull Market Top in U.S. Steel was a three-month Diamond that might also beconstrued as a Head-and-Shoulders.
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AMERICAN BOSCH CORP.
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Figure 10.10 A Diamond (November) that broke out topside and thus functioned as Consolidation ratherthan Reversal.
obviously furnishes no clue, while the very looseness and lack of definition of the price pattern preventthe drawing of any line that surely says, “this far and no farther.” (We are referring now to the“Symmetrical” type only of Broadening Formation.) Once prices have run well away, either up or down,from the pattern area, it becomes plain that a breakout has occurred, but by that time, it may be too late torisk a trade on the situation; the move may already have gone too far. What can we do about BroadeningFormations then? Well,
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Figure 10.11 Diamond Reversal Formations are often easier to detect on weekly than on daily charts.Trace out the price swings and volume in this May-June 1946 Diamond in Shell. Note also the remarkableDescending Triangle that developed from September 1946 to February 1947, and the March Pullback toits apex, another ideal place to sell short.
we have already noted 9 times out of 10 they carry Bearish implications. They appear most often at ornear an important topping out of the trend. Hence, it is reasonably safe to assume that prices, when theyfinally break away from the formation, will go down, or if they do go up, will very soon turn around and
come back down again. Therein lies one answer to the problem of what to do about a BroadeningFormation.
In addition, the price action within the formation, in many cases, furnishes an advance indication ofbreakout direction. If the trend is going to break down from the Broadening Area, the last rally within thearea may fail to rise as high as its predecessor, thus breaking the sequence of ever higher Tops within thepattern. Alternatively, if the trend is going to emerge on the topside, the last reaction within the patternmay fail to depress prices as low as the preceding reaction. These “failures” within the pattern occur, aswe have stated, in a majority of all Broadening Formations. Note that one cannot be sure of such asignificant development (what we have referred to above as a failure, for lack of a better descriptivename) until prices go on and out the other side of the formation or, more precisely, have exceeded the lastpreceding move in that direction by a decisive margin (our 3% rule again).
A typical example
No doubt the foregoing paragraph sounds rather complicated. It will be easier to visualize thedevelopment of a “failure” signal if we cite an example using actual price figures. Easier yet, perhaps, ifthe reader will sketch out our example on a scrap of chart paper. Suppose stock XYZ, after advancingsome 30 points on gradually increasing turnover, runs into heavy selling at 62 and reacts to 58. But thereis still plenty of interest in the issue; it stops
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Figure 10.12 Technicians in the future will look back with amazement at the Top, which put theexclamation point on the Bull 1990s. The most amazing thing being that what was going on at the timewas recognizable and subject to analysis with a ruler (see Resources). The analysis furthermore indicatedthe party was over (or at least the fat lady was in the process of singing). As Edwards noted, theBroadening Top, which had (and has) implications of its own, morphed into a Diamond, which threw off afalse signal, breaking out on the upside, which developed into another triangular-like pattern (could belooked at as ragged triangular or ascending—only bottom line shown here), which after a head fake brokedown, made a modified V-Bottom and returned to the top of what could be looked at as a monsterrectangle. The top horizontal line, drawn in August 2000, stops the 2001 rally cold and from there it is aslippery slide to the tragedy of September 11, 2001. It was obvious that the investor had no business being
long and that trading strategy was in order. Was there any prescience in recognizing the mulish sidewaystrend of the market? None whatsoever. Is all this hindsight? The reader may see for himself by examiningthe record of how this market was analyzed at the time at the edwards-magee.com newsletter archives.
at 58 and then swings up to a new peak at 63. It “churns” there for a day or two and drops back again, thistime to 56% before it is halted by another burst of buying. Its third rally takes it up to 62, where ithesitates and falls back to 59, but it is then picked up again and carried on to 65. (By this time, aBroadening Formation has become evident on the chart.) At 65, there is a great show of trading, followedby another reaction that drops quotations quickly back to 60. Support appears there momentarily andprices fluctuate for three or four days between 60 and 62 and then fall away again, finally to close at 56,with volume running high all through this phase. A fourth rally starts, but now the traders who bought inat 60 on the preceding downswing are frightened and looking for a chance to “get out even,” and theadvance is stifled at that level. Quotations start to slip and soon are down to 55, below the previous patternBottom. When this occurs, the “failure” of the preceding rally is confirmed—its failure, that is, to riseabove 65 and, thus, carry on the Broadening Movement. The decline below 56, by virtue of that failure,may be regarded as a breakout.
If you followed the foregoing example closely, you will have noted there can be (and very often are)Minor Fluctuations inside the pattern that do not affect its outcome. Thus, the rise from 56% to 65 reallyconsisted of three moves, first from 56% to 62, then from 62 back to 59, and, finally, from 59 up to 65.The reaction from 62 had no significance so long
Figure 10.13 Hudson is another stock that ended its Bull Market in 1946 with a Major Diamond, whichalso could be taken as a Complex Head and Shoulders. This formation was plain on the weekly chart but
hard to see on the daily. Note how the Diamond gave a sell signal about 2 points higher than the Head-and-Shoulders. The 14%-17% area at the end of the year, when construed as a weak Rectangle, was barelyfulfilled in February 1947.
as it stopped above 56% and was succeeded by a new rise carrying beyond the previous pattern high,which, in this case, had been 63.
The example just detailed is one of the more common types in which the failure occurs on a rally and thebreakout eventuates on the downside. But it could have been converted into the opposite form if the lastdecline had stopped at 60, and then, instead of fluctuating for a few days between 60 and 62 and breakingdown again, had pushed right back up and past 65. That action would have given us a failure on a declineand an upside breakout. (The odds would be, however, that the final Top was not far away.)
The Orthodox Broadening Top
There is one particular manifestation—a special case, as the mathematicians might say—of theBroadening Price Formation whose general nature we have discussed in the preceding paragraphs. Thisparticular form appeared at the 1929 Tops of many of the active and popular stocks of that day, but it hasdone so with less frequency at Bull Market highs since 1929, and rarely has done so at high-volume Topspreceding extensive Intermediate Declines, as in 1933 and 1934. It is known to market technicians underthe specific name of Broadening Top, and although it conforms to our general descriptions for allSymmetrical
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*G
U. S. STEEL X
tllHWHHlHtt j 1937
APRIL MAY ' JUNE ’ JULY AUGUST SEPTEMBER
3 10 17 24 1 8 15 22 29 5 12U9 26 3 10 17 24 31 7 ’14 21 28 4 11 18 25
Figure 10.14 As U.S. Steel approached the Top of its Secondary Recovery in August 1937, its pricefluctuations tended to grow narrower, between upward sloping but converging boundaries, while volumediminished. This pattern—a Wedge—carried a definitely Bearish message. The entire swing from July tothe end of August was essentially a Rounding Top. The three Gs mark Breakaway Gaps (see Chapter 12),the last (September 7) made as prices broke down through a Support Level (see Chapter 13).
Broadening Price Patterns, it has been so precisely defined, and so often cited in technical writings, thatwe may well take some time to examine it.
The Orthodox Broadening Top has three peaks at successively higher levels with two Bottoms betweenthem, with the second Bottom lower than the first. The assumption has been it is completed and in effectas an important Reversal indication just as soon as the reaction from its third peak carries below the levelof its second Bottom.
Perhaps we can best see what this formation is like if we examine one of the classic patterns thatdeveloped in 1929. Our chart (Figure 10.2) shows the daily market action (price and volume) of AirReduction from July 1 to December 31 of that year. We have numbered from 1 to 5 the significant turningpoints within the Broadening Top that ended that stock's Bull Market in October. A Broadening PricePattern was not detectable until prices had started to move up from the second Minor Low (point 4); bythen 3 had formed above 1 and 4 below 2. New highs at 5 (a and b), followed by the definite downsidebreakout at B (nearly 6% under 4), completed the pattern and, according to the rules, signaled a MajorTrend Reversal. In this case, there can be no doubt as to the importance of the Reversal indication
because, as our chart shows, the price of Air Reduction dropped from above 220 on October 18 to below80 on November 14, just four weeks later, and the final Bottom was not seen until nearly three years laterin 1932.
There are some fine points of this classic example that should be noted. First, a new high, that is, a thirdand higher Top, was made at 5a and the subsequent reaction was halted at 195, well above 4, andsucceeded by renewed advance. This looked like one of the advance notices (“failures”) to which we havereferred on a preceding page, portending an upside breakout. But the example before us will serve toemphasize the warning
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Mil
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48
LOEW'S, INC.
LW
44
Sales
100's
125
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JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER
4 11 18 25: 1 8 15'22 29 5 12 19 26 3 10 17 24 31 '7 14 21 ' 28 5 12 19 26'
Figure 10.15 An “ideal” Falling Wedge that developed in Loew's in 1936. Note the volume trend therein,which is irregular but generally diminishing. July produced a small Flag (see Chapter 11), and at the endof the year, “LW” went into a Rectangle out of which prices “skyrocketed” to 75.
that we attached thereto—that such an indication is not to be trusted until prices have decisively exceededthe previous Top. At 5b Air Reduction was traded briefly at 223, 2 points, but less than 3% higher than 5a,and the day closed with quotations below 5a. The break on October 24 (to B) took prices more than 3%under the level of 4. Now occurred a development typical of Broadening Tops—a Pullback Rally (to B)retracing about half of the ground lost between the last pattern Top (5b) and the end of the initial breakoutmove (B). Such a recovery (and failure) will be attempted, according to our experience, in at least four outof five Broadening Top Patterns, and it may not fail until it has regained two-thirds of the precedingdecline, although it usually peters out around or even below the halfway mark.
As stated, this is a classic example; there were many others at that time. The very fact that so manyevolved at the 1929 peak, which was followed by history's most disastrous losses, probably accounts forthe extremely Bearish implications market technicians have ascribed to the Broadening Top Formation.We regard it now with somewhat less awe; its measuring implications are probably no greater than thoseof a large, high-volume Head-and-Shoulders, but it is a pattern characteristic of the last stages of aPrimary Uptrend.
The insistence that the third Top (our number 5), when followed by a decline below the second Bottom(our number 4), completes the Reversal Pattern may be regarded, in the light of experience, as setting toostrict a limitation because Broadening Formations do, on occasion, go on to make a fourth and higher Top.Yet this rule may be, and usually is, justified by the fact the overall indications are undeniably Bearishand, hence, one should not wait too long to get out. On the other hand, the requirement for a third Topdoes seem to be justified on the score that Major Reversals are seldom completed until at least three
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Figure 10.16 Wedges seldom appear at Major Trend Reversals, but Schenley's Bull high in 1946 wasmade at the end of an eight-month Rising Wedge, plainly seen on its weekly chart. The dashed line at 60marks a Support Level (see Chapter 13) that served to stem the subsequent decline for nine weeks.
attempts have been made to push prices on in the direction of the previous trend. This is the reason whypioneer technical students lumped together many formations under the classification “Five-PointReversals.” The Broadening Top is a Five-Point Reversal (our numbers 1-5) and so it is a Head-and-
Shoulders. A Broadening Top might, in fact, be called a Head-and-Shoulders with a high right shoulderand a down-sloping neckline.
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MARCH
MAY
AUGUST
TRANSCONTINENTAL & WESTERN AIRLINES TWA
OCTOBER N
APRIL
13 20 2
JANUARY FEI 12 19 26 2.
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Figure 10.17 There are many interesting and technically significant features in this 12-month daily chartrecord of “TWA.” Note the extraordinary One-Day Reversal, December 3, which marked its Major Top.Although the next four weeks produced a sort of poorly formed Descending Triangle, the Reversal Daywas the only clear-cut and unmistakable signal to sell. When you study Pennants, turn back to this chartfor its November Pennant. Its long Intermediate Down Trendline was tentatively broken in August 1946,without confirming volume (see Chapter 14). Note that at no time during the decline did a “Buy” Patternappear.
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GREYHOUND CORP.
UllulllLillU
AUGUST
1 8 15 22 29 6 :13 20 27 3 :10 17 24 :31 7.14 2128
Figure 10.18 The strong One-Day Reversal that marked Greyhound's 1946 Bull Market high; note theclimax volume. A less conspicuous Reversal Day appeared on August 26. It is suggested the reader goback over all charts in the preceding chapters; he will find many Reversal Days of greater or lesserconsequence. Many gaps (G) were of measuring type (see Chapter 12).
Figure 10.19 Apple, 1987 Reagan Crash. Does this plunge appear to be out of the blue? Not really.Numerous signs are given: break of major trendline; short-term momentum down before the crash in anenvironment of extreme top psychology; then the crash itself, the Panic Selling exhibiting the typicalpattern of short covering; and then further decline.
Why no Broadening Bottoms?
All of the other types of Reversal Formations we have studied thus far can occur as either Tops orBottoms; they can develop at the end of a decline to turn the trend up or at the end of an advance to turnthe trend down. But this does not seem to be true of the Broadening Formation. It has been assumed in thepast that Broadening Bottoms must exist, but the writer has never found a good one in his examination ofthe charts of thousands of individual stocks over many years, and only one or two patterns that bore a
resemblance to it in the charts of the Averages. Apparently, the circumstances that create BroadeningFormations do not exist after a prolonged decline in prices. This would seem to bear out our earliercharacterization of this sort of pattern as suggesting active, excited trading with much public (and, hence,not too well-informed or managed) participation. Such conditions are naturally associated with the finalphases of a Bull Market.
Right-Angled Broadening Formations
Price patterns of the “Inverted Triangle” shape, having a horizontal Top or Bottom boundary, occur aboutas often as the symmetrical type, which is to say, not nearly as often as true Triangles, Rectangles, and soon. In the mid-twentieth century, there were very few of them (EN9: Still scarce in the 2000s). Althoughthe true Right-Angle Triangle with a horizontal top line and up-slanting bottom line is called an AscendingTriangle, just as its counterpart with
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Figure 10.20 The Panic Selling of October 19, 1937, produced a conspicuous Climax Reversal Day innearly all leading stocks, as well as in the Averages. This New York Central chart shows, beside theSelling Climax (SC), its Head-and-Shoulders Recovery Top of July-August and a Consolidation Rectanglethat ended as a Triangle in early October. “CN” made a final Bear Market low the following March at10%. On a logarithmic price scale, its down trendline from August was not broken until June 1938.
a horizontal bottom boundary and a down-slanting top boundary is called a Descending Triangle, wecannot apply these terms to the Inverted or Broadening Forms. Generally speaking, Right-AngledBroadening Formations carry Bearish implications, regardless of which side is horizontal, in nearly thesame degree as the symmetrical manifestations.
Obviously, however, they differ essentially from Symmetrical formations in one respect: a horizontal sideindicates either accumulation or distribution at a fixed price, depending on which side is horizontal.Logically, it follows any decisive break through that horizontal side has immediate forceful significance.Thus, if a Broadening Price Pattern with a flat top boundary develops after a good advance, and if pricesfinally burst up through that top line on high volume and close above it to a conclusive extent (roughly3%), then it is safe to assume the preceding uptrend will be resumed and carried on for a worthwhilemove. This does happen, although it is rare. The odds favor the opposite, that is, the eventual victory ofthe forces of distribution that created the horizontal Top and a breakaway into an extensive decline.
Moreover, if an advance is to ensue from a Flat-Topped Broadening Formation, chances are the thirdreaction in the formation will be attended by much diminished trading activity
Figure 10.21 Dow Industrials, 1987 Reagan Crash. Rumors proliferated—ironically, one that Reagan hadAlzheimer's. Proximate cause: professional panic exacerbated by an ill-considered portfolio insurancescheme propagated by academics. Note the authoritative (lower) trendline here (75 days) is broken bymore than 2% (Magee's suggestion) in early September. The broken upper trendline (25 days) would havepulled the ripcord for the more agile trader. Savvy investors were hedging and liquidating throughSeptember, and fund managers panicked in October. According to the Brady Report, Hull Trading Co.bought the bottom on October 20, thus saving American capitalism.
instead of the continued high or irregular volume characteristic of Bearish Broadening Movements; eitherit or the fourth reaction will be halted and reversed above the low point of the preceding reaction. Thisturns the formation into a Consolidation Head-and-Shoulders, a Continuation-of-Trend Pattern, which weshall take up in Chapter 11. The message here for the trader owning a stock whose chart begins to developa Broadening Formation of this type is to watch the third reaction. If it carries below the second andvolume does not fall off to a marked degree, sell out on the next rally. (You can always repurchase thesame stock, if you wish, without much “loss of position” should prices finally and, improbably, recoverand push up through the Top.)
Right-Angled Broadening Formations with horizontal lower boundaries (flat Bottoms) almost alwaysbreak down. Once prices have fallen below the lower boundary line, there is frequently a Pullback Rallyto that line, either in a few days or in two or three weeks, similar to the Pullbacks that so often follow thebreakdown from a Head-and-Shoulders Top.
(Note that the third or fourth rally in a pattern that starts out as a Flat-Bottomed Broadening Formationmay fail to carry prices as high as its predecessor, in which case a Head-and-Shoulders deal will instill. Inother words, every Head-and-Shoulders begins as a Broadening Formation and the statement of thatrelation takes us logically to our next type of Reversal picture.)
The Diamond
The Diamond Reversal Formation might be described either as a more or less Complex Head-and-Shoulders with a V-shaped neckline or as a Broadening Formation which, after two or three “swings,”suddenly reverts into a regular Triangle that is nearly always of the Symmetrical form. So far as theaccompanying volume pattern is concerned, the latter is
NC
NATIONAL CASH REGISTER
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Figure 10.22 The Selling Climax discussed on the preceding pages is typically a one-day phenomenon,and on only one occasion (April 1939) in history has a general market One-Day Reversal signaled thefinal low of a Primary Bear Trend (although many individual stocks evinced a Selling Climax on theircharts in March 1938).
possibly the better description; its name obviously derives from its pictorial resemblance to theconventional diamond shape.
Although it is fairly conspicuous and easily detected when it appears on the charts, the Diamond is not acommon pattern. Since its development requires fairly active markets, it rarely occurs at BottomReversals. Its “natural habitat” is Major Tops and the High-Volume Tops that precede extensiveIntermediate Reactions. Many Multiple Head-and-Shoulders Formations are borderline Diamond cases;that is, they permit the drawing of slightly bent necklines. The reader is cautioned, however, against tryingtoo hard to make Diamonds out of price patterns of the Head-and-Shoulders type. There is a temptation todo so because a V-shaped neckline may promise to give an earlier (and, hence, more profitable) breakoutsignal than the straight neckline of the Head-and-Shoulders. It is much safer to stick to the latter, however,unless the second half of the formation consists of a series of cleancut, converging Minor Fluctuations,which plainly demands definition by converging boundary lines, and unless activity shows some tendencyto diminish during this period as it would in a Triangle.
The Diamond requires little further comment. Our illustrations will suffice to acquaint you with its typicaldetails. It carries a minimum measuring implication that, having studied
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Figure 10.23 A church spire top in Qualcomm. The December gap might be mistaken for a buy signal, asmight be the runaway days, but they are actually hand-engraved invitations to leave the party with nearprogressive stops a hair off the day's low. Also valid is the exit on the Key Reversal on day two after thegap. How does the trader know this is a blow-off and not a signal to pyramid? By the age, length, state,and slope of the market. When trendlines go vertical, blow-off management must be used. The return tothe base of the first runaway day is notification that it is a Bull trap—the first Bull trap. The second Bulltrap is the breakout of the triangle in March. A wonderful chart filled with fin de siecle and fin demillennium lessons.
the Head-and-Shoulders and Triangle formulas, you can probably deduce for yourself. Prices should moveat least as far from the breakout point as the greatest width in points of the pattern from its Top (head) toBottom (V in neckline). This, it must be emphasized, is a minimum rule and subject only to the usualqualification that a Reversal Formation must have something to reverse. Generally, the new trend carriesprices eventually well beyond the minimum measurement.
Wedge Formations
All of the chart formations we have discussed up to this point can and do develop at changes in the MajorTrend of prices; a few of them seldomly occur at any other change than a Major Reversal. We have toconsider three patterns that are ordinarily Minor, or, at most, only Intermediate in their trend implications.They are useful, nevertheless, in trading operations. One of them, the Wedge, we have already alluded to(in Chapter 8) as having some resemblance to the Triangles.
The Wedge is a chart formation in which the price fluctuations are confined within converging straight (orpractically straight) lines but differs from a Triangle in that both boundary lines either slope up or slopedown. In a Symmetrical Triangle, the Top border slants down, whereas the Bottom border slants up. InRight-Angle Triangles, one boundary slopes either up or down, but the other is horizontal. In a RisingWedge, both boundary lines slant up from left to right, but because the two lines converge, the lower mustproject at a steeper angle than the upper. In a Falling Wedge, the opposite is true.
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Figure 10.24 Microsoft. A Key Reversal Day in March. Department of Justice breakaway gaps: runawaygaps, exhaustion gaps. Selling Climax. As usual, further lows are achieved. A cornucopia of chartists'
delights.

Figure 10.25 eBay. As eBay broke its trendline and drifted sideways, it became a good subject for KeyReversal Day trading. Note several instances.
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Figure 10.26 If you cannot deliver groceries electronically what good is the internet? Meg Whitman (acompetent, well, more than competent, CEO) and eBay found a use for it: the biggest flea market everinvented (and growing every day). Every military commander knows the axiom, Exploit Success! andeBay exploits and exploits and exploits. Is there a fundamental lesson here for the technician? Absolutely.Although the technician should be able to take a nameless chart and trade it competently (CEO of his ownship) no real information or data should be ignored. In this case, the real information—that eBay was an800-pound gorilla (or flea)—fit the chart perfectly. So eBay separated itself from a bunch of nags to runlong and hard. Handicappers know to always keep an eye on winning jockeys: Whitman. Ellison atOracle. Moore at Intel. Gates at Microsoft. Jobs at Apple (and Pixar and NEXT and so on ... and so on ..In2005, what is to be done with eBay? Draw a trendline, raise your stops, and sell it if it reverses.
Superficially, one might think because an Ascending Triangle with one horizontal and one up-line is aBullish picture, the Rising Wedge, with both of its pattern lines up, should be even more Bullish. But suchis not the case. Remember, the flat top of an Ascending Triangle signifies a supply of shares beingdistributed at a fixed price; when that supply has been absorbed (and the rising lower boundary lineindicates it will be absorbed), the pressure is off and prices will leap forward. In a Rising Wedge, on theother hand, there is no evident barrier of supply to be vaulted, but rather, a gradual petering out ofinvestment interest. Prices advance, but each new up-wave is feebler than the last. Finally, demand failsentirely and the trend reverses. Thus, a Rising Wedge typifies a situation that is growing progressivelyweaker in the technical sense.
It might be said any advance in prices, no matter what shape it may take on the chart, weakens thetechnical status of the market. Prospective buyers are—or, at least, should be—more reluctant to pay highprices than low, and owners are more willing to sell at high prices than at low; in other words, any sort ofrise tends to increase supply and diminish demand. (Although theoretically true, the preceding statementmust be qualified by the fact that rising prices actually attract rather than discourage public buying.) Thedifference between a Rising Wedge and what might be called a normal Uptrend Channel (of which we
LU (Lucent Tech Inc) 08/26/2006 3:34 PM EDT
Figure 10.27 Lucent. Late twentieth- and early twenty-first-century schizophrenia. Runaway Days,Breakaway Gaps. Maalox is to be prescribed for the investor. Ecstasy for the trader. Reversal Days andshort-term tactics win the day when the subject is insane. An excellent example of fitting the trader to thestock. Why would a rational investor own such a stock?
shall have more to say later) is the Wedge sets a sort of limit on the advance. Its converging boundarylines focus on a point near where the advance will halt and reaction will set in.
We can state most of the essential facts about the Up-Pointed Wedge Formation in a few short sentences.It can develop either as a sort of Topping-Out Pattern on a previously existing uptrend or start to formright at the Bottom of a preceding downtrend. It (the Wedge) normally takes more than three weeks tocomplete; a shorter pattern of this shape is nearly always better classified as a Pennant, which we willdiscuss in the next chapter. Prices almost always fluctuate within the Wedge's confines for at least two-thirds of the distance from the base (beginning of convergence) to the apex; in many cases, they rise clearto the apex, and in some, they actually go a short distance beyond, pushing on out at the Top in a last-gasprally before collapsing. Once prices break out of the Wedge downside, they usually waste little time beforedeclining in earnest. The ensuing drop ordinarily retraces all of the ground gained within the Wedge itself,and sometimes more. Trading volume in a Wedge tends to follow the regular Triangle Pattern, diminishinggradually as prices move up toward the apex of the Wedge.
The Falling Wedge
Except for the fact it is pointed down, the Falling Wedge appears in all respects like the rising form justdescribed, except the price trend that follows its completion differs in character. When prices break out ofa Rising Wedge, they usually fall away rapidly, but when they
Figure 10.28 In the caption to Figure 10.27, the editor asked, apparently rhetorically, why a rationalinvestor would own Lucent. The picture here shows what happens when apparently rational investors donot set a stop to protect themselves from irrational volatility. The market knows things investors do notknow, but it will reveal these things to the most basic of investors if he reads the chart. This chart is addedfor the ninth edition to pick up the picture where the eighth left off.
move out of a Falling Wedge, they are more apt to drift sideways or in a dull “Saucering-around”movement before they begin to rise. The Rising Wedge may, therefore, call for quick action to secureprofits, whereas with a Falling Wedge, the trader ordinarily can take his time about making hiscommitment for the ensuing rise.
Both types of wedges should be well defined on the chart. Unless a trend pattern is quite compact withfrequent fluctuations, nicely bounded by lines that clearly converge to a point, and their up (or down) slantis marked, the Wedge construction must be considered doubtful. You will find borderline cases in whichone of the pattern lines so nearly approaches the horizontal in direction that it resembles a Right-AngleTriangle, and the latter would carry quite different implications for future trend development. It is difficultto lay down any hard and fast rules for distinguishing the two. If one boundary line is nearly horizontal, orif the daily closing prices tend to fall at about the same level, then the formation is more safely construedas a Triangle. The reader need not let this problem worry him unduly, as he will rarely be left in doubt forlong after he has acquired a little experience with charts. One soon gets to recognize the characteristic“symptoms” of the different formations and make correct diagnoses almost instinctively.
Wedges on weekly and monthly charts
Most true Wedges are too short-lived (seldom longer than three months) to take on a recognizabledefinition on a monthly chart, but they may be spotted occasionally on the weeklies. Longcontinued, gradual downtrends, when plotted on arithmetic scale, sometimes assume the Wedgeform. Thus, an entire Major Bear Decline on any arithmetic monthly chart may appear like a giantFalling Wedge. This is due to the fact that the up and down fluctuations that compose the MajorSwing, while maintaining about the same extent in percentage, tend to shorten in terms of points(dollars) as prices move from higher to lower levels. Such Major chart patterns are not the trueWedges we have discussed herein. When plotted on semilogarithmic scale, these same moveswould normally show a Parallel or even slightly widening, instead of Converging, Channel.
Rising Wedges common in Bear Market Rallies
As a final note, we might add that the Rising Wedge is a quite characteristic pattern for Bear MarketRallies. It is so typical, in fact, that frequent appearance of Wedges at a time when, after anextensive decline, there is some question as to whether a new Bull Trend is in the making may betaken as evidence that the Primary Trend is still down. When a Major Bear Swing ends in a Head-and-Shoulders Bottom, the last Rising Wedge will often appear as prices rally from the left shoulderto the neckline and just before they break down to the head (final low). A Rising Wedge on anarithmetically scaled weekly chart is almost invariably a Bear Market phenomenon, expressing thediminishing vigor that is the normal property of any reaction against a prevailing Primary Trend.
The One-Day Reversal
We referred in Chapter 6 to a price pattern known as the One-Day Reversal. This particulartechnical Reversal indication, when taken alone, can be accorded only temporary or strong MinorTrend significance. True, it may appear at the very peak of a long advance, forming perhaps on thehigh day of the head in a Head-and-Shoulders Pattern, which will be followed by a long decline,but it can hardly be credited with forecasting that entire decline; all it really signaled was the turn inthe “head” itself. A One-Day Reversal may just as well occur, for example, at the beginning (thefirst peak) of a Symmetrical Triangle which only Consolidates instead of Reversing the previousuptrend. Even so, as you can see, it warns us of at least temporary exhaustion of Bullish forces.
On the downside, a One-Day Reversal often appears in magnified and conspicuous form at the endof a Panic Sell-Off, in which case it usually is referred to as a Climax Day or Selling Climax. Thismanifestation of it has special significance, which we shall take up later. First, however, just what isa One-Day Reversal?
To begin, it is a day of unusually high volume, exceeding, as a rule, by a notable margin any tradingturnover registered in any one-market session for the past several months. It comes after a fairlylong and steady advance (or a similar decline), on which activity has been increasing gradually.Prices push right ahead from the opening gong as if nothing could stop them. Frequently, even theopening sales are so far beyond the previous day's closing level as to leave a large gap on the chart.(We shall discuss gaps later.) The tape runs late and before the advance (or decline) halts, priceshave been carried as far in an hour or two as three or four days would ordinarily take them. But thehalt does come finally, maybe at the end of the first hour or perhaps not until late in the day. Then
quotations “churn,” registering only fractional changes to and fro, with the tape still “fast” andoften running late by spurts. Suddenly, the trend reverses and prices move just as rapidly in theopposite direction. The session ends with a final burst of activity that puts the price at the closeright back where it started the day. There has been an enormous amount of activity, and quotationsmay have traversed intraday a range of 2% or 3%, but the net change from the previous day at theend of trading is very small.
One-Day Reversals at Tops appear quite often in the charts of individual stocks that are thin(relatively small floating supply of shares), have had an active advance, and have attracted a largepublic following. They rarely develop in the Averages. Selling Climaxes (One-Day Reversals atBottoms), on the other hand, are found conspicuously in the Averages at the end of many abnormalor Panic Declines.
One-Day Reversals, as already stated, do not carry Major Trend implications. The nimble in-and-out trader can capitalize on them—maybe pick up several points if he has funds available andjumps in at the right moment. But, as a rule, the new trend (i.e., the trend at the close of the day)does not carry very far right away; prices usually “work” around in the nearby ranges for some timeand build some sort of area pattern before they move away in a swing of Intermediate proportions.The One-Day Reversal, as a phenomenon that occurs frequently within or at the start of morepregnant technical formations, gives an important clue to probable trend developments. In anyevent, it is an urgent warning to watch closely the chart in which it has appeared to see what patternof price action may follow and be prepared for the worthwhile move when it comes.
The type of false move or shakeout described in Chapter 8 as occurring at the apex end of aSymmetrical Triangle often takes the form of a One-Day Reversal.
The Selling Climax
In the “bad old days” when stocks could be bought by putting up as little as 10% of their cost incash and there were no restrictions on short selling, professional operators could (and tradition saysthey often did) organize Bear Raids to shake out weakly margined holdings. By selling short inquantity at a favorable moment when the “public” had gotten itself pretty well extended on the longside, they could break prices down. Brokers then would send out calls for more margin from their“long” accounts, many of whom could not or would not put it up, with the result of their stocksdumped on the market, which in turn produced further declines. The professionals could then stepin, cover their shorts with a profit, and secure a line of long stock for the next advance. Bear Raidsof this sort were effectively checked by the imposition of the Securities and Exchange Commission(SEC) regulations, but margin calls and forced selling will always exist as a market factor so longas stocks can be bought on margin and whenever prices drop extensively following a spree ofpublic buying.
Most true Selling Climaxes, if not all, have been produced by distress selling such as referred to inthe preceding paragraph. They have come at the end of rapid and comprehensive declines thatexhausted the margin reserves of many speculators and necessitated the dumping of their shares atwhatever the market would bring. This process is progressive—feeding upon itself, so to speak—with each wave of forced sales jeopardizing another lot of margined accounts, until, at last, millionsof shares are tossed overboard, willy-nilly, in a final cleanup. Such is a Selling Climax in which thetotal turnover may exceed any single day's volume during the previous upswing. It is a harvest time
for traders who, having avoided the Bullish infection at the top of the market, have funds in reserveto pick up stocks available at panic prices.
Obviously, a cleanout day or Selling Climax radically reverses the technical condition of themarket, for in its process, shares have passed from weak hands into strong hands at very muchlower prices. The ominous weight of potential selling that has been overhanging the market hasbeen removed. Usually, the Panic has carried quotations (although only temporarily, as a rule) wellbelow even conservative values based on current business conditions.
A Selling Climax need not be completed, and the Reversal of Trend actually becomes evident,within a single day. We have classified it as a variety of One-Day Reversal, but some of them haveactually spread out over two days, with the decline exhausted and coming to a halt late on the firstday, too near the end of the session to permit much recovery. The next day sees an extensive rallyright from the opening gong, as it is immediately apparent then, if not late on the preceding day,that there are no more distress offerings.
The all-time percentage record for Selling Climaxes is held by October 29, 1929. Prices in terms ofthe Dow-Jones Industrial Average opened that day practically at their high, 252.38, which was morethan 8 points below the previous day's closing level. Panic selling flooded the Exchange from thestart; before it was over, the Industrial Average had lost 40.05 points. From that low, 212.33, itrallied in the final two hours to 230.07 for a gain of nearly 18 points and went on up another 28points the following day. This 1929 climax set the alltime record also for daily turnover: 16,410,000shares were traded in those five hours, more than twice as many as in any one day during the entirepreceding Bull Market. But the low level of October 29 was broken a week later, and the bottom ofthat particular early phase of the 1929-1932 Bear Market was not reached until November 13. EN:See comments on the following page on the Reagan Crash of 1987.
The Panic of 1937 ended with a classic Selling Climax on October 19, another “Black Tuesday” instock market annals. The Dow Industrials had closed at 125.73 the night before; prices had alreadyfallen without a rally of consequence from a high of 190 in mid-August, and margin accounts werenearly all in a precarious situation. The telephones had worked overtime the preceding day bybrokers demanding additional margin, most of which was not forthcoming. When the Exchangeopened on the 19th, quotations hit the toboggan under a flood of offerings. By 11:30 a.m., with theIndustrial Average around 115, the selling was over and offerings disappeared. An hour later, priceswere jumping a point between sales and the day closed at 126.85, recovering its entire loss. Volumeon that climax was 7,290,000 shares, double that of any day at the top of the preceding BullMarket. An intraday high of 141.22 was reached 10 days later, but the Panic Low was subsequentlybroken on November 20, 1937, and that Bear Market finally ended at 98.95 (Dow-Jones Industrials'closing level) on March 31, 1938.
EN: No wonder investors have instinctual angst on October 19. In 1987, the Bear returned tocreate another great Panic—on the very same date. From a high of 2746.65 on August 25 the Dowbungeed to a low of 1,616.21 on October 20. The actual full-blown panic took place from October14 (high 2,485.15) to October 20 (low 1,616.21) with October 19 and 20 traversing a range of547.95 points or 25% of the market at that point. Top to bottom, 1130 points were lost, comprisinga retracement of 41%. The more things change the more they stay the same, as Andre Malraux issaid to have remarked. Actually, he said it in French, which is more elegant, and expresses the sameidea: Plus ga change, c'est plus la meme chose. Readers should not assume that similar crashes willnot occur in the future.
The foregoing were general market climaxes, a phenomenon that produces (or rather is producedby) simultaneous selling in practically every actively traded individual issue. A Climax Bottom, asa matter of fact, appears in an individual stock chart, as a rule, only as a concomitant of a generalmarket cleanout, although there are cases in which some particular and completely unexpectedpiece of bad news affects one certain company and causes panicky liquidation of its shares alone,terminating with a One-Day Reversal. The Top Reversal Day, on the other hand, is normally amanifestation of an individual stock rather than of the general market average.
The two outstanding examples of Selling Climaxes (cited above) and numbers of others that haveappeared at the conclusion of various Panic Sell-offs offered extraordinary opportunities for a quickturn to the trader who was smart (or lucky) enough to get in at the bottom. He could cash in a fewdays later with exceptional profits. Professional operators capitalize on such opportunities. Theproblem is to recognize the climactic nature of the selling in time to seize the chance—and that isnot as easy as it may have sounded in our discussion. Just to emphasize the possibilities of error,there was a 30-point drop, followed by a 30-point recovery, on a turnover of nearly 13 millionshares, on October 24, 1929, but the trader who did not grab his profits within 48 hours never hadanother chance to get out even (in terms of the Averages, that is).
But it is not impossible to recognize a Selling Climax, if you have friends in the Street to keep youinformed on the condition of margin accounts and the amount of necessitous selling to be expected.EN: This information is now not difficult to come by. It is easily obtainable in the general financialpress. The climax comes after a decline approaching Panic proportions. The day usually opens witha substantial Downside Gap (opening prices considerably below the previous night's closing);offerings appear too great to be absorbed; prices collapse; volume is extreme; the market isexceptionally “broad” with nearly every listed stock crowding into the record. Then, some timeafter 11:00 a.m., perhaps not until afternoon, the selling appears to dry up; a few issues continue todecline while others begin to climb. Suddenly prices are jumping, which is the time to act. Buy astock that has been thoroughly depressed but normally has a good following at all times (e.g., U.S.Steel). Do not hang on too long; take a reasonable profit as soon as it is available and sell, in anyevent, whenever the recovery shows signs of bogging down.
Remember, a One-Day Reversal is not a dependable Major Trend indicator. Selling Climaxes donot normally occur at the final Bottoms of Bear Markets—weak holdings usually have been shakenout long before that stage is reached. Only one Primary Downtrend in all the record has, in fact,ended with the first Panic Phase, that being the five-month Bear Market of 1938-1939 that wasfollowed by an equally short Bull Market.
Occasionally, a weekly chart will produce a formation that might be called a “One-Week Reversal,”in some such conspicuous fashion as is shown above in “NC.” In this instance, the subsequent riseproves that a Major change in its technical balance occurred in December 1941. Curiously enough,no other obvious Reversal Pattern appeared on the weekly chart at this turn in the Primary Trend of“NC.” (Its daily chart showed an Ascending Triangle.) But this example of a One-Week Reversal isnot shown to give the idea that such phenomena carry important technical indications. On thecontrary, most “Reversal weeks” are followed by very disappointing moves.
One remaining Reversal Formation, the Island Pattern, involves the whole subject of Gaps, whichwill be taken up in detail in Chapter 12; thus, we will defer our discussion of the Island Reversaluntil then.
Short-term phenomena of potential importance
Very short-term phenomena—of a one-day or a few days' duration—can sometimes be indicative ofnot only short-term direction, but also give hints as to long-term price behavior. Gaps (see Chapter12) and One-Day Reversals (this Chapter) belong to this group. Other short-term patterns of interestinclude Spikes, Key Reversal Days (sometimes merely called Reversal Days), and Runaway Days(sometimes called Wide-Ranging Days).
Spikes
On the day it occurs, a Spike is not immediately identifiable for by definition it protrudes Head-and-Shoulders above days before and after if it is at or near a Top and plunges much below thesurrounding days if it occurs at a Bottom. So after a day that exhibits an unusually wide range, thesubsequent days must be observed to discriminate the day from a Runaway Day. Both are the marksof a far-ranging battle between Bulls and Bears, with the close giving a clue as to whom theeventual winner will be.
The importance of the spike is highlighted by the following:
1. The strength and length of the action that preceded it.
2. The close of the day, whether up on a Bottom or down on a Top.
3. Its prominence when compared with the days before and after it.
An extremely wide-range day at the end of a long Bull move that closes down after making unusualnew highs might even be construed as a one-day signal. Whether one trades on it or not woulddepend on his particular style and taste and the nature of his trading—long range, scalping, and soon. In fact, the Spike might also be a One-Day Reversal—that pattern in which an opening gapoften is followed by avid buying that collapses and closes below the opening or at the low of theday. Such action might be compared with an army pursuing a seemingly defeated enemy only todiscover the retreat was a ruse, then turning and fleeing the other way in a rout.
Turn this description on its head and you have a Spike Bottom. It is not infrequent that a Spike willbe followed by significant price movement in the opposite direction. Figure 10.23 illustrates amodern Spike. Figures 1.1 and 7.16 show some spikes on Edwards' and Magee's charts.
Runaway Days
A Runaway Day is a day that stands out on the chart as having an unusually long range, oftenopening at the low and closing at the high, or vice versa for Bear runaways. Here the enemy hasretreated precipitously, or treacherously, to draw the Bulls into a trap. The holders and sellerscannot or will not satisfy the eager demand of the buyers and so the price transverses perhaps twoto three times the daily range. Although the agile speculator may jump on this charging train andrealize a nice scalp, it is the following days that reveal the true significance. Nice consolidation andcontinued volume will confirm the day as significant while a tapering of volume and rounding orvolatile pullback will call into question its validity. Although these days may be taken as hair-trigger buy signals (or sell signals, depending) the return of prices to the low of the Runaway Day
will probably indicate the day was a false signal and a trade in the opposite direction is shaping up.See Figure 7.20 for runaways complete with gaps.
One such example is shown in Figure 10.24 in which a bull trap precipitated by a Runaway Daywith a subsequent collapse foretold the 50% decline in Microsoft stock in 2000.
Key Reversal Days
The Key Reversal Day pattern occurs when one sees a new high in an up-move and then a closebelow the close of the previous day. As a short-term trading signal it has much to recommend it, butlike every other technical pattern, judgment and timing are required to profit from it. In a BullMarket, there will be some if not many such interim highs marked by Key Reversal Days. On theKey Reversal Day at a major or important Top, the trader shorts the stock on the close with a stop atthe high of the reversal day, or slightly above. He may then exit on the profit side on the occurrenceof a Key Reversal Day in the opposite direction, or on a profit target, or a chart pattern. Ifadventurous, he may use the trade as the first of accumulating a position for an anticipated BearMarket, adding other positions as more significant patterns occur and as support levels are broken.
This pattern also is useful in trading range markets, as shown in some internet stocks from 2000,where trading with Key Reversal Days would have allowed the trader to escape unscathed in theminicrash of the NASDAQ in early 2000 (see Figures 10.25 and 10.27 for eBay and Lucent.)
Of all the Very Short-Term Patterns, Gaps, One-Day Reversals, Key Reversal Days, Spikes, andRunaway Days, it should be noted that the return of prices to the origination of the formation marksthe formation as a false signal and a reason to reverse the trade direction and look for significantprofits.
Clearly, these are the tactics of scalpers and speculators, but it profits the long-term investor toknow and understand them.
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter eleven
Consolidation Formations
An army, which has pushed forward too rapidly, penetrated far into enemy territory, sufferedcasualties, and outrun its supplies, must halt eventually, perhaps retreat a bit to a more easilydefended position and dig in, bring up replacements, and establish a strong base from which later tolaunch a new attack. In the military parlance with which we have all become more or less familiarthese past few years, that process is known as consolidating one's gains. Although it will not do tooverwork the analogy, there is much in the action of the stock market that may be compared to amilitary campaign. When a stock pushes ahead (up or down) too fast, it reaches a point at which theforces that produced its move are exhausted. Then it either reverses its trend (in a Major orIntermediate sense), reacts to a good Support Level, or Consolidates its position, in some sort of“sideways” chart pattern composed of Minor Fluctuations, until it has caught up with itself, so tospeak, and is ready to go on again. (For illustrations in this chapter, see Figures 11.1 through 11.18.)
We already have had occasion to refer to Consolidation Formations in our study of SymmetricalTriangles and Rectangles; exactly how those two chart formations might either reverse the previoustrend or Consolidate it in preparation for its continuation were shown. We noted about three out offour Symmetrical Triangles will turn out to be Consolidations rather than Reversals—andRectangles in about the same proportion. Even a Flat-Topped Broadening Pattern constructed at theTop of an Intermediate Advance may, despite its normally Bearish implications, be converted into aConsolidation or Continuation Formation if its Flat Top is decisively penetrated on the upside.
A Dow Theory Line in the chart of one of the Averages may be a Consolidation or ReversalFormation, but is rather more likely to be the former than the latter. A Dow Line is, of course, a sortof loose Rectangle. The fact is almost any sort of sideways price pattern, such as is often termed a“Congestion” or trading area, provided trading volume tends to diminish during its construction(and provided it does not show definite broadening tendencies), usually functions as aConsolidation. But most areas of Trend Consolidation are fairly well defined, taking on arecognizable pattern.
Flags and Pennants
We do not need to spend more time here on the Triangles and Rectangles; they have been examinedin both their Reversal and Consolidation manifestations in previous chapters. Our first twoformations, which are characteristic of Consolidation only, are the Flags and Pennants, which arecuriously related in certain aspects to Triangles, Rectangles, and Wedges.
A Flag looks like a flag on the chart. That is, it does if it appears in an uptrend; the picture isnaturally turned upside down in a downtrend. It might be described as a small, compactparallelogram of price fluctuations, or a tilted Rectangle that slopes back moderately against theprevailing trend. Let us consider the Uptrend Flag first. It usually forms after a rapid and fairlyextensive advance that produces a nearly vertical, or at least quite steep price track on the charts.On such moves, volume normally shows a progressive increase until it reaches a high rate. Thisvolume (since every transaction signifies a sale as well as
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Figure 11.1 This is a typical and practically perfect Flag, constructed May 12 to June 2, 1945, inMartin-Parry. Daily turnover diminished to a low rate as prices settled down for exactly three weeksafter their swift advance from 11 to 16 1/2 but held up away from the lower boundary line duringthe third week, and then burst out topside with high volume in another straight-line push from 15 to21. Study this chart again when you come to the Flag-measuring formula later in this chapter. Thedashes at 12 indicate the upper range of an old Resistance Level (see Chapter 13).
a purchase) is a warning that many holders of the stock are taking profits. Eventually the pressureof profit-taking halts the markup. Prices “churn” without further gain and then react 2 or 3 pointson reduced turnover. A new rally occurs but fails to equal the previous high or attain the previoustop volume. Another reaction carries quotations slightly below the preceding Bottom with further
diminution of activity and then follows a series of similar Minor Fluctuations, each of whose Topsand Bottoms are successively a trifle lower than its predecessor, and with volume shrinkingmarkedly and constantly as the pattern develops. On the chart, the initial, steep up-move followedby the compact, sideways, and slightly down-sloping price Congestion Area, which can be roughlybounded, top and bottom, by parallel lines, takes on the appearance of a mast (or halyard) with aflag flying from its peak, hence, the name of the formation.
Sometimes each rally and setback within the Flag takes three or four days, rarely more. In othercases, prices will skip back and forth between the upper and lower Flag boundaries in a single dayor two, in which event the pattern on the chart consists of an almost solid block of price range lines.The wider the pattern (from top to bottom) the longer time,
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Figure 11.2 Another typical Flag of three weeks' duration, August 30 to September 18. ThisNational Gypsum chart overlaps that in Figure 8.6, showing the false move at the apex of the May-June Symmetrical Triangle. A buy signal was given when prices pushed up through the old apexlevel on August 23 with increased volume. Most interesting is the second Symmetrical Triangle thatformed in October-November, an almost exact replica of the first, but with a downside false moveat its apex. The sharp increase in volume on November 27 left no doubt as to its being aConsolidation rather than Reversal Pattern. “NG” went on up to 33.
naturally, it should take for each swing within it to be completed. This process of MinorFluctuations may continue for only five days to a week if the Flag is narrow, or it can go on for aslong as three weeks. Daily turnover by that time usually will have shrunk to a relatively low ebb.Then, suddenly, prices will erupt with a new burst of activity from the end of the Flag and pushstraight up again in another advance that practically duplicates the original “mast” atop which theFlag was constructed.
We have spoken of the Flag pattern as being moderately down-slanting, but the very short and“solid” ones will frequently develop horizontally and look like small squares. (On rare occasions, apattern of the Flag type in an uptrend will even slope up a trifle.)
Flags form on steep down moves in much the same manner and with precisely the sameimplications as they do in uptrends. Down Flags, of course, tend to slope up—that is, they simplyinvert the picture presented by an Up Flag. Trading volume diminishes during their formation andincreases again as prices break down away from them.
The Pennant: a pointed Flag
The only important difference between a Pennant and a Flag is the former is bounded byconverging boundary lines rather than parallel lines. The normal Pennant, in other words, is a small,compact, sloping Triangle. It slants down when it appears in an uptrend, and it
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Figure 11.3 Flags of the “Half-Mast” type appear most often in the later and most active stages of aPrimary Advance. The above example (January) was the last Consolidation Formation before“NK's” 1937 Bull Market Top. Note the Rectangle Reversal Pattern in March and the series of step-down patterns that followed.
slants up in a downtrend. It forms, as a rule, after a rapid advance (or decline), and trading volumeshrinks notably during its construction. In fact, activity tends to diminish even more rapidly in aPennant than in a Flag (which we naturally would expect on account of the progressively shorterfluctuations that compose it), and it may drop almost to nothing before the Pennant is completedand prices break away from it in a new and rapid move.
The Pennant might also be described as a short, compact Wedge, characterized by markeddiminution of activity. When, as is usual, it slants back against the preceding trend, its forecastingimplications are similar to those of the Wedge, in that prices break out of it in a direction oppositeto its slant. But there are rarer Minor variations of the Pennant, comparable with those sometimesfound in the Flag, in which the price area is very short and “solid” and practically horizontal (like aSymmetrical Triangle), or in which the slope is actually slightly in the same direction as thepreceding trend instead of against it. When prices move out of the last-named type, they ordinarilydo so, not in a sudden straight-line breakaway, but rather in an accelerating curve with volumeincreasing gradually instead of abruptly at the break; the whole pattern resembles a curved horn thatruns to a long, slender point. Do not let these variations worry you; there is nothing deceptive abouttheir appearance; their kinship to the more common, normal form is quite apparent.
The measuring formula
The same approximate measuring formula applies to the Pennant as to the Flag. They are both“Half-Mast” Patterns that ordinarily form after a fairly steady and rapid (steep) price movement. Inapplying the measuring rule, go back to the beginning of that immediately preceding move, to thepoint at which it broke away from a previous Consolidation or
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Figure 11.4 Sometimes a stock will make a long series of small Consolidation Patterns in itsuptrend, one following right on the heels of another as successive groups of traders buy in whileothers take their profits on previous purchases. In this sequence of step-ups in Vanadium, the FlagPattern formed in January 1937 ran a few days over, but the volume breakout of February 4 left nodoubt the trend was still up. A final Top was made at 39 1/2 in March. Note the strong buy signalgiven on December 14. Refer to this record again in connection with Support and Resistancestudies in Chapter 13.
Reversal Formation (or through a significant trendline or Resistance Level, with which laterchapters are concerned), a point recognizable as a rule by a quick spurt in activity, and measurefrom there to the Minor Reversal level at which the Flag or Pennant started to form. Then measurethe same distance from the point at which prices break out of the Flag or Pennant, and in the samedirection. The level thus arrived at is the minimum expectation of this type of ConsolidationPattern. As a matter of fact, advances from Flags
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Figure 11.5 A Bull Flag in February and a Bear Flag in April 1936, in Briggs. The Top betweenwas a Symmetrical Triangle. April 30 was a Reversal Day. Prices recovered to 64 1/2 in November1936, making there a long-term Major Double Top with this March high. The Support-ResistanceZone at 51-53, indicated by dashed line, was still effective in 1946 (see Chapter 13).
or Pennants in an uptrend generally go farther (in terms of points or dollars) than the precedingmove, whereas declines may not carry quite so far. Hence, the formula is best applied on asemilogarithmic chart by measuring actual chart distance rather than by counting points. You cancheck this by referring to the examples illustrating this study.
Reliability of Flags and Pennants
These pretty little patterns of Consolidation are justly regarded as among the most dependable ofchart formations, both as to directional and measuring indications. They do fail occasionally, butalmost never without giving warning before the pattern itself is completed. All that is necessary toguard against such failures is to strictly apply the tests as to the authenticity of the patternincorporated in their description. These are as follows:
1. The Consolidation (Flag or Pennant) should occur after a “straight-line” move.
2. Activity should diminish appreciably and constantly during the pattern's construction andcontinue to decline until prices break away from it.
3. Prices should break away (in the expected direction) in not more than four weeks. A patternof this type that extends beyond three weeks should be watched with suspicion.
The matter of practical trading on these particular formations will be taken up in Section II of thisbook, which is devoted to tactics. Our second test deserves some further
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Figure 11.6 The down-sloping, Converging Price Formation of November 4 through December 9might be called either a short Wedge or a Pennant. Note the small Flag in October; also RunawayGaps November 4 and February 19, and the Breakout Gap December 10.
comment here though. If a pattern begins to develop on the chart—which, so far as the price picturealone is concerned, qualifies as a Flag or Pennant, but during which trading volume remains high orobviously irregular instead of diminishing—then the outcome is more apt to be a quick reactionagainst, rather than continuation of, the previous trend. In other words, such high or irregularactivity formations are characteristically Minor Reversal Areas rather than true Consolidations.Watch the volume half of your chart at all times.
Where they may be expected
Flag and Pennant Consolidations are characteristic of fast moves. Therefore, they show up mostfrequently in the later, dynamic phase of Bull Markets, after the first accumulation and the moreorderly early markup stages have passed. Hence, the appearance of these patterns may be taken as awarning that an advance is approaching its final weeks. The rapid phase of a Major Bear Trend, onthe other hand, is its second stage, often characterized by almost “vertical” Panic Declines. TheFlags and Pennants that develop therein are usually short— completed in a matter of three or fourdays rather than weeks. In the late months of a Bear Market, formations that evolve on the charts inthe Flag or Pennant similitude often will run too long (four weeks or more), begin to show anincrease in volume on the rallies, and be succeeded by only dull and limited reactions.
Figure 11.7 An example (in June 1944) of the brief and compact type of price “Congestion” thatcan be classed as a Flag. The advance here started at 5 from a 13-month Symmetrical Triangle ofwhich only the last two months appear above. The measuring implication of this tiny Flag was notfulfilled until after prices had undergone a sort of Triangular Consolidation in July.
In general, it may be said these particular chart patterns are most common (and most dependable) inuptrends. The appearance, after a Major Decline, of price pictures that, at the start, assume thedowntrend Flag or Pennant form must be regarded with caution. Unless such developments holdstrictly to the limitations we have stated above under the heading of “reliability,” do not trade onthem.
Flag pictures on weekly and monthly charts
One of our requisites for a dependable Flag (or Pennant) was it should not take more than fourweeks to complete its pattern and break out in a new move. It stands to reason, therefore, that a true
Flag cannot show up at all on a monthly chart and barely appears on a weekly chart. You will findprice areas on long-range charts, patterns that have taken 8 or 10 weeks to as many months,sometimes a year or two, in their construction, which assume the shape of a Flag, but do not expectthem to function as Flags. Examined in detail on a daily chart, these same long areas almost alwayswill be found to contain price formations having entirely different significance. Frequently, what isreally a Major Reversal Area following a long, rapid advance will look something like a Flag whenit is condensed on a monthly chart. So, do not trust such pictures on long-range charts; do not takeit for granted that they represent Consolidation for a new rise; find out what the detailed dailyplotting for the same period says.
The July-August Flag ran for five weeks—too long to be trusted without additional technicalevidence (see point 3 under “Reliability of Flags and Pennants”). The danger in
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MULLINS MANUFACTURING B MNS
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MAY
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Figure 11.8 Another example of the series of Flag-type Consolidations that may form in a rapid,third-phase Bull Market Advance. Mullins went from 15 to above 39 in six months in 1936,dropped back to 31, and then rose again in March 1, 1937, to its previous high, making a MajorDouble Top. (Note that “MNS” was split 2-for-1 in 1937.)
such prolonged formations is either when the breakout finally appears it will fail to follow through,or prices will keep drifting right on down. For the moment—on August 25—it looked as thoughthis Flag had “gone stale,” but when prices rose above the previous high on August 27, with a smartpickup in volume, purchases were obviously safe.
Rectangular Consolidations: an early phase phenomenon
In contrast with Flags and Pennants, which are typically last-stage Bull Market Concomitants,Consolidations of the Rectangle class are found more often in the earlier phases of Bull Trendevolution. In Major Bear Moves, Rectangles may develop in the first stage just before a PanicDecline, or in the last stage preceding a strictly limited final sell-off. The latter manifestationpresumably betokens premature accumulation by interests who feel that prices have already gonelow enough to suit their purposes. (They come out all right, if they are able to hold on through theremainder of the Bear Swing and long enough for the next Bull Market to put prices back up againto profitable levels.)
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WYANDOTTE WORSTED WYO
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JANUARY FEBRUARY ----- ______ _____
^22'29 5 112'19^6 2 1 9*16'23 2 1 9 )16l23l30 6 ‘13 l20T2^rTr11 t18l29 1 1 8 1151
Figure 11.9 The vertical lines marked “M” show how the measuring formula is applied to a FlagPattern. Note the first measurement is taken from the level at which the mast leaves the previous“Congestion” up to the peak of the Flag. This same distance is then measured up from the Flagbreakout. In “WYO,” the formula worked out exactly. Trading commitments should normally have
been cashed in above 36 on this move. They might then have been reinstated when it becameapparent by April 2 that a Rounding Bottom was completed (note volume) for a new advance.
Head-and-Shoulders Consolidations
All our references to the Head-and-Shoulders Formations up to this point (see Chapters 6 and 7)have considered that pattern as typifying a Reversal of Trend, and, in its normal and commonmanifestation, that is most definitely the Head-and-Shoulders function. But, occasionally, priceswill go through a series of fluctuations that construct a sort of inverted Head-and-Shoulders picture,which in turn leads to continuation of the previous trend.
There is no danger of confusing such Continuation or Consolidation Formations with regular Head-and-Shoulders Reversals because, as stated, they are inverted or abnormal with respect to thedirection of the price trend before their appearance. In other words, one of the patterns thatdevelops in a rising market will take the form of a Head-and-Shoulders Bottom. Those that appearin decline assume the appearance of a Head-and-Shoulders Top. By the time these price formationsare completed (left shoulder, head, and right shoulder evident), there is no question as to theirimplications. But at the head stage, before the right shoulder is constructed, there may be—usuallyis—considerable doubt as to what really is going on.
AMERICAN WOOLEN
WY
1946
44 **
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Figure 11.10 A 1946 chart that delighted technicians contains a perfect “Half-Mast” Pattern inJanuary, with measuring gaps (G, G) above and below it; a downside Flag in early February (checkmeasurement); a fine Ascending Triangle at the bottom of this reaction with a Throwback in April,giving an ideal “buy spot.”
The volume pattern in Consolidations of this type does not follow the rule for Reversal Head andShoulders. In a downtrend, for example, the Consolidation Formation resembled in its price contoura Head-and-Shoulders Top, but the attendant volume will diminish instead of increase on the leftshoulder and head as well as on the right shoulder. The same holds true for the “Bottom” Patternsthat develop as Consolidation in an advance market; however, Breakouts resemble, in all respects,those arising from Reversal Formations.
Head-and-Shoulders Consolidations of the Complex or Multiple type seldom appear on the charts.Theoretically, they might and should be as easy for the chart technician to handle as the simpleforms.
The formula for determining the probable minimum price move (beyond the neckline) from aHead-and-Shoulders Reversal Formation was discussed in Chapter 6. To anyone familiar with theverities of stock market trends and the endless variety of pictures that the charts can present, it isamazing how accurately that formula works out and how often the first consequential move awayfrom a Head-and-Shoulders Top or Bottom will carry through to the point (or a little beyond)implied by the measurement of the formation. But, the same formula applied to ConsolidationPatterns of the Head-and-Shoulders form does not work out as well. Such patterns are usually quite“flat,” and the ensuing move generally
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Figure 11.11 MO. Talk about your technician's delights. Altria Group throws off some pretty gooddelights here: a breakaway gap and run days to the downside, a down flagpole with flag, andpattern gaps. But they are good pattern gaps and really interesting. Then a triangle complete with abreakaway and an up flagpole with flag. The non-technician probably is suffering from nausea atthis point. It is a roller coaster that bodes ill for everyone. Additionally note a completely tradablesituation for the alert short-term technician.
extends well beyond the measurement implied thereby, although, in some cases, it may not go quiteas far. Consequently, the Head-and-Shoulders formula cannot be applied to Consolidation Areaswith the assurance that it sets up a definite and dependable objective; one has to look, in thesecases, to a variety of other chart indications to appraise the probable proportions of the move tofollow.
Scallops: repeated Saucers
Our next chart picture differs from the Consolidation Formations previously discussed, in that itdoes not constitute a more or less definite area of Congestion or fluctuation to which one or morecritical boundary lines can be affixed. We could, perhaps, take it up as well in a subsequent chapterunder the general heading of normal trend action. Yet it is a pattern so characteristic of certain typesof stocks and certain types of markets, and so nearly related to the principle of Consolidation forfurther advance, that it may be better treated here.
When a stock for which there is a large number of shares outstanding, and for which there is, at alltimes, a fairly active and “close” market emerges from a long-time Bottom (as exemplified by thepast history of Radio Corporation and Socony-Vacuum), which will often make a long MajorAdvance in a series of “Saucers.” These successive patterns, each of which resembles, in both priceand volume action, the Reversal Formation described in Chapter 7 as a Rounding Bottom, areslightly uptilted, that is, the rising end always carries the price a little higher than the preceding Topat the beginning of the Saucer. The net gain accomplished by each Saucering movement will varyfrom stock to stock, but there seems
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Figure 11.12 A Flag (end of November) that seemed for several weeks to have failed completely.Prices, however, rose quickly to 36 1/4 from their December 23 low, thus finally carrying throughaccording to formula. Note the Flat-Topped Broadening Formation that started the move.
to be a strong tendency for it to amount to about 10%-15% of the price of the issue. The totalreaction from the left-hand lip of each Saucer to its Bottom level is usually a little greater, from20% to 30%, and the length (duration) of the Saucers is normally five to seven weeks, rarely lessthan three. Thus, the overall advance is slow but steady, in much the same sense as the progress ofthe man who eventually got out of the deep well by climbing three steps for each two that heslipped back.
The charts of stocks that take this sort of course show a picture of strikingly similar andsymmetrical Rising Scallops, one succeeding another with little or no pause between. Tradingactivity runs up to a peak at the latter stage of each Scallop, as the previous high is approached andexceeded, then diminishes into dullness as prices curve down and flatten out at the Bottom of thenext Saucer, picking up again as prices curve up into their next rise.
The trading opportunities afforded by stocks of the Saucering habit hardly require extendedcomment (although we shall set down some detailed specifications in Section II of this book). TheBottom level of each Scallop is usually easy to detect by watching price trend and volume, and so isthe topping out at the end. Yet it is curiously a fact that most “tape watchers” handle such stocks inthe wrong way, becoming interested in them and buying when they show activity (“make a newhigh on volume”) and neglecting them entirely when they are in the dull, rounding-out stage oftheir trends.
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1936
(ULY
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Figure 11.13 Typical of the form that Head-and-Shoulders Consolidation Patterns may take, bothas to price pattern and volume, was this development in Anaconda. Measuring formula for the smallFlag in October should be applied from the point of breakout through the Head-and-Shouldersneckline.
Figure 11.14 A 1945 Head-and-Shoulders Consolidation in which both of the shoulders and thehead took a “Saucer” form. Compare price and volume trends. Prices advanced to 31 1/2 in July,came back again to 25 1/2 in August, and then shot up to 40 in November.
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1945
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Figure 11.15 Part of a genuine “Scallop” uptrend, typical except for the short duration andrelatively small decline in the October Saucer. The next Scallop, which started in December,dropped prices back to 12 1/2 in January, and then carried them to 18 1/2 in February. A four-monthSaucer, from February 1945 to June, preceded this chart. Note the position traders found themselvesin if they bought at 9 on the “new high volume” in June.
COMMONWEALTH EDISON CWE
1945
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7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1 8 15 22 29
Figure 11.16 Although the Scalloping habit characteristically appears in low-priced issues, it issometimes found in widely held, semi-investment stocks of medium price, such as “CWE.”
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INTERNATIONAL TEL. & TEL. IT
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JANUARY FEBRUARY MARCH
APRIL
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Figure 11.17 This chart shows the last five months of a broad, 13-month Saucer-like Consolidationin “IT,” which followed its rapid run up from 3 to 16 in late 1943 and early 1944. “IT” is an erraticactor, and its volume is apt to be particularly deceptive in day-to-day movements. Major PricePatterns in it, however, are dependable. This final phase of its long Consolidation (distribution andre-accumulation) first took the form of a Rectangle (with a premature breakout) and then anAscending Triangle. Its 1945-1946 Bull Market Top was a massive Head-and-Shoulders.
Many boardroom tape watchers scorn charts with unfortunate consequences to their capital in thelong run. Genuinely expert tape readers—those who are able to show fairly consistent profits intheir trades—are really extremely rare. (EN: For “tape readers” substitute “day traders,” 99% ofwhom are unsuccessful.) When you do meet such an individual, you will find that he either, ineffect, “carries charts in his head” or else takes a careful look at the record before he buys on aticker showing activity.
As a stock with the Scalloping habit finally works up in price to 15 or so, its pattern tends tobecome less regular; it begins to depart from the smooth, narrow Saucer-like curve of the lowerlevels. Above 20, it is apt to break away entirely from the Scallop sequence and produce, from thereon, more rapid straight-line advances, interspersed with sharp reactions and standard types ofConsolidation Formations, which are characteristic at all times of medium- and high-priced issues.(There are exceptions: some high-priced preferred stocks for which there is always a market, butwhose trends depend almost entirely on the gradual changes in prevailing interest rates and supplyof funds for investment, have a persistent Scallop habit in their Primary Upswings.)
We have named rather specific price levels (15 and 20) in the preceding paragraph, but price is notthe sole factor determining the departure of a stock from a Scallop Trend. The only safe assumptionis that, once such a habit is detectable, it will be continued until the chart shows a definitedivergence from it, and such divergence usually takes first the form
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Figure 11.18 There are times when a Consolidation Pattern gives the only good technical signalthat a Reversal in an issue's Primary Trend has actually taken place. Although cases of a MajorTurn, particularly a Bottom, without some sort of recognizable Reversal Formation on the chart arequite rare, they do occur. This weekly chart of Flintkote illustrates such a phenomenon. A BearMarket low, from which it rose to 47 in 1946, was made at 8 5/8 in December 1941. Withoutdeveloping any important technical foundation on either a daily or weekly chart, its first upswingtook it to 11 7/8 the following April. From that point, it went into a six-month Symmetrical Triangleand then broke out topside at the three-quarters stage on increased volume. This action, plus the factit immediately thereafter burst up through an old and highly significant Resistance Level at 12, wassufficient to mark it as being in at least a strong Intermediate if not a full Primary Uptrend. Thecombination of technical developments illustrated in this chart—a large Consolidation Patternforming just under a Major Resistance and then a breakout upside from both—is something towatch for when it appears a Reversal from a Bear to Bull Trend is due. Resistance Levels will bediscussed in Chapter 13.
of a greater-than-wanted advance arising at the end of one of the Saucers. Consequently, if youhave previously taken a position in it at a favorable point (near the Bottom of a Scallop), you willunlikely be hurt when the stock finally alters its action.
Very low-priced issues may persist in a Scalloping Trend right up to their Major Bull Tops, andeven attempt another Saucer Movement following what turns out to have been the final high, whichattempt then fails to carry out the previous successively higher and higher pattern. Such failures arenot difficult to detect; the change from the previous pattern appears before any appreciable damageis done to a properly assumed commitment.
Modern versus old-style markets
We have mentioned in our discussion of Reversal Formations that some of them have appeared lessfrequently in the charts of the 1960s than they did in prior years, and others more frequently. Thesame is true of Consolidation Formations. Patterns of the compact, strictly defined sort such asRectangles and Right-Angle Triangles are less common now. Symmetrical Triangles are apt to besomewhat looser than they were in the 1920s and 1930s—not as clean-cut and conspicuous on thecharts. Typical profit-taking patterns such as Flags and Pennants seem to be as common as ever,whereas “normal” trend pictures, including those formations associated with normal trenddevelopment (such as Head-and-Shoulders, Rounding Turns, and so on), are more common.
The reasons for these changes are fairly apparent; Securities and Exchange Commission (SEC)regulations, higher margin requirements, greater public sophistication, and a more conservative—we might better say more pessimistic—approach to the problems of investment and stock tradinggenerally have all played a part in this evolution. SEC and Stock Exchange vigilance have doneaway with the flagrant pool manipulations designed to take advantage of the “lambs” of formeryears. Nowadays, there is even very little of the more “legitimate” sort of syndicate operationplanned to facilitate large-scale accumulation or distribution.
It is still possible for “insiders” to hold back for a limited time, or to prematurely releaseannouncements of good or bad portent with regard to the affairs of a particular corporation to servetheir personal strategic purposes. But the stock purchase and sales of officers, directors, andprincipal owners are now too closely watched to allow a great deal of “skullduggery.”(Nevertheless, the average investor had better still be a trifle skeptical as to the probability of anygreat advance in the market following publication of a good report.) Collusion between investmentadvisory services and trading pools has been effectively outlawed. (It is safe to say it never did existas flagrantly, even in the 1920s, as many amateur traders seem to think.) The SEC (with thethorough cooperation of the Stock Exchange) polices the investment counsel profession thoroughly,constantly, and most effectively. No well-established investment counsel can afford to indulge indeceptive or collusive practices even if the desire were there. Most professionals go far beyond themost reasonable needs to safeguard themselves against any contacts that, however innocent oruseful, might be viewed with suspicion.
The old-time “plunger” has not disappeared entirely, but high margins and regulations preventing“Bear Raiding” have made present-day stock markets relatively difficult and unprofitable for him.The out-and-out boardroom gamblers (EN: day traders rushing to and fro probably exacerbatesdaily volatility) still come in, although high margins have cramped them too. In recent years, theyhave appeared in numbers only in the final stages of Bull Markets. (EN: Note the day-trading crazethat infected the markets in the late 1990s.) Their operations never did affect the charts muchexcept to augment activity.
On the other hand, higher taxes and greater regulation have most certainly not provided safer,closer, or more stable markets for the small investor. Higher margins have not prevented Panic
Collapses. If anything, markets have been “thinner” on the downside, more vulnerable to rapid anddrastic decline than they were before modern regulation. We still have the very same sort of Bulland Bear Markets, and much the same sort of market trend development as 50 years ago. Thesurprising thing is not that a few types of chart patterns that were, on occasion, produced byunregulated trading are now less common, but rather that the great majority of technical phenomenahave been practically unaffected. The chart student of 1907 would be quite at home with the chartsof 1966. (EN: And with those
Chapter eleven: Consolidation Formations 169 of 2000. That is why so little change has beennecessary to bring Edwards' classic account current to the third millennium. EN9: A note to a note.Pools and manipulators disappear and are replaced by some new pernicious form of skullduggery.Specialists and market makers are hauled before the bar of justice for cheating. In the twenty-firstcentury, hedge funds proliferate like rabbits in Australia. For any exacerbation of volatility theycause, they probably make up for in additional market liquidity. The same patterns keep appearingbecause, computers to the contrary notwithstanding, humans are eventually responsible for pullingthe trigger. It does seem that frequently patterns are not so neat as they were “in the old days.”Trendlines, especially horizontal lines, seem to be more “zones” than hard and fast lines and morejudgment might be necessary in interpretation. But everything that Edwards says here might havebeen written in 2005 instead of in the mid-twentieth century.)
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter twelve
Gaps
A gap, in the language of the chart technician, represents a price range at which (at the time itoccurred) no shares changed hands. This is a useful concept to keep in mind because it helps toexplain some of their technical consequences, which are illustrated in Figures 12.1 through 12.13.
Gaps on daily charts are produced when the lowest price at which a certain stock is traded on anyone day is higher than the highest price at which it was traded on the preceding day. When theranges of any two such days are plotted, they will not overlap or touch the same horizontal level onthe chart; there will be a price gap between them. For a gap to develop on a weekly chart, it isnecessary for the lowest price recorded at any time in one week be higher than the highest recordedduring any day of the preceding week. This can and does happen, of course, but for obvious reasonsnot as often as daily gaps. Monthly chart gaps are rare in actively traded issues; their occurrence is
confined almost entirely to those few instances in which a Panic Decline commences just before theend of a month and continues through the first part of the succeeding month.
Which gaps are significant?
From the earliest days of stock charting, gaps attracted attention. These “holes” in theprice trend graph were conspicuous. It was only natural that observers should attachimportance to them and should try to assign some special significance to theiroccurrence. But the result was unfortunate, for there soon accumulated a welter of“rules” for their interpretation, some of which have acquired an almost religious forceand are cited by the superficial chart reader with little understanding as to why theywork when they work (and, as is always the case with any superstition, an utterdisregard of those instances where they do not work). We refer to this situation asunfortunate not so much because the gap “rules” are wrong, but rather because theirblind acceptance has barred the way to a real understanding of a gap's implications andthe establishment of a more logical basis for its uses in trading.
The most common superstition is that “a gap must be closed.” Sometimes it is statedmore cautiously in such words as follows: “If a gap is not closed in three days, it willbe closed in three weeks, and if it is not closed in three weeks, it will be closed in threemonths, etc.” There are numerous variations, but they all add up to the belief that a gapmust be closed and the trend is not to be trusted until the gap has been covered. It is thelatter inference that leads to error.
Closing the gap
But first, what is meant by “closing” or “covering” a gap? Suppose a stock in anAdvancing Trend moves up day after day, from 20 to 21, 22, 23, 24, and closes onenight at the top of its range for that day, at 25. The next morning it opens at 26 andkeeps right on moving up from there. This action leaves a 1-point gap, between 25 and26, on the chart. Then suppose the rise continues to 28, halts there and is followed by areaction in the course of which prices
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Figure 12.1 The April-June Rectangle on this 1945 chart of "AW" contained a numberof insignificant Pattern Gaps. The two larger gaps marked “G” are of the Continuationor Runaway class. Note that prices closed at or near the top on each day that made agap; neither of these was closed for two years.
slip to 28, and then halts there and is followed by a reaction in the course of whichprices slip back to 27, 26, and finally to 25. The return move has carried prices backthrough the gap area (25-26); the gap has thereby been covered or closed. In brief, agap is closed when a subsequent price trend comes back and retraces the range of thegap.
Must a gap be closed before prices move very far away from it? Certainly not. Will itbe closed eventually? Probably, yes. If it is not closed by the next Minor Reaction,there is a chance it will be covered by the next Intermediate Retracement, and if notthen, pretty surely by the next great Major Swing in the opposite trend. But that maybe years later—hardly a matter of interest to the ordinary trader. The investor whobought Chesapeake and Ohio shares at 260 on October 21, 1929, counting on theclosing of the gap which that issue had made on the preceding Friday, 2 points downfrom 266 to 264, had to wait nearly seven years to get out even. Not until it neared theTop of the next Major Bull Market did CO attain an equivalent market value (65, sinceit was split 4-for-1 in 1930). In the meantime, he saw his investment shrink in 1932 toless than a sixth of his purchase price. As a matter of fact, there were hundreds of gaps
made in the charts of the 1929-1930 markets that never have been covered since then,and many of them, it is safe to say, never will be closed.
If you will think the matter over for a moment, you will see that the probabilities wehave stated above for a gap's being closed apply just as well to a stock's returning toany price range at which it has once been traded, gap or no gap.
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Figure 12.2 The large up-gap made on July 5 in this chart was a typical BreakawayGap, occurring as prices broke out of the complex base for the July-August SecondaryRecovery. (Compare this chart with Figure 7.14.) Another type of Breakaway Gap—through a trendline—occurred on August 26. That of September 7 was primarily due to
the “ex-dividend,” whereas that of September 18 was still another type of breakaway—through a Support Level. The first gap marked, on April 26, must be classified as aRunaway; it made a sort of an “Island” of the whole April-June complex base.
Another point: there are thousands of price gaps made in trading—some of them quitewide—that do not appear at all on the standard daily range charts because they aremade during a single day and not between one day's closing and the next day'sopening. Such intraday gaps are ordinarily overlooked entirely; the gap theorists areoblivious of them, although their significance is often greater than that of manyinterday gaps. Practically every emphatic breakout move from a strictly definedRectangle or Right-Angle Triangle is attended by a gap, but only those few show up onthe charts that occur at the day's opening gong.
If we seem to have “protested too much” in the foregoing, it is only because we wantour readers to study this topic with an open mind, free from preconceived notions as toany mystic qualities that gaps may possess. Turning to the other side of the picture,some gaps have technical import. Some gaps are useful to the chart analyst inappraising trend possibilities. Let us see what we can make of them.
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Figure 12.3 A potent Breakaway Gap that showed on Zenith's weekly chart when itbroke out of a Head-and-Shoulders Bottom in early 1942. Note high volume developedbeyond the gap, suggesting it would not be quickly closed. The April reaction stoppedshort of it. In fact, this gap still had not been closed in 1956, more than 14 years later.
Ex-dividend gaps
First, however, we must eliminate from consideration the gaps that do not meananything. An eighth-point gap obviously has no technical significance as it representsonly the minimum permitted change in price. By the same token, a gap of a quarter ofa point or even a half point in a high-priced stock, such as Norfolk & Western (beforethe split), represents only a normal, in fact tight, spread between successive bids. Inbrief, to carry interest for the chart technician, a gap must be wider than the usualchanges in price that occur under normal or prevailing trading conditions. A secondclass of gaps that have no forecasting implications are those formed consistently andhabitually by “thin” issues in
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Figure 12.4 As a matter of interest, this monthly chart of Zenith Radio is reproducedfor comparison with Figure 12.3. The Head-and-Shoulders Bottom is easily seen.
the medium- and high-price brackets. You can spot them easily; if your chart of acertain issue shows numerous gaps as a regular thing, then no one of them is apt tomean anything special.
Finally, gaps that appear on the charts when a stock goes ex-dividend (whether thedividend be in cash, stock, rights, or warrants) possess no trend implications. They areoccasioned not by a change in the Supply-Demand relation that governs the trend, butrather by a sudden and irreversible alteration in the actual book value of the issue.
Also of interest in this chart is the Descending Triangle, which started to form inMarch, but it was never completed—a deceptive and discouraging picture until theApril 7 gap was made.
The Flag of mid-April “measured” the move from 9 1/2 to 14. The gaps measured thetwo halves of it, on either side of the Flag.
Eliminating the technically meaningless types named above, we are left with the gapsthat occur infrequently (and that are not occasioned by an ex-dividend change in value)
in issues that are so closely and actively traded as ordinarily to produce “solid” charts.A 1-point gap, for example, in the chart of New York Central would be an unusualevent; it would demand attention and presumably have some forecasting significance.
Such gaps, for the purposes of our study, may be divided into four classes: Common orArea Gaps, Breakout Gaps, Continuation or Runaway Gaps, and Exhaustion Gaps.
The common or area gap
This type of gap gets its name from its tendency to occur within a trading area or PriceCongestion Pattern. All of the Congestion Formations we have studied in the precedingchapters—both Reversal and Consolidation types—are attended by a diminution intrading turnover. The more strictly defined sorts—the Triangles and Rectangles—show
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Figure 12.5 The early 1946 daily chart of Blaw-Knox contained a number ofinteresting technical features. Its spurt from 19 to 25 in December 1945 was followedby a nine-week Rectangle Consolidation, the end of which appears in the chart above.Prices erupted from this Rectangle on February 11 with a typical Breakaway Gap. Fourdays later, another gap appeared on even greater volume, and prices closed at the top ofthe day's range. This looked like a Runaway Gap, in which case continuation to 32 wasimplied according to the “rule” stated above. (Note the Rectangle “measurement”called for only 31.) On the following day, however, a One-Day Reversal, from 31 backto 30, appeared and the next session closed the February 15 gap, which now had to berelabeled, tentatively, as an Exhaustion Gap. Prices subsequently dropped back to thesupport of the nine-week Rectangle, rallied grudgingly along an establishedIntermediate Up Trendline, and broke that on April 24 to return again to the 25 support.In May, another advance took “BK” up once more to 30, where it bumped against thepreviously broken trendline. That was its last effort; in late July, the “valley” level at25 was penetrated and a Major Double Top had been completed. To return to theFebruary 15 gap, this is fairly typical of many cases in which it is impossible to saywhether Continuation or Exhaustion is being signaled until two or three days after theday the gap is made.
this characteristic most conspicuously. Moreover, activity in these patterns tends to beconcentrated pretty much at or near the top and bottom edges, their Supply andDemand Lines, while the area in between is a sort of “no-man's land.” It is easy to see,therefore, why gaps develop frequently within such areas. You will find numbers ofgood examples of Pattern Gaps in the charts illustrated in Chapters 8 and 9.
Such Pattern Gaps are usually closed within a few days, and for obvious reasons,before the Congestion Formation in which they have appeared is completed and pricesbreak away from it, but not always. Sometimes a gap will develop in the last traverseof prices across the pattern area just before a breakout, and in such cases, it is notclosed for a long time, nor is there any reason why it should be.
The forecasting significance of Common or Pattern Gaps is practically nil. They havesome use to the technician simply because they help him recognize an Area Pattern—that is, their appearance implies a Congestion Formation is in the process ofconstruction. If, for example, a stock moves up from 10 to 20, drops back to 17, and
then returns to 20, making a gap in the course of that rally, it is a fair assumption thatfurther pattern development will take place between approximately 17 and 20. This is aconvenient thing to know and may, on occasion, be turned to profit in short-termtrading policy.
Pattern Gaps are more apt to develop in Consolidation than in Reversal Formations.Thus, the appearance of many gaps within an evolving Rectangle or SymmetricalTriangle
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Figure 12.6 This is a good example of a Runaway Gap that performed according torule. After reacting from 26 1/4 in late 1936, “BO” formed a Head-and-ShouldersBottom (the left shoulder was a Triangle) and broke out of it on February 6, 1937. Asmall Flag formed immediately thereafter, calling for 28. At that level, another Flagdeveloped which signaled 30 1/4 or better. As prices reached this latter goal, however,a gap was made, on March 3, on extraordinary volume. The next two days confirmed
this to be a Runaway or Continuation Gap. As such, it implied further advance(measuring from the Head-and-Shoulders neckline) to 37 plus. “BO” made its BullMarket high at 40 1/4 on March 17. The measuring-gap rule should be used forpurposes of “getting out” rather than “getting in.” It does not guarantee a move willcontinue to the implied limit, but it does give assurance the move is near an end whenthe rule has been fulfilled.
reinforces the normal expectation that the pattern in question will turn out to be aConsolidation rather than a Reversal Area.
Breakaway gaps
The Breakaway type of gap also appears in connection with a Price CongestionFormation, but it develops at the completion of the formation in the breakaway move.Any breakout through a horizontal pattern boundary, such as the Top of an AscendingTriangle, is likely to be attended by a gap. In fact, it is safe to say that most of themare. And, if we consider what goes on in the market to create a Flat-Topped PriceFormation, it is easy to see why Breakaway Gaps should be expected. An AscendingTriangle, for example, is produced by persistent demand for a stock meeting a largesupply of it for sale at a fixed price. Suppose that supply is being distributed at 40.Other holders of the stock, who may have intended originally to liquidate at 40.5 or 41,see quotations come up to 40 time after time, stop there, and turn back. They tend, inconsequence, either to join the crowd selling at 40,
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Figure 12.7 Panic Declines often produce large Runaway Gaps. The September 7 gapin this chart, judged by its size, volume, subsequent action, and the fact that it wasmade in “new low ground,” marked it as being of the measuring type. The implied goalwas 26 or below. All other gaps in this chart were obviously of the “common” variety.
or else to figure that once through 40, prices will go much higher; they may eitherlower or raise their selling price. The result is a “vacuum” on the books, a dearth of
offerings in the price range immediately above the pattern. Hence, when the supply at40 in our Ascending Triangle example is finally all absorbed, the next buyer of thestock finds none offered at 40.125 or 40.25 and he has to bid up a point or more to gethis shares, thus creating a Breakaway Gap.
As we remarked earlier in this chapter, gaps of this type actually occur on almost everydecisive breakout from a Horizontal Congestion, although many of them do not showon the charts because they occur during a day and not between one day's close and thefollowing day's opening. Breakaway Gaps also develop at times when prices move outof other types of Reversal or Consolidation Formations; they are not uncommon inconnection
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Figure 12.8 The "skyrocket" run-up of Willys-Overland in June 1944 was marked by anumber of small gaps. The first two were too small to have much technicalsignificance. The larger gap made June 16 was marked by the "stickiness" of prices onthat day as Exhaustion. A small Flag Consolidation ensued. The June 27 gap also actedlike an Exhaustion Gap insofar as price action was concerned, but volume had declinedinstead of climbing to a new peak. On June 28, prices jumped away again, so the June27 gap was marked as another Runaway with an implied objective of 18 1/4 plus,which had already been reached. Note the Head-and-Shoulders Reversal that formedand the subsequent Intermediate Reaction.
with Head-and-Shoulders Patterns, for instance, and they even occur on the penetrationof trendlines, which we shall discuss in a subsequent chapter.
What forecasting value can we ascribe to them? First, they serve to call attention to,and emphasize the fact of, a breakout. There can be little doubt that a genuine breakouthas eventuated when prices jump out of a pattern with a conspicuous gap. False movesare seldom attended by gaps. Second, they carry the suggestion that the buying demand(or selling pressure, as the case may be) that produced the gap is stronger than wouldbe indicated by a gapless breakout. Hence, it may be inferred the ensuing move willcarry
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Figure 12.9 “SMC” is a thin stock whose daily chart is usually “full of holes,” but thislarge gap that appeared on its weekly chart in September 1946 evidently possessedtechnical significance. Treated as a Runaway measuring from the eight-weekCongestion at 68, it called for a downside objective of 44 or below, which was dulyfulfilled.
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Figure 12.10 A small Island in the right shoulder of the Head-and-Shoulders Top thatmarked this issue's Major Reversal. The Island served only to emphasize the chart'sBearish implications.
Figure 12.11 Island “shakeouts” are not uncommon in “thin” stocks. Why they shoulddevelop as they do is hard to explain, but their forecasting implications are obvious.
prices farther or faster, or both. It does not do to make too much of this point; it is alogical inference and one that has been borne out in the majority of cases, but it has itsexceptions and may prove most disappointing on occasion. Nevertheless, other thingsbeing equal, of two stocks that emerged from Ascending Triangles at the same time,we should choose to buy the one that gapped out over the one that pushed its way outby small fractional steps.
Except for the presumption of somewhat greater “steam” behind the move, theBreakaway Gap carries no particular measuring implication, nor any other forecastingsignificance. The next question is this: should we expect a Breakaway Gap to be closedwithin a relatively short time? Or, to put the question in more practical and pragmaticterms: should we defer buying in the expectation that it will be closed before anyworthwhile move develops?
To give a fair answer to that question, it is necessary to scrutinize the volume oftransactions before and after the gap. If a great many sales were recorded at the takeofflevel from which prices jumped the gap, but relatively few as prices moved away fromthe far side of the gap, then there is a chance—perhaps about 50-50—that the nextMinor Reaction will carry prices back to the edge of the pattern of origin, thus fillingthe gap. On the other hand, if high volume developed at the far side of the gap, and a
great many transactions took place there as prices moved on away from the gap, thenthe chances are remote that any near-term Throwback will close the gap. In such cases,a Throwback reaction is almost always stopped at the outside of the gap.
(One is constantly tempted in a work of this sort to employ the words always or neverwithout qualification. Unfortunately, the authors have never been able to discover arule of techniques to which the market did not, on rare occasion, produce an exception.It is always necessary to be on guard against such exceptional developments. Many ofthem are caused by general market conditions that counteract the technical trend inindividual issues. Keep an eye on the charts of the “Averages,” as well as the particularissues in which you are interested.)
Where Breakaway Gaps develop intraday, the daily chart cannot, of course, indicatehow the day's volume was distributed. In that event, it may be necessary to examinethe
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Figure 12.12 This Island Reversal Pattern at Bethlehem Steel's Major Top in 1937 is a“classic,” yet it was followed by a curious and disturbing abnormality in the strongrally that developed on March 30. Those who sold out on the Island's signal around 95on March 19 or 20 were startled, and, if they had also sold short, justifiably alarmedwhen prices jumped up a week later, not only through the second gap level but wellabove it. But eventually, as can be seen, everything worked out according to theoriginal forecast. This incident will illustrate a general principle: when a clear-cuttechnical pattern of unquestionable significance has been completed on your charts, donot let some apparently contrary development that occurs shortly thereafter lead you toforget or neglect the previous plain signal. Give such situations time to work out.Figure 12.2 shows the sequel to the above chart and, incidentally, another Island.Compare the volume.
ticker tape or ask your broker to refer to the published record of individual transactionsto which most brokerage firms subscribe. (EN: This data may now be easily obtained.See Appendix D, Resources. EN9: Candlestick charts, now much in use, will allow theanalyst to see the intraday breakaway gap.) Lacking any clear-cut volume clue, it issafest to figure that a Breakaway Gap will not be filled until long after the full moveimplied by the pattern of origin (usually a move of Intermediate Extent in the Dowsense) has been carried out.
Continuation or runaway gaps and the measuring rule
Less frequent in their appearance than either of the two forms we have discussedabove, gaps of the Continuation or Runaway type are of far greater technicalsignificance because
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Figure 12.13 This looked like an Island in “PA,” but the second gap was actuallyattributable to a $0.50 dividend which went ex on November 20 and, therefore, had tobe discounted technically. Due to this dividend, it was necessary to lower the SupportLine at 40 (see Chapter 13) by half a point. That Support, therefore, was not violated inDecember and prices subsequently advanced to above 50 the following March.
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Figure 12.14 TLT shown here in computer notation produces gaps in profusion. As thereader can see, if one just traded in the direction of the gap many short-term scalpswould be garnered. This chart also lends perspective to the hand drawn charts. A gap isa gap is a gap.
they afford a rough indication of the probable extent of the move in which they occur.For that reason they have sometimes been called “Measuring” Gaps.
Both the Common or Pattern Gap and the Breakout Gap develop in association withPrice Formations of the Area or Congestion type, the former within the formation andthe latter as prices move out of it. The Runaway Gap, on the other hand, as well as theExhaustion Gap, which we will take up later, is not associated with Area Patterns, butoccurs in the course of rapid, straight-line advances or declines.
When a dynamic move starts from an area of accumulation, the upward trend of priceswill seem often to gather “steam,” to accelerate for a few days, perhaps a week ormore, and then begin to lose momentum as supply increases when the very extent ofthe advance invites more and more profit-taking. Trading volume jumps to a peak on
the initial breakout, tapers off somewhat in the middle of the advance, and then leapsup again to a terrific turnover as the move is finally halted. In such moves—and inrapid declines of corresponding character—a wide gap is quite likely to appear at thetime when the Runaway is at its height, when quotations are moving most rapidly andeasily with relation to the volume of transactions. That period comes normally at justabout the halfway point between the breakout that inaugurated the move and theReversal Day or Congestion Pattern that calls an end to it. Hence, a Continuation orRunaway Gap affords an approximate measurement of the move in which it develops.Its inference is that prices will go as much farther beyond the gap as they already havegone between the beginning of the move and the gap, as measured directly (andvertically) on the chart.
Since there is a tendency for advances to run, in terms of points, beyond the pricelevels arithmetically implied by this rule, and for declines to be more strictly limited,the gap-measuring rule works out particularly well when applied directly onsemilogarithmic scale charts. On arithmetic charts, look for a trifle more on the upsideand a trifle less on the downside. (In any event, you will be wise to “bank” onsomething short of the theoretical goal.)
Runaway Gaps are easy to find and identify in retrospect, but our task is to recognizethem as such at the time they appear; there is no danger of confusing them with Patternor Breakout Gaps. With those aside, any gap that shows up in a fast advance or declineafter prices have moved well away from an Area Formation (or the penetration of animportant trendline or break through a potent Support or Resistance Level, which weshall discuss later) may be a Runaway Gap. What then becomes necessary is todistinguish it from our next type, the Exhaustion Gap. Usually, the price and volumeaction on the day following the gap furnishes the evidence required for a safediagnosis.
Two or more runaway gaps
It will be much easier to bring out the characteristics distinguishing Runaway andExhaustion Gaps when we take up the latter in detail. Before doing so, we mustmention those cases in which two and, rarely, even three gaps intervene in a fast moveand are evidently all classifiable as of the Continuation or Runaway breed. It does nothappen often and is particularly unlikely to appear in the chart of a fairly large andactive issue, but one of the thinner stocks in the midst of a “skyrocket” move may goskipping along for three or four days, making gaps between each successive pair. Theonly question of practical importance that arises in such cases is this: where should thehalfway measuring point be located? No quick and easy rule can be laid down, butstudious inspection of the chart, especially of the volume trend, will usually afford ananswer. Remember that halfway in these fast moves tends to come at the stage at
which prices are moving most easily and rapidly with respect to the number oftransactions recorded (hence the tendency to gap). If there are two gaps, the halfwaystage may very likely have been reached somewhere between them. Inspect your chartcarefully and try to “average” the picture mentally; look for what appears to be thecenter of “thinness” and use that for your measuring level. But remember also thateach successive gap brings the move inevitably nearer to Exhaustion, so let yourjudgment lean to the conservative side; do not expect too much of the second or thirdgap.
Exhaustion gaps
The Breakout Gap signals the start of a move; the Runaway Gap marks its rapidcontinuation at or near its halfway point, and the Exhaustion Gap comes at the end.The first two of these are easily distinguished as to type by their location with respectto the preceding price pattern, but the last is not always immediately distinguishablefrom the second.
Exhaustion Gaps, like Runaway Gaps, are associated with rapid, extensive advances ordeclines. We have described the Runaway type as the sort that occurs in the midst of amove that accelerates to high velocity and then slows down again and finally stops asincreasing Resistance overcomes its momentum. Sometimes, however, “skyrocket”trends evidence no such gradual increase of Resistance as they proceed, showing notendency to lose momentum, but rather continue to speed up until, suddenly, they hit astone wall of supply (or, in cases of a decline, demand) and are brought to an abruptend by a day of terrific trading volume. In such moves, a wide gap may appear at thevery end, that is, between the next to the last and the last day of the move. This gets thename of Exhaustion Gap because the trend seems thereby to have exhausted itself inone final leaping spurt.
The best test of whether a gap formed in a rapid, straight-line advance or decline is ofthe Continuation or Exhaustion type comes on the day after the gap (more precisely,the day that makes the gap), although there are frequently other clues in the precedingchart picture. If trading activity mounts to an extraordinary height during the sessionfollowing the gap, and particularly if the previous trend in prices does not appear to becarried along at a pace commensurate with that day's activity, the gap is probably ofthe Exhaustion class. This interpretation is reinforced, in fact, made a virtual certainty,if the day after, the gap develops into a Reversal Day (as described in Chapter 10) withthe closing price registered back near the edge of the gap.
Evidence that may be derived from the chart anteceding the gap may be enumerated asfollows: If the trend has already carried out the full implications of the price formationor Congestion Area from which it emerged, Exhaustion is more likely than
Continuation. By the same token, if the reasonable measuring implications of thepattern of origin are still far short of attainment, the gap is probably of theContinuation type. An Exhaustion Gap is seldom the first gap in a runaway move; it isusually preceded by at least one Continuation Gap. Thus, you may ordinarily assume(unless the contrary appears from other and weightier indications) the first gap in arapid advance or decline is a Continuation Gap, but each succeeding gap must beregarded with more and more suspicion, especially if it is wider than its predecessor.
We have referred to Exhaustion Gaps as wide gaps. Width is, of necessity, relative inthis study; it is impossible to lay down any exact rules to define wide or narrow. Do notlet this bother you too much. Recognition of what constitutes an unusually wide gapfor the particular stock you have under observation soon comes with a little chartingexperience.
Runaway Gaps are usually not covered for a considerable length of time, as a rule, notuntil the market stages a swing of Major or full Intermediate proportions in theopposite direction. But Exhaustion Gaps are quickly closed, most often within two tofive days, a fact that furnishes a final clue to distinguish Exhaustion fromContinuation, if it should still be needed at that stage. This, incidentally, upsets thecommon superstition that all gaps must be closed before the trend can be trusted tocontinue very far. In the case of the Runaway Gap, it is not closed, but the trend movesright along, nevertheless, and often for a surprising distance. In the case of theExhaustion Gap, the closing of it actually contributes to the signal the trend has runout.
An Exhaustion Gap, taken by itself, should not be read as a sign of Reversal, or even,necessarily, of Reversal at all. It calls “stop,” but the halt is ordinarily followed bysome sort of area pattern development that may, in turn, lead to either Reversal orContinuation of the move before the gap. In practically every case, however, enough ofa Minor Reaction or delay ensues from the formation of an Exhaustion Gap before anew trend is established to warrant closing out commitments at once. (One can alwaysreenter if it subsequently appears that the previous trend is to be resumed.)
The Island Reversal
We mentioned (at the end of Chapter 10) a Reversal Pattern, the Island, which was tobe taken up under the general study of gaps. The Island Pattern is not common and it isnot, in itself, of major significance in the sense of denoting a long-term Top or Bottom,but it does, as a rule, send prices back for a complete retracement of the Minor Movethat preceded it.
An Island Reversal might be described as a compact trading range separated from themove that led to it (and that was usually fast) by an Exhaustion Gap and from the move
in the opposite direction that follows it (and that is also equally fast, as a rule) by aBreakaway Gap. The trading range may consist of only a single day, in which event itnormally develops as a One-Day Reversal, or it may be made up of from several daysto a week or so of Minor Fluctuations within a compact price zone. It is characterized,as might be expected, by relatively high volume. The gaps at either end occur atapproximately the same level (they should overlap to some extent) so that the wholearea stands out as an Island on the chart, isolated by the gaps from the rest of the pricepath.
We have said an Island does not, of itself, appear as a Major Reversal Formation, butIslands frequently develop within the larger patterns at turning points of Primary orimportant Intermediate consequence, as, for example, in the head of a dynamic Head-and-Shoulders Top. By the same token, they appear occasionally at the extremes of theMinor Swings that compose a Triangle or a Rectangle (in which event, the gaps that setthem off are really better classified as Common or Pattern Gaps).
The reasons why Islands can and do develop—in other words, why gaps can and dorepeat at the same price level—will be more apparent when we take up the generalsubject of Support and Resistance in a later chapter. Suffice it to repeat at this pointthat prices can move most rapidly and easily, either up or down, through a range wherelittle or no stock changed hands in the past, where, in other words, previous ownershave no “vested interest.”
Sometimes the second gap—the Breakaway that completes the Island—is closed a fewdays later by a quick Pullback or reaction. More often it is not. Rarely, the first gap—the Exhaustion Gap that starts the Island—is covered in a few days before the secondgap appears, in which event the Island Congestion takes on a sort of V-Shape (if it is aTop), and there is no clear “open water” across the chart horizontally between theIsland and the trends preceding and following it. Yet, in any of these variations, theinterpretation remains the same: the preceding Minor Move should be practicallyretraced.
An Island Pattern is not easy to trade on unless it be for a short-term “scalp,” as,obviously, a good share of the retracement already may have been accomplished by thetime the Island is charted and an order to buy or sell on its indications can be executed.If the entering gap is recognized as an Exhaustion Gap, the trader who is interested inthe stock presumably will take action before the second gap forms and before theIsland is in evidence. Perhaps the greatest utility that Islands have for the chart analystis that of calling attention to a situation of putting him on the alert as to itspotentialities.
Gaps in the Averages
Gaps appear also in nearly all Averages but, for obvious reasons, with rather lessfrequency than in the charts of individual issues. Although it is not necessary for all ofthe stocks composing an average to make a gap simultaneously to produce a gap in theAverage figures, a majority of them must. As might therefore be expected, Common orPattern Gaps are particularly rare in Average charts, but Breakaway and Runawaytypes are not uncommon, although they are small as compared with the size of suchgaps in single stocks. Exhaustion Gaps, and, in consequence, Islands, again are rare.The conditions that create an Exhaustion Gap seldom develop in a sufficient number ofindividual issues at any one time to produce a counterpart in the Averages.
The technical interpretation of gaps in Averages is, in the main, the same as in singlestocks. The authors have not found that an Average gap possesses any peculiar potencyor significance over and above that attributable to a gap in the chart of any actively andclosely traded single issue.
The broader, and hence, most representative market indexes show the fewest andsmallest gaps. EN: On the other hand, the NASDAQ is quite volatile and a good gapproducer.
It is suggested the reader review this chapter after he has finished studying theprinciples of Support and Resistance in Chapter 13. (EN9: The truth is there is nothingmore that need be said about gaps, and the truth also is that no modern examples needbe added. But gaps are fun, so see Figure 11.11 and Chapter 16 for modern examples.)
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter thirteen
Support and Resistance
As illustrated by Figures 13.1 through 13.12, the phenomena we shall study in this chapter aremarkedly different in kind from those discussed in preceding sections. We shall look at the stockmarket from a new angle and, in so doing, may find it possible to develop some very practicaladditional rules to guide us in selecting stocks for purchase or sale, in estimating their potentialmoves, and in foreseeing where they are likely to “run into trouble.” As a matter of fact, someexperienced traders have built their “systems” almost entirely on the principles of what we callSupport and Resistance, paying no attention to the specific pictorial patterns of price and volumeaction we have been investigating in preceding pages.
Support and Resistance phenomena are not, by any means, unrelated to the various patterns andformations previously studied. We have already had occasion to hint at a basic principle of Supportand Resistance in our explanation of gaps, and, as you read on, you will find a number of the otherpatterns of price behavior are explained thereby, or at least become more readily understood.
The term Support is commonly used in the Street. In one or more of its connotations, it must befairly familiar to the reader. For example, we may hear such-and-such a crowd is supporting XYZ at50 or is prepared to support the market by buying all stock offered on any 5-point concession. Forthe purposes of this chapter, we may define Support as buying, actual or potential, sufficient involume to halt a downtrend in prices for an appreciable period. Resistance is the antithesis ofSupport; it is selling, actual or potential, sufficient in volume to satisfy all bids and, hence, stopprices from going higher for a time. Support and Resistance, as thus defined, are nearly but not quitesynonymous with demand and supply, respectively.
A Support Level is a price level at which sufficient demand for a stock appears to hold a downtrendtemporarily at least, and possibly reverse it, that is, start prices moving up again. A Resistance Zone,by the same token, is a price level at which sufficient supply of a stock is forthcoming to stop, andpossibly turn back, its uptrend. There is, theoretically, a certain amount of supply and a certainamount of demand at any given price level. (The relative amount of each will vary according tocircumstances and determine the trend.) But a Support Range represents a concentration of demand,and a Resistance Range represents a concentration of supply.
According to the foregoing definitions, you can see the top boundary of a Horizontal CongestionPattern such as a Rectangle is a Resistance Level, and its bottom edge is a Support Level; the topline of an Ascending Triangle is unmistakably a Resistance Level, and so on. But we are moreinterested now in the reasons why Support or Resistance, as the case may be, can be anticipated toappear at certain price ranges. Within reasonable limits, and with a certain few exceptions to beexamined later, it is quite possible to do this. Expert chart readers are frequently able to make someamazingly accurate predictions as to where an advance will encounter Resistance (supply) or wherea declining trend will meet Support.
The basis for such predictions—the elementary data from which Support and Resistance theories arederived—is that turnover in any given issue tends to be concentrated at the several price levels atwhich a large number of shares changed hands in times past. Since any level at which a greatvolume of transactions takes place usually becomes a Reversal point (Major, Intermediate, or Minor)in that stock's trend, it follows naturally that Reversal Levels tend to “repeat.” However, here is theinteresting and the important fact that, curiously enough, many casual chart observers appear never
to grasp: these critical price levels constantly switch their roles from Support to Resistance and fromResistance to Support. A former Top, once it has been surpassed, becomes a Bottom zone in asubsequent downtrend; and an old Bottom, once it has been penetrated, becomes a Top zone in alater advancing phase.
Normal trend development
Perhaps we can make this plainer by citing a typical example of normal trend development. Supposea stock in a Bull Trend moves up from 12 to 24, and there runs into a large volume of selling. Theresult is a reaction that may take the form of a full Intermediate Correction to, say, 18, or a series ofMinor Fluctuations forming a Consolidation Pattern between, say, 24 and 21, the effect being thesame in either case. Following this Correction or Consolidation, a new advance gets under way andcarries the price on up to 30 before running again into supply in sufficient concentration to stifle themove. Now another reaction is evidently due. Again, it may take the form of a sidewaysConsolidation Pattern or an Intermediate Correction. If the latter, where will that corrective setbackbe reversed, or in other words, will it meet Support? The answer is at 24, the level of the first Top inthe trend. That is the level (below current quotations) where a large turnover had previouslyoccurred. Then it functioned as Resistance, producing a halt or Reversal in the first upswing; now itfunctions as Support, stemming and reversing, at least in a Minor sense, the latest downswing.
Why should this be? It will be easier to suggest an answer to that question if we first go on with asimilar example of typical action in a downtrend. This time, suppose our stock makes a Major Topand declines from, say, 70 to 50. There, at 50, a temporary Selling Climax occurs; there is a largeturnover, prices rally, perhaps slip back for a “test” of 50, and then stage a good recovery to 60. At60, buying peters out, the trend rounds over, turns down, and accelerates in renewed decline, whichcarries to a new low at 42. Again, a wave of buying comes in and a second recovery swing getsunder way. We can confidently expect this recovery (from 42) will run into strong Resistance at 50.The price level that functioned as a Support for the first phase of decline, now that it has beenbroken through the downside by the second phase, will reverse its role and function as Resistance tothe second recovery move. The former Bottom level will now become a Top level.
Here, we may ask again why this should be so, and now we can suggest an answer. In the exampleof downtrend action cited in the preceding paragraph, our stock first dropped to 50, ran intoconsiderable volume there, reversed its trend, and rallied to 60 with activity dwindling on the rise. Alot of shares changed hands at 50, and for every seller there was a buyer. A few of those buyers mayhave been covering short positions and, having done so, had no further interest in the issue. Othershort-term traders and professionals may have purchased simply because they sensed a temporaryBottom in the making and hoped to scalp a few points on the ensuing rally; presumably, they (or atleast some of them) took their profits and were out before prices broke very far on the next decline.But a majority of those who acquired shares at 50, it is safe to say, did so because they thought thestock was cheap at that price, figuring it had gone low enough. Only a few months ago, it was sellingabove 70; surely, it was a bargain at 50 and could be picked up and put away “for the long term.”
The explanation
Imagine yourself, for the moment, in the place of those new owners. They see prices turn up, reach55, 58, 60; their judgment appears to have been vindicated. They hang on until the rally peters outand prices start to drift off again, slipping to 57, 55, 52, and finally 50. They are mildly concernedbut still convinced the stock is a bargain at that price. Most likely, there is momentary hesitation in
the decline at 50 and then prices break on down. Briefly, there is hope the break is only a shakeout tobe recovered quickly, but that hope vanishes as the downtrend continues. Now our new ownersbegin to worry. Something has gone wrong. When the stock gets down below 45, the former bargaindoes not look so good. “Well, I guess I picked a lemon that time, but I won't take a loss in it. I'll justwait until it gets back up to 50 some day where I can get out even (except for expenses), and thenthey can have it.” (Does this sound familiar, by any chance?)
We can skip over the next few swings that “followed the rules” and go on to the change in thepicture, which came with the first notable violation of a Support Level in 1946. Prices had pushed upthe first of February nearly to 54, well out above the Tops around 46, which formed the previousNovember. The late-February reaction should have “caught Support”
I 1944 I 1945 I 1946 I 1947 !
Figure 13.1 Why now was so much time spent and "work" done during mid-1945 under 33-34? Wecannot see it on this chart, but the previous monthly history shows that the Bottoms of longCongestion Areas were made in this zone in late 1939 and late 1940. These old Bottoms,representing Support, originally, were able to produce some supply (Resistance) five years later.Once prices had worked through that supply, however, they were able to rise quickly to 44, and thentheir subsequent reaction found Support just where you might have expected—at 33-34. Support hadturned to Resistance and then to Support again.
around 46—but it did not; it crashed on down to the “round figure” 40. This was an ominous(although not necessarily “fatal”) development. Thereafter, a massive Symmetrical Triangle was
formed and broke downside in September.
The first Panic Decline in the Bear Market is no respecter of Support Levels. This one was noexception, although it is noteworthy that prices “bounced” several times from the important old 33-34 zone. By November, the Top Triangle's measurement had been exactly fulfilled. (You should turnback to this record and study it again after you have read further in this chapter.)
Take the opposite side of the picture—the uptrend process. You, along with many others, boughtXYZ at 12, carried it up to 24, decided that was plenty high for it, and cashed in. Thereupon XYZreacted to 20, and you congratulate yourself on your astuteness. But then, unexpectedly, it turnsaround and rushes up to 30. Now you do not feel as smart knowing that was a better stock than yougave it credit for being. You wish you had it back, yet you will not pay more for it; if it comes backdown to 24, the price at which you sold, you'll “reinstate your position.”
Perhaps you have never been in either of these situations. Perhaps your own reactions would not, insuch cases, have been the same as those we have indicated. If you have had a fair amount ofexperience in the market—have some knowledge of the psychology of the “average investor”—youknow the pictures described are typical.
At this point, you may not be satisfied we have succeeded in giving an adequate explanation for ourbasic principle of Support and Resistance Levels. Remember, however, that the supply and demandbalance in the market is nearly always a delicate thing. Only a moderate oversupply at any one pricewill suffice to stifle an advance; only a little extra demand concentrated at a certain level will stem adecline. Remember, other traders are watching the tape as well and will be quick to sense anychange in the situation and be quick to join the parade whenever a change in trend appears to bedeveloping. Consequently, orders to buy or sell a few hundred shares may induce the transfer ofseveral thousand.
Another point worth bearing in mind is that the traders and investors who (because of thepresumption their previous mistakes in either selling or buying prematurely) created Support andResistance Levels are not necessarily ignorant or inexperienced. On the contrary, we must list themamong the wiser and more alert of those who operate in the market. To make one more use of ourprevious theoretical example of typical downtrend action, those who bought at 50 were certainlysmarter than those who bought at the top (70) or on the way down to 50, even though the latter pricewas broken later on. Giving them credit for somewhat superior judgment, it follows that they may beexpected to appraise later developments pretty carefully and display something better than a woodenand stubborn determination to “get out even” when it comes to selling on a Recovery Move. Hence,in a marked Bear Trend “overhanging supply”; that is, stock bought at higher levels by holders nowwaiting for a good chance to unload, will begin to come on the market below the theoreticalResistance Level. Wise owners will be willing to sacrifice a point or so to avoid getting caught in aworse loss.
By the same token, “sold-out Bulls,” when a Major Uptrend is under way, may be willing to pay apoint or two more to replace the shares they had previously cashed in too soon. Thus, it ischaracteristic of reactions in well-established (second phase) Bull Markets to drop back only to thevery uppermost limits of a Support Range—and for recoveries in established Bear Markets to reachonly the lowest edges of Resistance Zones, or perhaps even fail of that by an appreciable margin. Weshall have more of this sort of thing to point out later on, but first we must take up two other matters—how to estimate the potential importance of Support and Resistance Zones, and how to moreaccurately locate the centers of axes of such zones.
Estimating Support-Resistance potential
To go back to first principles, the Resistance that an upward move may meet at any given leveldepends on the quantity of stock overhanging there—the number of shares previously bought at thatprice by owners who now would like to get out without loss. Obviously then, volume is our firstcriterion in estimating the power of a Resistance Range. An old Minor Bottom level, at which onlyfour or five hundred shares changed hands, cannot set up much Resistance to a subsequent advance,but a Selling Climax Bottom, where several thousand shares were bought, will provide a lot ofpotential supply after prices have dropped well below it, at some later date, and then attempt to riseup through it again.
A long Rectangle or a Descending Triangle has a number of Bottoms at the same level. We can get acrude approximation of the amount of Resistance there by summing up the volume of trading on allits Bottoms, but then some discount must be taken for the shares that may have been bought at theBottom of the pattern in its early stages and then sold near the Top before it was completed. In brief,a single, sharp, high-volume Bottom offers somewhat more Resistance than a series of Bottoms withthe same volume spread out in time and with intervening rallies.
Another criterion is the extent of the subsequent decline. Or, to put it another way, how far priceswill have to climb before they encounter the old Bottom zone whose Resistance potential we areattempting to appraise. Generally speaking, the greater the distance, the greater the Resistance.Suppose PDQ sells off from 30 to 20, “churns” at that level for several days, rallies to 24, and thendrifts back down to 19. Investors who picked it up at 20 will not be greatly concerned at that stage. Ifa rally now develops from 19, there will be little or no disappointed selling at 20. Should prices dipto 18 before the rally starts, there may be some supply forthcoming at 20, but still not a formidablequantity. From 17, Resistance will become evident. In brief, prices have to break far enough belowthe price at which a trader bought his stock to convince him that he made a bad investment and,hence, that he should sell when he gets a chance to do so without too great a loss.
It is impossible to formulate any precise rule or equation to define how far a decline must proceed toset up Resistance above it. However, do not look for much supply to come out of a Bottom level inthe low-middle price ranges (20-35) unless the trend later takes quotations more than 10% under it.This 10% rule cannot be applied to very low-priced issues. A man may buy a stock at 5 and see itdrop to 4 or 3.5 with considerable equanimity despite the fact he stands a loss of 30% at the latterfigure. His “dollar” loss looks small, and he still thinks it will be easy for his stock to get back up to6 or 7; so, he is willing to wait.
Another factor enters into and reinforces the “extent of decline” criterion. If our PDQ rallies, asbefore, from 20 to 24 and then drops rapidly to 12, not only will many of the old owners at 20 bethoroughly disgusted and glad to get out at that price, given an opportunity, but the new owners at 12also will be pleased to take 20 (66 2/3% profit) and quick to do so if they detect any signs of troublethere. New buyers at 18, needless to say, would not be quite so ready to sell at 20.
A third criterion for appraising the Resistance potential at an old Bottom level is the length of timethat has elapsed since it was formed and the nature of general market developments in the interim.You will, no doubt, find it reasonable to suppose that an Intermediate Bottom formed in the earlystages of a Bear Market will offer relatively little Resistance after prices have fallen far below it,have taken perhaps the better part of a year
56
52
48
44
40
38
36
34 Sales 100's
50
40
30
20
10
Figure 13.2 Support-Resistance Levels in a long Intermediate Uptrend. The reader will need noguidance in applying the principles stated in this chapter to the Bendix weekly chart reproducedabove. Observe that when prices broke down in 1945 through a long trendline, their decline stopped,nevertheless, at the Support set up by the previous November's Top.
to make a Major base, and then have gradually climbed up to it again four or five years later. Tosome small extent, this is true. A supply only a year or two old is apt to be more effective than onethat is four or five years old, but the latter does not lose all of its potency by any means. In fact, it isoften surprising how effective the Resistance will be at a very old Bottom zone, provided it has notbeen “attacked” in the interim, and provided no changes have been made in the capitalization of thecompany that might obscure, in the mind of the owner, the original cost of his stock. Under the latterheading, we would put split-ups and large stock dividends, or even an unusually generous cash“melon.” We do not mean to imply that an investor is ever actually deceived as to the actual cost ofhis shares, no matter how they may have been split, or what dividend distribution has been made,but his disappointment (and desire to get out even) may be abated.
If, however, a Resistance Zone has once been attacked—if prices have come back up to it, hit it, andthen retreated—some of its power has obviously been removed. Some of its overhanging supply hasbeen used up in repelling the first attack. The next advance, therefore, will have less stock to absorbat that level. Here again, the volume chart may be looked to for some approximation of the amountof Resistance consumed. In any event, it is an odds-on assumption that a third attack at a ResistanceLevel will succeed in penetrating it.
We have named three criteria—volume, distance away, and time elapsed—to be used in assessingthe amount of Resistance to be expected at any given level. At this point, it must be apparent (andperhaps disappointing) to the reader that his own judgment must play a large role in applying them.This cannot be helped; it is impossible to set up an exact mathematical formula for any of them.
But, after all, the problem is not too complicated. The general principles are simple enough and, webelieve, easy to understand. We can look back at the charted history and see where, in the lastpreceding downtrend, a Bottom formed that may produce more or
30
25
20
15
10
5
Figure 13.3 For Major Support-Resistance Level study, monthly charts are most useful. This onepresents many points of interest. Observe how important levels are formed and how, once formed,they appear again, and reverse their roles. The price scale shows 1947 values with previous yearsadjusted for the splits of 1933 and 1946.
less Resistance when the current advance reaches back up to its range. We have to estimate howmuch supply resides there, how many shares were bought originally at that price and are still held byowners who may welcome a chance to get out even.
The greatest danger in applying judgment to the measuring of these factors lies in underestimatingthe amount of Resistance to be expected. Guard against that effort; it is safer always to overestimateit. You may be Bullishly disposed yourself; you may say, “Those fellows who were hung up there inthis stock must realize that conditions have improved, and they will not be so anxious now to sell.”Don't count on it. Recall, they have been “hung up” for a long time; even if they are mildly Bullishon the market in general, they may be so disappointed with this particular stock that they want toswitch out of it and try something else. (The stubborn and often costly refusal of the averageAmerican investor to “take a loss” operates even against timely switching.)
Everything we have said in the foregoing paragraphs about estimating potential Resistance appliesas well—but in a reverse direction, of course—to estimating potential Support. The principles areprecisely the same, even though the underlying rationale may be less easy to grasp.
40
30
20
10 Sales 100's
800
400
Figure 13.4 Particularly noteworthy in this monthly record is the Resistance met in 1939, 1940,1941, and even in 1944, at the Bottom level (just above 26), the three-month Congestion of 1936.Also, the appearance eight years later (!) in 1945 of Resistance at the Bottom level (28) of the High-Volume Top Congestion of 1936-1937.
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Prices were able to “skyrocket” when that Resistance was finally overcome. You will find thatseveral additional Support-Resistance Lines might have been drawn on this chart. Note MajorBottom Formations of 1937-1938 and 1942.
Locating precise levels
Our next problem to consider is how, in practical day-to-day chart analysis, we can locate as exactlyas possible the limits of a Support or Resistance Range and, in many cases, the specific price figurerepresenting the core or axis of such a range. In the theoretical examples we have made up so far toillustrate basic principles, we have used even figures, but in actual trading, the levels are seldom sonicely marked. Even the sharp and relatively patternless Bottom of a Recession may consist of aweek of price fluctuations within a narrow range. Perhaps the lowest day of that week's Congestionwill appear on the chart as a One-Day Reversal, or there will be two or three days that “spike” downbelow the general mass. Here again, although no mathematical rule can be laid down, it is easy torelate the price and volume patterns visually, and by simple inspection, arrive at a near estimate ofthe figure at which supply in quantity is likely to be forthcoming. Look particularly at the closinglevels of the days making up the Bottom Congestion and average them mentally; this figure is apt tobe pretty close to the “center of gravity” of the entire Resistance Area.
Some supply is likely to start coming in as soon as a subsequent advance reaches the bottommostfraction of the Resistance Zone, and more and more will appear as the move pushes up into it.Sometimes, it is possible to predict “to a hair” just how far prices will penetrate a Resistance Rangeby carefully comparing the vigor (volume of trading) on the advance with the volume registered atvarious levels in the original formation of the Resistance. This takes experience, but it is experiencethat you will find quite easy and not at all costly to gain. In most cases, however, it is neithernecessary nor particularly desirable to be so exacting.
Nearly every chart in this book shows some example of Support and Resistance phenomena, and thereader should make it a point when he has finished this chapter to go back over and study them all indetail. The practical application of the rules we have been discussing will be greatly clarified.Equally instructive, if you can manage to obtain such a collection, is a study of the Support andResistance Levels appearing in the monthly charts of all actively traded stocks over a period of 10
years or more. EN: Easily generated by most currently available software and on the internet atstockcharts.com and other sites. You will undoubtedly be amazed to see how Tops, Bottoms, andSideways Congestions tend to form at the same approximate levels in successive Major Swings,while prices move freely and rapidly, up or down, through the ranges between such levels. It ishardly necessary to dwell on the practical dollars-and-cents value of such information that may bederived from the chart history.
This brings up a matter that we may as well pause to consider here—the kind of charts most usefulfor locating and appraising Support and Resistance Levels. For near-term Minor Moves, the dailychart is naturally the only source of information, and a daily chart record that extends back for a yearor more may, if necessary, be used in the location of levels of Intermediate Trend importance. Thewriters have found, however, that a daily chart does not give the perspective on the long range thatone really needs to determine Major and Intermediate Support and Resistance Zones. It is apt tooveremphasize the potential of a recently set up Minor Support (or Resistance) Zone and obscure theimportance of a true Intermediate Level. For true perspective, a weekly chart, showing volume aswell as price ranges, and covering at least the whole previous Major Bull and Bear cycle, is mostdesirable. Also, very good results can be obtained with a little study and experience from monthlycharts.
To return to our study of Support phenomena, we have had several occasions to refer in previouschapters to a “normal” trend. What we have had in mind might perhaps be better called an “ideal”trend because, like so many other so-called normal things, it represents a pattern from which thefacts of experience frequently deviate. In stock trends, nevertheless, this normal or ideal appears as afairly common pattern. If it is an uptrend, it consists of a series of zigzags (EN10: think waves, as inChapter 28), each “zig” carrying prices to a new high and each “zag” taking them back to theapproximate top of the preceding “zig.” To illustrate with figures, up to 10, back to 6, up to 15, backto 10, up to 20, back to 15, up to 26, back to 20, and so on. Such a move is what technicians refer toas “self-correction” and regard as particularly sound and, hence, likely to be continued. You can seeit really represents a reaction to the nearest Minor Support Level following each step forward. If youbecome interested in an issue with such a trend pattern, the normal return to a Support produces agood place to buy.
Significance of Support failure
Sooner or later, however, a normal Minor Wave Pattern is bound to be broken up. This generallyoccurs in one of two ways (although there is an infinity of possible variations). In one, prices spurtaway in an advance out of all proportion to the previous succession
Figure 13.5 A monthly chart of Jewel Tea Company with its Major Support-Resistance Levelsmarked. Note the reversal of roles.
of up waves. Such a move is seldom followed by a reaction to the Support now left far behind, butrather, by the construction of some sort of Area Pattern—which may be either Consolidation orReversal.
The other type of disruption appears when a reaction does not halt and reverse at the level of theprevious Minor Top, but sifts on down through that zone, perhaps to the level of the preceding MinorBottom. This move has “broken its Support,” and any such action carries a distinct warning of achange in trend, a particularly emphatic warning if activity shows a tendency to increase as or afterthe Support is violated. Note we said change in trend rather than Reversal because the puncturing ofa Minor Support Level may signify only a halt for sideways Consolidation, yet it may also foretokenan impending Reversal; either of these is a change.
If you will now call to mind the picture of a typical Head-and-Shoulders Top, you will see thedecline from the head constitutes just such a break in Minor Support because it comes down throughthe level of the top of the left shoulder. You will recall this decline is often the first intimation wehave that something in the nature of a Reversal Formation is developing.
Thus, even the violation of a nearby Support Level has a practical meaning in technical chartanalysis. The breaking of a Minor Support should always be regarded as the first step in the Reversalof the Intermediate Trend. (If it turns out to be Consolidation only, there will be an opportunity laterto reenter an abandoned commitment if desired.) By the same token, the breaking of an IntermediateSupport Range is frequently the first sign of a Reversal in the Major Trend. We do not believe it isnecessary to expatiate further on this principle. Recommended trading tactics based thereon arediscussed in Section II of this book; Support and Resistance Levels are particularly useful as BasingPoints for stop-loss orders, which are discussed there.
Popular misconceptions
The reader will understand all we have said here about the breaking of Supports applies as well, butin reverse direction to the penetration of Resistance Levels. One more point may well be mentionedbefore we leave this subject; if you happen to have spent much time in
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Figure 13.6 When prices broke down out of the large Descending Triangle that formed onRemington Rand's weekly chart in 1946, the decline might have halted, at least temporarily, around37 at the level of the four-week Congestion made in April and should have “caught Support” at 35-36, the level of the February top. Failure of the latter carried Major Trend significance. Note laterResistance at 40 1/2.
boardrooms, you will have noticed the concepts of Support and Resistance prevalent there aresomewhat different from those outlined in this chapter. For example, if X has advanced to 62,reacted to 57, and then pushed on to 68, many traders will speak of 57 as being the Support Level,presumably because that was the last price at which X was supported in sufficient strength to turn itstrend from down to up. We, as you have seen, would name the vicinity of 62 as the Support Range.The distinction is important to grasp and sometimes extremely important in practical results.
Admittedly, it does not come easy to think of a former Top as denoting the level at which a laterBottom should form, or vice versa; it would seem superficially to be much more logical to relate Topto Top and Bottom to Bottom. Moreover, it is perfectly true, to use our X example again, that someof the investors who wanted to buy it at 57 might not have succeeded in getting it before the secondadvance to 68 took it away, and their buy orders might still stand at 57 or might be reentered on anyreturn to that price. Nevertheless, there is certainly no assurance that such is the case; there is no“vested interest” in X at 57 that will “automatically” bring in new buying. On the other hand, wehave seen how there is a sort of vested interest set up at an old Bottom that produces selling(Resistance), and thereby creates a new Top, and at an old Top that produces buying (Support) andthereby creates a new Bottom.
The reader is urged to keep this concept well in mind. Any analytical study of the chart records willquickly show it is much easier for prices to push up through a former Top level than through theResistance set up at a previous volume Bottom (and vice versa, of course, with respect to declines).You will find a little selling may come in at a former high, but usually only enough to cause a briefhalt rather than the more or less extensive reactions or Consolidations that develop when the trendcomes up against a real Resistance Zone.
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Figure 13.7 York is a relatively thin stock, which normally makes many small, technicallymeaningless gaps, but its large, high-volume gap of October 8, 1945, demanded attention. It lookedlike a Runaway Gap, and as such implied continuation to 26 1/2 plus, but prices halted their advanceat 24 1/2 and went into a three-month Rectangle. An upside breakout on January 10, 1946, carriedout the minimum measurement of the Rectangle (and October gap); prices then reacted. See sequelin Figure 13.8.
The round figures
There are certain other levels that may, at times, evidently produce considerable Resistance orSupport without any reference to a previous “vested interest.” We have in mind the “round” figures20, 30, 50, 75, 100, etc. In setting a goal for taking profits when we buy a stock, it is natural for us tothink in terms of such round prices. If a low-priced stock has advanced steadily from around 10, it ispretty certain on this account to meet with profittaking sales at 20, especially if that figure representsa new high for several years. In fact, any time an issue gets out into new all-time high ground, wherethere is nothing in its chart history to indicate otherwise, it is a fairly safe bet that Resistance willappear at the round figures. In old and actively traded stocks, such as U.S. Steel (EN: or IBM andGE), the round figures diminish in importance.
Repeating historical levels
If, once they had been set up, important Support and Resistance Levels always “worked,” we shouldsee Intermediate Tops and Bottoms form at exactly the same ranges year after year in one Bull andBear cycle after another. As a matter of fact, there is a well-marked tendency for this to occur in old-line, actively traded stock. In General Electric, for example, the 22-24, 34-35, 40-42, and 48-50zones were characterized by large turnover (and, consequently, by many Intermediate Reversals oftrend) throughout the 1920s and into the 1950s. In Southern Pacific, there are historical Support andResistance Zones at 21-22, 28-30, 38-40, and 55-56. In U.S. Steel, 42-45, 55-58, 69-72, 78-80, and93-96 are conspicuously marked as Reversal
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Figure 13.8 The February reaction in Figure 13.7 met momentary Support at 24; prices bounced farenough to close the February 7 gap and then broke down through the Rectangle Top-Line Supporttechnically a distinct warning. Then a Symmetrical Triangle formed, but the breakout came too nearthe apex, produced only a rally to the former high, and then an “end run.” One did not need to waitfor the Double Top signal on August 22 to forecast a decline of more than minor consequence.
Ranges. Additionally, many other stocks might be cited. (EN9: While the particular stocks are deador transmogrified, the principle is alive and well.)
Over long periods, however, such Support and Resistance Levels do tend to be gradually modified,broadened, or “blurred” as new ones are created. One source of many important new Supply Zonesis a Bear Market Panic. For this is the one type of decline that can be counted on to pay no heedwhatsoever to previous underlying Support Zones. Panics (which, as seen in our earlier study ofPrimary Swings in connection with Dow Theory, typify the second phase of Bear Markets), oncethey get under way, seem to sweep away all potential Support in their calamitous plunges until theyexhaust themselves in a general market Selling Climax for which may or may not come at a levelthat bears a relation to some previously established Support. To use U.S. Steel again as an example,the 1937 Panic Decline took the stock down through its 93-96 range, hesitated briefly at the 78-80level, and then plunged through 69-72 and 55-58 to stop just above 50. In the 1946 Panic, X againbroke swiftly through 78-80 and 69-72 to halt at 66.
When there is a large turnover at a Panic Bottom in any given stock, that level acquires a strong“vested interest” for the future and will usually furnish conspicuous Resistance to a subsequentadvance (after another Bear Market Decline has taken quotations below the Panic Level).
This discussion of Panics brings us back to a consideration of Support and Resistance performanceat other stages of the Primary Trend. Bearing in mind the relation of Resistance to volume, it is easyto see why in a long drawn out but otherwise typical Bear Swing in which trading interestdiminishes to a very low ebb as the final low is approached, the next to the last Intermediate Bottommay produce relatively little supply and, consequently, only a small reaction when the new uptrendreaches its level. Add to this the fact that many of the buyers in the last stages of a Major Decline aredeliberate scale-down investors who fully expect prices will go lower and, hence, are not easilyshaken out. The slow progress so often seen in the first part of a new Primary Bull Market is due notso much to overhead Resistance as to lack of impatient public bidding.
The Recovery Trends that follow precipitous Bear Market Panics usually exhaust themselves, forobvious reasons, long before they get back up to the last Resistance Level left behind in that PrimaryDownswing (which is usually the Bottom of the first Intermediate Decline from the extreme Top ofthe cycle), but they often meet supply at a lower Resistance Zone set up in the preceding BullMarket. Look way back on your charts, therefore, when sizing up the prospective advance in suchsituations.
A further thought along that line is this: there is no law that requires an advancing trend to keep righton climbing until it reaches a distant overhead Supply Zone. It is true, as a corollary that we havealready mentioned to our Support and Resistance Theory, that prices can and do rise easily through aprice range at which no Bottoms or Congestion Areas have formed in previous downtrends, but ifthe first established Resistance Level is a long way above, the advance may exhaust itself before itgets there. Heavy supply may come in for other reasons at a lower level. Think, then, of a distantResistance Level as a maximum possibility rather than as a certain goal. However, between twostocks whose purchase you are considering, you should select the one, other things being equal, withthe “thinner” track overhead and can rise farther before it encounters a charted Supply Zone.
Pattern Resistance
We can revert now to some of the Minor phenomena discussed in connection with Reversal andConsolidation Patterns in earlier chapters. Take gaps, for instance. You will now see why it is easyand, hence, quite in order for a reaction that comes soon after a gap has been made to slip back andclose that gap. There is no “vested interest” whatever in the range through which prices skipped to
form the gap on the chart. You will also see why such a reaction may stop short and reverse as soonas it has closed the gap, provided there was a high-volume turnover in the price range immediatelypreceding the gap. Such is usually the case with a Breakaway Gap.
Any gap, for the same reason, is easy to close once a reaction starts prices moving back in thatdirection, if it is not too far away and if there are no intervening Resistance Levels to stop thereaction before it gets there. In the case of a Runaway Gap, however, there is no reason why areaction should halt as soon as it has covered the gap range; on the contrary, it will probablycontinue on through the “thin” price track that preceded the gap.
Pullbacks and Throwbacks—the quick return moves that we noted as developing so often shortlyafter a breakout from a Head-and-Shoulders or other Area Pattern—exemplify the principles ofSupport and Resistance. When prices break down, for example, out of a Descending Triangle, thehorizontal lower boundary of the formation, which was originally a Demand Line, promptly reversesits role and becomes a Resistance Level. Any attempt to put prices back up through it, therefore,after a decisive breakout, is stopped by supply at or near the line. By the same token, the neckline ofa Head-and-Shoulders Top, which was a Demand Line, becomes a Resistance Level after it has beenbroken. The Top or Supply Line of a Rectangle becomes a Support after prices have pushed above iton volume and by a decisive margin.
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Figure 13.9 We first discussed Pullbacks in connection with the Head-and-Shoulders in Chapter 6and refer to them again in this chapter as Support-Resistance phenomena. At least one Pullback tothe neckline (after the breakout) occurs in the great majority of cases. Many Head-and-ShouldersFormations produce two, the first within a few days after the breakout and before prices have gottenvery far away, and the second weeks later, sometimes after the minimum measurement of the Head-and-Shoulders has been fulfilled. Goodyear saw the unusual number of four Pullbacks to its 1946neckline in the first two weeks after the August breakout, another in October, a third in November,and a fourth in February 1947, which met the Double Resistance of the neckline and the downtrendline (see Chapter 14) projected from the 1946 April head and August right shoulder.
Earlier in this chapter, in our discussion of the three criteria for appraising the amount of Resistanceto be expected at a former Bottom level, we named “distance away” as one of the criteria and statedas a general rule that prices should have gone at least 10% beyond that level in a medium-pricedstock before much Resistance would be set up. This 10%-away rule does not apply in the case of aThrowback to a well-defined area formation when it follows shortly after a breakout. All that isnecessary to establish strong Resistance to such moves at the pattern boundary is a conclusivebreakout.
The Symmetrical Triangle has a different sort of Support and Resistance “field.” You will recall thatthe first Reversal point in the formation of a Symmetrical Triangle (a Top, if it forms on a risingtrend, or a Bottom if on a decline) is normally accompanied by high trading volume, but that activitydiminishes rapidly on succeeding fluctuations within its converging boundaries. Consequently, onceprices have broken out of the Triangle and have proceeded well beyond the level of the pattern's firstReversal point, that level, because of the volume of shares traded there, becomes a Support (orResistance) against a subsequent reaction. But, if the breakout move does not carry beyond theTriangle's first Reversal Level by a clear margin, any Throwback will probably bring quotationsback to the extended (sloping) pattern boundary. If the reaction does not occur until the trend hasworked out to or beyond the Triangle's apex, then the Throwback usually will not meet Support (or
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Figure 13.10 Several examples of the Support “field” of the Symmetrical Triangle appear in this1945 daily chart of “IT.” Following the belated February 5 breakout from the first Triangle, pricesreturned on the 9th to the level of the mid-January Top, but then suffered a more extensive reaction,which came down on February 26 to the Triangle's apex level. This was a critical juncture. The apexpoint itself is a strong Support (or Resistance), but its level becomes weaker as time passes. In thiscase an “end run” might have been developing. Stop-loss orders should always be entered under anapex level (see Chapter 27). Here the apex held, however, and prices went into another “Coil,”breaking out topside on March 10. Their next reaction was supported, as was to be expected after an
early breakout like this, at the Top Pattern Line. The price track from mid-March to the end of Aprilfell into an Ascending Triangle Pattern, the top boundary of which functioned as Support in June butwas broken in July. Refer to Figure 11.17.
Figure 13.11 In this instance, a belated upside breakout (August 10) from a Symmetrical Trianglefailed quickly and the subsequent reaction, after holding for several days at the apex level, finallybroke down for an “end run.” Thereafter, note the apex level turned into a Resistance againstRecovery Moves.
Resistance) until it has carried back to the level of the apex, which, in brief, represents theconcentration level or axis of the Triangle's Support and Resistance.
The intersection of the two converging boundary lines of a Symmetrical Triangle has sometimesbeen called a “cradle.” The axis Support (or Resistance) is strongest near the cradle point and getsweaker as the axis line (apex level) is extended out to the right on the chart (i.e., as time passes).Thus, if a late breakout move fails to carry prices very far from the Triangle area, and the trend thenpeters out, flattens, and begins to react after the cradle point has been passed in terms of time, itsaction, as it reaches the axis line, must be closely watched. (A stop-loss order may be indicatedhere.) Should the axis Support fail to hold, the reaction may plunge through and accelerate in a moreextensive swing, which has aptly been termed an “end run around the line.”
Volume on breaks through Support
On those occasions when prices fail to retreat when they hit a Resistance (or Support) Range, butperhaps after holding there for several days, push on through, there is nearly always a suddenacceleration and a marked pickup in volume. This may be taken as confirmatory evidence of adecisive break and, consequently, an indication the move will carry on. The reasons for this volumeincrease are obscure. Some say, “It takes volume to overcome
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Figure 13.12 Here is a typical case of two Pullbacks to a Head-and-Shoulders neckline, the firstimmediately after the breakout and the second three weeks later. Note the initial breakthrough“bounced” from the early April Top Support and the late July decline met Support at the generalApril-May Congestion Area. However, what this chart particularly illustrates is how volumeincreases when a good Support Range is penetrated. Note the decided pickup on August 27, whenthe April-May area was left behind.
Resistance,” which is true enough, but the volume usually comes after the Resistance has beenpenetrated. Therefore, others say, “The volume is evidence that technicians see what has happenedand are now jumping in.” But that line of thought, in the authors' opinions, also has little tosubstantiate it. (We shall have more to say about the questionable influence of technicians on thetrend later on.) Many of the arguments over volume change versus price change smack of the oldhen-or-egg riddle. In any event, causes for many technical phenomena, such as this one, may be leftto the academicians, provided the practical implications are clear.
Support and Resistance in the Averages
As has been the case with nearly every other technical phenomenon we have studied, the principlesof Support and Resistance apply, with suitable allowances, to Averages as well as to individual
stocks. Since an Average reflects the combined charts of the majority of the issues that compose it,but with a minority of them frequently evincing quite divergent patterns, it follows naturally thatSupport and Resistance Zones in the Averages cannot be as sharply and narrowly construed. MinorTops and Bottoms in the Averages, particularly, are less dependable as Resistance Levels. Clearlydefined and important Intermediate Reversals, however, as they nearly always represent Reversals inthe entire market (practically all stocks), will normally produce strong Resistance (or Support, as thecase may be) in the subsequent Average Trend.
When the Averages break down through a Support Level, but simultaneously one or more stockshold firm at or above their corresponding individual Supports, there is a presumption that thoseparticular stocks are in a stronger position than others to participate in the next recovery. The phrase“other things being equal” should be added, however, for there are qualifications to this presumptionthat must be considered. For instance, it may be that the stock that has resisted decline will, for thatvery reason, be less attractive to new buyers than one that broke drastically and is now purchasableat a more “attractive” price.
Many of the claims made regarding future prospects for stocks that have, by one criterion or another,previously evinced “better-than-Average” or “worse-than-Average” market performance permitargument either way. It is safest to treat all such relative performance indications as only one minorfactor to be appraised in the overall chart picture.
chapter fourteen
Trendlines and Channels
One of our basic tenets in this system of technical stock chart analysis—
indeed, a fact that any neophyte can quickly verify for himself by inspection
of the market records for whatever period he chooses—is that prices move
in trends. The market, in general, and the many stocks that compose it, do
not jump up and down in an altogether random fashion; on the contrary,
they show definite organization and pattern in their charted course. (For
illustrations in this chapter, see Figures 14.1 through 14.17.)
Prices move in trends. These trends may be either up or down or sideways
(horizontal). They may be brief or of long duration. They may be classified
as Major (Primary), Intermediate (Secondary), or Minor, according to the
rules of Dow Theory, or as Horizontal Line Formations. (The distinction
between a short Intermediate and an extended Minor Trend is often more
difficult to make with individual stocks than it is with the Averages, but it is
not so important.) Sooner or later, trends change; they may change by
reversing from up to down or down to up, or they may also change direction
without reversing as from up to sideways and then perhaps to up again, or
from a moderate slope to a steep slope, and vice versa.
Profits are made by capitalizing on up- or downtrends by following them
until they are reversed. The investor's problem is to recognize a profitable
trend at the earliest possible stage of its development and then later to
detect, again as quickly as possible, its end and Reversal. The Reversal of
any important trend is usually characterized, as we have already seen, by
the construction of some sort of joint price and volume pattern—in brief, of
a Reversal Formation.
The Trendline
All of the foregoing statements regarding trends have been expressed or
implied in earlier chapters of this text. It is our purpose now to examine
trends, as such, more closely, to see how they may be plotted most
effectively on the charts, and to determine to what extent they can be used
to reinforce or supplement the technical forecasts derived from our other
chart formation and Support-Resistance studies—sometimes to furnish even
earlier forecasts or warnings of change.
One of the first discoveries a new student is likely to make when he begins
to inspect stock charts with a critical eye is that nearly all Minor and most
Intermediate Trends follow nearly straight lines. A few readers will,
perhaps, dismiss this as perfectly natural, something to be taken for granted.
But the majority become increasingly amazed and excited as they delve
deeper. Not only the smaller fluctuations, but also the great Primary Swings
of several years' duration frequently appear on the charts as though their
courses had been plotted with a straight-edge ruler. This phenomenon is, in
truth, the most fascinating, impressive, and mysterious all the stock charts
exhibit.
If we actually apply a ruler to a number of charted price trends, we quickly
discover the line that most often is really straight in an uptrend is a line
connecting the lower extremes of the Minor Recessions within those trends.
In other words, an advancing wave in the
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Figure 14.1 A series of Intermediate Trendlines drawn to illustrate the
“basic” principle (see “How Trendlines Are Drawn”) on a weekly chart of
Atlantic Refining, extending from January 1944 through August 1947.
Observe that each up trendline required two distinct Bottom points to
determine it, and each down trendline, two Tops. In some cases, the two
determining points were formed only a few weeks apart, as in August and
September 1945. The Bottom points that fixed the early 1946 up trendline,
on the other hand, were months apart—February and June. Note that only
final Trendlines are shown here. Many other experimental lines might have
been drawn on this chart originally, including several uptrends whose
Intermediate authority was questionable because they were “too steep”—as
in early 1944, late 1945, and early 1946. There are also some interesting
examples of Pullbacks (after trendline penetration) that are discussed later
in this chapter. Note July 1944, April 1945, September 1945, and May
1947.
stock market is composed of a series of ripples and the Bottoms of each of
these ripples tend to form on, or very close to, an upward-slanting straight
line. The Tops of the ripples are usually less even; sometimes they also can
be defined by a straight line, but more often, they vary slightly in
amplitude, and so any line connecting their upper tips would be more or
less crooked.
On a Descending Price Trend, the line most likely to be straight is the one
that connects the Tops of the Minor Rallies within it, while the Minor
Bottoms may or may not fall along a straight edge.
These two lines—the one that slants up along the successive wave Bottoms
within a broad up-move and the one that slants down across successive
wave Tops within a broad down-move—are the basic trendlines.
It is unfortunate that a more distinctive name for them has never been
devised than the threadbare word “line,” which has so many other uses and
connotations. A few analysts have called them “tangents,” a term that has
the advantage of novelty, but, because it is a distinct perversion of the true
meaning of the word tangent, confuses many readers even more. Perhaps
tangent will eventually become established in this new sense. We shall be
satisfied herein with the overworked “line,” and will give it some
distinctiveness in its present context by joining it to trend in the one word
“trendline.”
Figure 14.2 This 1935-1936 daily chart of Atchison illustrates how the
latter part of a long, strong Intermediate Advance may accelerate away from
its trendline. Notice the action in late January and early February. Prices
dropped back to 66 in April 1936 after this Up Trendline was broken at the
end of March. Note also at the point at which the December 1935 reaction
met Support, the trendline coincided with a Triangle apex level. Such
“coincidences” appear frequently in technical studies.
Trendlines, you may have heard it said, “are made to be broken,” but that is
one of those exasperatingly sententious remarks that fails to clarify
anything. Of course they are broken; they are all always broken, ultimately,
and some very shortly after they are set up. The problem is to decide which
breaks (i.e., penetrations by a price movement) are of important technical
significance and which are of no practical consequence, requiring possibly
only a Minor Correction in the drawing of the original trendline. There are
no 100% certain quick answers to this problem; the significance of some
penetrations cannot be determined as soon as they appear, but rather must
await confirmatory indications from other chart developments. In a great
majority of instances, however, an important break—one that requires a
prompt review and possibly a revision of trading policy—is easy to
recognize.
How Trendlines are drawn
First, how are trendlines drawn? A straight line is mathematically
determined by any two points along it. To draw a trendline, therefore, we
require two determining points— two established Top Reversal points to fix
a Down Trendline and two established Bottom Reversal points to fix an Up
Trendline. The principle here is the same as the one we laid down in our
specifications for drawing Triangle boundary lines in Chapter 8. The fact is
that boundary lines of Triangles and Rectangles, as well as necklines of
Head-and-Shoulders Formations, are simply special types of trendlines.
Suppose we start with a Major Bottom point and describe how a series of
Up Trendlines might develop therefrom. To make this first illustration
simple, let us assume the Bear
36
34
CRANE COMPANY
32
30
28
26 Sales 100's
125
100
75
50
25
JANUARY FEBRUARY MARCH ApRIL MAY JUNE
■ 6 M3 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30
Figure 14.3 Trendlines that defined the short-term swings in Crane
Company in 1945. Note three Bottoms formed on the first up-line and the
third rally (late February) in this advance failed to reach a line drawn across
the earlier Tops parallel to the Basic Trendline. A failure of this sort
frequently precedes a break in the trend. The same thing happened at the
end of the second uptrend in late May. “Failures” and the use of parallel or
“Return” Lines will be discussed later in this chapter. The downtrend in
March assumed a Wedge form. Observe how the April 6 reaction met
Support at its previously penetrated Top line. In June, a rally met Resistance
at the previously broken Up Trendline. Such Pullbacks are common. The
small Complex Head-and-Shoulders in June was never completed because
prices did not break down out of it by the required margin.
Market Bottom in our stock consisted of a Rectangle area between 6.5 and
8, and the last move in this formation arose from the 6.5 level, broke
through the pattern's Top at 8, and proceeded to 9. From 9, prices reacted to
8 and then headed back up again. As soon as this last rally had gone far
enough to leave the dip to 8 showing in the clear as a Minor Bottom, we
could draw our first Up Trendline because we then had two Bottom points,
the second (8) higher than the first (6.5), to fix its slope. This would be a
Minor Up Trendline. We would rule it in lightly on our chart in pencil and
extend it on up and ahead for, perhaps, a week or more. (It will help you to
visualize our example if you sketch it on a scrap of chart paper.) To
proceed, suppose prices push up to 10, then move sideways for a few days,
or dip slightly, until they have approached and touched, once more, our
extended Minor Trendline. Then they start to move up in a third advance,
but they run into supply again without making much progress, quickly
make a fourth contact with the trendline, hesitate, and then break down
through it. If prices now close clearly below the line and if there has been
some pickup in trading volume evident on the penetration, we may
conclude our first Minor Trend is completed, plus our stock either will build
some sort of Consolidation Pattern before it stages another advance or it
will suffer a more extensive “Correction” than any of the brief dips it
registered during its first Minor Upswing.
The whole Minor Uptrend we have described as an example in the
foregoing paragraphs might well have run its course in two weeks; our first
trendline would then have been very steep—too steep, obviously, to hold
for any very long period of time. Now, let us assume a series of downward
fluctuations produces the more extensive correction that we have foreseen
as one probability following the trendline break that carries prices back to
the Support Level set up at the Top of the original Rectangle, that is, at 8.
(From our previous Support-Resistance studies, we would recognize this as
a prime “buy spot.”) Assuming
32
30
28
26
24
22
20 Sales 100's 250 200 150 100
50
COMMERCIAL SOLVENTS
CV
1946
MAY
‘JANUARY- ,
' 5 12 19 26 2 9 16 23 2 9 16 23 30 6 13 20 27 4 11 18 25 1
JUNE
8 15 22 29
Figure 14.4 Intermediate Downtrend and Uptrend in Commercial Solvents
in 1946. Note the increased volume on the March 30 penetration of the
basic Down Trendline (and, at the same time, a breakout from a small
Head-and-Shoulders Bottom). The drop through the lower parallel at the
end of February had no technical significance. The Up Trendline from the
March low was broken on June 14, simultaneously with a breakout from a
Descending Triangle, which, as it turned out, was the final Bull Market Top.
that subsequent developments pursue a normal course, prices should not
linger long at 8, but should start promptly on a new series of advancing
fluctuations. As soon as this becomes evident and the new Bottom at 8 is
“in the clear,” we can rule in a new trendline across the original base point
at 6.5 and the new point at 8. This should be, and probably is, an
Intermediate Up Trendline that will not be penetrated for several weeks,
maybe for several months, until the Intermediate Advance tops out.
Subsequently, if that Intermediate Top takes the form of a Head-and-
Shoulders Reversal Pattern, our Intermediate Up Trendline may be broken
by the recession from the top of the head to the neckline. As a rule,
however, the final advance in a strong Intermediate Move accelerates far
enough away from the extended trendline to leave room (to the right on the
chart) for considerable pattern construction before the line is again touched
and penetrated. Hence, the actual puncturing of the trendline is more apt to
occur either on the decline from the right shoulder to the neckline, or at
about the same time as prices break down through the neckline to complete
the Head-and-Shoulders signal. It is surprising to see how often the two
lines, neckline and trendline, are broken simultaneously. In other instances,
and there are many of them also, in which the trendline is the first to be
punctured, perhaps shortly after prices turn down from the right shoulder,
we do not have to wait for a neckline break but can take action at once.
Here is one type of trendline indication that produces a working signal a
little earlier, and often at a much more favorable price level, than is given
by the completion of a Reversal Formation.
Arithmetic versus logarithmic scale
By this time, the more mathematically inclined among our readers must
have begun to ponder the difference between trendlines projected on the
ordinary or arithmetic scale
20
19
18
17 Sales 100's
- —
ii iln i n>
PHILLIPS PETROLEUM P
1935
1936
1937
1938
Figure 14.5 Valid trendline penetration and its normal consequences—
Reaction or Consolidation—is illustrated on nearly every chart in this
chapter and on many others throughout the book. This weekly chart of
Phillips Petroleum is reproduced here to show an outstanding exception.
The Intermediate Up Trendline projected from “P's” September 1936 low
up across its early October and late-November Bottoms was penetrated
downside decisively the third week of May 1937. Moreover, a Multiple
Head-and-Shoulders Top Reversal Pattern had been forming since February,
with a critical neckline at 52. And the then-current Bull Market had already
run for four years; “P” had come all the way up from 2! Cover up the chart
from July 1, 1937, and you will agree there was plenty of reason for any
technician to sell at once without waiting for the 52 neckline to be broken.
But this, as we have said, was one of the exceptions that occurs to all
technical patterns and rules. “P” turned right around and shot up to 64
before it was finished. Nevertheless, developments such as this carry a
valuable warning. They very seldomly appear unless the Major Trend has
almost run out; any further rise is dangerous to follow. and on the
logarithmic or ratio scale. A series of points that fall on a perfectly straight,
up-sloping line on arithmetic chart paper will, when transferred to a
semilogarithmic sheet, produce a curved line that rises sharply at first and
then gradually rounds over. Points that fall on a straight line on a
semilogarithmic sheet will produce an accelerating curve on an arithmetic
sheet, a line that slants up more and more steeply the farther it is projected.
As a matter of fact, this variance is of little or no importance in defining
Minor Trends, as they seldom run far enough for the dissimilar
characteristics of the two types of scales to become effective. The same
holds true for average Intermediate Moves of normal slope. However, when
it comes to very long and strong Intermediates, the divergence may become
marked and may make a considerable difference in the time and level of
ultimate trendline penetration. Therein lies one of the strongest reasons for
using semi-logarithmic paper in charting stocks for technical analysis. Let
us postpone further discussion of this point until we take up Major Trends
and go on now with the Intermediate Lines that are much the same on either
type of scale, concentrating on Intermediate Uptrends. (Intermediate
Moves, rather than Minor, are emphasized for the obvious reason Minors
are of little practical importance in either trading or investing.)
40 Sales 100s
125
100
75
50
25
PX
PARAMOUNT PICTURES
1945-1946
Jllll llllfllll
—MARCH
Biu_____
OCTOBER NOVEMBER DECEMBER JANUARY FEBRUARY ....._____
6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 2V9 16 23 2 9 16 23 30
Figure 14.6 Double Trendlines (see next section) usually are not evident
until after a trend has run for several months. In Paramount's accelerated
phase of Intermediate Uptrend, which began in October 1945, the double
nature of the basic trendline was not detectable until January 1946. The
inner (upper) line was broken again in April, but the outer (lower) line was
not decisively penetrated downside until May, at the Bull Market Top.
96
88
80
76 Sales 100's
125
100
75
50
25
Figure 14.7 Trend Channels in Bethlehem Steel in 1945. Prices burst out of
the 92-98 Horizontal Channel (Rectangle) on the upside in January 1946
and went on to 114. A short-term trader might have sold around 94-96 in
early November (because of the uptrend break) and rebought at 99 in
January on the Rectangle breakout. (See discussion of Channels.)
14
Sales 100's
500
400
300
200
100
MARCH
’JUNE
S
PN
APRIL
M11M "DECEMBER •
24 1-8 15 22 29
JANUAR^FEBRUAR^
5 12 19 26 2 9 16 23
AUGUST SEPTEMBER ’
10 17 24 31 7 14 21 28 5 ’
Figure 14.8 A 10-month downtrend, extraordinarily long and straight,
which was nicely defined by Double Basic Trendlines above the Price
Channel and also by a double set of Return Lines below it. The Major Top
started with a strong One-Day Reversal on December 3, 1945 and worked
out into a Descending Triangle that broke February 19, 1946. The
Symmetrical Triangle beginning to appear in September 1946 also broke
out downside.
1 7 14 21 28 5 12 19 26 2 9 16 23 30 7 • 14 21 28 4 11 18 25 18 15 22 29
Figure 14.9 Well-marked Intermediate Basic Trendline and Return Lines in
Southern Pacific, 1945. Note the Flags within Trend Channels—an up Flag
in June and a down Flag in August. The Uptrend Channel, which began
August 22, ran until February 1946.
34
32
30
28
26 Sales

26
24
22
20
19
18
Figure 14.10 Note the extent by which prices failed to come down to their
Return Line in late November measured the distance by which they
advanced through and above the Basic Down Trendline in early December.
This rule is stated in the discussion of Trend Channels.
Sales
Figure 14.11 Six months of an Uptrend Channel that actually started to
form in December 1943. It was broken downside in August 1945.
To go back to first principles, granting that price advances trend up in more
or less straight lines, it follows that finding and drawing the lines that
accurately define those trends, they will serve two purposes:
1. When the trendline is broken (i.e., when prices drop down through it
in decisive fashion), it signals the advance has run out. It calls time for
the intermediate-term trader to sell out that issue and to look for
reinvestment opportunities elsewhere.
2. When a small Top Reversal Pattern forms on the chart of an issue
well up and away from that issue's Intermediate Up Trendline, so that
there apparently is room for
24
22
20
19
18
17
16 Sales 100's 125 100
75
50
25
NASH - KELVINATOR
NK
1946 g
JULY
AUGUST SEPTEMBER
ApRIL MAY, , , JUNE , ,
6 13 20 27 4 11 18 25 1 8 15 22 29" 6 13 20 27 3 10 17 24' 317 14 21 28
Figure 14.12 The downtrend that started in June 1946 in Nash-Kelvinator,
signaled by the break of both its Intermediate and Major Up Trendlines
(MUT) on July 15, made a nice channel until September. An Intermediate
Down Trendline, drawn across the June 17 and July 1 highs, held for the
August rally. The Return Line, drawn parallel to it across the June 20 low,
held in late July but remained intact for only a few days at the end of
August. The August rally in both price and volume pattern showed Bear
Market characteristics. Compare this chart with Figure 8.25 and you will
see that a Major Double Top was signaled on July 23.
the downside implications of the Reversal Formations to be carried out
before the trendline is violated, then the intermediate-trend trader may well
decide to ignore the small Reversal Pattern. He can hold on so long as the
trendline holds.
The advantages of the first-named trendline function are obvious. Those of
the second, although less obvious to the inexperienced, are equally
important to the investor who has learned it is an expensive practice to
switch out of every holding as soon as it shows evidence of a Minor
Setback, provided the chance of further Intermediate Advance still exists.
To accomplish these purposes it is necessary, as we have said, to find and
draw the line that accurately defines the Intermediate Trend, and then to
recognize when that line has been broken in decisive fashion. Our earlier
quick review of how a trendline is constructed did not attempt to cover
these points thoroughly.
Tests of authority
The following are some of the tests that may be applied to judge the
technical validity, or authority, of an Up Trendline:
1. The greater the number of Bottoms that have developed at (or very near)
a trendline in the course of a series of Minor Up Waves, the greater the
importance of that line in the technical sense. With each successive “test,”
the significance of the line is increased.
Figure 14.13 The decline that took Macy down through an Intermediate Up
Trendline (IUT) in June 1946 turned out to be also the drop from the head
of a “Flat-Shouldered” Head-and-Shoulders Top, which was, in turn, part of
a larger Complex. The upper neckline was broken June 19 and the lower on
July 16. Note Pullbacks to each. F1, F2, and F3 are tentative Fan Lines.
Prices were finally able to clear F3 in December, but by that time, a Primary
Bear Market had been signaled, so the Fan Rule no longer applied. Fans call
the turn only on Secondary (Corrective) Moves.
A first and tentative Up Trendline can be drawn as soon as two Bottoms
have formed, the second higher than the first, but if prices move back to
that line a third time, make a third Bottom there, and start a renewed
advance, then the validity of that line as a true definition of the trend has
been confirmed by the action of the market. Should a fourth Bottom later
form on it, and prices move up away from it again, its value as a trend
criterion is very considerably enhanced.
2. The length of the line, that is, the longer it has held without being
penetrated downside by prices, the greater its technical significance. This
principle, however, requires some qualification. If your trendline is drawn
from two original Bottoms that are very close together in time—say, less
than a week apart—it is subject to error; it may be too steep or (more often)
too flat. If the latter, prices may move away from it and stay high above it
for a long time; they may then turn down and have declined well along in
an Intermediate Correction before the trendline thus drawn is reached. But
if the trendline has been drawn from Bottoms that are far enough apart to
have developed as independent wave components of the trend you are
trying to define, with a good rally and “open water” between them, then it is
more apt to be the true trendline. Greater weight should be given to the
number of Bottoms that have formed on a trendline (Test 1) than to its
length alone (Test 2).
3. The angle of the trendline (to the horizontal) is also, to some degree,
a criterion of its validity as a true delimiter of Intermediate Trend. A
very steep line can easily be broken by a brief sideways Consolidation
move—as, for example, by a compact Flag forming on an advance of
the “mast” type—only to have prices shoot up again in another
extensive advance. Such steep lines are of little forecasting value to the
technician. The flatter, more nearly horizontal the trendline, the more
important it is technically and, in consequence, the greater the
significance of any downside break through it.
ARKANSAS BEST
34
30
32
25
20
15
28
10
26
85
I—
>80'81',82:83 84
8687
24 -
22
20
19
18
17
16
15
14
13
12
11
Sales 100's
JANUARY Fl
ARKANSAS BEST'
F1 tati
EBRUARY MARC
11412128 7 1141211
AUGUST
7 114'21128 4
XD.09
XD.09
Figure 14.14 “ABZ” dropped sharply following its late January high,
capping off a nearly uninterrupted two-year rally. But despite the rapidity
and severity of the Pullback, it was, in fact, a picture-perfect reaction,
which stopped just above excellent long-term Support at the 1983 high after
retracing almost exactly 50% from its January peak. Not only is the reaction
a classic, but so, too, is the Fan Line development, which, when coupled
with the recently completed Head-and-Shoulders Bottom, suggests “ABZ”
has reversed its short-term downtrend.
But “steep,” as applied to stock trends, is a relative term and one that we
defies exact definition. Experience, which can only be gained by studying
many charts and by actually building and working with them over a period
of many months, brings an almost intuitive ability to distinguish between a
trendline that is “too steep to hold” and one whose angle of rise is
reasonable and should be maintained until such time as the trend is actually
reversed from Intermediate Up to Intermediate Down. Trend slopes will
vary from stock to stock according to their characteristic market habits.
They will vary also according to the stages of the Primary Cycle—tending
to become somewhat steeper in its later phases. The more chart history you
have on any particular issue in which you are interested, the better able you
will be to judge its present trend. (The foregoing statement, we might
remark, applies to the interpretation of most other technical patterns and
phenomena as well as to trendlines.)
38
36
34
32
30 Sales 100's 125 100
75
50
25
56
52
48
44
40
38
36 Sales 100's
50
40
30
20
10
Figure 14.15 A valid application of the Three-Fan Principle. Note prices
after they pushed up through F1 in March fell back to it but did not
repenetrate it. When F2 was broken in late March, prices came back to it at
the end of April but did not go below it. F3 was surmounted in May. This
was a Bull Market Reaction; "AS" made its final Top above 64 in August.
The March-May pattern might be called a weak Double Bottom.
DELAWARE & HUDSON DH
JULY ' AUGUST SEPTEMBER ’OCTOBER NOVEMBER DECEMBER
8 15 22 29 5 12 19 26 2 9 16 23 30 7 14 21 28^4 11 18 25 29 16 23 30
Figure 14.16 Try the Three-Fan Principle on this chart of the late 1944 Bull
Market Reaction out of a Symmetrical Triangle in "DH." F1 should be
drawn from the August 30 high down across the September 12 closing. F2
is already marked on the chart but not labeled. F3 would extend from
August 30 across the Rally Top of November 9. It was surmounted on
increased volume November 21. The mid-September to November price
pattern looked at first like a Descending Triangle, but volume began to rise
in October.
One clue to relative steepness is afforded to those who employ the
TEKNIPLAT semilogarithmic chart sheet, which has been used for most of
the illustrations in this book. When projected on this scale, Intermediate
Uptrends on the daily charts, in the great majority of issues selling in the 10
to 50 range, rise at an angle of approximately 30 degrees to the horizontal.
Some will be a trifle flatter, some a trifle steeper, but it is surprising to see
30
28
26
24
22
BUCYRUS ERIE CO.
1984
20
19
18
17
16
15
14
13
12
F.
11
Sales ~
100's
1000
800
600
400
200
M ARCH  APRIL MAY IUNE IUL Y AUGUST SEPTEMBER O CTOBER
N OVEMBER  DECEMBER ~
17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 301 7 14 21 28 4 11 18 25 1 8 15
22 29 6 13 20 27 3 <10 17 24 1 8 15 22 29
XD. 11 XD. 11
Figure 14.17 In a downtrend throughout the first half, “BY” gave back a
large part of its 1983 rally by mid-summer. Nevertheless, the 1982 low held
the Bears in check, and over the following several months, this issue etched
out an excellent Fan Pattern. Fan Line 1 gave way in mid-September on a
high-volume penetration. The advance quickly lost its momentum, but old
Resistance-new Support contained the Pullback perfectly, setting the stage
for a rally through Fan Line 2. This occurred in mid-November on good
volume. Following a five-week correction, “BY” charged through Fan Line
3 on the best volume of the three breakouts.
how often the trendline falls very close to the 30-degree slope in stocks of
average volatility and activity. Thin, highly speculative issues and heavy
investment stocks offer exceptions, the former usually steeper and the latter
flatter. The semilogarithmic scale has the virtue of reducing all movements,
regardless of price level, to a ratio or percentage basis. On a straight
arithmetic scale, the trendline will ordinarily be steeper on a stock trading in
the
On weekly charts employing the same price scale, the angle of Intermediate
Advance will be much steeper than on the daily plotting. Different scaling
will produce different angles. It is pure happenstance that TEKNIPLAT
sheets tend to produce the 30-degree ascending line.
Unfortunately, TEKNIPLAT paper is no longer produced but a comparable
analysis is
Validity of penetration
We have these three criteria, then, for appraising the authority or accuracy
of an Intermediate Up Trendline: (1) the number of times it has been
“tested” or contacted without breaking,
(2) its length or duration, and (3) its angle of ascent. Given a trendline that,
by the application of one or more of these criteria (preferably by at least
two of them), appears to be a reasonably accurate delimiter of the trend, our
next problem is to determine when it has been finally and definitely broken.
Again, we can set up three tests or criteria, two of which are practically
identical with the rules laid down in earlier chapters for determining
decisive breakouts from Reversal or Consolidation Formations. The first is
extent of penetration. To be decisive, prices must not only push through the
line but also close beyond it by a margin equal to about 3% of the stock's
price. This does not need to be accomplished in a single day, although it
often is. The 3% penetration may come as a result of two or three days of
gradual decline.
The second is volume of trading. We saw how activity should always be
expected to rise notably on a genuine upside breakout from an Area Pattern
but need not increase to confirm a downside break. We have seen how, in
many cases, volume does not show much increase on the first day of a
down-break from Descending Triangles, for example, but usually it picks
up rapidly as the decline proceeds. In our present discussion, we are dealing
with Up Trendlines, and their penetration is, therefore, analogous to a
downside breakout. We should expect the same rules to apply, and in
general, they do. Given a close beyond the line by a price margin of 3%, it
is not necessary for volume to have expanded much at that point to confirm
the validity of the penetration.
The fact is, however, that the breaking of an Intermediate Up Trendline,
much more often than not, is attended by some visible intensification of
trading activity. To that extent, then, an increase in volume may be regarded
as confirmation of a decisive penetration. It is a particularly useful adjunct
in borderline cases. If, for example, prices start to decline from a point
somewhat above the trendline, move down through it on conspicuously
expanding turnover, and close beyond it, say, only 2% of the price but at or
near the bottom of the day's range, then our 3% margin rule has not been
satisfied, but the lesser margin plus the volume action may be construed as
decisive.
Beware, however, and do not be stampeded into a hasty commitment by the
shakeout move that cracks down through a trendline with a great flurry of
activity—perhaps several minutes of late tape—and then turns up again to
close the day back above the trend or at least very close to it. This may very
well be—in fact, usually is—a false move so far as that particular moment
is concerned. But watch the next few days' performance very closely; the
technical situation is evidently critical, or else a shakeout could not have
been easily staged.
The third test is also one that applies particularly to breaks that are
borderline so far as margin of penetration is concerned. Suppose a stock
that is quoted in the neighborhood of 40 declines through a well-established
Intermediate Up Trendline and closes 1 or 1 1/4 points below it—a margin
that is only slightly less than our specified 3%—without much, if any,
enlargement in trading volume. Suppose it fluctuates there for a day or two
in a dull and narrow market and then starts to rally; if there is no pickup in
activity on this recovery move—if prices simply edge up feebly to the
underside of the trendline and tend to “round over” there without being able
to close clearly above it—then the situation is indeed critical, and the
slightest sign of renewed selling pressure may be taken as a signal that the
uptrend has been decisively broken.
Such a return move as we have described in the preceding paragraph is
known as a Throwback or Pullback. We previously described analogous
developments that follow breakouts from Head-and-Shoulders and other
patterns, and we will have more to say about them in connection with
trendlines later on.
The three tests we have been discussing, which help to establish the validity
of a trendline penetration, cannot, unfortunately, be applied inflexibly and
without a modicum of judgment. The majority of Intermediate Trendlines
can hardly be said to possess the precision of pattern boundary lines, and
even in the latter, some leeway must be allowed. There are exceptions, as
we have taken occasion to remark several times before, to every technical
rule of price action, but judgment in the establishing of significant
trendlines and in interpreting their penetrations does come with experience.
Amendment of Trendlines
When a trendline is broken by a margin less than decisive, and prices
subsequently rally back up through it again, doubt naturally arises as to the
continued authority of the original line. Should it be discarded, revised, or
allowed to stand as is?
Here again, judgment and experience must be called into play, but a few
general principles are helpful in deciding. If the original trendlines
depended on only 2 points, that is, on the first two Bottoms across which it
was projected and the indecisive penetration occurred when prices returned
to it for the third time, then the line had better be redrawn across the
original first and the new third Bottoms. (Of course, you will not do this
until prices have moved up from the third Bottom point and it has become
clearly established as a Minor Bottom.) Or, you may find in such cases that
a new line drawn across the second and third Bottoms works better; if the
first Bottom was a Reversal Day with its closing level well above the low of
its range, you may find this new line, when extended back, strikes just
about at that closing level.
If, on the other hand, the original trendline has been “tested” one or more
times after it was drawn—if, that is, a third and perhaps a fourth Bottom
have formed on it without penetrating it and have thus “confirmed” it—then
the subsequent indecisive penetration may be disregarded and the original
line considered to be still in effect.
An intraday break through an established trendline that, however, does not
result in prices closing beyond the line may be disregarded and the line left
as is. In fact, as has already been suggested, the closing prices frequently
make a better trendline than the extreme intraday lows of successive
Bottoms, which is most apt to be true with “thin” stocks subject to erratic
swings. A bit of experimenting with different lines often pays. A thin,
transparent ruler is especially useful for trendline study.
There is another type of price action that may require redrawing a trendline.
Sometimes, after a line has been projected up across the first two Minor
Bottoms in an advancing trend, a third Minor Bottom will form, not on that
line, but well above it. In such cases, let the original line stand, but draw in
a new one across the second and third Bottom points, and watch
developments. If the rally from the third Bottom peters out quickly, and the
new trendline, as a consequence, is soon broken, then the original trendline
is probably the correct one. But, if the third Bottom turns out to be a
“strong” one, and the new line stands up well for several weeks (and if it
was not, patently, too steep to begin with), then the old line may be
abandoned and the new one regarded as the better trend definer.
Double Trendlines and trend ranges
In the course of your “cutting and trying” in an effort to fit a good line to an
Intermediate Uptrend, you may find that two parallel lines, perhaps a point
or so apart in a stock selling in the 30s, will define the true trend pattern
much better than any single line that can be drawn. Sharp Bottoms and
shakeout thrusts in such cases will often fall along the outer or lower line,
while the duller, more rounded reactions will stop at or near the upper or
inner line. Or the two lines will mark off a range somewhere within which
successive Minor Down Waves tend to halt and reverse.
Such Double Trendlines are really plentiful, although most chart technicians
seem to be quite unaware of them. It pays to develop an eye for them—to
watch constantly for trends to which they can be applied. They will clear up
many situations in which attempts to find a single critical line lead only to
frustration and to your finally giving up in disgust.
Trends that you find are best defined by Double Trendlines (or by a very
Broad Trendline, if you prefer) cannot be regarded as having ended until the
outer, lower line has been decisively penetrated. In that connection, note
what we said at the beginning of this topic: sharp, shakeout Bottoms tend to
fall on the outer line. The recoveries from such Bottoms are usually just as
sharp, and prices, therefore, rally back above the upper, inner line quickly.
Warning of an impending break in the trend is given when prices come
down to the outer line steadily, rather than by the quick “shake” type of
reaction, and then have difficulty rallying back through the inner line.
Watch such developments closely. A break down may not follow; the
situation may still be “saved,” but the chances are that the trend is near its
end.
Trend Channels
At the start of this trend study, we applied the term Basic Trendline to the
line that slopes up across the Wave Bottoms in an advance and to the line
that slopes down across the Wave Tops in a decline. Furthermore, we noted
the opposite Reversal Points, that is, the wave crests in an advance and the
wave troughs in a decline, were, as a rule, less clearly delimited. That is one
of the reasons why all of our discussion up to this point has been devoted to
Basic Trendlines. Another reason is that the technician's most urgent task is
to determine when a trend has run out, and for that purpose, the Basic Line
is all important.
In a fair share of normal trends, however, the Minor Waves are sufficiently
regular to be defined at their other extremes by another line. That is, the
Tops of the rallies composing an Intermediate Advance sometimes develop
along a line that is approximately parallel to the Basic Trendline projected
along their Bottoms. This parallel might be called the Return Line because
it marks the zone where reactions (return moves against the prevailing
trend) originate. The area between Basic Trendline and Return Line is the
Trend Channel.
Nicely defined Trend Channels appear most often in actively traded stocks
of large outstanding issue—least often in the less popular and the relatively
thin equities that receive only sporadic attention from investors. The value
of the Trend Channel concept for the technical trader would hardly seem to
require extended comment here; its tactical utilization is discussed in the
second half of this book.
Its greatest utility, however, is not what usually appeals to the beginner
when he first makes its acquaintance, namely, the determination of good
profit-taking levels. Experienced technicians find it more helpful in a
negative sense. Thus, once a Trend Channel appears to have become well
established, any failure of a rally to reach the Return Line (top parallel of
the channel in an Intermediate Advance) is taken as a sign of deterioration
in the trend. Furthermore, the margin by which a rally fails to reach the
Return Line (before turning down) frequently equals the margin by which
the Basic Trendline is penetrated by the ensuing decline before a halt or
Throwback in the latter occurs.
By the same token, given an established Trend Channel, when a reaction
from the Return Line fails to carry prices all the way back to the Basic
Trendline but bottoms out somewhere above it, the advance from that
Bottom will usually push up out of the channel on the top side (through the
Return Line) by a margin approximately equal to the margin by which the
reaction failed to reach the bottom of the channel (Basic Trendline).
Experimental Lines
Your experienced technician, in fact, is constantly drawing trendlines of all
sorts—Minor, Intermediate, and Major—on his charts. He will first very
lightly pencil them in wherever he can find an excuse to draw one. Many
will quickly prove to be of no significance; those he may erase. Others will
“stand out,” showing evidence of technical authority, which he will make
heavier or color, as suggested later on. He will be constantly on the watch
for Double Trendlines and will draw tentative Return Lines to mark off
possible channels at every opportunity. As soon as he has what appears to
be a Basic Up Trendline, for example projected from two Bottoms, he will
go back to the Top of the rally between those two Bottoms and draw from
that parallel to the Bottom Trendline. If the next rally comes up to that
parallel, stops there and turns down, he has a probable Return Line and
channel established.
This practice of drawing in and experimenting with every trendline, which
the price action permits or suggests, is earnestly recommended to the reader
of this book, particularly if the technical approach is new to him. It is the
quickest way—in fact, the only way— of acquiring the experience we have
stressed as essential to recognition, judgment, and utilization of trendline
implications in trading.
Perhaps we should add here one “don't” for the beginner. You will have
noted we have not mentioned a line projected from a Bottom to a Top, or
vice versa. Trendlines are always drawn across two or more Bottoms, or
two or more Tops. They should never be drawn to cross through the price
track. (Prices may cross their extensions later, but this should not have
happened at the time the lines are first drawn.) If you did not know better,
you might, for example, put in a line from the Top of the left shoulder to the
Top of the right shoulder of a Head-and-Shoulders Formation, thus cutting
through the head, but such a line would have no technical validity.
Consequences of Trendline penetration: Throwbacks
At the beginning of this chapter, we mentioned the probable consequences
of a breakdown through an Intermediate Up Trendline. To repeat, if an
Intermediate Up Trendline has been constructed, has qualified as
technically significant by the tests previously discussed, and has then been
decisively broken, the inference is the uptrend is finished. And the
consequences to be expected are either a full Intermediate Recession or a
period of Consolidation (usually becoming a recognizable Area Formation).
Technical indications of other sorts may be seen on the chart, which will
suggest which of these two consequences is the more likely. In either event,
the Intermediate Trend trader will certainly look twice before attempting to
find further profit in that particular situation at that time.
A more immediate but less important probable consequence of trendline
penetration has also been mentioned—the “Pullback.” Pullbacks that follow
breakouts from Reversal and Consolidation Formations have been
described in our earlier studies of those price patterns. It is easy to
understand why a rally that develops after prices break out through the
lower boundary of a Rectangle, for example, will be stopped when it gets
back to that boundary by the Resistance (supply) now residing there.
Support-Resistance Theory enables us to rationalize most of the Throwback
moves that occur after prices have broken out of other types of Reversal or
Consolidation Areas. The Pullbacks that follow trendline penetrations
cannot be thus rationalized; yet they occur much more frequently, and they
appear to be stopped much more exactly at the old trendline level than is the
case with Area Formations. Why should prices, after they have thrust down
through a rising trendline, perhaps for several points, turn back up and
ascend to or very near the old trendline, stop there, and then go off in
renewed decline? The Top of that Pullback Rally may be 2 or 3 points
above the original penetration level, because the trendline is sloping up all
the time; nevertheless, there it stops, falters, and gives up. No one knows
why supply should overcome demand or why Resistance should be so
plainly evident at that particular point whose level is determined by two
variants—the slope of the line and the time it is reached.
You cannot reasonably expect a Pullback Rally to climb all the way back to
a trendline that is ascending at a very steep angle, which may mean the
attainment of a new high price for the entire Intermediate Uptrend; yet even
that happens in more than just a few cases. What can be counted on in the
great majority of typical Up Trendlines (those that slant up at a normal or
fairly flat angle) is that after the line has been broken, a Pullback Rally will
develop, either in a few days or in the usual Minor Wave tempo and will
carry prices back up to the projected trendline.
Throwbacks do not occur, it should be noted, when prices erupt through a
Return Line, that is, break out of the top side of an Uptrend Channel. Or,
more correctly stated, the Return Line does not function as a Support
against a Throwback after prices have gone through it. An unusually strong
upswing in a Rising Trend Channel may carry beyond the top of the
Channel as defined by its Return Line, but the next reaction may go right
back down through it without evidencing any hesitation at its level.
The Throwback is one of the mysteries in trendline price action to which we
alluded at the outset. The technical analyst who studies trends and
trendlines over any considerable period will discover many other even more
mysterious phenomena that cannot find space in this treatise, as no way has
yet been found to put them to practical use in trading and investing. They
are extraordinarily interesting in retrospect, but they are not subject to
forecast.
Intermediate Downtrends
In all of the foregoing discussion of trends and trendlines, we have
concentrated on uptrends; we have, in fact, had in mind specifically
Intermediate Advances in the direction of the Primary Trend, that is, within
a Major Bull Market. Those particular trends are most apt to develop
“normally” and are most amenable to trendline definition. Intermediate
Down Moves in a Major Bear Market may well be taken up next. Before
discussing the respects in which they differ from Primary Advances, recall
that the Basic Trendline on a down-move is the line projected across the
Tops of the rallies within it. The Trend Channel will be to the left of that
trendline and below it on the chart. The Return Line (if any) will define the
Bottom of the channel.
Intermediate (Bear Market) Downtrends are far less regular and uniform in
their development than Bull Market Advances. Their angles of decline are
characteristically steeper, and this is particularly true, of course, of the
Panic Moves typical of the second phase of a Bear Market, as in our
discussion of Major Trends in Chapter 3. Moreover, prices have a tendency
to drop away from any trendline drawn across the first two Rally Tops; in
other words, to curve down or accelerate as the move proceeds. This shows
plainly on an arithmetically scaled chart and even more conspicuously on a
semilogarithmic sheet.
The practical results of this down-curving tendency are not so important,
insofar as it delays the penetration of the original trendline and, hence, the
giving of a signal of trend change. The fact is prices tend to thrash around
for some time, making a base at the Bottom of one of these precipitous
declines. In so doing, they work out sideways on the chart and the trend
frequently does not turn up visibly until after the trendline has finally been
reached and broken through on the upside after all. Thus, there is
justification for drawing down trendlines and keeping them in view even
though they may seem, for some time, simply to travel off into space with
no apparent relevance to the actual trend of prices.
It naturally follows from the above that Return Lines on most Bear Market
Declines have little practical utility; they are, more often than not, very
quickly broken downside. Good channels are hard to find.
However, and this is of considerable practical importance, the very last
Intermediate Downswing in a Major Bear Market is the last Primary Move
that leads to the final, longterm Bottom, which is usually cleaner, more
regular, and less precipitous—in other words, it is a more nearly normal
trend of the sort we expect to find in most Intermediate Advances in a Bull
Market (except that it slants down instead of up). This interesting habit is,
as we said, of practical importance. Knowing it, we have an additional and
very useful clue to the end of a Bear Market.
When, after a Major Bear Trend has proceeded for some time and distance,
and has experienced at least one Panic Sell-Off, it then goes off in another
but less active and more orderly decline, and this decline develops and
follows a good trendline. Watch it closely though. If this Intermediate holds
to its steady and not-too-steep downward course—if its trendline is
contacted several times by Minor Rallies or it produces a fairly consistent
channel and prices do not “fall out of bed” down through its parallel Return
Line, then the eventual upside penetration of this trendline may well signal
a Major Turn, that is, the inception of a new Bull Market.
Corrective trends: the Fan Principle
In this study of Intermediate Trendlines, we have left to be taken up last the
subject of Secondary or Corrective Trends. These are the Intermediate
Declines that interrupt the Primary Advances in a Bull Market, and the
Intermediate Recoveries that alternate with Primary Declines in Bear
Markets.
Intermediate Reactions against the Major Direction of the market take a
variety of forms. Sometimes, as we have seen in our earlier study of chart
patterns, they run out into Consolidation Formations—Triangles,
Rectangles, and so on—in which the net price reaction is of minor
consequence, but time is consumed in backing and filling before the
Primary Trend can be resumed. In such cases, there is no basis for drawing
an Intermediate Trendline, nor is one needed for any practical purpose.
At the other extreme, so to speak, we find Corrective Swings that develop
as a more or less orderly straight-line return of moderate slope to the nearest
good Intermediate Support or Resistance Level, retracing perhaps a third to
a half of the preceding Primary Swing. These reactions produce good
trendlines, as a rule, and the eventual penetration of their trendlines is a
good technical signal of Reversal. Intermediate Corrections clearly of this
type are relatively rare.
A third form taken by Intermediate Corrections is nearly as common as the
first named above (Consolidation Pattern) and much more common on the
charts than the second. In a Bull Market, it starts with a sharp reaction that
proceeds for several days—perhaps for as much as two weeks—producing
a steep Minor Trendline. This line is broken upside by a quick Minor Rally,
after which prices slide off again in a duller and less precipitate trend. A
second Minor Trendline may now be drawn from the original high point
across the Top of the upthrust that broke the first trend. This second
trendline is broken by another partial recovery thrust, and a third and still
duller and flatter sell-off ensues. A third trendline can now be drawn from
the original high across the Top of the second upthrust. The whole move, by
this time, has taken roughly and irregularly a “Saucering-out” form. The
three trendlines drawn from the original Reversal points from which the
Corrective Decline started, each at a flatter angle than its predecessor, are
known as Fan Lines. The rule is when the third Fan Line is broken upside,
the low of the Intermediate Correction has been seen.
There are exceptions to this rule—as there are to every so-called rule of
technical chart analysis. Rarely, a correction of this type will go on to make
another dip to a new low for the whole corrective move before prices really
start to round up again. But the Three-Fan Principle works in the great
majority of cases. Moreover, it offers the trader an opportunity to take a
position at a point at which he can logically employ a very near stop order
and, thus, limit his loss to a controlled amount if the rule does not work out.
It is interesting to note that prices consistently throw back in these
movements to the preceding Fan Line after each upthrust. The new Primary
Swing, once the low has been passed, usually starts slowly and carries out
for a time the Saucer picture.
The Three-Fan Rule works just as well in calling the turn on Intermediate
Recoveries in a Bear Market, the majority of which take the rounding form
that is adapted to its use. Note, however, that the Fan Principle is normally
applied only to corrective moves, that is, to determine the end of
Intermediate Reactions in a Bull Market and the end of Intermediate
Recoveries in a Bear Market.
Major Trendlines will be outlined in the following chapter, but before we
leave this study of Intermediate Trends, it will be well to state again that the
practical application of trendlines in actual trading requires experience and
the good judgment to be attained only therefrom. Some technical analysts
depend largely on trendline studies, few attempt to use trendlines almost
exclusively, but the majority have found they are best employed as an
adjunct to other technical data.
Technical analysis of a stock chart is something like putting together a
jigsaw puzzle. There are many items to be considered, among them volume,
pattern, and the measurements derived therefrom, Support and Resistance
Levels, trendlines, and general market prospects—and all fit into place to
get the complete picture.
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter fifteen
Major Trendlines
In the preceding chapter on Intermediate Trendlines, mention was made of
the distinctive effects produced by arithmetic and semilogarithmic plotting,
but it was noted that these differences were unimportant in connection with
Minor Trends or Intermediate Trends of average duration. When we come
to Major Trends, however, we find the difference does become important.
Major Trendlines are illustrated by Figures 15.1 through 15.20.
If you will examine a large collection of arithmetically scaled monthly
charts covering 10 years or more of market history, you will quickly see
that Bull Trends, in the great majority of actively traded, more or less
speculative common stocks, tend to accelerate. They start slowly and push
up at a steeper and steeper angle as they approach a Major Top. This up-
curving path takes them farther and farther away from any straight trendline
drawn from two Bottom points in the first, slow-moving stage of advance.
As a consequence, they top out and have gone down a long way in a
recession that may be of Major consequence before their straight trendline
is again touched.
Many of the stocks that show such typical accelerating curves in their
advance (Major) Trends on arithmetic paper produce straight trends on a
logarithmic scale. As a consequence, their logarithmic Major Trendlines are
broken more quickly, and usually at a higher price level, when at last their
trends do top out and turn down. In the case of such stocks, then, the
logarithmic scale gives a better trend signal.
But there are other stocks—mostly of the more substantial investment or
semiinvestment type—that tend to advance in straight arithmetic trends.
Consolidated Edison, General Motors, and Libbey-Owens-Ford Glass are
examples. (The trends of these on a logarithmic scale show a decelerating
curve.) Still a third class, made up largely of highgrade preferred stocks,
produces a rounding over or decelerating Bull Trendline even on the
arithmetic scale. And, finally, there are a number of issues whose normal
Bull Market Trendlines fall somewhere between our first two types—that is,
they curve up away from a straight path on the arithmetic scale, but curve
over to the right (breaking through a straight line) on the logarithmic scale.
(EN: Fortunately, in this age of computers and easily processed data, there
is analytical software that allows the analyst to instantaneously switch
between the scales. Desktop packages are available[(see Appendix B,
Resources] and a number of internet sites have these capabilities.)
All of which, the reader, at this point, no doubt finds most discouraging.
Some stocks do this and some stocks do that, but what help is there for us in
such a mix-up? The answer lies in studying the history of each issue in
which you may be interested. Most stocks do not change their habits and
their technical characteristics much from one Bull and Bear cycle to the
next. An issue, like General Motors, that produces a straight-line Bull Trend
on an arithmetic chart in one Primary Upswing is likely to repeat that
performance in the next. EN10: GM after the fall will, we suspect, retain its
previous habits, but that remains to be seen.
As a matter of interest, stocks do sometimes change over a long period of
years. Companies that were regarded as extremely speculative when their
shares were first listed
60
40
20 Sales 100's 4000 2000
Figure 15.1 The straight-line Bull Market Trend of General Motors on an
arithmetic monthly chart: 1941 low, 28 5/8; 1946 high, 80 3/8.
Figure 15.2 The up-curving trend of a speculative motors stock, Hudson
Motors. Compare this with “GM”: 1941 low, 2 5/8; 1946 high, 34.
Figure 15.3 Typical decurving Major Bull Trend of a high-grade preferred
stock. This is Curtis Publishing $7.00 Preferred: 1942 low, 12; 1945 high,
154.
30
20
10
Sales
100's
1200
1000
Figure 15.4 The accelerating uptrend of the common stock of the same
publishing company: 1942 low, 3/8; 1946 high, 26.
Figure 15.5 A conservative investment-type utility stock makes a straight-
line Major Bull Trend. This is Commonwealth Edison: 1942 low, 17 3/8;
1946 high, 36 1/8. Leverage is an important factor in trends.
15
10
5
Figure 15.6 The up-curving trend of a low-priced “junior” utility,
International Hydro-Electric: 1942 low, 1/4; 1946 high, 15 1/2.
Sales 100's 400 200
Figure 15.7 A speculative oil stock, Houston Oil: 1942 low, 2 1/4; 1946
high, 30. Compare this picture with “SOH” in Figure 5.8.
Figure 15.8 Straight-line uptrends in an investment oil, Standard Oil of
Ohio: 1942 low, 10 1/8; 1946 high, 30. Note: trendline unbroken until 1948.

Figure 15.9 Steel stocks have the speculative or accelerating type of
Primary Uptrend, Republic Steel: 1942 low, 13 3/8; 1946 high, 40 7/8.
Figure 15.10 The normal Major Bull Trend of heavy industrial issues is up-
curving, American Car & Foundry: 1942 low, 20; 1946 high, 72 3/8.
40
80
60
Figure 15.11 A low-priced building stock, Celotex Corporation: 1942 low,
6 1/8; 1946 high, 38 1/8.
Figure 15.12 A highly speculative, low-priced issue, traded on the Curb
Exchange, Claude Neon Lights: 1942 low, 1/8; 1946 high, 9.
Figure 15.13 The tobacco stocks follow the investment type of trend. This
is Liggett & Myers: 1942 low, 50 1/2; 1946 high, 103 1/2. Note the Double
Trendline.
70
60
50
40
Sales
100's
400
200
Figure 15.14 High-grade food issues (Corn Products Refining) resemble
the tobaccos: 1940 low, 40 1/4; 1946 high, 75 3/4.
192
176
160
152
144
136
128
120
112
104
96
88
80
76
72
68
64
60
56
52
48
44
Sales
100's
1935
1936
1937
1938
Figure 15.15 In the process of “pulling back” to a very steep Up Trendline,
prices may easily go to a new high. Note the Pullback of August 1936 in
this weekly chart of Westinghouse Electric. The second, less steep line
turned out to be the true Major Bull Trend. Note that the February-April
price pattern in 1936 could not be considered a true Double Top Reversal of
Primary import because the recession between the two highs was only about
10% of the Top's value (around 122). Figure 8.21 shows on a daily chart the
final Top Reversal Formation that “WX” made in 1937.
may attain an increasingly important and stable position in the general
economy, with the result that, eventually, their stock acquires a solid
investment rating. Their Bull Market Trends will then gradually change
from an up-curve to a straight line and, finally, to a decelerating curve.
Other old, established corporations may lose position and rating, as well as
shift from the investment type of trendline to the speculative. But, it is true
in general, that Major Patterns do repeat.
If you are keeping your own set of manual monthly charts, you can choose
whichever scale you please. But most technical chart followers prefer to
buy their long-range pictures readymade, thereby getting a much more
extensive history of many more issues than they could hope to chart
themselves. Since the only comprehensive portfolios of monthly charts that
are available at reasonable cost are arithmetically scaled, you will possibly
have to make these serve all purposes. (EN: No longer necessary because of
the availability of good software and internet chart sites. See Appendix B,
Resources.) You will find with a little experimentation that an architect's
French curve can be used to plot good Major Uptrend Lines on many of the
issues whose normal Bull Trends accelerate away from a straight line.
400
360
320
280
240
200
160
120

DOW - JONES INDUSTRIAL AVERAGE ranmnnninnmnsjwssss
::::::::::::::
Figure 15.16 The 1929-1932 Primary Bear Market was the only one in all
stock market records that produced a Straight-Line Major Downtrend. Trace
also the Support and Resistance Levels throughout this 14-year history of
the Dow Industrials. Each rally in the great Bear Move stopped at or near a
previous Bottom level. Each decline stopped near the level of a Congestion
in the 1924-1929 Bull Market. See also the level of 1937 Top. (Source:
Chart courtesy of Market Research, Inc., at http:// wwwbarchart.com.)
Figure 15.17 S&P Reagan Crash. As can be clearly seen, this crash sent
numerous signals, starting with the breaking of a Major Trendline by more
than 2% in late August. Once this occurs extreme caution and watchfulness
must be exercised. The darker and darker complexion of things is brought
out by the “smart selling,” which shows many “downthrust days" toward
the end (October 10-20). The April trendline breaks (by more than 2%)
would have ejected the trend trader also to be put back long in June.
Observance of the 2%-3% trendline-break rule or use of Basing Points and
progressive stops (see Chapters 27 and 28) would have avoided much
needless grief.
Figure 15.18 S&P Long-Term Perspective. Viewed from afar it seems an
exercise in futility to attempt to “time the market.” One must keep in
perspective the crashes in market prices are timed to coincide with personal
and business needs for short-term liquidity, or cash. One must also
remember the market behavior from 1965-1982, as well as the table of Dow
Theory Performance from Chapter 4 (Table 4.2).


Figure 15.19 Three Bull Market Tops, 1929, 1987, 1998. Notice here that
in each case the crash occurred after the nearest important trendline had
been decisively broken—usually trendlines of approximately three months
by 2% or more, and sometimes accompanied by reversal formations. All
historic tops will show evidence of attempts to resume the trend after a
break of this kind. Belief dies hard. Nonetheless, hedging or exiting on
these trend breaks proves to be the best strategy over and over again.
Figure 15.20 The Bull 1990s top in the S&P gave much clearer readings
than the Dow top, with the broken trendlines being paramount. But while
the Dow flirted with the emotions of Bulls who wanted to believe in the
Dow 36,000, the S&P broke its trendlines and went south for the winter, a
potentially very long winter. This might have started off as a rounding top
and then became a complex-complex top, and you can even see traces of a
Head-and-Shoulders top in it. It is the editor's opinion we may never see
such unruly tops again in this generation. The pent-up greed, lust, and
naivete as even the bootblacks (they still have those don't they?) rushed to
get the latest tulip bulbs. Tulips are like century plants; they only bloom
once each hundred years. A little old lady with a ruler could have saved her
portfolio here. All it takes is not believing the hype (Dow 36,000 indeed!)
and making an unemotional analysis and honoring the stops.
The tests for the technical significance of a Major Trendline are
substantially the same as those specified for Intermediate Lines in the
preceding chapter. A little more leeway must be allowed on penetrations—
again, a matter of judgment—but you are dealing with coarse data and long
swings here, and what you want from your monthly charts, primarily, is
perspective on the broad picture.
One more point regarding the construction of Major Bull Trendlines: the
best lines—the most useful—are drawn, as a rule, not from the absolute low
of the preceding Bear Market but starting from the next Intermediate
Bottom. The accumulation area at the beginning of a Bull Market is usually
long and drawn out in time and relatively flat. The first trendline that can be
drawn from the extreme low point may, therefore, be too nearly horizontal
to express the genuine Bull Trend that starts with the markup phase. The
several charts showing Major Trendlines that illustrate this chapter will
demonstrate this point (EN: Especially Figure 15.14). It applies as well to
many Intermediate Moves that start from Area Formations. Take the Head-
and-Shoulders Pattern, for example: the true Intermediate Trendline usually
starts from the right shoulder rather than from the head.
Major Downtrends
From the technical analyst's point of view, it is regrettable that few Bear Markets haveproduced Major Trendlines of any practical significance on the charts of individualstocks. A notable exception was the long Bear Market of 1929-1932, which producedmagnificently straight trendlines on the arithmetic plotting of a host of issues (as wellas in the Averages, to which we shall refer later). But it is almost impossible to findother instances in which a Bear Trendline having any forecasting value can be drawnon either arithmetic or semilogarithmic scale.
The normal Major Bear Market Trend is not only steeper than the normal Bull Trend(because Bear Markets last, on the average, only about half as long as Bull Markets),but it is also accelerating or down-curving in its course. This feature is accentuatedand, hence, particularly difficult to project effectively on the semilogarithmic scale.
The technician cannot expect to obtain much in the net of it, help from his MajorTrendlines in determining the change from a Primary Downswing to a PrimaryUpswing. This should not be taken, however, as advice to not draw trendlines on aMajor Down Move, or to disregard entirely any trendlines that may develop withsome appearance of authority. If you do not expect too much of them, they may,nevertheless, afford some useful clue as to the way in which conditions are tending tochange.
The student of stock market action who is not altogether concerned with dollars andcents results from his researches will find Bear Market Trendlines a fascinating fieldof inquiry. They do some strange things even though they fail in the practical functionof calling the actual Major Turn and go shooting off into space, they sometimesproduce curious reactions (or, at least, appear to produce what would be otherwiseinexplicable market action) when the real price trend catches up with them months oryears later. But such effects, interesting as they may be, are, in our present state ofknowledge, uncertain and unpredictable. (EN: This fact may persist into the mists ofthe future and be thought of like Fermat's Last Theorem. Our present state ofknowledge in the twenty-first century is no further advanced than it was in Magee'stime.)
We must dismiss this rather unfruitful topic with the reminder that one clue to the endof a Primary Bear Market is afforded by the Intermediate Trendline of its final phase,which we cited in the preceding chapter.
Major Trend Channels
Another difficulty is met when trying to draw Return Lines and construct channels forMajor Trends on an arithmetic chart. Owing to the marked tendency for prices tofluctuate in ever-wider swings (both Intermediate and Minor) as they work upward ina Primary Bull Market, their channel grows progressively broader. The Return Linedoes not run parallel to the Basic Trendline (assuming there is a good Basic Trendlineto begin with) but diverges from it. Occasionally, a stock produces a clear-cut MajorChannel Pattern, but the majority do not.
A large Rectangle base was made on this weekly chart in April, May, and June 1937,but observe the poor volume that accompanied the breakout and rise from thatformation—an extremely Bearish indication for the Major Trend. The “measurement”of the Rectangle was carried out by August, but that was all.
As is usually the case, it was impossible to draw a Major Down Trendline that hadany forecasting value on this chart. The beautiful straight trendlines that appeared inthe 1929-1932 Primary Bear Market led many chart students to expect similardevelopments in every Bear Market, but the fact is that 1929-1932 was unique in thatrespect.
Semilogarithmic scaling will correct, in many cases, for the Widening Channel effectin Bull Trends, but then we run into the opposite tendency in Primary Bear Markets,and for that, neither type of scaling will compensate.
Trendlines in the Averages
Practically everything stated in the preceding chapter regarding IntermediateTrendline development in individual stocks applies, as well, to the various Averages.The broad Averages or Indexes, in fact, produce more regular trends and, inconsequence, more exactly applicable trendlines. This may be partly due to the factmost Averages are composed of active, well-publicized, and widely owned issueswhose market action individually is “normal” in the technical sense. Another reason isthe process of averaging smooths out the vagaries of component stocks, and the resultmore truly reflects the deep and relatively steady economic trends and tides.
In any event, it is a fact that such averages as the Dow-Jones Rails, Industrials, and65-Stock Composite, The New York Times 50, and Standard & Poor's Average of 90stocks (the last two named being probably the most scientifically composed to typifythe entire broad market) do propagate excellent trendlines on their charts. (EN: As thereader will note, most of these indices are obsolete. In the modern age, the S&P 500probably best fulfills this function.)
The very accuracy of their trends, particularly their Intermediate Moves, permits us toconstrue their trendlines more tightly. Less leeway need be allowed for doubtfulpenetrations. Thus, although we ask for a 3% penetration in the case of an individualstock of medium range, 2% is ample in the Averages to give a dependable breaksignal.
Experienced traders know it pays to heed the Broad Market Trend. It is still easier toswim with the tide than against it.
EN: Trendlines in the Averages and Trading in the Averages
Numerous averages and indexes have come online since the fifth edition, includingthe S&P 100, S&P 500, Russell 2000, and so on. It would be an exercise in dailyjournalism to attempt to list all the indexes now available, as new ones spring up likeweeds after the spring rain. This is because the invention of a widely adopted indexcan be very lucrative for its creator S&P and Dow-Jones collect licensing fees fromthe “use” of their indexes by the exchanges. The constant addition of new tradinginstruments requires that current lists be kept in Resources, and the reader may alsoconsult the Wall Street Journal, Barron's, and the Investor's Business Daily whereprices of indexes and averages are reported. Online brokerages and financial newssites also offer up-to-the-minute lists and quotes on virtually all trading instruments.A list and links to these sites may also be found in Appendix B, Resources, and athttp://www.edwards-magee.com.
As of the turn of the century, the most important of these indexes joining the Dow areprobably the S&P 500, the S&P 100, and the NASDAQ. In fact, these are probablysufficient for economic analysis and forecasting purposes, and certainly good tradingvehicles by means of surrogate instruments, options, and futures. Some would includethe Russell 2000 in this list. These indexes and averages have been created to fillneeds not addressed adequately by the Dow-Jones Averages.
With this proliferation of measures of the market and various parts of it, a differentquestion arises questioning the value of the Dow alone in indicating the BroadMarket Trend. Limited research has been done on this question; however, my opinionis the Broad Market Trend must now be determined by examining the DowIndustrials, the S&P 500, and the NASDAQ Composite.
Trading the Averages in the 21st century
As pointed out in other new chapters and notes in the eighth edition, the ability totrade the Averages instead of individual stocks is a powerful choice offered bymodern markets. The index ETFs offer ideal vehicles for investing: The DIA, SPY,
QQQ and IWM give the modern investor unparalleled flexibility and convenience.Magee was of the opinion that the Averages offered technical smoothness oftenlacking in individual issues. This would seem to be true intuitively. After all, just as amoving average smooths data, the average of a basket of stocks should dampen pricevolatility. Of course, as Mandelbrot pointed out, in a 10-sigma market stormeverything sinks.
Illustrated in this chapter are several detailed cases following Magee's suggestion ofAverage trading. I attempt to demonstrate here two perspectives: one, the horror ofthe immediate, what the crash and panic look like as they occur; and two, what thecrash and panic look like in retrospect. We all live in the present, except for the greatbillionaires who can afford to doze through horrific Bear Markets. Bill Gates' networth varied by $16 billion or $17 billion in early 2000. This would put the ordinaryinvestor out of business.
So the ordinary investor, you and I, have to respect the great yawning Bear Market.We must step to the sidelines and let the bear eat the foolish virgins, to borrow aBiblical metaphor.
You will remember Magee opined that a trendline break of 2% was sufficient to causeliquidation of longs when analyzing the Averages. In the accompanying figures, thishypothesis is examined.
EN9: In respect to the breaking of trendlines (by 2% or 3%), I should note thebreaking of a trendline is as much a warning as a signal to act. The break, instead ofa change of trend to the reverse, may indicate a change of trend to the sideways—intoa reversal or continuation pattern.
chapter sixteen
Technical analysis of commodity charts (EN9: Following the practice of allowing thereader to discriminate between the work of Edwards and Magee and that of the editor,a section on commodity trading, Chapter 16, has been added to the ninth edition. Seesame.)
A little thought suggests the variously interesting and significant patterns we haveexamined in the foregoing chapters on stock charts should logically appear as well inthe charts of any other equities and commodities that are freely, constantly, andactively bought and sold on organized public exchanges. In general, this is true. Theprice trends of anything for which market value is determined solely (or for allpractical purposes within very wide limits) by the free interplay of supply anddemand will, when graphically projected, show the same pictorial phenomena of riseand fall, accumulation and distribution, congestion, consolidation, and reversal that
we have seen in stock market trends. Speculative aims and speculators' psychologyare the same whether the goods dealt in are corporate shares or contracts for the futuredelivery of cotton bales. (For illustrations in this chapter, see Figures 16.1 through16.13.)
It should be possible in theory, therefore, to apply our principles of technical analysisto any of the active commodity futures (wheat, corn, oats, cotton, cocoa, hides, eggs,etc.) for which accurate daily price and volume data are published. It should be, thatis, if proper allowance is made for the intrinsic differences between commodityfutures contracts and stocks and bonds.
In previous editions of this book (EN9: up to the eighth), traders who cast longingeyes on the big, quick profits apparently available in wheat, for example, werewarned that commodity charts were “of very little help,” as of 1947.
It was pointed out that successful technical analysis of commodity futures charts hadbeen possible up to about 1941 or 1942, but the domination of these marketsthereafter by government regulations, loans, and purchases completely subject to thechanging (and often conflicting) policies and acts of the several governmentalagencies concerned with grains and other commodities had seriously distorted thenormal evaluative machinery of the market. At that time, radical reversals of trendcould and did happen overnight without any warning so far as the action of the marketcould show. The ordinary and orderly fluctuations in supply-demand balance, whichcreate significant definite patterns for the technician to read, did not exist. Yet, whilefortunes were made (and lost) in wheat, corn, and cotton futures during the World WarII period, it is safe to say they were not made from the charts.
During the past five or six years, however, the application of technical methods tocommodity trading has been reexamined. Under 1956 conditions, it appears thatcharts can be a most valuable tool for the commodity trader. The effects of presentgovernment regulation have apparently resulted in “more orderly” markets withoutdestroying their evaluative function. Allowing for the various essential differencesbetween commodities and stocks, the basic technical methods can be applied.
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Figure 16.1 Oats, for obvious reasons, traced more “normal” patterns than Wheatduring the 1940s. This chart contains an H & S bottom, a Symmetrical Triangle thatmerged into the Ascending form, a gap through a former top level, and an interestingtrendline. The Island shake-out through the trendline was an extremely deceptivedevelopment.
It may be in order here to discuss briefly some of the intrinsic differences betweencommodity futures and stocks referred to above and to some of the special traits ofcommodity charts. First, the most important difference is the contracts for futuredelivery, which are the stock-in-trade of the commodity exchange, have a limited life.For example, the October cotton contract for any given year has a trading life of about18 months. It comes “on the board” as a “new issue,” is traded with volumeincreasing more or less steadily during that period, and then vanishes. Theoretically, itis a distinct and separate commodity from all other cotton deliveries. Practically, itseldom gets far out of line with such other deliveries as are being bought and soldduring the same period, or with the “cash” price of the physical cotton in warehouses.Nevertheless, it has this special quality of a limited independent life, as a consequenceof which long-term Support and Resistance Levels have no meaning whatever.(EN10: This absolute may not be absolute. Evaluate the longterm charts for yourissue to see whether influence is evident.)
Second, a very large share of the transactions in commodity futures—as much as 80%certainly in normal times—represents commercial hedging rather than speculation.(EN10: Less true in the twenty-first century.) It is, in fact, entered in to obviate riskand to avoid speculation. Hence, even near-term Support and Resistance Levels haverelatively less potency than with stocks. Also, because hedging is to a considerabledegree subject to seasonal factors, there are definite seasonal influences on the
commodity price trends that the commodity speculator must keep in mind, even ifonly to weigh the meaning of their apparent absence at any given period.
A third difference is in the matter of volume. The interpretation of volume withrespect to trading in stocks is relatively simple, but it is greatly complicated incommodities by the fact that there is, in theory, no limit to the number of contracts fora certain future delivery that may be sold in advance of the delivery date. In the caseof any given stock, the number
Figure 16.2 In contrast with the grains, the technical action of the Cotton futuresmarkets has been fairly consistent with normal supply-demand functioning ever since
prices rose well above government support levels. In this daily chart of the 1947October delivery (New York Cotton Exchange), the reader will find a variety offamiliar technical formations, including critical trendlines, a Head-and-Shoulders topthat was never completed (no breakout), and Support-Resistance phenomena muchthe same as appear in stock charts. Double trendlines are not at all unusual in Cottoncharts.
of shares outstanding is always known. As this is written (1956), there are in thehands of stockholders 13,700,203 common shares of Consolidated Edison, and thatquantity has not varied for many years nor is it likely to change for several years tocome. Every transaction
In the case of commodity future contracts—say, September wheat—trading beginslong before anyone knows how many bushels of wheat will exist to be delivered thatcoming September, and the open interest at some time during the life of the contractmay exceed the potential supply many times over, and all quite legitimately. (EN9: Asalways, volume data is a supplementary indicator to price. No one makes a profit onit.)
One more important difference may be mentioned. Certain kinds of news—aboutweather, drought, floods, and so on that affect the growing crop, if we are dealingwith an agricultural commodity—can change the trend of the futures marketimmediately

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Figure 16.3 A Rounding Bottom in Gold 1997-2004. “These patterns, when theyoccur after an extensive decline, are of outstanding importance, for they nearlyalways denote a change in Primary Trend and an extensive advance yet to come. Thatadvance, however, seldom carries in a ‘skyrocket' effect, which completes the entireMajor Move in a few weeks. On the contrary, the uptrend that follows the completionof the pattern itself is apt to be slow and subject to frequent interruptions, tiring outthe impatient trader, but yielding eventually a substantial profit.” So said RobertEdwards in remarking on Rounding Bottoms in stock charts. As may be seen here,this Rounding Bottom consists of a downtrend, a false signal off the Double Bottom(upon which a pretty penny might have been made by the agile trader), and ahandsome uptrend—and it all looks like a huge Rounding Bottom.
and drastically and are not foreseeable given the present stage of our weatherknowledge. Analogous developments in the stock market are extremely rare. (EN:Except for acts of God and Alan Greenspan [and Ben Bernanke]).
It is not the purpose of this book to explain the operation of commodity futuresmarkets, nor to offer instruction to those who wish to trade therein. This brief chapteris included only as a starter for readers who may want to pursue the study further.They should be advised that successful speculation in commodities requires far morespecialized knowledge and demands more constant daily and hourly attention. Theordinary individual can hope to attain a fair degree of success in investing insecurities by devoting only his spare moments to his charts, but he might better shuncommodity speculation entirely unless he is prepared to make a career of it.
(EN: The editor has been, during his checkered career, a registered commoditytrading advisor. At the beginning of that career, I discussed these subjects with Mageeand received essentially the above comments, which are here reproduced from thefifth edition. Subsequently, I observed among my associates and partners, and on myown, that futures are eminently tradable with the adaptation of techniques andmethods described in this book. It is also true, as Magee says, that futures trading isso different in tempo, leverage, and character that the novice risks life, limb, andcapital in entering the area unescorted. Resource references are essential reading, butthe beginner is urged to educate himself before beginning trading with extensive studyand paper trading.)
Figure 16.4 Gold, October 2011. The momentous earth-shaking power of a massiverounding bottom is vividly dramatized by the gold chart since 2005, as well as thepower of chart analysis to anticipate it. Regrettably, the editor did not compute theprice target implications of the pattern in the ninth edition in 2005. That computationwas made at the http://www.edwards-magee.com website at the time. There it wascomputed as follows (and the reader can do it for himself): depth of pattern, 248.20plus neckline 507.40, target 755.60. In fact, the possibility was entertained that theentire formation from 1980 to 2008 might be a Rounding Bottom. In which case, thedepth was 700.70, added to the neckline of 959 and resulted, actually achieve, in atarget of 1,660. Remember Edwards said these were probable minimummeasurements.
Technical analysis of commodity charts, part 2: a 21st-century perspective
In the search for the Philosopher's Stone, more sweat and money have been put intothe area of commodities and futures than were ever expended in the securities arena.There is a simple reason for this—great fortunes are made and lost with much greaterrapidity in the futures area than in securities. Of all the great dramatic moments instock market history, few are so memorable as the great Hunt silver market, or Sorosfacing off against the Bank of England, or of gold soaring to $1,000 an ounce(deferred contracts). And the saga continues in 2005: $50 oil? $60? $70? $100? Andthe effects, economic and psychological! In dimly lit garrets and brightly lit computerrooms thousands of researchers concoct systems to trade these markets—corn,soybeans, silver, copper ...
Rocket scientists
At times, individual traders and groups of traders have plundered (harvested?) thesemarkets for fairy tale profits. I know whereof I speak, having been a principal inCalifornia's first licensed commodity trading advisor that was founded by the NASArocket scientist R. T. Wieckowicz. During the 1970s, as the stock markets groundfutilely around the 1,000 level on the Dow, the futures markets returned yearly gainsin the 100% range. Consistently. For years. Those were the years of the Californiasystems traders and the beginning of computerized trading. From the primeval slimeof NASA, rocket scientists emerged to create a renaissance in market technology. Atthe time it seemed clear that science and genius had at last conquered the markets andthat clients would come buzzing from the world over like bees to a honey
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Figure 16.5 A Rounding Bottom in Silver, 1998-2005. The apparent RoundingBottom in silver, combined with the same pattern in gold, would seem to cast a pallover the economic situation for some time to come in 2005. This coincides with theapparent long-term patterns setting up in the securities markets. If the best that can behoped for in securities is a 1965-1982 kind of widely whipping market, commoditiesmay react as they did in the 1970s—with tidal wave markets. These markets can betraded by the well-capitalized chart analyst who is well seasoned. Tyros will losemoney learning the game whatever markets they trade. Their chances will beimmeasurably improved by applying the techniques taught in this book. In addition tothe technical pattern pictured here, there is every reason to suspect that a largefundamental shortage of silver bullion exists and will worsen. Ted Butler, athttp://www.doomgloom.com, is a long-term silver analyst (and associate of the editor)who anticipates a new silver blow-off is coming. One wonders what Nelson andBunker Hunt are doing at present. A very cautious investor (like Warren Buffet who isreported to have invested $1 billion in silver bullion) may defeat futures silvervolatility by buying the bullion.
pot and that the rivers of profits would last forever. They did last for some time, andthen the markets changed. Mechanical systems that cut through the markets like areaper in a wheat field in Bull Markets grind up capital like sausage in sidewaysmarkets. Science and genius were revealed as the happy combination of man,moment, system, and market.
Turtles?
During the 1980s from the sea came crawling the Turtles. Progeny of the proteantrading wizard, Richard Dennis, the Turtles again harvested outsize profits from themarkets, reportedly running in the 80% yearly range. The so-called Turtles got theirname from a comment that Dennis is reported to have made that traders were madenot born, and he was going to raise traders like turtles. Additional reading about theTurtles is available in Jack Schwager's fascinating books, including Market Wizardsand others. Schwager's books are required reading for aspiring futures traders.Additionally, the trading manual of the Turtles will be found online athttp://www.originalturtles.org. This workbook, written by
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Figure 16.6 Silver, May 2005. Although the long-term silver outlook may be Bullish,the short term will be very volatile, especially for the thinly capitalized trader. Thenshort-term tactics must be adopted. The Island Top here at 1 is a gentle invitation tothe trader to take his profits and be gone. Even to short, with a stop just above thehigh. The run day after 1 adds a note of urgency to the invitation. The gap ispunishment for the hard of hearing and a bonus for the quick-witted (everybody whosurvives in futures is either quick witted or extremely well financed). The stop movesdown to the top of the gap day, then to the top of the next gap day, and for the veryapt profits are taken on the next run day down, on the principle of sell weakness, buyweakness. The tight trendline at 2 crossed by the heavy run day is a buy signal with
the stop moving to the bottom of the gap at 3, where it is taken out a few days later bythe long-range day down. The run day at 4 is a short signal with the stop being at theday's high. Is it necessary to say short-term futures trading can be quite rapid? Thereis always bullion or associated stock plays.
Curtis Faith, an original Turtle, contains virtually all of the elements necessary in atrader's systems and procedures manual. The manual was prepared according to thetraining Dennis gave his Turtles. Serious traders do not operate without some suchdocument. Certainly all of the serious traders I have known (a considerable number)have had fully developed manuals like the Turtle workbook. I cite the Turtleworkbook rather than others in my possession because it is publicly available athttp://www.originalturtles.org (as well as in the 9th edition of this book) and becauseit is beautifully articulated.
In the late 1990s, the Turtles were made into turtle soup in the futures markets as themajority of systems traders wound up as hamburger meat. Is there a moral? Yes. Themarkets giveth and the markets taketh away. Science and genius are again revealed tobe the happy combination of man, method, moment, and market.
The Turtle system is basically an adaptation of Richard Donchian's channel breakoutsystem. In the Donchian system, the trader goes long when the 20-day high is brokenand sells and goes short when the 20-day low is broken. In the 1970s, Dunn andHargitt evaluated a number of mechanical trading systems and found that Donchian'ssystem was superior to the others evaluated at that time. Will Donchian's system stillwork? Yes,

Figure 16.7 Silver, October 2011. Here is what happened in silver after the ninthedition was published. Could there be any greater vindication of the value of chartslooking at the issue six years later? Just as in the case of gold, the analysis allowedthe analyst to anticipate a monster Bull Market. On http://www.edwards-magee.com,the authors wrote letters all during this time pointing out the silver Bull. Measuringthe entire formation, the depth is 33.96, added to the neckline of 37.5 equals 71.46.This seems quite fanciful to us, but that is the measurement.
in broadly trending markets. Will the Turtle system still work? Yes, in broadlytrending markets. Plus, like virtually all mechanical systems, they do not knowwhether they are in a broadly trending market or not. They are blind—all they see areones and zeros. The addition to these systems of prudently applied chart analysis willimmeasurably improve their performance and risk characteristics.
The application of Edwards and Magee's methods to 21st-century futuresmarkets
During my career as a commodity trading advisor, I have known a number ofsuccessful traders and advisors who used what I would describe as Magee-type chartanalysis to make their trades. Often, other elements were input into their decision-making process, but manual charting was a key factor in their operations. Some ofthese traders used simple trendline analysis with price or volume filters and someused a combination of trendlines and support and resistance. All were trend followers.
Having looked at the futures markets with some attention over the past several years,it seems to me there is no reason why chart analysis should not work as well now infutures as it has always worked in stocks. Essentially, the questions raised bysecurities trading are the same as those presented by futures trading in the analysis ofa chart. Is there a trend? Where are support and resistance? Is there a breakout? Arethere waves and wavelets? How do you enter and how do you exit?
The great bug-a-boo of securities traders coming to the futures trading is the speed ofthe game. Like college football players stepping up to the NFL, there is a brutallearning curve and rookies are the most likely to get killed. I am not going to makeany effort here to present a primer for new futures traders, but rather, I will look atsome futures charts at the end of this chapter to show the journeyman that chartanalysis can be used
Figure 16.8 Treasury Bonds. The double-pump triple-nod head fake is a specialty offutures markets. The fear and greed factor are multiplied by 10, like the leverage. Buthere in September 2004 Bonds, we can see how simple chart analysis can serve thetrader. The downtrend from March (1) is completely manageable with a simpletrendline and trend analysis. The end of the downtrend in May is marked by twostrong run days. At any rate, the stop would have been at May 1, using a Basing Pointkind of analysis. If we were going to trade it long, this would have been traded for ascalp (because we do not know whether or not there is a bottom). The break of thetrendline at 2 is an engraved invitation to get long and the trendline at 3 keeps us longuntil broken by the signal day at the end of July. This would put us short again,whereas a two-day trade as the signal day on the trendline at 4 puts us long again.Obviously, we are using very tight, short trendlines and long-range days (or run days)as signals. The use of the run day as a signal, combined with other indicators, iscommon in my experience among traders.
as a decision-making method in these dramatic markets. Again, chart analysis has theweakness (or strength) of being a qualitative process. It will not make decisions forthe average trader, as a mechanical system will.
On the other hand, a breakout is a breakout. A gap is a gap, leaving aside the questionof limit move gaps for the moment. A trend is a trend. And here is the great advantage
that a firm grasp of charting methods can give the practitioner. It can give him theperspective to recognize the essential nature of the market at hand and choose to waitor to enter. Mechanical methods not having the qualitative discrimination of anexperienced chartist will blindly take every trade until they are out of money. Theexperienced chart analyst can sit back and say, this market has not yet made a bottomand the time to begin trading it long has not yet come. Or, he can recognize theessential differences between a trading and a trending market and adjust his tacticsaccordingly. As Magee noted in Chapter 16:
Under what might be called normal market conditions, those chart patterns whichreflect trend changes in most simple and logical fashion work just as well withcommodities as with stocks. Among these we would list Head-and-Shouldersformations, Rounding Tops

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Figure 16.9 Commodity Research Bureau Index, April 2005 Futures. Just asTriangles often work in securities, they often work in futures. Breakaway gap, secondbreakaway gap, runaway gap, second runaway gap—this is the formation before thesecond runaway gap is somewhat quizzical—it might be considered a flag, but it hasthe same effect, and depending on the trader's operating methods, the stop would bejust under the gap/run day anyway. It will not take much study for the reader to seethe principles of chart analysis used in this entire book are validated here. The maindifference is in the setting of stops, and in fact, the same stop methods may be used ifthe trader is sufficiently well financed.
and Bottoms, and basic trendlines. Trendlines, in fact, are somewhat better definedand more useful in commodities than in stocks. Other types of chart formations whichare associated with stocks with short-term trading or with group distribution andaccumulation, such as the Triangles, Rectangles, Flags, etc., appear less frequently incommodities and are far less reliable as to either direction or extent of the ensuingmove. Support and Resistance Levels, as we have already noted, are less potent in
commodities than in stocks; sometimes they seem to work to perfection, but just asoften they don't. For similar reasons, gaps have relatively less technical significance.
These words remain true today, as do virtually all the principles enunciated in thisbook by Edwards and Magee and myself. In fact, if most futures charts were given toan
Figure 16.10 Commodity Research Bureau (CRB), long-term view. It does not takemuch analysis of this 10-year CRB chart to see a huge Double Bottom and to considerits implications. If China and India are going to compete with us for natural resources,we could see an entirely new economic paradigm, if the reader will excuse the term.Clearly, there is a Bull market in commodities. In Chapter 42, Pragmatic PortfolioManagement, it is suggested that capital should flow to markets that are moving,rather than remaining committed to markets that are mired in mulish trends.Furthermore, it is suggested in that chapter that a good natural hedge is to go long onthe uptrend of an index and short the components of it that are in downtrends. TheCRB is somewhat thin but might lend itself to this strategy.
Figure 16.11 The 20-year bonds as expressed in the TLT; ETF Bonds displayclassical signals of absolute clarity.
Figure 16.12 September, 1994. Coffee was so easy in retrospect that it should beengraved on a brass plate. The long is taken on the breakout of the horizontaltrendline. The position is never in any danger, as there is no down-wave ofsignificance until May when stops are advanced to stay 5% under lows (Basing
Points). The May down-wave allows a Basing Point stop to be established. Thebreakaway gap is a windfall profit. The flag tells us that more is coming—as it doeswith another gap and run days—until the spike reversal, which is a clear signal to beout on the close. A gap up on the open, an exploration up, and a close down—anabsolutely clear message of reversal from the market.
256 Technical Analysis of Stock Trends
Figure 16.13 The May 11 top in silver. In the first quarter of 2011, silver took off in aroaring uptrend. Any surprise here, after looking at the Bounding Bottom? As seen inthe chart, it came near to going parabolic. The top notice came on April 25—interestingly on a reversal bar. Reading the Candlestick, the market gapped wide onthe opening and took a long excursion down to close the opening gap. Then bargainhunters thought they were getting a good price on silver and drove the price back up,so it did not close on the lows. The next day, it gapped down on the open andbasically wandered down all day long—the party was over. The signs were subtle.
Chapter sixteen: Technical analysis of commodity charts 257
analyst, without issue identification and dates would not be identifiable as commoditycharts. When limit moves appear, the difference slaps one in the face. On this point Imight differ from Magee slightly as regards to gaps. Obviously, limit move gaps havebreathtaking significance. All in all, it seems to me gaps often say the same thing tofutures analysts as they do to stock analysts.
Another mathematical reason might be adduced for the practicality of using simplechart analysis to trade futures. That is the tautological nature of the method. A trend isa trend, and a trendline is a trendline. If you enter a suspected trend (setting a
protective stop at a technically analyzed place) and follow the trend using BasingPoints or observing the trendline and exiting on a break and reversal there will be nodifference from doing the same with a stock. Well, some difference. Due to theleverage, you will be required to be hyperaware of risk. In futures, the penalty forholding a position through “a normal reaction” can be extremely harsh. That is whystops are so important.
The TLT chart from late 2008 is a spectacular display of patterns and signals. Thispattern has appeared many times before and will appear again in the future.
Prices break out of a sideways pattern on a strong gap. The gap is across the trendline,which is what makes the signal significant. Every gap is not a signal. In this case, thegap is extra significant because there is a power bar on the gap day—it should bebought. This is called a breakaway gap. Prices continue to progress, and a few dayslater another gap occurs. This is a runaway gap and is another signal.
Shortly thereafter, prices drift sideways for a few days. This is a flag. Flags are vividmessages to traders. Robert Edwards described how they are used. He said, “The flagflies at half-mast,” meaning after a rocket-like advance and this formation, pricesshould advance on at least as far as they had come.
Power bars (signals) exit from the flag, and then another gap occurs. This is theexhaustion gap. This is a message to exit longs and to short the issue. The messagecould not have been clearer.
The skilled trader, first of all, catches the original signal—the power bar exiting fromthe sideways pattern. He then pyramids on the subsequent signals. Exiting from theflag, a good trader should have a boatload of this issue, and at the top, selling after theexhaustion gap, he should have made at least a small killing.
Stops
Some traders set their stops using money management rules rather than technicallyidentified points. I believe it is always better to find the technical point using a BasingPoint, or support and resistance. To me it makes better sense to adjust position size tocontrol risk as I describe in Chapter 26. The use of money management stops hasbeen very successful for many traders. If some logical and disciplined method ofsetting and observing stops is not installed, the trader is assured of failure.
A money management stop is, simply enough, a stop calculated by deciding to risk2% (or 3% or 4% or x%) of capital on a trade. For example, William O'Neil says thatwhen a stock trader enters a position, he should set a stop 8% under his entry price.
This is a little crude, and not strictly speaking, a money management stop, but it isbetter than no risk calculation at all. In a stricter sense, if we said we wanted to limitthe risk of the trade to 3% of capital, we would use the 8% rule to set the stop and theScott Procedure in Chapter 26 to determine the number of shares or contracts. TheTurtle system contains similar procedures. Numerous studies have proven the size ofthe risk per trade—1%, 2%, 3%—is directly correlated to equity volatility.
The 25th looked like a reversal day. The gap down on the 26th could have beenconsidered the closing of an exhaustion gap—not apparent here because the tails(shadows) of the candlesticks obscure the complete price behavior.
(EN10: In the 10th edition, a new section on stops in Chapter 27 examines a numberof stop methods.)
A variety of methods
As noted above, a competent chart analyst may, in my opinion (and in Magee'sopinion), perform profitably in the futures markets. There are other questions, ofcourse, namely of character, temperament, intelligence, judgment, and so on. Let usleave those questions to Dr. Elder and confine ourselves to the method question. Chartanalysts proved their abilities in the futures markets long before computers existed. Infact, long before in the case of Japanese rice traders, enlightening their efforts withcandlesticks in the eighteenth century.
In the 1970s, I saw point and figure chartists enjoy great success at Dean Witter andMerrill Lynch and other major firms in futures. I have seen least squares curve fitters,moving average calculators, and abstruse statistical analysts all enjoy profitableoutings in commodities. Not to speak of the Turtles who, using naturalistic high-lowsystems, harvested good profits in the markets. As the saying goes, gateless is the gateand many are the ways to the great Dow. Although I have enjoyed great successmyself using mechanical number-driven systems over the years, I have become moreand more attracted to “natural” systems. Chart analysis is essentially natural, as is theTurtle system. The Dow Theory is a natural system in which no mathematicalalgorithm comes between the analyst and the data. The essential, more, quintessential,weakness of all number-driven systems is their blindness. They do not have the abilityto discriminate between the forest and the trees. The experienced human chartist cansee (and hear) the changing rhythms of the market and respond to them, responding tofactors too subtle (and even subconscious) to program. Nevertheless, even naturalsystems, like the Turtle systems, can fall into this trap. When the markets learn a lotof capital is waiting just above the 20-day high, they will set a trap for it. For“markets” you may read “they.” If you apply the knowledge of this book to suchsituations, you may avoid the trap.
Everything you need to know as a chart analyst trading futures
“Jack be nimble, Jack be quick, Jack jump over the Candlestick.” Yes, it is true, as theleverage is 10 times greater and the speed is 10 times faster. I have illustrated inFigure 16.9 the combination of a very tight trendline with a run day, which it seems tome is a good current (twenty-first century) combination. Otherwise, the same qualitiesthat make a good securities trader make a good futures trader once the great leap toleveraged quick-fire markets is made. If you have been successful trading stocks, youwill probably be successful trading futures, and you probably should practice onstocks while studying futures. A sobering fact I often recount to my graduate studentsis that Richard Wyckoff worked in the securities business for eight years beforemaking his first investment; he studied the markets an additional six years beforetrading.
The Magee methodology will serve as a valuable cornerstone of your futuresoperations and you must never cease studying. Mechanical systems have theirattractions, especially when seasoned with experienced chart analysis. No methodwill survive unless practiced with diligence, persistence, judgment, and patience.Time and again you will hear famous traders say discipline is the secret of theirsuccess. What they mean by discipline is their ability to measure and contain the risk,set a stop based on technical or money management procedures, and then honor thestop. The most important lesson the futures trader has to learn from Edwards andMagee is the ability to see the character of the market, trading or trending, and then toadjust his tactics accordingly.
In the next great Bull Market in commodities, which is inevitable, these methods andsystems derived from them will once again reap windfall profits.
I have attempted in the ninth edition of this classic book to show the book'susefulness to the intelligent futures trader. Simple classical chart analysis alone can besuccessful in the futures markets in the hands of an experienced competent analyst.Natural mechanical systems such as the Turtle system have been effective and will beagain, perhaps with some tweaking (such as imposing a chart analysis superstructure).Wave analysis methods such as the Basing Points Procedure of Chapter 28 can beused. Even number-driven systems, such as moving averages, can be successful,especially if combined with chart analysis.
chapter seventeen
A summary and concluding comments
We began our study of technical stock chart analysis in Chapter 1 with a
discussion of the philosophy underlying the technical approach to the
problems of trading and investing. We could ask the reader to turn back
now and review those few pages to recapture a perspective on the subject
that must have been dimmed by the many pages of more or less arduous
reading that have intervened. (For illustrations in this chapter, see Figures
17.1 through 17.4.)
It is easy, in a detailed study of the many and fascinating phenomena that
stock charts exhibit, to lose sight of the fact they are only the rather
imperfect instruments by which we hope to gauge the relative strength of
supply and demand, which, in turn, exclusively determines what way, how
fast, and how far a stock will go.
Remember, in this work, it does not matter what creates the supply and the
demand. The fact of their existence and the balance between them are all
that count. No man, no organization (and we mean this verbatim et
literatim) can hope to know and accurately appraise the infinity of factual
data, mass moods, individual necessities, hopes, fears, estimates, and
guesses that, with the subtle alterations ever proceeding in the general
economic framework, combine to generate supply and demand.
Nevertheless, the summation of all these factors is reflected virtually
instantaneously in the market.
The technical analyst's task is to interpret the action of the market itself—to
read the flux in supply and demand mirrored therein. For this task, charts
are the most satisfactory tools thus far devised. Lest you become enrapt,
however, with the mechanics of the chart— the minutiae of daily
fluctuations—ask yourself constantly, “What does this action really mean in
terms of supply and demand?”
Judgment, perspective, and a constant reversion to first principles is
required. A chart, as we have said and should never forget, is not a perfect
tool nor a robot; it does not give all the answers quickly, easily, or
positively, in terms anyone can read and translate at once into certain profit.
We have examined and tested exhaustively many technical theories,
systems, indexes, and devices that have not been discussed in this book
(chiefly because they tend to shortcircuit judgment) to see the impossible by
a purely mechanical approach to what is far from a purely mechanical
problem. The methods of chart analysis that have been presented are those
that have proved most useful because they are relatively simple and easily
rationalized since they stick closely to first principles. Additionally, they are
of a nature that does not lead us to expect too much of them and they
supplement each other and work well together.
Let us review these methods briefly. They fall roughly into four categories:
1. The Area Patterns or formations of price fluctuation that, with their
concomitant volume, indicate an important change in the supply-demand
balance. They can signify Consolidation, a recuperation or gathering of
strength for renewed drive in the same direction as the trend that preceded
them. Or they can indicate Reversal, the playing out of the force formerly
prevailing, and the victory of the opposing force, resulting in a new drive in
the reverse direction. In either case, they may be described as periods
during which energy is brewed or pressure is built up to propel prices in
Figure 17.1 Spiegel's Bear Market started in April 1946 from a
Symmetrical Triangle that changed into a Descending Triangle. Note the
Pullback in June and two Flags. This history is carried on in Figure 17.2,
which overlaps Figure 17.1; this chart shows the move that ensued from the
wide Descending Triangle of early 1947, culminating in a Reversal Day on
May 19. Note various Minor and Intermediate Resistance Levels.
Technical Analysis of Stock Trends
Figure 17.2 Overlapping Figure 17.1, this chart shows the move that
ensued from the wide Descending Triangle of early 1947, culminating in a
Reversal Day on May 19. Note various Minor and Intermediate Resistance
Levels.
Chapter seventeen: A summan/ and concluding comments
a move (up or down) that can be turned to profit. Some of them provide an
indication as to how far their pressure will push prices. These chart
formations, together with volume, furnish the technician with most of his
“get-in” and many of his “get-out” signals.
Volume, which has not been discussed in this book as a feature apart from
price action, and which cannot, in fact, be utilized as a technical guide by
itself, deserves some further comment. Remember it is relative that it tends
naturally to run higher near the top of a Bull Market than near the bottom of
a Bear Market. Volume “follows the trend,” meaning it increases on rallies
and decreases on reactions in an overall uptrend, and vice versa. But use
this rule judiciously; do not place too much dependence on the showing of a
few days and bear in mind that even in a Bear Market (except during Panic
Moves), there is always a slight tendency for activity to pick up on rises.
(“Prices can fall of their own weight, but it takes buying to put them up” as
Edwards said.)
A notable increase in activity, as compared with previous days or weeks,
may signify either the beginning (breakout) or the end (climax) of a move,
temporary or final. (More rarely, it may signify a “shakeout.”) Its meaning,
in any given case, can be determined by its relation to the price pattern.
2. Trend and trendline studies supplement Area Patterns as a means of
determining the general direction in which prices are moving and of
detecting changes in direction. Although lacking the nice definition of Area
Formations, they may frequently be used for “get-in” and “get-out”
purposes in short-term trading, as well as provide a defense against
premature relinquishment of profitable long-term positions.
3. Support and Resistance Levels are created by the previous trading and
investment commitments of others. They may indicate where it should pay
to take a position, but their more important technical function is to show
where a move is likely to slow down or end, and at what level it should
encounter a sudden and important increase in supply or demand.
Before entering a trade, look both to the pattern of origin for an indication
of the power behind the move and to the history of Support-Resistance for
an indication as to whether it can proceed without difficulty for a profitable
distance. SupportResistance studies are especially useful in providing
“cash-in” or “switch” signals.
4. Broad market background, including the Dow Theory, should not be
scorned. This time-tested device designates the (presumed) prevailing
Major Trend of the market. Its signals are “late,” but with all its faults (like
the greatly augmented following it has acquired in recent years resulting in
a considerable artificial stimulation of activity at certain periods), it is still
an invaluable adjunct to the technical trader's toolkit.
The general characteristics of the various stages in the stock market's great
Primary Bull and Bear cycles, which were discussed in our Dow Theory
chapters, should never be lost to view. This brings us back to the idea of
perspective, which we emphasized as essential to successful technical
analysis at the beginning of our summary. The stock that does not, to some
degree, follow the Major Trend of the market as a whole is an extraordinary
exception. More money has been lost by buying perfectly good stocks in the
later and most exciting phases of a Bull Market, and then selling them,
perhaps from necessity, in the discouraging conditions prevailing in a Bear
Market, than from all other causes combined.
Hence, keep your perspective on the broad market picture. The basic
economic tide is one of the most important elements in the supply-demand
equation for each individual stock. It may pay to buck “the public,” but it
does not ever pay to buck the real underlying trend.
Major Bull and Bear Markets have recurred in fairly regular patterns
throughout all recorded economic history, and there is no reason to suppose
they will not continue to recur for as long as our present system exists. It is
well to keep in mind that caution is in order whenever stock prices are at
historically high levels and that purchases will usually work out well
eventually when they are at historically low levels.
If you make known your interest in your charts, you will be told the chart
analyst (like the Dow theorist) is always late—buying after prices have
already started up (maybe not until long after the “smart money” has
completed its accumulation) and sells after the trend has unmistakably
turned down. Partly true, as you have no doubt already discovered for
yourself. The secret of success lies not in buying at the very lowest possible
price and selling at the absolute top, but rather in the avoidance of large
losses. (Small losses you will have to take, and as quickly as possible as
warranted by the situation.)
One of the most successful “operators” Wall Street has ever seen, Bernard
Baruch, a multimillionaire and a nationally respected citizen today, is
reputed to have said never in his entire career had he succeeded in buying
within 5 points of the bottom or selling within 5 points of the top! (EN: For
perspective, the 5 points mentioned constituted roughly 10% of the market
at that time.)
Before we leave this treatise on theory and proceed to the more practical
matters of application and market tactics that are the province of Section II
of this book, the reader will, we hope, forgive one more admonition. There
is nothing in the science of technical analysis that requires one always to
have a position in the market. There is nothing that dictates something must
happen every day. There are periods—sometimes long months—when the
conservative trader's best policy is to stay out entirely. What is more there is
nothing in technical analysis to compel the market to go ahead and
complete (in a few days) a move the charts have foretold; it will take its
own good time. Patience is as much a virtue in stock trading as in any other
human activity.
Technical analysis and technology in the 21st century: the
computer and the internet: tools of the investment/information
revolution
The purpose of this section is to put computer and information technology
into proper context and perspective for chart-oriented technical analysts.
In John Magee's time, in his office in Springfield, Massachusetts, there was
a chart room—a room filled with all-age chartists from teenagers to senior
citizens. These people spent all their time keeping charts and assisting
Magee in interpretation. These were wonderful and intelligent people who
developed marvelous insights into the stocks they charted as well as created
the manual charts that adorn this book.
Today, that room and all those technicians have been replaced by a beige
(sometimes lime) box that sits crowded on our desktops and that is often
worshipped as a fount of insight and wisdom: “Computer, analyze my
stocks.”
Unfortunately, the computer does not have the discrimination and pattern
recognition ability of the people in that chart room. Undeterred by this
weakness in computer technology, traders and investors have poured
incalculable money and effort into computer-aided research, attempting to
discover the keys to market success. More money has been spent in this
effort than was ever put into the search for the philosopher's stone. Much of
it was wasted, but it has not all been spent in vain. In some areas, it has
been quite productive. But no fail-safe algorithm, in spite of all this effort,
has been found for investment success, and certainly not for stock trading.
The research has demonstrated that even the algorithm of “buy low, sell
high” has fatal flaws in it.
To fully understand the importance of the computer, the reader should
appreciate some basic differences in participants' approach to the markets,
or, we might say, schools of analysts and investors. We will not bother with
fundamental analysts here, as they are of a different religious persuasion.
Chart analysts, or Magee-type technical analysts, pretty much confine their
analysis of the market to the interpretation of bar charts. (This does not
mean their minds must be closed to other inputs. On the contrary—anything
that works.) Another chart analyst school uses point and figure charts, and
another candlestick charts. Another breed of technical analysts takes basic
market data, price and volume, and uses them as the input to statistical
routines that calculate everything from moving averages to mystically
designated indicators like %R or Bollinger Bands (see Glossary); they are
known as statistical or number-driven technical analysts. All these analysts
attempt to invest or trade stocks and other financial instruments (not
including options) using some form of what is called technical analysis—
that is, they all take hard data that people cannot lie about, misrepresent,
and manipulate, (unlike the data inputted to fundamental analysis like
earnings, cash flow, sales, etc.) as input to their analysis.
Using number-driven or statistical technical analysis, these latter schools
attempt, just as chart analysts do, to predict market trends and trading
opportunities. This can be more than a little difficult because the stock and
bond markets are behavioral markets driven by human emotion, perhaps the
most important of many variables influencing price. Plus, human emotion
and behavior dictates manic and depressive elements, which have not yet
been quantified. Yet, some chart analysts believe they can recognize it when
they see it on the charts.
In another area, the computer has yielded much more dramatic and
profitable results, but that is in a model-driven market, namely the options
markets. Quantitative analysts, those who investigate and trade the options
markets, are a breed apart from technical analysts. In an interesting irony,
emotion-driven markets, the stock markets, are used as the basis for
derivatives, or options, whose price is determined largely by the operation
of algorithms called “models;” for example, the Black Scholes model.
Quantitative analysts believe, as does this editor, the options markets can be
successfully gamed through quantitative analysis. Results of skilled
practitioners indicate this belief is accurate.
Alas, life is not so simple for the simple stock trader. Stock prices having
nothing to do with mathematics, except for being expressed as natural
numbers, are not susceptible to easy prediction as to their future direction.
Not even with Magee chart analysis or any other form of analysis—
technical, fundamental, or psychic. (From a theoretical point of view, each
trade made on the basis of a chart analysis should be looked at as an
experiment made to confirm a probability. The experiment is ended quickly
if the trend does not develop.) The fact chart analysis is not mechanizable is
important. It is one reason chart analysis continues to be effective in the
hands of a skilled practitioner. Not being susceptible to mechanization,
counterstrategies cannot be brought against it, except in situations whose
meaning is obvious to everyone, for instance, a large important Support or
Resistance Level or a glaringly obvious chart formation. These days
everyone looks at charts to trade even if they do not believe in their use. In
these obvious cases, some market participants will attempt to push prices
through these levels to profit from volatility and confusion. Indeed, human
nature has not changed much since Jay Gould and Big Jim Fisk.
When these manipulations of price occur, they create false signals—Bull
and Bear traps. Interestingly, the failure of these signals may constitute a
reliable signal in itself—but in the direction opposite to the original signal.
The importance of computer technology
Of what use and importance then is this marvelous tool—the most
interesting tool man (homo) has acquired since papyrus? (Numerous
computer software packages available are capable of executing the
functions described in the following discussion.) If the computer cannot
definitively identify profitable opportunities, what good is it?
Probably the most important function the computer has for the Magee
analyst is the automation of rote detail work. Data can be gathered by
downloading from database servers. Charts can be called up in an instant.
Portfolio accounting, maintenance, and tax preparation can be disposed of
with one hand while drinking coffee with the other. All in all, this might
make it sound as though the computer is a great tool, but with a pretty dull
edge. Not strictly true. There is at least one great leap forward for Magee
analysts with this tool, leaving aside the rote drudgery it saves. This great
advantage is portfolio analysis. In Appendix B, Resources, a complex
portfolio analysis of the kind used by professional traders (Blair Hull and
Options Research Inc.) is illustrated. Even simpler portfolios of the average
investor can benefit from the facilities afforded by most portfolio programs,
either on the net or in commercial software packages (locations and
software identified in Appendix B, Resources).
Another advantage is the ability to see basic data displayed in many
different forms: point and figure charts, candlestick charts, close-only charts
—these are prepared in the flick of an eyelash and may indeed contribute to
understanding the particular situation under the magnifying glass. The
effortless quantification of some aspects of analysis may be useful—volume
studies, for instance, and given the popularity of moving averages, seeing
the 50- and 200-day moving averages can be interesting. These moving
averages are considered significant by many market participants—even
fundamental analysts. The analysis of any of these should be considered in
relation to the current state of the market as understood by the careful chart
analyst.
But what about (the strangely named) stochastics, Bollinger Bands, %R,
MACD, Moving Averages (plain vanilla, exponential, crossover, etc.),
price/volume divergence, RSI (plain vanilla and Wilder), VP Trend, TCI,
OBV, Upper/Lower Trading Bands, ESA Trading Bands, and AcmDis?
Well, there is a certain whiff of alchemy to some of them, and some have
some usefulness sometimes. What is more, all systems work beautifully at
least twice in their lives: in research and in huge monumental Bull Markets.
These number-driven indicators are also the times when trading genius is
most likely to be discovered. (EN9: It is also true, as I have said, that you
can drive a nail with a screwdriver. And the inventor of a tool may be
fabulously successful with it while its adopters lose their assets.)
It is also possible the excess of technical information created by these
indicators may be like the excess of fundamental information—another
shell to hide the pea under, another magician's trick to keep the investor
from seeing what is truly important, and what is necessary and sufficient to
know to trade well. Perhaps the investor would be better off with a
behavioral model because the markets are behavioral. Number-driven
technical analysis can do many things, some like Dr. Johnson's dog, which
walked on its hind legs, but they cannot put the market in perspective—only
the human mind can do that. Number-driven models after all do not
consider skirt lengths, moon cycles, sun spots, the length of the economic
cycle, or the Bullish or Bearish state of the market (if Bear Markets still
exist) (EN9: A wry ironical comment written before the market crash of the
2000s.) In the end, the human brain is still the only organ capable of
synthesizing all this quantitative and qualitative information and assessing
those elements that cannot be reduced to ones and zeros. The educated mind
is still the best discriminator of patterns and their contexts.
Summary 1
The computer is a tool, a powerful tool, but a tool nonetheless. It is not an
intelligent problem solver or decision maker. We use a mechanical ditch
digger to dig a ditch, but not to figure out where the ditch should be.
The multitude of indicators and systems should be viewed with a skeptical
eye and evaluated within the context of informed chart analysis. Sometimes
an indicator or technique will work for one user or its inventor but strangely
mislead the chart analyst who tries to use it—or buys it, even based on a
verified track record.
Therefore, the experienced investor keeps his methods and analysis simple
until he has definitive knowledge of any technique, method, or indicator he
would like to add to his repertoire. Most of all, he depends on his own
observations and experience to evaluate his and others' trading techniques.
Other technological developments of importance to the technical
Magee analyst and all investors
The computer is not the only technological development of interest to the
technical investor. A number of information revolution technologies need to
be put in perspective. These are, in broad categories, the internet and all its
facilities, developments in electronic markets, and advances in finance and
investment theory and practice. This last is treated in the final section of this
chapter.
Owing to the enormous body of material on these subjects, no attempt will
be made to explore these subjects exhaustively, but the general investor will
be given the information he needs to know to put these subjects in their
proper perspective. Resources will point the analyst to avenues for further
investigation if the need is felt.
First of all, are there any technological developments of whatever sort that
have made charting obsolete? No. Are there any developments that have
made trading a guaranteed success? No. The only sure thing is some
huckster will claim to have a sure thing. Those who believe such claims are
the victims of their own naivete.
The Internet: the eighth wonder of the modern world (EN9: Appendix B,
Resources, for the ninth edition has been enormously expanded and is of
paramount importance to modern investors.)
The internet has been called the most complex project ever built by man,
which is probably true. Complex, sprawling, and idiosyncratic, it has
something for everyone, especially the investor. Every form of investment
creature known to man has set up a site on the internet and waits like the
hungry arachnid for the casual surfer: brokers and advisors—technical and
fundamental; newspapers, news magazines, newsgroups, and touts; mutual
funds, mutual fund advisories, critics and evaluators of all the above;
database vendors, chat rooms, electronic marketplaces and exchanges, and
Exchange Traded Notes (ECNs)—the only unfilled niche that seems to exist
is investment pornography. Perhaps naked options will be able to satisfy
this need.
This is a bewildering array of resources. How does one sort them out? The
implications of all this for the electronic or cyber investor may be further
expanded to indicate the services and facilities available: quotes and data;
portfolio management and accounting; online interactive charting;
automatic alerts to PBDAs (personal body digital assistants or gizmos
carried on the body, for example, cell phones and handheld computers, and
so on); analysis and advice; electronic boardrooms; and electronic
exchanges where trading takes place without intermediaries. Appendix B,
Resources, supplies the specifics on these categories while this chapter
supplies perspective. It is one thing to contemplate this cornucopia of
facilities and another thing to appreciate the importance and priority of its
elements. What good are real-time quotes if you are only interested in
reviewing your portfolio once a week, except for special occasions? What
good are satellite alerts and virtual reality glasses to a long-term investor? It
is easy for the investor with no philosophy or method to be drawn into the
maelstrom of electronic wonders and stagger out of it a little wiser and
much poorer.
Observe then the goods and services of all of this are of importance to the
levelheaded investor with his feet on the ground and his head out of the
clouds (or Cloud). This, hopefully not, abstract investor, the object of our
attention here, needs what? He needs data, charts, and a connection to a
trading place. Data are available at the click of a mouse. A chart occupies
the screen in another click. Another click and a trade is placed. In the
Internet Age, it would be tautological to attempt to describe this process in
prose when live demonstrations are as close as the desktop computer and an
internet connection. A demonstration of this rather simple process (easy to
say when one does it without thinking) may be seen at locations linked in
Appendix B, Resources. The trade will be made, of necessity, through a
broker of some sort, perhaps an electronic broker or even a non-virtual
broker who communicates via telephone. This will occur shortly, if not
already, an electronic pit where one matches wits with a computer instead
of a market maker or specialist.
How long brokers will be necessary is a question that is up in the air in the
new century. (The broker who earns his keep will always be with us, and
welcome, too.) Electronic marketplaces where investors meet without the
necessity of a broker or specialist are already proliferating (see Appendix B,
Resources) and will continue to gain the advantage for the investor over the
trading pit, which is one of the last remaining edges the professionals hold
over off-floor traders. Suffice it to say, their initial phases will undoubtedly
be periods of dislocation, risk, and opportunity as their glitches are ironed
out.
Placing electronic orders, whether to an electronic exchange or to the New
York Stock Exchange, has certain inherent advantages over oral orders. No
one can quarrel about a trade registered electronically as opposed to orally
where the potential for disagreement exists. In addition, the trader has only
handled the data once—rather than making an analysis, calling a broker,
recording the trade, and passing it to the portfolio. If he just hits the trade
button and the transaction is routed through his software package, no one
will have any doubt as to where an error might lie. The manual method
presents an opportunity for error at each step. Rest assured, errors occur and
can be disastrous to trading.
The efficiency and ease of the process with a computer have much to
recommend it— automation of trade processing, elimination of confusion
and ambiguities, audit tracks, automation of portfolio maintenance, and,
perhaps most important of all, automatic mark-to-market of the portfolio
(the practice of valuing a portfolio at its present market value whether
trades are open or closed).
Marking-to-market
This book might have been entitled Zen and the Art of Technical Analysis if
that title were not so hackneyed and threadbare. It conveys, nonetheless, the
message of Zen in the art of archery, that of direct attachment to reality and
the importance of the present moment. In his seminal book The General
Semantics of Wall Street (now Winning the Mental Game on Wall Street),
John Magee inveighed at some length against the very human tendency to
keep two sets of books in the head—one recording profits, open and closed,
and another recording losses, but only closed losses. Open losses were not
losses until booked. Having an electronic portfolio accountant that refuses
to participate in such self-deception has much to recommend it. If the
portfolio is always marked to the market when the computer communicates
with the data vendor, or the trade broker, it is difficult not to see red ink, and
to see the equity of the account reflects all trades, open and closed.
Separating the wheat from the chaff
It requires a gimlet-eyed investor to pick his way through the minefield of
temptations in electronic investing and number-driven technical analysis.
Playing with the toys, seeing what the pundits have to say, and fiddling with
“research” can subtly replace profitable trading as the activity. Actually,
almost all the research the Magee analyst must do is addressed in this book.
Chaff
Chat rooms, touts, news, predictions, punditry, brokerage house buy, sell,
hold, strong hold, weak buy, strong buy, and any other species of brokerage
house recommendation should be taken at face value. Remember, brokerage
firms survive by selling securities and make their money in general on
activity. Actually, much of their money is made servicing their institutional
clients and distributing their clients' shares to their retail clientele—a blatant
conflict of interest that blew up in their faces in the early 2000s, resulting in
many fines and some jail terms (plus ga change ... ). In the surging Clinton-
Gore Bull Markets of the 1990s, all of these worked. In a serious Bear
Market, none of them will work. (EN9: A serious Bear Market started in
earnest in 2000 and was correctly identified with Magee chart analysis as
may be seen from the John Magee Letters at the http://www.edwards-
magee.com.)
Summary 2
Never in the history of the markets have so many facilities for private
investors been available. The computer is necessary to take advantage of
those facilities.
Data may be acquired automatically via internet or dial-up sites at little or
no cost. A (as they say) plethora of websites offer cyber investors
everything from portfolio accounting to alerts sent to their personal body-
carried devices (cell phones, pagers, handheld PDAs, and so on). Some of
these even offer real-time data, which is a way for the unsophisticated
trader to go broke in real time. Many of these sites offer every kind of
analysis from respectable technical analysis (usually too complicated) to
extraterrestrial channeling.
Internet chat rooms will provide real-time touting and numerous rumors to
send the lemmings and impressionable scurrying hither and yon. But, one
expects, not the readers of this book.
Of more importance, the information revolution and the computer will:
1. Relieve the analyst of manual drudgery, accelerate all the steps of
analysis: data gathering, chart preparation, portfolio accounting, and
analysis and tax preparation.
2. Give the analyst virtually effortless portfolio accounting and mark-
to-market prices—a valuable device to have to keep the investor from
mixing his cash and accrual accounting, as Magee says.
3. Enable processing of a hitherto unimaginable degree. An unlimited
number of stocks may be analyzed. Choosing those to trade with a
computer will be dealt with in Chapter 21, Selection of Stocks to
Chart.
4. Allow the investor to trade on ECNs or in electronic marketplaces
where there are no pit traders or locals to fiddle with prices.
Advancements in investment technology, part 1: developments in
finance theory and practice
Numerous pernicious and useless inventions, services, and products litter
the internet and the financial industry marketplace; but modern finance
theory and technology are important and must be taken into consideration
by the general investor. This chapter will explore the minimum the
moderately advanced investor needs to know about advances in theory and
practice. And it will point the reader to further resources if he desires to
continue more advanced study.
Instruments of limited (or non) availability during the time of Edwards and
Magee included exchange traded options on stocks, futures on averages and
indexes, options on futures and indexes, and securitized indexes and
averages, as a partial list of only the most important instruments.
Undoubtedly, one of the most important developments of the modern era is
the creation of trading instruments that allow the investor to trade and
hedge the major indexes. Of these, the instruments created by the Chicago
Board of Trade (CBOT®) are of singular importance. These are the CBOT®
DJIASM Futures and the CBOT® DJIASM Futures Options, which are
discussed in greater detail at the end of this chapter. (EN9: Not so singular,
perhaps. Probably of greater importance to readers of this book are the
AMEX iShares, particularly DIA, SPY, and QQQ, which are instruments
(ETFs) that offer the investor direct participation in the major indexes as
though they were stocks.)
General developments of great importance in finance theory and practice
are found in the following sections.
Options
From the pivotal moment in 1973 when Fischer Black (friend and college
classmate) and his partner, Myron Scholes, published their—excuse the
usage—paradigm-setting Model, the options and derivatives markets have
grown from negligible to trillions of dollars a year. The investor who is not
informed about options is playing with half a deck. The subject, however, is
beyond the scope of this book, which hopes only to offer some perspective
on the subject and guides to the further study necessary for most traders and
many investors.
Something in the neighborhood of 30% or more of options expire
worthless. This is probably the most important fact to know about options.
(There is a rule of thumb about options called the 60-30-10 rule: 60% are
closed out before expiration, 30% are “long at expiration,” meaning they
are worthless, and 10% are exercised.) Another fact to know about options
occurred in the Reagan Crash of 1987; the money puts bought at $0.625 on
October 16 were worth hundreds of dollars on October 19—if you could get
the broker to pick up the telephone and trade them. (The editor had a client
at Options Research, Inc. during that time who lost $57 million in three
days and almost brought down a major Chicago bank; he had sold too many
naked puts.)
The most sophisticated and skilled traders in the world make their livings
(quite sumptuous livings, thank you) trading options. Educated estimates
have been made that as many as 90% of retail options traders lose money.
That combined with the fact that by far it is the general public that buys
(rather than sells) options should suggest some syllogistic reasoning to the
reader.
With these facts firmly fixed in mind, let us put options in their proper
perspective for the general investor. Options have a number of useful
functions, such as offering the trader powerful leverage. With an option, he
can control much more stock than by the direct purchase of stock—his
capital stretches much further. So options are an ideal speculative
instrument (Exaggerated leverage is almost always a characteristic of
speculative instruments.), but they can also be used in a most conservative
way—as an insurance policy. For example, a position on the long security
side may be hedged by the purchase of a put on the option side. (This is not
a specific recommendation to do this. Every specific situation should be
evaluated by the prudent investor with professional assistance as to its
monetary consequences.)
The experienced investor may also use options to increase yield on his
portfolio of securities. He may write covered calls or naked puts on a stock
to acquire it at a lower cost (e.g., he sells out of the money put options. This
is a way of being long the stock; if the stock comes back to the exercise
price, he acquires the stock. If not, he pockets the premium.)
There are numerous tactics of this sort that may be played with options.
Played because, for the general investor, the options game can be
disastrous, as professionals are not playing. They are seriously practicing
skills the amateur can never hope to master. Many floor traders, indeed,
would qualify as idiot savants—they can compute the “fair value” of
options in their heads and make money on price anomalies of 1/16, or, as
they call it, a “teenie.” For perspective, the reader may contemplate a
conversation the editor had with one of the most important options traders
in the world who remarked casually that his fortune was built on teenies.
The reader may imagine at some length what would be necessary for the
general investor to make a profit on anomalies of 1/16. (EN10: The advent
of digital pricing has given market makers and specialists even more
flexibility to beat the investor by shaving spreads, theoretically, to $0.01.)
This does not mean the general investor should never touch options; it just
means he should be thoroughly prepared before he goes down to play that
game. In options trading, traders speak of bull spreads, bear spreads, and
alligator spreads. The alligator spread is an options strategy that eats the
customer's capital in toto.
Among these strategies is covered call writing. This strategy is touted as
being an income producer on a stock portfolio. There is no purpose in
writing a call on a stock in which the investor is long—unless that stock is
stuck in a clear congestion phase that is not due to expire before the option
expires. Besides, if the stock is in a downtrend, it should be liquidated, but
to write a call on a stock in a clear uptrend is to make oneself beloved of the
broker, whose good humor improves markedly with account activity and
commission income. The outcome of a covered call on an ascending stock
is that the writer (you, dear reader) has the stock called at the exercise price,
losing his position and future appreciation, not to mention costs. The
income is actually small consolation, a sort of booby prize—a way of
cutting your profits while increasing your costs. Nevertheless, covered
writes are justified and profitable in some cases.
Quantitative analysis
The investor should be aware of another area of computer and investment
technology that has yielded much more dramatic and profitable results, but
that is in a model-driven market—namely, the options markets. Quantitative
analysts, those who investigate and trade the options markets, are a breed
apart from technical analysts. In an interesting irony, behavioral markets,
the stock markets, are used as the basis for derivatives, or options whose
price is determined largely by the operation of algorithms called “models.”
The original model that created the modern world of options trading was
the Black-Scholes options analysis model, which assumed the “fair value”
of an option could be determined by entering five parameters into the
formula: the strike price of the option, the price of the stock, the “risk-free”
interest rate, the time to expiration, and the volatility of the stock.
The eventual universal acceptance of this model resulted in the derivatives
industry we have today. To list all the forms of derivatives available for
trading today would be to expand this book by many pages, and it is not the
purpose of this book anyway. The purpose of this paragraph is to sternly
warn general investors who are thinking of “beating the derivatives
markets” to undergo rigorous training first. The alternative could be
extremely expensive.
At first, the traders who saw the importance of this model and used it to
price options virtually skinned older options traders and the public, who
traded pretty much by the seat of the pants or the strength of their
convictions, meaning human emotion. But professional losers learn fast and
now all competent options traders use some sort of model or anti-model, or
anti-antimodel to trade. True to form, options sellers, who are largely
professionals, take most of the public's (the buyers) money. This is the way
of the world.
Options pricing models and their importance
After the introduction of the Black-Scholes model, numerous other models
followed, among them the Cox-Ross-Rubinstein, the Black Futures, and
others. For the general investor, the message is this: he must be acquainted
with these models and what their functions are if he intends to use options.
Recall, the model computes the “fair value” of the option. One way
professionals make money off amateurs is by selling overpriced options and
buying underpriced options to create a relatively lower risk spread (for
themselves). Not knowing what these values are for the private investor is
like not knowing where the present price is for a stock; it is a piece of
ignorance for which the professional will charge him a premium to be
educated about. Unfortunately, many private options traders never get
educated, in spite of paying tuition over and over again. But ignorance is
not bliss—it is expensive.
Technology and knowledge works its way from innovators and creative
geniuses through the ranks of professionals and sooner or later is
disseminated to the general public. By that time, the innovators have
developed new technology. Nonetheless, even assuming that professionals
have superior tools and technology, the general investor must thoroughly
educate himself before using options. As it is not the province of this book
to dissect options trading, though the reader may find references in
Appendix B, Resources.
Here it would not be untoward to mention one of the better books on
options as a starting point for the moderately advanced and motivated
trader. Lawrence McMillan's Options as a Strategic Investment is necessary
reading. In addition, the newcomer may contact the Chicago Board Options
Exchange (the CBOE) at http://www.cboe.com, which has tutorial software.
Futures on indexes
Futures, like options, offer the speculator intense leverage—the ability to
control a comparatively large position with much less capital than the
purchase of the underlying commodity or index. Futures salesmen are fond
of pointing out the fact that, if you are margined at 5% or 10% of the
contract value, a similar move in the price of the index will double your
money. They are often not so conscientious about pointing out a similar
move against your position will wipe out your margin (actually earnest
money). Unlike (long) options, a mishap in the market can result in more
than the loss of margin; it can become a deficit account and debts to the
broker—in other words, losses of more than 100%. For this, among other
reasons, it is wise not to plunge into futures without considerable
preparation. This preparation might well begin, for the adroit investor, with
the reading of Schwager's Technical Analysis, Schwager on Futures,
currently one of the better books on the subject.
Let us say that, instead of using futures to speculate, we want to use them as
a hedge for our portfolio of Dow-Jones DIAMONDS (DIA) or portfolio of
Dow-Jones stocks. Now we are purchasing insurance, rather than
speculating. As an oversimplified example, the investor might see the
failure of the DJIA to break through a top as the beginning of a congestion
zone (a consolidation or reversal pattern). He could then hedge his position
by shorting the Dow-Jones futures. Now he is both long and short—long
the cash, short the futures. He would place a stop on the futures above his
purchase price to close the trade if the market continued rising. If the
market fell, he would maintain the futures position until he calculated that
the reaction had passed its worst point, or until it were definitely analyzed
to have reversed. He would then take his profits on the futures position
(taxable), but his cash position would be intact, and presumably, the greater
capital gains on those positions would be safe from taxation, and also safe
from the costs, slippage, and difficulties of reestablishing the stock position.
Options on futures and indexes
Conservative as well as speculative use may be made of options. For
example, the investor might, after a vigorous spike upwards, feel the
Standard & Poor's (S&P) 500, or the SPYs which he is long, were
overbought. He might then buy an index put on the S&P as a hedge against
the expected decline. If it occurs, he collects his profit on the option and his
cash position in the S&P is undisturbed. If the index continues to climb, he
loses the option premium—an insurance policy he took out to protect his
stock portfolio.
Note: The tactics described here are for the reader's conceptual education.
Before executing tactics of this kind, or any other unfamiliar procedure, the
investor should thoroughly inform himself and rehearse the procedure,
testing outcomes through paper trading before committing real capital. He
must, in short, figure out how you lose. A number of websites offer facilities
of this kind, and the investor may also build on his own computer a research
or paper-trading portfolio segregated from his actual transactions.
The trader might also choose to buy an option on a future. At the CBOT®,
the trader can trade both options and futures on the DJIA. These can be
used as the above examples for speculating or hedging, except in this case,
the successful option buyer might wind up owning a futures contract instead
of the cash position. This could be disconcerting to one not accustomed to
the futures market, especially if large price anomalies between futures and
cash occurred, as happened in 1987 and 1989 when futures prices went to
huge discounts to cash. A primary reason for employing the futures would
be for leverage and the reason for using the options on futures would be the
analysis that uncertainty was in store and the wish to only risk the amount
of the options premium.
Obviously, a speculator can choose to forget the stock or futures part of the
portfolio and trade only options. Before taking such a step, the trader should
pass a postgraduate course. The proportion of successful amateur option
traders to successful professional traders is extremely skewed. In fact, one
might say all successful options traders are professionals.
Modern Portfolio Theory
Modern Portfolio Theory (MPT) is a procedure and process whereby a
portfolio manager may classify and analyze the components of his portfolio
in such a way as to, hopefully, be aware of and control risk and return. It
attempts to quantify the relationship between risk and return. Rather than
analyzing only the individual instruments within a portfolio, MPT attempts
to determine the statistical relationships among the members of the
portfolio and their relationships to the market.
The processes involved in MPT analysis are as follows (1) portfolio
valuation, or describing the portfolio in terms of expected risk and expected
return; (2) asset allocation, determining how capital is to be allocated
among the classes of instruments (bonds, stocks, and so on); (3)
optimization, or finding the trade-offs between risk and return in selecting
the components of the portfolio; and (4) performance measurement, or the
division of each stock's risk into systemic and security-related classes.
How important is this for the general investor? Not very and there is a large
question among pragmatic analysts, such as the editor, as to its pragmatic
usefulness for professionals, although they cling to it as to a life ring in a
shipwreck. Mandelbrot observed in articles (“A Multifractal Walk Down
Wall Street”) and letters in the Scientific American (February 1999 and June
1999) that MPT discards about 5% of statistical experience as if it did not
exist (although it [the experience] does). He also observed the ignored
experience includes 10-sigma market storms that are blamed for portfolio
failures as though it were the fault of the data instead of the fault of the
process.
The wonders and joys of investment technology
Are there any other innovations in finance and investment theory of which
the general investor should be aware? (See Chapter 42 for discussion of
Value at Risk and Pragmatic Portfolio Theory.) Well, it never hurts to know
everything, and the very best professionals not only are aware of
everything, but also are in the constant process of finding new wrinkles and
glitches and anomalies. Though, as Magee would ask, what is necessary and
sufficient to know (see Winning the Mental Game on Wall Street)? Absolute
certainty is the hallmark of religious extremists and the naive, who do not
know what they do not know. So I will remark that probably this book
contains either what is necessary and sufficient for the investor to know
about these matters or guides the reader to further study.
Not to mention, nota bene, any number of little old ladies with a chart, a
pencil, a ruler, and previous editions of this book have beaten the pants off
professional stock pickers with supercomputers and MPT and Nobel
Laureates and who knows what other resources. I personally know
investment groups that have thrown enormous resources into the
development of real-time systems that, in research, were 100% successful
in beating the market. The only real glitch was the systems required so
much computer power they could not be run quickly enough in real time to
actually trade in the markets. Philosopher's stone redux.
Advancements in investment technology, part 2: futures and
options on futures on the Dow-Jones Industrial Index at the
CBOT
(EN9: The general investor must be aware that the methods and techniques
described in this chapter are for advanced practitioners. Careless use of the
described instruments can be extremely damaging to a portfolio.)
Investment and hedging strategies using the CBOT® DJIASM futures
contract
A futures contract is the obligation to buy or sell a specific commodity on
or by some specified date in the future. For example, if one went long corn
futures, he would be obligated to accept delivery of corn on the delivery
date, unless he sold the contract before the settlement date. Shorting the
contract would obligate the seller to deliver corn unless he offset (by
repurchase) the contract. The “commodity” in our present case is the basket
of stocks represented by the DJIA futures index. All futures contracts
specify the date by which the transaction must conclude, known as the
“settlement date,” and how the transaction will be implemented, known as
“delivery.” The DJIA futures contract price closely tracks the price of the
Dow-Jones Industrials as computed from stock market values.
The value of the future is found by multiplying the index price of the
futures contract by $10.00. For example, if the futures index price is 10,000,
the value of the contract is 10,000 x $10.00 = $100,000. So the buyer or
seller of the futures contract is trading approximately $100,000 worth of
stocks at that Dow futures level. The value may be higher or lower owing to
several factors, for example, cost of carry, which will be discussed below.
Settlement of futures contracts
All futures contracts must be “settled.” Some futures are settled by delivery,
the famous nightmare of finding 5,000 bushels of soybeans delivered on
your front lawn. Dow Index futures “settle” (are delivered) in cash. The
short does not dump a basket of Dow stocks on the yard of the long. Thus,
on the settlement date of the contract, the settlement price is $10.00 times a
figure called the “Special Opening Quotation,” a value calculated from the
opening prices of the member stocks of the Dow Future following the last
day of trading in the futures contract. This value is compared with the price
paid for the contract when the trade initiated. For example, if the Dow
Future is 10,000 at expiration, a long who bought the contract at 9,000
receives $10,000 ($10.00 x 1000) from the short.
Marking-to-market
This $10,000, however, is paid daily over the life of the contract, rather than
in one payment upon expiration of the contract. It is paid as successive
daily “margin” payments. These payments are not really margin but are in
effect “earnest money” or a performance bond. The practice of squaring up
accounts at the end of every day's trading is called “marking-to-market.”
These daily payments are determined based on the difference between the
previous day's settlement price and the contract settlement price at the close
of trading each day.
As a practical example, if the settlement price of June Dow Index futures
increases from 9,800 to 9,840 from May 17 to May 18, the short pays $400
($10.00 x 40) and the long's account is credited $400. If the futures
settlement price decreases 10 points the following day, the long pays $100
to the short's account—and so on each day until expiration of the contract,
when the futures price and the index price achieve parity.
At any time, the trader can close his position by offsetting the contract, that
is, by selling to close an open long, or buying to close an open short. At the
expiration date, open contracts are settled in cash at the final settlement
price.
Fungibility
One of the great contributions of the great established exchanges like the
CBOT® and the Chicago Mercantile Exchange is their institutionalization
of contract terms and relationships is known as “fungibility.” Any one
futures contract for corn, or an index, or any other commodity is
substitutable for another of the same commodity. Similarly, the Exchange
has negated counterparty risk by placing a Clearing Corporation between all
parties to trades. Thus, even if the other party to a trade went broke, the
Clearing Corporation would assume his liability and, using the mechanism
of daily settlement, whereby losers pay winners daily, the danger of major
default is avoided.
Futures “margins” (or “earnest money”) are deposited with the broker on
opening a trade. The leverage obtainable is quite extreme for a stock trader.
The initial margin is usually 3%-5% of the total value of the contract. Each
day thereafter, margins vary according to the process described above of
marking-to-market.
As the reader can see, the purchase or sale of a Dow Future is the
equivalent of a fairly large portfolio transaction, with the understanding it is
a transaction that will be closed in the future, unlike a stock purchase,
which may be held indefinitely.
Differences between cash and futures
The main two differences between the cash and the futures transactions are
as follows:
1. In cash, the value of the portfolio must be paid up front or financed
in a stock margin account.
2. The owner of the cash portfolio receives cash dividends.
These are not the only differences. The leverage employed in the futures
transaction is a two-edged sword. If the trader has no reserves, a minor
move in the index wipes him out. Such a minor move would be barely
noticed by the owner of a cash portfolio.
Dow Index futures
The price of the future and the price of the index are closely linked. Any
price anomaly is quickly corrected by arbitragers. On any significant price
difference, arbitragers will buy the underpriced and sell the overpriced,
bringing the relationship back in line. Their prices are not exactly the same
because the futures contract value must reflect the costs of short-term
financing of stocks and the dividends paid by index stocks until futures
expiration, known as the “cost of carry.” The “theoretical value” of the
future should equal the price of the index plus the carrying cost, what is
called the “fair” or “theoretical” value.
Using stock index futures to control exposure to the market
The owner of a cash portfolio in the Dow, or of DIAMONDS, can control
his exposure, his risk, by using futures to hedge. If, for example, he is
pessimistic about the market, or more to the point, a lot of uptrend lines
have been broken and the technical situation seems to be deteriorating, he
can sell a futures contract equivalent to his portfolio and be flat the market.
Readers will immediately recognize the advantages of this strategy. Tax
consequences on the cash portfolio are avoided, as are the other negative
consequences of trading— slippage, errors, and so on. Long-term positions
are better left alone. By flattening his position, the investor has now insured
the future value of his portfolio, and the capital involved is now earning the
money market rate of return.
What happens if the forecast market decline occurs? The portfolio is
protected from loss and the capital earns the market rate of return; however,
the investor should monitor his hedge closely, lifting it when he calculates
the correction has run its course. Taxes will then be due on the profits on the
hedge.
In monitoring the hedge, the possibility the market rises instead of falls
must be considered. In planning the hedge in the first place, the investor
must plan for this eventuality and determine at which point he will lift the
hedge on the losing side. At worst, the investor has surrendered portfolio
appreciation. Not considering cash flow implications.
It is worth emphasizing, in fact strongly emphasizing, that these techniques
require knowledge, expertise, and study. Careless use of techniques of this
nature can bloody the amateur investor. Hence, it is probably best to have a
professional guide for the first several of these expeditions and to execute
first a number of paper transactions.
The canny investor can increase his exposure to the market and the risk to
his capital by buying index futures. But the canny investor must be careful
not to turn into a burned speculator. Futures trading, because of the extreme
leverage, is an area for dedicated and experienced speculators.
A Dow futures transaction costs less than if you had to buy or sell a whole
basket of stocks. Professional fund managers—as well as other
professionals—regularly use futures for asset allocation and reallocation. In
all likelihood, they are not using the extreme leverage afforded by futures.
In other words, if they have a $1 million cash portfolio, they do not buy $10
million worth of futures. It is not the leverage in which they are interested,
but rather it is the extreme convenience and agility offered by doing short-
term allocations in futures. The ability to almost instantaneously move in
and out of the market without disturbing the underlying portfolio is a
powerful feature of these “proxy markets.”
Figure 17.3 Diamonds and Futures. The 2% plus break at the arrow of an
11-month trendline is an unmistakable invitation to hedge the DIAMONDS
by shorting the futures. Profits on the short would have offset losses in the
DIAMONDS. This convenient drill would have preserved liquidity,
postponed capital gains taxes, and avoided loss of equity. Notice the return
to the trendline after the break. More of the foolish virgin syndrome?
Investment uses of Dow Index futures
The following examples describe the basic mechanics of using Dow futures
contracts. These can be used to adjust equity exposure in anticipation of
volatile market cycles and to rebalance portfolios among different asset
classes. The futures also may be used for other purposes not illustrated here.
The following examples are not intended to be absolutely precise, but only
to illustrate the mechanics involved. For the sake of simplicity, mark-to-
market payments and cost of carry have been eliminated from the examples.
Situation 1: Portfolio protection
You are a long-term Magee-type investor and you have old and profitable
positions with which you are satisfied. Yet, you have seen the broadening
top of the Dow Jones (ca. 2000) and it is almost October, so you would not
be surprised to see a little bloodshed. You have $400,000 in the Dow and
$100,000 in money market instruments. You decide to reverse this ratio, but
you do not want to liquidate the Dow portfolio, as there is no sign of a
confirmed downtrend, only that of consolidation. You sell $300,000 of
index futures, leaving yourself with a $100,000 kicker in case you are
wrong about the market's declining. At the time, the market is 10,000 and
the futures are 10,500, meaning the cost of carry is approximately 0.5%
(10,500/10,000 - 1).
You sell three futures contracts [$300,000/($10 x 10,000)]. You now have
reversed your position and are long $100,000 Dow stocks and long
$400,000 money market equivalents.
Validating your technical analysis, the market has begun to swing in broad
undulations and, at the expiration of the futures, the Dow is at 10,000. On
your stocks, you have a return of -0.5%, and the money market position has
a rate of return of 0.5%.
What would have been the situation had you not hedged?
Stock Portfolio $400,000 x 0.95$380,000
Money Market + 100,000 x 1.005$100,500
Total $480,500
How the futures position affects the portfolio:
Short three futures 3 x $10.00 x (10,000-9,500)+$15,000
Total $495,000
Value of portfolio with reallocation of assets in cash market:
Stocks $100,000 x 0.95 $95,000
Money market + $400,000 x 1.005$402,000
Total $497,000
By hedging in the futures market, you now have the equivalent of a
$100,000 investment in Dow futures stocks and a $400,000 investment in
the money market instrument. The stock market decline now affects only
$100,000 of your stock portfolio rather than $400,000; in addition, you earn
a money market rate of return of 0.5% on the $300,000 difference.
Without the futures transaction, the portfolio is worth $480,500. The
$15,000 profit on the short futures position offsets the loss on the $300,000
of the portfolio that was moved out of equities by the short futures position.
In brief, by selling futures, you are able to protect $300,000 of your initial
portfolio value from a stock price decline, nearly breaking even, an
achievement given these market conditions. Had you been more confident
of the market decline, you might have completely neutralized the equity
risk on the portfolio by selling more futures contracts. This would have
converted the entire stock position to a $400,000 investment in the money
market. The amount of protection you should obtain depends on your
assessment of the market and your tolerance for risk.
Situation 2: Increasing exposure with futures
Now let us look at the other side of the coin. The market has come off its
highs in a predictable and controlled secondary reaction and your technical
analysis is that the Bull Market will continue. At 10,000, it appears headed
for 11,000, and you want to increase your commitment. Your portfolio is as
previously described, split 80/20 between Dow stocks and money markets.
It is time to go whole hog, you decide. You are acutely aware of the market
maxim (bulls make money and bears make money and hogs wind up
slaughtered), but there is also a market maxim that no market maxim is true
100% of the time, which is also true of this maxim.
Rather than liquidate your money market holdings, you buy one futures
contract, which puts you long another $100,000 of stocks. The rate of return
on the money markets in your portfolio is 0.5%. To get a $500,000 exposure
in blue chips, you buy the following number of contracts: $100,000/($10 x
10,000) = 1 contract.
Results: Your technical analysis of the direction of the market is correct,
and the Dow future rises to 11,000 at the September expiration, or by 10%.
Value of portfolio with passive management:
Stocks $400,000 x 1.10$440,000
Money market+$100,000 x 1.005$100,500
Total $540,500
Value of portfolio with futures position:
Long DJIA futures 1 x $10.00 x (11,000 - 10,000)$10,000
Total $550,500
Value of portfolio with reallocation of assets in cash market:
Stocks $500,000 x 1.10$550,000
Money market $0
Total $550,000
In buying Dow Index futures, you are able to “equitize” $100,000 of your
money market investment, effectively increasing your return from the
money market rate of 0.5%-10%. If you had not bought futures, the total
value of your portfolio at the September expiration would have been
$540,500 instead of $550,500. Not only do you have a $10,000 extra gain in
your portfolio, but also you have taken advantage of the market's continuing
upward climb without having to adjust your portfolio.
Situation 3: Using bond and index futures for asset allocation
Speculation in bonds can be quite profitable, notwithstanding David
Dreman's assertion that long-term investments in bonds are net losers.
(EN9: An oversimplification of a sophisticated thesis by an important
figure.) Subsequently, it is not unusual for an investor to have both bonds
and stocks in his portfolio. In this event, the portfolio can be managed with
facility by using both Index futures and Treasury bond futures.
Many investors consider it prudent to reallocate their capital commitments
based on inflation rates, interest rates, and the reported expression on Alan
Greenspan's (or Bernanke's) face before congressional testimony.
An efficient and inexpensive way to reallocate assets between stocks and
bonds is to put on spreads of Treasury bond futures and Dow Index futures.
Analysis of recent long- and medium-term trends in the market, however,
has led you to consider increasing your equity portfolio and decreasing your
bond portfolio. You have $200,000 invested in Dow stocks and $200,000
invested in Treasury bonds. You would like to take advantage of the
sustained market rally by increasing your equities exposure to 75% and
decreasing your bond holdings to 25%.
As for tactics, you can reallocate both sides of your portfolio—buying
$100,000 of stocks and selling $100,000 of bonds—with the sale of
Treasury bond futures and the purchase of Dow Index futures.
The Treasury bonds in your portfolio have a market price of 103-20. The
price of September Treasury bond futures is 102-20 per $100 of face value,
and $100,000 of face value must be delivered against each contract. The
value of the Dow futures is 10,000, and the price of the Dow Index futures
contract is 10,000 (ignoring the cost of carry).
The number of T-bond futures to sell is: short T-bond futures: $100,000/
(102 - 20 x $1,000) = 1 (number of futures is rounded to the nearest whole
number). The number of stock index futures to buy is as follows: long stock
index futures: $100,000/ ($10.00 x 10,000) = 1 (number of futures is
rounded to the nearest whole number).
Results: at the September futures expiration, the value of the Dow future is
11,000, a rate of return of 10%, and the market value of the bonds is 101-
08, a rate of return of -1%.
Portfolio value with no market action taken:
Stocks $200,000 x 1.10$220,000
Money market$200,000 x 0.99$198,000
Total $418,000
Value of futures positions:
Long Dow futures$10 x 1 x (11,000 - 10,000)$10,000
Short bond futures+$1000 x 1 x (102-20 - 101-08)$1375
Total $11,375
Grand total $429,375
Value of portfolio had transaction been done in cash market:
Stocks$300,000 x 1.10$330,000
Bonds+$100,000 x 0.99$99,000
Total $429,000
By this simple maneuver, you have quickly and easily changed your market
posture to add an additional $100,000 exposure to stocks and subtract
$100,000 exposure to bonds.
Figure 17.4 Dow-Jones Futures and Options. A put purchased at the arrow
on the break would have protected patiently won gains over the previous 11
months. The increase in the value of the put can be seen as futures track
declining Dow cash. A theoretical drill, but theoretical drills precede actual
tactics in the market.
Having correctly analyzed market trends, your action results in an increase
in portfolio value from $418,000 to $429,375. You could have
accomplished the same result by buying and selling bonds and stocks, but
not without tax consequences and the attendant transaction headaches. The
use of futures to accomplish your goals allowed you to implement your
Perspective
Although there can be no argument about the importance of CBOT®
DJIASM Index futures— they are markets of enormous usefulness and
importance—there can also be no doubt the futures novice should
thoroughly prepare himself before venturing into these pits. In such a highly
leveraged environment, mistakes will be punished much more severely than
an error in the stock market. By the same token, ignorance of this vital tool
is the mark of an investor who is not serious about his portfolio, or who is
less intense in his investment goals. “They” (the infamous “they”) use all
the weapons at their disposal; so should “we.”
Options on Dow Index futures
The buyer of this instrument has the choice, or the right, to assume a
position. It is his option to do so—unlike a futures contract in which he has
an obligation once entered. There are two kinds of options: calls (the right
to buy the underlying instrument) and puts (the right to sell). Also, options
can be bought (long) or sold (short) like futures contracts.
A long call option on Dow Index futures gives the buyer the right to buy
one futures contract at a specified price which is called the “exercise” or
“strike” price. A long put option on Dow Index futures gives the buyer the
right to sell one futures contract at the strike price. For example, a call at a
strike price of 10,000 entitles the buyer to be long one futures contract at a
price of 10,000 when he exercises the option. A put at the same strike price
entitles the buyer to be short one futures contract at 10,000. The strike
prices of Dow Index futures options are listed in increments of 100 index
points, giving the trader the flexibility to express his opinions about upward
or downward movement of the market.
The seller, or writer, of a call or put is short the option. Effectively selling a
call makes the writer short the market, just as selling a put makes the writer
long the market. As in a futures contract, the seller is obligated to fulfill the
terms of the option if the buyer exercises. If you are short a call, and the
long exercises, you become short one futures contract at 10,000. If you are
short one put and the long exercises, you become long one futures contract
at 10,000.
Buyers of options enjoy fixed risk. They can lose no more than the premium
they pay to go long an option. On the other hand, sellers of options have
potentially unlimited risk. Catastrophic moves in the markets often
bankrupt imprudent option sellers.
Option premiums
The purchase price of the option is called the option premium. The option
premium is quoted in points, each point being worth $100. The premium for
a Dow Index option is paid by the buyer at initiation of the transaction.
The underlying instrument for one CBOT® futures option is one CBOT®
DJIASM futures contract; so the option contract and the futures contract are
essentially different expressions of the same instrument, and both are based
on the Dow-Jones Index.
Options premiums consist of two elements: intrinsic value and time value.
The difference between the futures price and strike price is the intrinsic
value of the option. If the futures price is greater than the strike price of a
call, the call is said to be “in-the-money.” In fact, you can be long the
futures contract at less than its current price. For example, if the futures
price is 10,020 and the strike price is 10,000, the call is in-the-money and
immediate exercise of the call pays $10.00 times the difference between the
futures and strike price, or $10 x 20 = $200. If the futures price is less than
the strike price, the call is “out-of-the-money.” If the two are equal, the call
is “at-the-money.” A put is in-the-money if the futures price is less than the
strike price and out-of-the-money if the futures price is greater than the
strike price. It is at-the-money when these two prices are equal.
Since a Dow Index futures option can be exercised at any date until
expiration, and exercise results in a cash payment equal to the intrinsic
value, the value of the option must be at least as great as its intrinsic value.
The difference between the option price and the intrinsic value represents
the time value of the option. The time value reflects the possibility that
exercise will become more profitable if the futures price moves farther
away from the strike price. Generally, the more time until expiration, the
greater the time value of the option because the likelihood of the option
becoming profitable to exercise is greater. At expiration, the time value is
zero and the option price equals the intrinsic value.
Volatility
The degree of fluctuation in the price of the underlying futures contract is
known as “volatility” (see Appendix B, Resources, for the formula). The
greater the volatility of the futures, the higher the option premium. The
price of a futures option is a function of the futures price, the strike price,
the time left to expiration, the money market rate, and the volatility of the
futures price. Of these variables, volatility is the only one that cannot be
observed directly. Considering all the other variables are known, however, it
is possible to infer from option prices an estimate of how the market is
gauging volatility. This estimate is called the “implied volatility” of the
option. It measures the market's average expectation of what the volatility
of the underlying futures return will be until the expiration of the option.
Implied volatility is usually expressed in annualized terms. The significance
and use of implied volatility is potentially complex and confusing for the
general investor, professionals having a decided edge in this area. Their
edge can be removed by serious study.
Exercising the option
At expiration, the rules of optimal exercise are clear. The call owner should
exercise the option if the strike price is less than the underlying futures
price. The value of the exercised call is the difference between the futures
price and the strike price. Conversely, the put owner should exercise the
option if the strike price is greater than the futures price. The value of the
exercised put is the difference between the strike price and the futures price.
To illustrate, if the price of the expiring futures contract is 7,600, a call
struck at 7,500 should be exercised, but a put at the same or lower strike
price should not. The value of the exercised call is $1,000. The value of the
unexercised put is $0.00. If the price of the expiring futures contract is
7,500, a 7,600 put should be exercised but not a call at 7,600 or a higher
strike. The value of the exercised put is $1,000 and that of the unexercised
call is $0.00.
The profit on long options is the difference between the expiration value
and the option premium. The profit on short options is the expiration value
plus the option premium. The expiration values and profits on call and put
options can often be an important tool in an investment strategy. Their
payoff patterns and risk parameters make options quite different from
futures. Their versatility makes them good instruments to adjust a portfolio
to changing expectations about stock market conditions. Moreover, these
expectations can range from general to specific predictions about the future
direction and volatility of stock prices. Effectively, there is an option
strategy suited to virtually every set of market conditions.
Using futures options to participate in market movements
Traders must often react to rapid and surprising events in the market. The
transaction costs and price impact of buying or selling a portfolio's stocks
on short notice inhibit many investors from reacting to short-term market
developments. Shorting stocks is an even less palatable option for average
investors because of the margin and risks involved and semantical
prejudices.
The flexibility that options provide can allow one to take advantage of the
profits from market cycles quickly and conveniently. A long call option on
Dow Index futures profits at all levels above its strike price. A long put
option similarly profits at all levels below its strike price. Let us examine
both strategies.
Profits in rising markets
In August, the Dow Index is 10,000 and the Dow Index September future is
10,050. You expect the current Bull Market to continue, and you would like
to take advantage of the trend without tying up too much capital and also
undertake only limited risk.
You buy a September call option on Dow Index futures. These options will
expire simultaneously with September futures, and the futures price will be
the same as the cash index at expiration.
Your analysis is bullish, so the 10,500 call (out-of-the-money strike price) is
a reasonable alternative at a quoted premium of 10.10. You pay $1,010 for
the call ($100 x 10.10).
The payoff: at the September expiration, the value of the Dow Future is
10,610. Now, your call is in-the-money, and you exercise it and garner the
exercise value less the premium, or $90.00 = $10.00 x (10,610 - 10,500) -
$100 x (10.10) = $1,100 - $1,010. If the Dow future stays at or below
10,500, you let the call expire worthless and simply lose the premium. This
is the maximum possible loss on the call. If the Dow future increases by
101 points above the strike price, you break even.
Instead of buying the call option, the trader could have invested $100,500
directly in the Dow stocks. Given a value of the Dow future of 10,110 in
September, he would have had a gain of $3,030. If he had invested directly
in the stocks, however, an unexpected market decline would have led to a
loss.
Exploiting market reversals
The trader expects a reversal of the Bull Market now at 7,800 and would
like some downside protection.
He buys a put with a strike price of 7,700 (out-of-the-money). The put
premium is 9.80, for a total cost of $980 = $100 x 9.80. If the Index
decreases to 7,600, with a corresponding decrease in the futures contract in
September, the put is worth $1,000. The maximum loss is the premium cost,
which is lost if the Dow future is above 7,700 at expiration. The trader
breaks even if the Dow future decreases by 98 points below the strike price.
Using puts to protect profits in an appreciated portfolio
During a sustained Bull Market, investors often search for ways to protect
their paper profits from a possible market break. Even when fundamental
economic factors tend to support a continued market upside, investors have
to guard against unpredictable “technical market corrections” and market
over-reactions to news.
Selling stocks to reduce downside risk is costly in fees and taxes and
sacrifices potential price gains. What is desirable in a sideways market
environment is an instrument that protects the value of a portfolio against a
market drop but does not constrain upside participation. This is precisely
what put options are designed to do.
Situation 1
The market is in an uptrend in August, which is when the market lives with
the anxiety the Federal Reserve will tighten short-term interest rates further
in the coming months. The trader has $78,000 invested in the Dow
portfolio, and the Dow Future is at 7,800.
To hedge his portfolio, he purchases a put option on September futures
against a possible market downturn. He buys a 7,600 put at a premium of
6.60, cost $100 x 6.60 = $660.
Buying the put places a floor on the value of the portfolio at the strike price.
Buying a put with a strike price of 7600 effectively locks in the value of the
portfolio at $76,000. Above its strike price, a put is not exercised and the
portfolio value is unconstrained. If the trader is wrong, and the market goes
up, he loses the premium paid for the put. Depending on which strike price
he chooses, he increases or decreases downside risk. He breaks even when
the Dow future reaches a value of 7,534 = 7,600 - 66, the strike price less
the put premium. At this level, the unprotected and put-protected portfolios
are equally profitable.
The similarity to life insurance is striking. If you do not die, the premium is
wasted. But if you do...
Improving portfolio yields
Situation 2
All markets, as the reader is perhaps aware, are not trending. Days, weeks,
months, sometimes years can pass while the markets grind up and down in
what are euphemistically known as trading range markets. When the astute
technician identifies one of these market doldrums and judges that it will
continue, he can reap other returns on his portfolio by selling puts and calls
on Dow Index futures.
For example, when the Dow Index is 10,000 and the trader calculates it will
not break out for the next month above 10,200, he sells calls at a strike price
of 10,200. The quoted premium of the 10,200 call is, say, 10.10; selling a
10,200 call generates $1010 income.
The trader pockets the entire premium as a profit if the index remains below
10,200 at the September expiration. The downside of this trade is that the
trader gives up price appreciation above 10,200. Above 10,200, the
combined value of the portfolio and short call premium is $101,010. The
break-even point is 10,301, where the Dow Future is equal to the sum of the
strike price and call premium. Above this point the covered call portfolio
becomes less profitable than the original portfolio. Since the short call is
covered by the portfolio, this strategy is not exposed to the risk represented
by a naked call. The main risk is the trader giving up the profit potential
above the strike price of the call. As is obvious to the technician, this is a
bad strategy in trending markets. Only in clearly range-bound markets
would an enlightened trader want to write covered calls. The call premium
collected is some compensation for this risk, but cold comfort when the
trader has misanalyzed the market. The best strike price of the call depends
on the probabilities you have assigned to future increases and behavior of
the Dow.
Using option spreads in high- or low-volatility markets
Long and short stock positions reflect definite market opinions or analyses.
The market will go up or the market will go down and the moderately
competent technician should be right about this more often than the
unwashed general public. In markets of coiling volatility (i.e., lower than
average volatility and declining), it is sometimes possible to exploit
uncertainty by putting on a long straddle. The long straddle combines a long
put and a long call at the same strike price. This spread generates a return
over two ranges of market values: values below the strike price of the put
and values above the strike price of the call. It is a profitable strategy given
sufficient volatility; the editor's company used such a strategy immediately
before the crash of 1987 for managed accounts and collected
disproportionate profits on a very low-risk position. Experienced
speculators and traders generally sell high-volatility markets and try to
backspread (go long) in chosen less-volatile markets, expecting volatility to
return to the mean. Sometimes they do this by writing a short straddle, a
position with a short put and a short call at the same strike price.
Situation 3
In August, a technical analysis predicts that volatility will increase, and the
market is in a coiling process. The direction of prices is uncertain but
potentially explosive. The trader buys a straddle of a long put at 7,800 and a
long call at 7,800. The quoted call premium is 18.90 and the quoted put
premium is 13.90. The total cost of the straddle is $3280 = $100 x 32.80.
This is the maximum loss if the Dow Future stalls at 7,800.
The straddle makes a profit when the Dow Future moves enough to recover
the cost of the straddle, either below 7,472 = 7,800 - 328 or above 8,128 =
7,800 + 328. The potential upside profit is unlimited. The maximum profit
on the downside is $10.00 x (7,800 - 328), or $74,720, if the Dow future
goes to zero (somewhat unlikely, but one never knows what Chicken Little
the investor will do if he thinks the sky is falling).
Situation 4
In August, the investor calculates options are overvalued and volatility will
be lower than implied volatility. He expects a dormant market to continue
through the end of the summer. He decides to sell the September put and
call at 7,800, collecting $3,280. The return on this short straddle will turn
negative if the Dow future in September goes below 7,472 or above 8,128.
The maximum loss on the downside is $10.00 x (7,800 - 328), or $74,720,
and the loss on the upside is unlimited. The investor, however, perceives the
risk as limited because he believes the Dow future will neither increase nor
decrease to these levels within the next month when the options expire. In
these cases, the trader must also consider catastrophic risk—as, for
example, the editor's client who was short puts in the crash of 1987 and lost
$57 million.
Perspective
(EN9: Once again, do not practice the methods and techniques described in
this chapter without complete confidence in their use. A course in futures
and options is recommended, or professional consultation.)
I like to tell these stories so prospective options traders and general
investors are made dramatically aware of the potential dangers, as well as
the potential profits. As stated elsewhere in this book, the novice should
work to achieve competence and experience before attempting advanced
tricks in futures and options. On the other hand, the investment use of these
instruments for prudent hedging and insurance is recommended to the
investor willing to do his homework, acquire competence, and grow in
investment skills.
Dow Index futures and futures options present new techniques of portfolio
protection and profit-making for the general investor. Numerous strategies
can be practiced by the moderately competent investor using these
instruments. Keep in mind always that all the methods of analytical
investing espoused in this book are the base discipline—that is, knowledge
of the instruments and their use, prudent trade management, stop-loss
discipline, and close attention to the dynamics of the situation. Above all,
the existence of these instruments allows the most conservative of investors
insurance and hedging techniques not previously available.
In summation, knowledge of the DJIA futures and options on futures is
absolutely essential for the competent technical investor and trader.
Recommended further study
In view of the importance of this chapter, noted here are references to
advanced material, which are also found in Appendix B, Resources.
The CBOE has a website explaining the math behind hedging. To hedge a
portfolio of $500,000 tracking the S&P 500, you need four puts. The
address for the calculation of the hedging ratio is available at
http://www.cboe.com/portfoliohedge.
For further study, see the following:
• Options as a Strategic Investment by Lawrence Macmillan,
http://www.optionstrategist. com
• Chicago Board Options Exchange, http://www.cboe.com
• Chicago Board of Trade, 312-435-3558 or 800-THE-CBOT; 312-341-
3168 (fax); http:// www.cbot.com
part two
Trading tactics
Midword
As a kind of foreword to Section II of this book, we might mention a
commentary, “On Understanding Science: An Historical Approach,” by
James Bryant Conant, president emeritus of Harvard.
Dr. Conant points out that, in school, we learn science is a systematic
collection of facts that are classified in orderly array, broken down,
analyzed, examined, synthesized, and pondered; and then lo! a Great
Principle emerges—pat, perfect, and ready for use in industry, medicine, or
what-have-you.
He further points out that all of this is a mistaken point of view held by
most laymen. Discovery takes form little by little, shrouded in questioning,
and only gradually assumes the substance of a clear, precise, well-supported
theory. The neat tabulation of basic data, forming a series of proofs and
checks, does not come at the start but much later. In fact, it may be the work
of other men entirely, men who, being furnished with the conclusions, are
then able to construct a complete, integrated body of evidence. Theories of
market action are not conceived in a flash of inspiration; they are built, step
by step, out of the experience of traders and students, to explain the typical
phenomena that appear over and over again through the years.
In market operations, the practical trader is not concerned with theory as
such. The neophyte's question, “What is the method?” probably means,
actually, “What can I buy to make a lot of money easily and quickly?” If
such a trader reads this book, he may feel there is “something in it.” He may
feel “It's worth a try” (a statement, incidentally, that reflects little credit on
his own previous tries). He may also start out quite optimistically, without
any understanding of theory or any experience in these methods, and
without any basis for real confidence in the method.
In such cases, the chances are great he will not immediately enjoy the easy
success he hopes for. His very inexperience in a new approach will result in
mistakes and failures. Yet, even with the most careful application of these
methods, in correctly entered commitments, he may encounter a series of
difficult market moves that may give him a succession of losses.
Whereupon, having no solid confidence in what he is doing, he may sigh,
put the book back on the shelf, and say, “Just as I thought. It's no damn
good.”
Now, if you were about to go into farming for the first time, you might be
told (and it would be true) the shade tobacco business offers spectacular
profits. But you would not expect to gain these profits without investing
capital, without studying how shade tobacco is grown and in what kinds of
soils and what localities, nor without some experience with the crop.
Furthermore, you would need confidence—faith in the opportunity and also
in the methods you were using. If your first season's crop were blighted
(and these things do happen), you would naturally be disappointed. If it
should happen that your second year's crop were destroyed by a hailstorm,
you would be hurt and understandably despondent. Moreover, if your third
season's crop were to be a total loss because of drought, you would
probably be very gloomy indeed (and who could blame you?). But you
would not say, “There's nothing to it. It's no damn good.”
You would know (if you had studied the industry and the approved
cultivation methods) that you were right, regardless of any combination of
unfavorable circumstances, and you would know the ultimate rewards
would justify your continuation, no matter how hard the road, rather than
turn to some easier but less potentially profitable crop.
So it is with technical methods in the stock market; anyone may encounter
bad seasons. The Major Turns inevitably will produce a succession of losses
to Minor Trend operators using the methods suggested in this book. There
will also be times when a man who has no understanding of basic theory
will be tempted to give up the method entirely and look for a “system” that
will fit into the pattern of recent market action nicely, so he can say, “If I
had only averaged my trades ... . If I had followed the Dream Book ... . If I
had taken Charlie's tip on XYZ ... . If I had done it this way or that way, I
would have come out with a neat profit.”
It would be better, and safer, to understand at the start that no method ever
devised will unfailingly protect you against a loss, or sometimes even a
painful succession of losses. You should realize what we are looking for is
the probability inherent in any situation. Likewise, just as you would be
justified in expecting to draw a white bean from a bag which you knew
contained 700 white beans and 300 black beans (even though you had just
drawn out 10 black beans in succession!), so too you are justified in
continuing to follow the methods that, over long periods, seem most surely
and most frequently to coincide with the mechanism of the market.
Thus, this book should not be given a quick “once-over” and adopted
straightaway as a sure and easy road to riches. It should be read over and
over, a number of times, and it should be consulted as a reference work.
Furthermore, and most importantly, you will need the experience of your
own successes and failures so you will know what you are doing is the only
logical thing you can do under a given set of circumstances. In such a frame
of mind, you will have your portion of successes and your failures, which
you can take in stride, as part of the business, will not ruin either your
pocketbook or your morale.
In short, the problem stated and analyzed through this whole volume is not
so much a matter of “systems” as it is a matter of philosophy. The end result
of your work in technical analysis is a deep understanding of what is going
on in the competitive free auction, what is the mechanism of this auction,
and what is the meaning of it all. Be mindful this philosophy does not grow
on trees; it does not spring full-bodied from the sea foam either. It comes
gradually from experience and from sincere, intelligent, hard work.
Section II of this book, which follows, is concerned with tactics. Up to this
point, we have been studying the technical formations and their
consequences. We should have a good general understanding of what is
likely to happen after certain manifestations on the charts. Knowing that,
however, we will still need a more definite set of guides as to when and
how it is best to execute this or that sale.
These chapters are based on one man's experience and his analysis of
thousands of specific cases. It takes up questions of method, of detail, and
of application, and should provide you with a workable basis for your actual
market operations. As time goes on, you will very likely adopt refinements
of your own or modify some of the suggested methods according to your
own experience. However, the authors feel the suggestions made here will
enable you to use technical analysis in an intelligent and orderly way that
should help to protect you from losses and increase your profits.
John Magee
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter eighteen
The tactical problem
(EN: In this chapter, Magee addresses the question of tactics for the
“speculator” who follows short and medium-term trends. The later sections
of the chapter address the question of strategy and tactics for the long-term
investor and provide a discussion of the term “speculator.”)
It is possible (as many traders have discovered) to lose money in a Bull
Market—and, likewise, to lose money trading short in a Bear Market. You
may be perfectly correct in judging the Major Trend; your long-term
strategy, let us say, may be 100% right. Except, without tactics, without the
ability to shape the details of the campaign on the field, it is not possible to
put your knowledge to work to your best advantage.
There are several reasons why traders, especially inexperienced traders, so
often do so poorly. At the time of buying a stock, if it should go up, they
have no objectives and no idea of what policy to use in deciding when to
sell and take a profit. If it should go down, they have no way of deciding
when to sell and take a loss. Result: they often lose their profits; and their
losses, instead of being nipped off quickly, run heavily against them. Also,
there is this psychological handicap: the moment a stock is bought (or sold
short), commissions and costs are charged against the transaction. The
trader knows the moment he closes the trade there will be another set of
charges. Also, since he is not likely to catch the extreme top of a rally or the
extreme bottom of a reaction, he is bound, in most cases, to see the stock
running perhaps several points against him after he has made his
commitment. Even on a perfectly sound, wise trade, he may see a 10% or
more paper loss before the expected favorable move gets under way (see
Figure 18.1). Obviously, if he weakens and runs for cover without sufficient
reason before the stock has made the profitable move he looked for, he is
taking an unnecessary loss and forfeiting entirely his chance to register a
gain.
The long-term investor who buys in near the bottom and remains in the
market to a point near the top, to later liquidate and remain in cash or bonds
until (perhaps several years later) there is another opportunity to buy in at
the bottom, does not face the continual problem of when to buy and when to
sell. This assumes one can tell precisely when such a bottom has been
reached and when the trend has reached its ultimate top (and those are very
broad assumptions indeed). The long-term investment problem for large
gains over the Major Trends is by no means as simple as it sounds when
you say, “Buy them when they're low, and sell them near the top.” However,
such large gains have been made over the long pull, and they are very
impressive. (EN: Note the record of the Dow Theory in Chapters 4 and 5.)
This section of the book is concerned more particularly with the speculative
purchase and sale of securities.
There are some basic differences between the “investment” point of view
and the “speculative.” It is a good thing to know these differences and make
sure you know exactly where you stand (see Figure 18.2). Either viewpoint
is tenable and workable, but you can create serious problems for yourself,
and sustain heavy losses, if you confuse them.
One difference is a speculator deals with stocks as such. A stock, to be sure,
represents ownership in a company, but the stock is not the same thing as
the company. The securities
76
72
68
64
60 Sales 100's 125 100
75
50
25
CUX
CUDAHY PACKING
JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER
I 7 114 I 211 28> 4 i 111181 251 1 1 8 115122 ■ 29 I 6 113 120 127 1 3
110117 >241 1 * 8 11^ 22 • 29 •
Figure 18.1 It is possible to lose money owning stocks in a Bull Market.
Notice this Major Top Formation did not occur in 1929, but in the summer
of 1928. For more than a year after this, a majority of stocks and the
Averages continued the Bull Market Advance. But Cudahy declined
steadily, reaching a price below 50 well before the 1929 Panic, and
continued in its Bearish course for more than four years, ultimately selling
at 20. Except for the somewhat unusual volume on the head on August 21,
this is a typical Head-and-Shoulders Pattern with a perfect Pullback Rally in
mid-November. It underscores what we have mentioned before—a Head-
and-Shoulders Top in a stock, even when other stocks look strong, cannot
safely be disregarded.
The Head-and-Shoulders Pattern, either in its simple form or with multiple
heads or shoulders, is likely to occur at Major and Intermediate Tops, and in
reverse position at Major and Intermediate Bottoms. It has the same general
characteristics as volume, duration, and breakout as the Rectangles and the
Ascending and Descending Triangles. In conservative stocks, it tends to
resemble the Rounding Turns.
of a strong company are often weak, and sometimes the securities of a very
weak concern are exceedingly strong. It is important to realize the company
and the stock are not precisely identical. The technical method is concerned
only with the value of the stock as perceived by those who buy, sell, or own
it.
A second difference is in the matter of dividends. The “pure investor,” who,
by the way, is a very rare person, is supposed to consider only the “income”
or potential income from stocks—the return on his investment in cash
dividends. (EN: This rara avis is largely extinct now.) Nevertheless, there
are many cases of stocks that have maintained a steady dividend while
losing as much as 75% or more of their capital value. There are other cases
in which stocks have made huge capital gains while paying only nominal
dividends or none at all. If the dividend rate were as important as some
investors consider it, the only research tool one would need would be a
calculator to determine the percentage yields of the various issues; hence,
their “value,” which, on this basis, stocks paying no dividends would have
no value at all.
From the technical standpoint, “income,” as separate from capital gains and
losses, ceases to have any meaning. The amount realized in the sale of a
stock, less the price paid and plus total dividends received, is the total gain.
Whether the gain is made entirely in capital increase, entirely in dividends,
or in some combination of these, makes no difference. In the case of short
sales, the short seller must pay the dividends. Although, here again, this is
simply one factor to be lumped with the capital gain or loss in determining
the net result of the transaction.
Figure 18.2 What would you have done with Hudson Motors? The great
Panic Move of October-November 1929 carried the Dow-Jones Industrial
Average down from its September all-time high of 386.10 to a November
low of 198.69. A rally, bringing the Average back to 294.07 in April 1930,
recovered 95 points, or 51% of the ground lost, a perfectly normal
correction.
Suppose you had bought HT after the decline from its 1929 high of 93 1/2,
say at 56, in the belief that the 37-point drop had brought it into a “bargain”
range. On your daily chart, you would have seen the pattern shown above
(which you will now recognize as a Descending Triangle) taking shape in
the early months of 1930. Would you have had a protective stop at 51?
Would you have sold at the market the day after HT broke and closed below
54? Or would you have hoped for a rally, perhaps even bought more
“bargains” at 50, at 48, at 40? Would you still have been holding onto your
“good long-term investment” when HT reached 25 1/2 in June? Would you
still have been holding HT when it reached its ultimate 1932 bottom at less
than 3 (see Figure 8.22)? (EN: See Figure 18.4 for a recapitulation of the
lesson from the 2000s.)
There is a third source of confusion; very often, the “pure investor” will
insist he has no loss in the stock he paid $30.00 for, which is now selling at
$22.00, because he has not sold it. Usually he will tell you he has
confidence in the company and he will hold the stock until it recovers.
Sometimes he will state emphatically that he never takes losses.
How such an investor would justify his position if he had bought
Studebaker at more than $40.00 in 1953 and still held Studebaker Packard
at around $5.00 in 1956 (EN: Or Osborne at $25.00 and $0.00 in the 1980s
or Visacalc at similar prices in the same decade. EN9: Or Enron and
WorldCom in the 2000s. Or Bear Stearns, or Lehman, or ... ) is hard to say;
however, for him, the loss does not exist until it becomes a “realized” loss.
Actually, his faith the stock will eventually be worth what he paid for it may
be no more than a speculative hope—and a forlorn one at that.
Furthermore, one may question whether his reasoning is always consistent.
For example, suppose another stock this investor had bought at $30.00 was
now selling at $45.00. Would he tell you he did not consider a profit or loss
until the stock was sold? Or would he be tempted to speak of the “profit” he
had in this purchase?
It is all right to consider gains or losses either on the basis of “realized” or
completed transactions, or on the basis of the market values “accrued” at a
particular time? Yet, it is not being honest with yourself to use one method
to conceal your mistakes and the other method to accentuate your
successes. The confusion of these concepts is responsible for many
financial tragedies. (EN: One might almost say, in the modern context, such
confusion amounts to willful or neurotic behavior. Given the easy
availability of portfolio software that marks-to-market positions, avoidance
of this knowledge can only be regarded as self-defeating.)
As a trader using technical methods, you will probably find the most
realistic view is to consider your gains and losses “as accrued.” In other
words, your gain or loss at a given time will be measured with reference to
the closing pricing of the stock on that day.
Recapitulating, it is important (1) to avoid regarding a stock and the
company it represents as identical or equivalent; (2) to avoid the conscious
or unconscious attribution of “value” to a stock on the basis of dividend
yield, without regard to market prices; and (3) to avoid confusing “realized”
and “accrued” gains or losses.
The technical trader is not committed to a buy-and-hold policy. There are
times when it is clearly advantageous to retain a position for many months
or for years, but there are also times when it will pay to get out of a stock,
either with a profit or with a loss. The successful technician will never, for
emotional causes, remain in a situation that, on the evidence at hand, is no
longer tenable.
An experienced trader using technical methods can take advantage of the
shorter Intermediate Trends, and it can be shown that the possible net gains
are larger than the entire net gains on the Major Trend, even after allowing
for the greater costs in commissions and allowing for the greater income tax
liability on short-term operations.
It should be understood that any such additional profits are not easily won.
They can be obtained only by continual alertness and adherence to
systematic tactical methods. For the market, regarded as a gambling
machine, compares very poorly with stud poker or roulette, and it is not
possible to “beat the market” by the application of any simple mathematical
system. If you doubt this, it would be best to stop at this point and make a
careful study of any such “system” that may appeal to you, checking it
against a long record of actual market moves. Ask yourself whether you
have ever known anyone who followed such a system alone, as a guide to
market operations, and was successful. (EN: After Magee wrote this, many
successful traders, aided by computer technology and advances in finance
theory, have created algorithmic systems that have been successful in the
financial markets. However, the markets usually become aware of the
success of these systems and develop counterstrategies to defeat them. So
there is a tendency for the performance of mechanical systems to
degenerate or totally fail over time. It is the happy combination of the
system with markets hospitable to it that makes mechanical systems
successful over defined periods of time.)
The practice of technical analysis, on the other hand, is not a mathematical
process, although it does involve mathematics. It is intended to search out
the significance of market moves in the light of past experience in similar
cases, by means of charts, with a full recognition of the fact that the market
is a sensitive mechanism by which all of the opinions of all interested
persons are reduced by a competitive democratic auction to a single figure,
representing the price of the security at any particular moment. The various
formations and patterns we have studied are not meaningless or arbitrary.
They signify changes in real values, the expectations, hopes, fears,
developments in the industry, and all other factors that are known to
anyone. It is not necessary to know, in each case, what particular hopes,
fears, or developments are represented by a certain pattern. It is important
to recognize the pattern and understand what results may be expected to
emerge from it.
The short-term profits are, you might say, payment for service in the
“smoothing out” of inequalities of trends, and for providing liquidity in the
market. As compared with the long-term investor, you will be quicker to
make commitments and quicker to take either profits or (if necessary)
losses. You will not concern yourself with maintaining “position” in a
market on any particular stocks (although, as you will see, we will try to
maintain a certain “total Composite Leverage” [or risk and profit exposure]
according to the state of the market, which accomplishes the same result).
You will have smaller gains on each transaction than the long-term investor,
but you will have the advantage of being able to frequently step aside and
review the entire situation before making a new commitment.
Most particularly, you will be protected against Panic Markets. There are
times (and 1929 was by no means the only time) (EN: 1987 and 1989 also
come to mind. EN9: Add 20012002, if you please: May 2, 2001, Dow
11,350; September 17, 2001, 8,062; March 18, 2002, 10,673; and July 22,
2002, 7,532), when the long-term investor stands to see a large part of his
slowly accumulated gains wiped out in a few days. The short-term trader, in
such catastrophes, will be taken out by his stop-loss orders, or his market
orders, with only moderate losses, and will still have his capital largely
intact to use in the new trend as it develops. (EN: The best technical
analysts' opinion in “modern times” is that even long-term investors should
not grin and bear a Bear Market. This is a necessity only for bank trust
departments and believers in Burton Malkiel.)
Finally, before we get on with the subject of tactics, the operations we are
speaking of are those of the small and midsize trader. The methods
suggested here, either for getting into a market or getting out of it, will
apply to the purchase or sale of odd lots, 100 shares, 200 shares, and
sometimes up to lots of thousands of shares or more of a stock, depending
on the activity and the market for the particular issue. The same methods
would not work for the trader who was dealing in 10,000-share blocks
(except in the largest issues) because, in such cases, his own purchases or
sales would seriously affect the price of the stock. Such large-scale
operations are in a special field governed by the same basic trends and
strategy, but that requires a different type of market tactics (see Figure
18.3). (EN: Or, put another way, as Magee said to me one time, a mouse
can go where an elephant cannot.)
Strategy and tactics for the long-term investor— What's a
speculator? What's an investor?
In the years since Magee wrote the original Chapter 18, some different
connotations have attached themselves to the terms “speculator” and
“investor.” A great cultural shift has also occurred. The days when the New
Haven (New York, New Haven, and Hartford Railroad) was a beacon of
respectability (and lent luster to its investor) and paid “good dividends” are
gone forever; as is the New Haven. In fact, after the turn of the century,
corporations saw a change in investor sentiment about dividends. Investors
wanted capital appreciation
Figure 18.3 If an investor only learned one thing from this book, it would
be that one thing might be the salvation of his portfolio or his retirement
plan (if all his assets in the investment plan were shares of Enron). Instead,
the employees of Enron made a major mistake in not having a diversified
retirement portfolio—they had all their eggs in one basket, their income and
savings came from one source. But diversification is not even the crucial
lesson here; the lesson is get out of the stock when it reverses. The corollary
of that lesson is never buy a stock in a downtrend. However, the more
important lesson is never buy a stock when it is in a swan dive. So obvious
you say, but not so obvious at the time for portfolio managers for the
University of Miami who continued to accumulate Enron stock even as it
neared earth at 100 miles an hour. Of course, they had a sophisticated (?)
company; the Motley Fools had a death grip on the stock all the way to the
bottom.
and cared less for dividends. In fact, it has lately been considered the mark
of a “growth stock” not to pay dividends. Evidently, the days of the New
Haven are gone forever, when an “investor” was one who bought, held, and
collected dividends, and “speculators” were slightly suspect men like
Magee who played the medium-term trends and bought “unchic,
speculative” stocks. It all has a sepia tone to it. Yesterday's Magee
speculator might be called a medium-term investor today.
Although the term “speculator” could still be applied to anyone who
“trades” the market, today that old-time speculator and his kind would more
likely be called traders than speculators. Commodity traders who have no
business interest in the contracts they exchange are always referred to as
speculators, as opposed to commercials, who are hedgers and users of the
commodities they trade. Now “day traders” might be considered the
equivalent of the old-time speculators—except that day trading veers
dangerously close to gambling. And only the passive, in the opinion of this
editor, never trade at all and sit on their holdings during Bear Markets.
On the spectrum of investors, from investor to gambler, the old “New
Haven Investor” who “wants his dividends” is pretty rare these days, and,
again, may be one of those trust departments that does not want to get sued
and so stays out of stocks that go up. After all, prudent men do not “trade in
volatile stocks” but “invest in safe issues, like bonds,” which only lose
about 1.5%-2.0% of their purchasing value per year but preserve the
illusion of having “preserved principal.”
One definition of the long-term investor
Let us take as a long-term investor now one who expects to at least track
market returns, for it has been demonstrated over a relatively long period of
time that this can be done by passive indexing. At the turn of the century, as
this is written, it would seem neither longterm, medium-term, nor short-
term investors think about the risks involved in matching the market
because, entering the third millennium, it has been so many years since we
have had a really vicious Bear Market. Dow 36,000? This is a passing
phase. As each Bull Market reaches higher and higher, the odds are lower
and lower that it will continue— historic Bull Markets of the 1990s
notwithstanding.
What then are the strategy and tactics for the long-term investor to achieve
a goal of matching the market? (EN9: Is it necessary to remind the reader of
Chapter 4 and the Dow Theory?)
Let us remark immediately that the tactics Magee described for the
speculator—or trader if you will—are not at all in conflict with the short-
term tactics used occasionally by the long-term investor. As buying or
selling time approaches the stops of the long-term investor, that investor
becomes a trader who can and should adopt the trader's tactics. Sooner or
later, the focus even narrows to real time at the moment of trade execution.
Interestingly, the charting techniques we have described here work on tick-
by-tick data in real time also. Hence, if the trader wants to enter into the
real-time environment, he can attempt to time his trade right down to the
real-time chart formations. Only the really active and skilled long-term
investor will be concerned with squeezing the last half point or points out of
his position. This illustration of the time focus is addressed to any investor
or trader or speculator to demonstrate the fractal nature of both price data
and the applicability of Magee-type technical analysis to it.
The strategy of the long-term investor
The strategy of the long-term investor is to catch the long trends—to
participate in trades that lasts months and years. However, this strategy does
not intend to be sucked into long Bear Markets. Rather, portfolios are
liquidated or hedged when Bear Market signals are received. As has been
previously seen in examples of the performance of (more or less)
mechanical Dow Theory (see Chapter 4), this kind of performance can be
quite satisfactory—better indeed than buy-and-hold strategies that have
come much into vogue because of the Clinton-Gore Bull Markets of the
1990s.
If the goal is to beat not only the markets but also the mutual funds (only
20% of which outperform the market over the long term anyway—and
sometimes none of them make money), then passive indexing is the most
likely strategy. This may be done in a number of ways—index funds,
buying the basket, buying the futures, and so on. Nevertheless, the most
attractive method might be the use of the Standard & Poor's Depositary
Receipts (SPDRs; SPY) and DIAMONDS™ (DIA) and the like. The tactics
may be calibrated to the risk tolerance and character of the investor. He
might hedge or sell on Dow Theory signals, or on breaks of the 200-day
moving average, or on breaks of the long-term or intermediate trendlines
with a filter (Magee recommended 2%, and this might be calibrated to the
character of the markets and increased to 3% or a factor relevant to actual
market volatility). Basing Points (see Chapter 28) is also a powerful
method. Instruments we have previously discussed— SPDRs,
DIAMONDS, index futures, and options—can be used to execute these
tactics.
Suffice it to say that every strategy must provide for the plan gone wrong,
in other words, the dreaded Bear Market. Bear Markets would not be so
fearsome if the average investor did not insist on seeing only the long side
of the market. Long-term strategies go out the window quickly when blood
runs on the floor of the New York Stock Exchange. The well-prepared
technical investor has a plan that provides for the liquidation of positions
gone bad and presumably the discipline to execute it.
This involves the regular recomputation of stops as markets go in the
planned direction, and ruthless liquidation of losers that do not perform.
One may think of a portfolio as a fruit tree. Weak branches must be pruned
to improve the yield. Stop computation is treated in a number of places in
this book (see Chapters 27 and 28). For the investor trading long term, this
may be, as an example only and not as a recommendation, the breaking of
the 200-day moving average or the breaking of a long-term trendline. The
200-day moving average is widely believed to be the long-term trend
indicator, for which believing will sometimes make it come true. (EN9: Let
me emphasize here that “200” is a parameter and an example. Personal
research may fit a better parameter to the actual market.)
In reality, more than just the 200-day moving average or a manually drawn
trendline should be looked at. The chart patterns comprising the portfolio
should be considered also, as well as charts of major indexes and averages.
Also, consider the condition of the averages and their components—their
technical state—whether they are topping, consolidating, or trending as
indicated by their charts.
Moreover, it would be impossible not to mention Magee's Basing Points
Procedure (see Chapter 28). Possibly the most powerful trailing stop
method in existence.
Rhythmic investing
In addition, if Chapter 31 on “Not All in One Basket” is weighed seriously,
one might be rolling a portfolio from long to short gradually in natural
rhythm with the markets and in harmony with the Magee Evaluative Index
described there. That is the preferred strategy of the authors and editor of
this book.
These things all depend on the goals, temperament, and character of the
investor. If he is going to spend full time on the markets, he is probably not
a long-term investor. Such men eat well and sleep soundly at night. The
trader is lean and hungry—not necessarily for money, but for activity. It
behooves one to know his type as a trader or investor. Knowing one's type
or character is best established before finding it out in the markets, as the
markets can be an expensive place to search for self-knowledge.
There is no inherent conflict in holding long-term positions and also
attempting to profit from intermediate trends, depending on the amount of
capital in hand and how much time, energy, and capital the investor wants
to put into trading. A long-term strategy can be implemented with a
modicum of time and energy, as follows: pay attention to the major indexes
and averages and buy on breakouts, at the bottoms of consolidations and on
pullbacks; sell or hedge on the breaking of trendlines, calculated on Basing
Points (see Chapter 28) and the penetration of support zones.
The long-term investor will accept greater swings against his position than
the intermediate-term trader or speculator. As an example with the method
of using Basing Points in Chapter 28, the speculator is using a three-days-
away rule, whereas a long-term investor might be using a three-week
Basing Point or some such analogy. Plus, if interested, when he suspects or
analyzes a long Bull Market is approaching a climax, he might adopt the
three-days rule also, or even begin following his stock with a daily stop just
under the market. Beware though, as professionals look for stops just under
the close of the previous day in situations such as these.
It would be wise not to confuse long-term investing with “buy and hold,” or
as it was expressed in one investment fad in the 1970s, “one-decision
investing.” As an example of this misguided thinking, in 1972, the “best and
brightest” investment analysts (fundamental) on the Street picked a
portfolio of stocks for the generation, or 20 years. The companies would be
difficult to argue with as the creme de la creme of American business. After
all, who could kvetch at Avon, Eastman Kodak, IBM, Polaroid (unless he
happened to look at Figure 37.27), Sears Roebuck, and Xerox? Even today,
if you did not have a close eye on the market, you would immediately
respond, “blue chips.” Consider the following table showing the stocks and
the results achieved over the long term.
Price Price Percent
Stock 4/14/7212/31/92Change
Avon Products61.00 27.69 (54.6)%
Eastman Kodak42.47 32.26 (24.0)%
IBM 39.50 25.19 (36.2)%
Polaroid 65.75 31.13 (52.7)%
Sears Roebuck21.67 17.13 (21.0)%
Xerox 47.37 26.42 (44.2)%
In 2017, the vagaries of unsupervised portfolios is again seen: Avon 2.50;
Kodak 7.75; IBM 141; Polaroid unlisted; Sears 7.21; Xerox 32.64. Beware
of pundits and mindless investing.
Charts (Figures 18.4 and 18.5) showing activity for IBM and Xerox appear
on the following pages.
Figure 18.4 The questionable—even bizarre—results of “one-decision
investing” (i.e., buy and hold) are amply illustrated by this chart. First of
all, the “best and brightest” recommended IBM at a decade high to see it
decline by more than 50%. It subsequently recovered to double from their
original recommendation. Ah, sweet justification! Only, unfortunately, at
the end of 20 years to see it rest approximately 40% beneath the
recommendation. The analytical lines give some hint of how a technician
might have traded the issue. I like to say that there are bulls, bears, and
ostriches, and anyone who followed this one-decision investment proves
my case.
Figure 18.5 Like IBM in the previous figure, Xerox was recommended at a
place at which it should have been sold instead of bought. The comments
there might apply to the chart here. The foolishness of “buy and hold” or
“one-decision investing” is amply illustrated by observing the long-term
swings of the stock and thus of the investor's equity. Technical analysis is
intended to be an antidote to such foolishness.
Summary
The long-term investor attempts to catch major market moves—those
lasting hundreds, if not thousands, of Dow points and stay in trades for
many months if not years.
Within this time frame, he expects to take secondary trends against his
position. Depending on his temperament and inclination, he may attempt to
hedge his portfolio upon recognizing secondary market moves against his
primary direction.
His preference for stocks and portfolio will be for market leaders, for
baskets that reproduce the major indexes (or Index Shares) as the ballast for
his portfolio, and he may choose some speculative stocks to add spice to his
portfolio.
In spite of his penchant for long-lasting trades he will not tolerate weak,
losing, or underperforming stocks. They are the shortest of his trades. He
will cut losses and let profits run, the truest of the market maxims and the
least understood by unsuccessful investors. The other maxim least
understood by investors is “buy strength, sell weakness.”
Truly sophisticated investors attempt to participate in Bear Market trends
also. This is the greatest difference between professional and general
investors—professionals have no bias against the short side.
For the convenience of day traders, the URL of Gamblers Anonymous is
noted: http:// www.gamblersanonymous.org.
chapter nineteen
The all-important details
In this chapter and the one following, we take up a number of elementary
suggestions intended largely for the benefit of those who have never kept
charts before. Much of this will seem obvious and repetitive to the
advanced student, although even he may find some thoughts that will
simplify his work. The beginner should read these chapters carefully and
use them for later reference.
The details of how and when you keep the charts will not guarantee you
profits, but if you fail to work out these details in such a way as to make
your work easy, as part of a regular systematic routine, you cannot expect to
keep up your charts properly or make any profits.
Charting and analyzing your charts is not a difficult process, nor will it take
too much of your time if you have determined a reasonable number of
charts and have arranged for doing the work regularly, meaning every day
without fail.
You will need a source of data—the day's market prices and volume. If you
live in a big city, your evening paper will carry the complete list, and you
can plan to set aside a certain period before dinner, or after dinner, or during
the evening. If you cannot allot such a period and keep it sacred against all
other social or business obligations, then plan to do the charting in the
morning. The key is to set a definite time and let nothing interfere, ever, or
you are lost. (EN: This process is radically simplified by automated
computer downloading procedures and access to data sources and internet
sites, but the principle is the same.)
You should have a suitable place to work and keep your charts. If it is at
home, in the dining room or living room, other members of the family
should understand that what you are doing is important. You should be able
to shut the door and work without interruption. The light should be bright
and as free from shadows as possible. (It makes a big difference, especially
if you are keeping a large number of charts.) The ordinary desk lamp throws
a reflected glare directly across the paper and into the eyes. It can be a
strain if you are doing much of this close work. Better to have an overhead
light, placed just a few inches in front of your head and a convenient
distance above; and if this light can be a fluorescent fixture using two 40-
watt lamps, you will get almost perfect shadowless lighting. These
suggestions apply in case you are not working by daylight.
Additionally, have plenty of room. A big desk top or a dining room table
with a large clear space for chart books, extra sheets, pencils, scratch paper,
ruler, calculator, computer equipment, and anything else you need. If your
working surface is fairly low, say 28 or 29 inches from the floor, it will be
less tiring than the usual 30-inch desk height.
Whether you are working in ink or in pencil, pick out the writing tool that is
easiest for you to use. If you are using pencils, try several different makes
and degrees of hardness. Find one that is hard enough not to smudge too
easily, and yet is not so hard you have to bear down to make a clean black
mark. The wrong kind of pencil can tire you and irritate you more than you
realize. Also, have plenty of pencils, a dozen at least, well-sharpened, so as
soon as one becomes a trifle dull and you are not getting a clean, fine line,
you can simply lay it aside and continue at once with another freshly-
sharpened pencil.
Keep your charts in loose leaf books with big enough rings to make turning
the pages easy. Do not overcrowd the books; get new books if a volume is
too crowded. Finished charts may be kept in file folders. The only ones that
need to be in the books are the current sheets and the sheets for the
immediately preceding period. If possible, use a seven-ring binder. Pages
are easily torn loose from two- and three-ring binders, but seven rings will
hold the pages safely and you will seldom have one tear out.
The charts you keep will become increasingly valuable to you as the chart
history builds up. The old chart sheets will be very helpful to you for
reference. Provide a file or space where they can be indexed and kept in
chronological order, and also have file folders for brokers' slips, dividend
notices, corporate reports, clippings and articles, notes on your own
methods, and analyses and special studies of the work you are doing.
In this connection you will, of course, keep a simple but complete record of
each purchase, sale, dividend, and so on, on stocks you have bought or sold.
This record will make your work much easier when the time comes to
figure out income taxes. It will also give you all the statistical information
you need to judge the results of your trading operations.
(EN: At the beginning of my investment career, and often in the middle of it,
I thought the above was cracker-barrel wisdom. The longer I last the more I
think that homespun wisdom might be the best kind to have in investing—
somewhat like Mark Twain, who was astounded at how much his father
increased in wisdom the older Twain himself got.
We may restate the modest homilies above: Be serious. Be methodical. Be
disciplined. Be businesslike. Anyone who succeeds in investing without
these qualities is the recipient of blind luck and will be fortunate not to fall
into a hole before his career is over.
These thoughts occur when one is wondering how Magee would have
viewed the advent of the microcomputer and its impact on technical
analysis and investing. Might he have said, “What hath this tool wrought?!
Wonders and abominations!!”
Given the possibilities for complicating analysis and operations when
confronted with all the bells and whistles of the average computer software
package, the investor must maintain perspective. What, then, are the all-
important details in practicing technical analysis with the aid of a
computer?)
The simplest and most direct way to use
a computer for charting analysis
In reality, the computer can be used as a simple tool to do a simple job.
There is nothing inherently complicated about keeping a chart on a
computer. All computer software packages enable bar charting and many, if
not most, enable many other kinds of charting, from candlesticks to
oscillator charting. The process, in almost all commercially available
packages, is so simple that explaining it here would be superfluous (see
Appendix B, Resources, for demonstrations), except to generally say it
consists of retrieving data, updating the program's price database, and
clicking an icon to run a chart. The software packages themselves explain
their features better than can be done here. What is important here is to
give perspective. Even simpler when the whole process takes place on the
internet, as at http://www.stockcharts.com or http://www.bigcharts.com, or
http://www. tradestation.com.
In this respect, charting can be done with quite expensive programs and
also on publicly available free programs or freeware. Charting can also be
done with interactive charting programs on many internet sites. The basic
bar chart can be enhanced with an unending number of technical studies—
moving averages, oscillators, and so on. Therein lies the danger. Chart
analysis in itself is a qualitative process. Decorating graphic charts with
number-driven information and studies can lead the general investor astray
—and into confusion and indecision.
Thus, the first preference of this analyst is to keep the process as simple as
possible. Get the data, draw a chart, analyze the patterns, consider the
volume, and draw the appropriate analytical lines—this can usually be
done by the program on the screen. Often a better graphic picture may be
obtained by printing the chart and hand-drawing the analytical lines. This
brings to the fore one of the main problems of almost all the software
packages—screen graphics are poor and, at least to old chartists,
disorienting. They are especially befuddling to analysts who are
accustomed to working on TEKNIPLAT™ chart paper. With passing
editions of Resources, this problem will be dealt with. (EN9: In the
intervening years since the eighth edition, two things have occurred: the
editor adjusted to modern technology and the technology achieved a level
of excellence acceptable to a carping analyst. Internet technical analysis
sites such as http://www.stockcharts.com and http://www.thinkorswim.com
improved to be surprisingly valuable resources at unbelievably low prices—
even free.)
The question of graphic representation of the facts is worth noting as a
persistent one. To a certain extent, the individual analyst will solve this
conundrum by adapting his eye and mind to a graphic environment, using
one graphic method consistently and seeing how it relates to the facts in the
market. John Magee-oriented solutions to this problem will be available on
the website http:// www.edwards-magee.com.
In Appendix B, Resources, the reader may see some examples of simple and
inexpensive software packages and internet sites that are quite adequate to
the required tasks of charting technical analysis, as well as more complex
number-driven analysis.
Summary
The computer is an invaluable tool for analysis. Use of it will enable the
following:
• Data may be acquired automatically via internet or dial-up sites at
little or no cost. Some of these even offer real-time data, which is a
way for the unsophisticated trader to go broke in real time, but which
the general investor may desire on the day of executing a trade. Many
of these sites offer every kind of analysis from respectable technical
analysis (usually too complicated) to extraterrestrial channeling.
• A computer package and internet portfolio sites will give the analyst
virtually effortless portfolio accounting and mark-to-market prices—a
valuable device to have to keep the investor from mixing his cash and
accrual accounting, as Magee says.
• The computer will enable processing of a hitherto unimaginable
degree. An unlimited number of stocks may be analyzed. Choosing
those to trade with a computer will be dealt with in Chapters 20 and
21.
• Appendix B, Resources, contains information on software packages
that the reader may try and purchase at quite reasonable prices. In all
likelihood, the least expensive of these will be adequate to the needs of
most general investors. In addition, I present a brief discussion of
internet sites and resources.
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter twenty
The kind of stocks we want: the speculator's
viewpoint
The specifications of the kind of stock we want to chart are fairly simple
and few. We want a stock that will enable us to make a profit through
trading operations, meaning a stock whose price will move over a wide
enough range to make trading worthwhile. There are those who are
concerned mainly with safety of principal and the assurance of income from
a stock. For them, there are (EN9: or were) stocks that afford a considerable
degree of stability. You may (and probably will) want to keep a substantial
part of your total capital in stocks of this type. They move in a narrow price
range; are extremely resistant to downside breaks in the market; are also
(and necessarily) unresponsive to fast upside moves in the market as a
whole, and are highly desirable for the conservative investor. They are not,
however, the most suitable issues for trading operations, because their
swings are small, and commissions would tend to diminish the narrow
trading profits that could be taken. Also, they do not make the sharp, clear
chart patterns of the more speculative issues, but move in rounding,
sluggish undulations. (EN9: These remarks reflect a bygone time. The
described stocks by and large went the way of the Dodo. When T can
disappear from the market as a factor, there is no place to hide, except in
bonds, which, when stagnant, only lose real value at the rate of inflation
and loss of purchasing power of the dollar. Even bonds should be subject to
frequent reevaluation using the tools described in this book.) (For
illustrations in this chapter, see Figures 20.1 through 20.4.)
To amplify this comment and explain a bit about what underlies what we
are doing, let us assume a certain company has two issues of stock, a
preferred and a common. We will assume the concern has a certain steady
minimum profit it has earned for years, sufficient to pay the preferred
dividend, the continuance of these dividends seems practically assured. The
dividends on the preferred are fixed at, let us say, 6%. Now the common
stock gets all that is left. In one year, there may be $0.50 a share for the
common stockholders. The next year, there may be $2.00 a share or four
times as much. In a case like this, if there are no other factors, you would
expect the preferred stock to sell at a fairly steady price without much
change, whereas the common stock is subject to a “leverage” and might
shoot up to four times its former value. The more speculative issues
represent either a business that is, by its nature, uncertain as to net profit
from year to year, where the volume of business or the profit margin
fluctuates widely, or one in which the majority of the “sure” net profit has
been sheared off for the benefit of senior obligations. There are also other
factors that affect the speculative swing of a stock, and, as a result, one
issue may be very sensitive and another extremely conservative, and
between them there would be all shades and degrees of sensitivity or risk. It
is enough here to note briefly the nature of the business itself does not
always account for the habits of the stock because the other factors may be
very important. Most stocks have a fairly well-defined “swing” power,
which can usually be determined by past performance of
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been met, compared (at right) with the Goodyear $5.00 Preferred, which
carries a high degree of assurance that the $5.00 dividend will be met, but
no promise of further participation in profits. Monthly range of each stock
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leveling off at a point that represents the maximum price investors are
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Figure 20.2 S&P. Here the benefits of relaxed long-term investing may be
seen, buttressed, of course, by the longest and handsomest Bull Market in
American history in the Clinton-Gore years. At the end of this record, the
effects of public enthusiasm (or as Chairman Greenspan of the Fed said,
“irrational exuberance” vide tulipomania) can be seen in the wide
undisciplined swings (best seen in Figure 20.3). The dotted line represents
150-day (approximately) Moving Average. Just using the Moving Average
as a signal (or the Basing Points Procedure) would have beaten the market
and 99% (the 99%) of other investors.
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Figure 20.3 SPY. For illustration, here is a chart of the AMEX Index Share,
the SPY, or ETF based on the S&P 500. After the crash of 1998 (the Asian
Economic Flu crash), the fan lines tell a story, as does the last phase of the
chart where the market whips in what appears a Broadening Top. (EN9:
Note this Broadening Top was identified in 1999-2000 before the crash as
documented in the http://www. edwards-magee.com archives. See Figure
20.4.)
Figure 20.4 The S&P 500 in all its glory and tragedy. An especially good
portrait by Holbein, the younger. The Broadening Top pointed out in Figure
20.3 in 2000 foretold the decline of the S&P to below 790—not quite 50%
but close enough to catch the eye. Particularly fine lessons here, besides the
Broadening Top lesson. All of them screaming for action. The broken
trendline at A, the broken trendline at B, the broken “neckline” or
horizontal line at C. Notice the close correspondence of the break at B and
C. The next lesson is not to buy downtrends until a clear bottom is made in
a major bear market. Clearly no bottom is made until the Kilroy Bottom at
1-2-3. Even then, the least risky trade for the long-term investor is when the
Kilroy Fenceline (Neckline) is broken at D. All of this was knowable at the
time.
how a stock will behave in the future as to the extent of its swing. (EN9: Or
we might say, short-term volatility and long-term range.)
Incidentally, for short-term trading (EN9: amusing in the modern context;
by short-term trading Magee means trading of trends of shorter length than
Dow Waves), we are thinking about the habits of the stock that are only
partly determined by the business it represents. Purchase of stock in one
company that has a somewhat uncertain or fluctuating profit record may be
more conservative than purchase of a highly leveraged stock of another
company whose basic business is steadier and more conservative. We will
take up the matter of determining these risk constants a little later.
One should also understand the short sale of a stock does not imply any
feeling that the country is going to the dogs or even that the concern
represented is going to the dogs. Such a sale merely indicates your belief
the stock may be temporarily overpriced; that earnings or dividends may
have been abnormal in recent years and are likely to be reduced; or that for
one reason or another, the stock of the company may be worth a bit less
than it has been worth.
For technical trading, we want a fairly speculative stock, one that will make
sizable swings up in a Bullish Trend and down in a Bearish Trend. The very
factors that tend to make a stock safe and desirable to the investor may
make it entirely unsuitable for trading. Also, with certain reservations that
will be taken up later on, the more speculative the stock the better it is for
our purposes.
(EN: Entering the third millennium (since we Anglo-Saxons started
counting—the fourth or fifth by other measures), the distinctions between
“speculative” stocks and every other kind of stock has grown increasingly
blurry. Rather than apply a perhaps pejorative (in the minds of some
readers) term like “speculative” to otherwise-innocent stocks, we would do
better to describe stocks as wide ranging or narrow ranging, as volatile or
nonvolatile. Stocks may then be evaluated one against another by their
betas and historical volatilities, statistical data easy to obtain. “Betas” and
“volatilities” are dealt with in Chapters 24 and 42.)
In line with this more current thinking, there is another question for readers
of this book—the choice of trading (or investment) instruments for the long-
term investor.
The kind of stocks we want: the long-term investor's viewpoint
Changing opinions about conservative investing
Virtually no one invests like the conservative investor described above in
Chapter 20— except perhaps trust departments of antediluvian banks. There
may be some investors still out there who are so risk averse they still follow
the method described. Bank trust departments may be still doing it; they
used to do it so the trust beneficiaries could not sue them. This is the reason
trust departments exist, to give legal cover (the so-called prudent man rule)
to trustees in case of suit by beneficiaries. Most enlightened trust
departments and trustees now probably follow indexing or other more
productive strategies to cater to new understandings of the prudent man
rule.
“Indexing” refers to the practice of constructing a portfolio to replicate or
closely reproduce the behavior of a widely followed index such as the
Standard & Poor's (S&P) 500 or the Dow-Jones Industrials. These
portfolios never track the Indexes exactly because the advisors and funds
who manage them take management fees and expenses. These fees are
generally less than fees and expenses on actively managed funds, but in fact
are not necessary for the private investor to pay because even the tyro
investor can now use “Index Shares” (e.g., DIAMONDS™ [DIA], S&P
Depositary Receipts [SPDR; SPY, QQQ,] and so on) or other proxy
instruments to do what the funds and professionals do. Essentially what
indexing does is track the Averages, a strategy that was impossible or
difficult (expensive) when Magee examined it, as in Chapter 15. (EN9: In
the opinion of this editor, hiring a management company to run an indexing
strategy is a waste of capital. Much better for the investor to invest directly
in ETFs and to exit the market when uptrends end and reverse. This is a
much better strategy than “passive indexing,” which cleverly manages to
capture both losses and profits in the Averages.)
The kinds of stocks long-term investors want:
the long-term investor's viewpoint
Perhaps one of the most important actualizations of recent editions is to
bring current this book's treatment of the Averages, noting that it is now
possible to trade the Averages in stock-like instruments. This fact deserves
to be marked as a vitally important development in modern markets. This
chapter will confine itself to describing facilities for trading and investing in
the Averages and Indexes.
In 1993, the American Stock Exchange (AMEX) introduced trading in
SPDRs™, an Exchange-traded unit investment trust based on the S&P 500
Composite Stock Price Index. The AMEX calls these securities Index
Shares™, a name they also use for other similar instruments. As noted
above, large investors and funds have long traded “baskets” of stocks
representing the S&P 500, obviously an activity requiring large capital. In
fact, a certain class of investment managers and funds have practiced
“passive investing” meaning indexing, primarily for large clients. The
purchase and liquidation of these and other “baskets” is one form of
“program trading.”
Recognizing the utility of this investment practice, the AMEX created the
SPDR as a proxy instrument to allow the smaller investor to practice the
same strategy. The effectiveness of this product introduction may be
measured by public participation in the trading of the SPDR (SPY). By
2000, almost $15 billion was invested in SPDRs with more than
100,000,000 shares outstanding. These units allow the investor to buy or
sell the entire portfolio or basket of the S&P 500 stocks just as he would an
individual stock, but the capital required to do so is radically reduced.
In 1998, the AMEX introduced DIA, Index Shares on the Dow-Jones
Industrial Average™ (DJIA), which is analogous in every way to the
SPDRs. Thus, an investor may “buy the DJIA.” So in current financial
markets, it is possible to “buy the market,” unlike those conditions under
which Edwards and Magee operated.
Construction of the Index Shares and similar instruments
The AMEX unit investment trusts are constructed to replicate the
composition of their base instrument. The SPDR, for example, is an
instrument that represents one-tenth of the full value of a basket of the S&P
stocks and trades on the AMEX, just like a stock (SPY). Other
characteristics of stocks are also reproduced such as long life (the SPDR
Trust lasts into the twenty-second century) and quarterly dividends (cash
paid on the SPDRs reproducing dividends accumulated on the stocks of the
S&P 500). Even dividend reinvestment is possible, and the units may be
traded on the AMEX during regular trading hours. Under normal
conditions, there should be little variance in the price of the SPY relative to
the S&P 500. (In 2008, the AMEX merged with the New York Stock
Exchange. Trading and instruments remain as described.)
These elements, as discussed for SPDRs, are common to all the Index
Shares— DIAMONDS, World Equity Benchmarks (WEBs), and others.
There are, of course, some expenses and costs to using the Index Shares—a
small price to pay for the use of the instrument and generally less than the
costs of a fund. Index Shares are also much more flexible for the
independent investor. Among other advantages, the private investor can
control the tax consequences of his investment, which is not possible in
funds.
Other Exchanges have created similar security instruments or derivatives or
futures to replicate or track the well-known averages and indexes. Among
these are tracking shares or index shares or futures (let us call them
“instruments”) on other indexes (Russell, Nikkei, and so on) or options on
the futures or indexes until there is a bewildering array of instruments
available for trading, investing, and hedging. Among the more important
exchanges and instruments traded are the Chicago Board of Trade (futures
and options on futures on the Dow); the Chicago Mercantile Exchange
(futures on the S&P, Nikkei 225, Mini S&P 500, S&P Midcap 400, Russell
2000, and NASDAQ 100); and the Chicago Board Options Exchange (S&P
100 and 500 options). This, by no means, is an exhaustive list. All the
futures and options that matter will be found listed in the Wall Street
Journal under Futures Prices or Futures Options Prices.
This book does not deal in comprehensive detail with futures and options,
but it is worth mentioning these exchanges and their futures and options
products because of the facility they offer the investor and trader for
hedging portfolios in Index Shares and Average trading, not to mention
opportunities for speculating.
Briefly, hedging is the practice of being neutral in the market. That is, one
might be long the DIAMONDS and buy a put option on the DJIA at the
Chicago Board of Trade, meaning that advances in the DJIA would result in
profits in the DIAMONDS, and a loss of premium in the put. Conversely, a
decline in the Dow would result in profits in the put and losses in the
DIAMONDS. As this area is not the province of this book, this is a highly
simplified description of a hedge. Nevertheless, the reader should see and
understand that hedging can be an important strategy. Hedging can take the
place of liquidation of a portfolio when the analyst recognizes a change of
trend or unstable conditions but does not wish to incur taxes or wishes to
defer them.
An outline of instruments available for trading and investing
It would be herculean to attempt to list the entire panoply of averages,
indexes, futures, and options available for trading—herculean due to the
fact new trading instruments are constantly in creation and due to the fact,
now operating at internet speed, we may expect the rate of change to
accelerate. In addition to those listed above, there are WEBS (meaning that
exposure to world markets may be arranged).
In all, approximately 30 or more Index Share units or instruments were
available for trading on the AMEX at the turn of the century, in addition to
DIAMONDS and SPDRs. Similar instruments exist on the Philadelphia and
in Chicago, and others are being created daily. To reduce the confusion, the
general investor will probably find the major indices of the most
importance. The more instruments one deals with the more complicated the
strategy and tactics become. Therefore, the Dow, the S&P 500, and the
NASDAQ composite (DIA, SPY, QQQ) are probably sufficient for the
purposes of the gentleman (or lady) investor. The Mid-Caps, the Nikkei,
and others begin to come into play when the trader begins to try to catch
sector rotation, fads, short-term cycles, and so on.
The importance of these instruments: diversification, dampened
risks, tax, and technical regularity
It would be difficult to underestimate the importance of these new trading
instruments. First of all, they afford the private investor what was
previously reserved for the large capital trader—the ultimate in market
diversification. The S&P 500 represents stocks comprising 69% of the value
of stocks on the New York Stock Exchange. Buying it is buying the
American economy. The 30 Dow Industrial stocks represent the most
important symbol in the American economy—and perhaps in the world.
Investors are well advised to pay attention to both Averages if they would
fare well in the markets (Note the plural: markets). These two Averages
now have the influence or clout that once the Dow alone had to express the
state of the markets and stocks in general.
Buying the SPY or DIA then represents the immediate acquisition of a
diversified portfolio. And buying the NASDAQ or QQQ gives one
immediate exposure to the more speculative and volatile sector of the
American economy. Given the long-term bullish bias of the averages and
the American economy, it is difficult to argue with this as both strategy and
tactics for the long-term investor. This does not mean positions should be
taken blindly without thought or not monitored. On the contrary, recall if
you will the record of the Dow Theory; even for the long-term investor,
bear markets should not be allowed to destroy liquidity and equity value.
These questions are discussed at greater length in Chapter 18.
Although we believe these instruments are good vehicles, it is wise to
remember Magee's frequent admonition (less important now than when
spoken) that it is a market of stocks, not a stock market. Meaning when the
tide is flowing down with the Dow and S&P, prudence and care must be
used in taking long positions in stocks that are in doubt as to direction.
Additionally, it is worth noting investments in these instruments will be less
profitable than an astutely chosen individual stock. For example,
Qualcomm appreciated approximately 240% (temporarily) in 1999-2000
compared with about 24% in the S&P over the same period. Those who
bought Qualcomm at its top and sold it at the bottom of its reaction lost
about 75% or about $148 a share. Traders in Qualcomm tended to obsess
and pay hyper attention to the stock, whereas investors in the SPY reviewed
it once a week or less or told their computers or their brokers to give them a
call if it broke the trendline or entered stops. Then they slept at night and
had eupeptic digestion.
Other advantages accrue to the trading of the SPDRs. Ownership of a fund
can result in tax liabilities as managers adjust portfolios to reflect changing
membership in the fund or withdrawals in capital by irate stockholders.
Since Index Shares last into the twenty-second century, the long-term
investor has no need to realize gains and pay taxes. Bear markets may be
dealt with by hedging with other instruments—futures, options, or proxy
baskets of stock, or individual stocks, and accepting the tax consequences
of these trades.
John Magee aptly observed before the direct trading of the Averages was
possible that the Dow-Jones Industrials were very regular and dependable
from the technical point of view. This observation is annotated at some
length in comments on Dow Theory in Chapter 36. Therefore, the investor
in the Index Shares may have a smoother time technically than a trader of
an individual stock.
Summary
The long-term investor and mid-term speculator attempt to capture long
secular (as well as cyclical) trends in the markets. They shun frequent
trading and capital-eroding transactions. They recognize that risk fluctuates
with time and trend, and they know that frequent turnover benefits mainly
the broker.
The strategy of the long-term investor may be to match the market by using
funds or SPDRs or baskets, but he does not like to participate in Bear
trends. He hedges or liquidates his positions on major trend shifts. In fact,
he may even short the indexes if his analysis indicates major bear markets.
If he desires to outperform the market (which will happen automatically if
he follows the methods of this work), he finds some individual speculative
stocks to trade in addition to his foundation portfolio. Depending on his risk
tolerance, he may always be somewhat hedged. When long the indexes, he
finds some stocks in downtrends to short. When he is short the indexes, he
finds some strong stocks to hold long. There is no excuse for a moderately
skilled and reasonably capitalized investor to lose money over the long term
in the market.
As a reminder, Chapters 5 and 28 describe powerful methods for the long-
term investor using Magee's Basing Points Procedure.
chapter twenty-one
Selection of stocks to chart
The trader who operates on the “fundamental” basis, making his
commitments on his analysis of earnings, dividends, corporate
management, prospects for the industry, and so on, will usually (of
necessity) confine himself to a few stocks or a single group of stocks in the
same field.
To the contrary, the technical trader, using daily charts, should have a large
portfolio of issues. Since he is primarily interested in the technical chart
patterns, he will not try to make an exhaustive study of the background of
each company. In fact, the characteristics of the stocks themselves, as they
act in the market, are more important to him than what these companies
make or what they are earning. This is because, although the stocks
represent ownership in the company, the capital structure, “leverage,” and
floating supply of the stock may (and very often does) mean fluctuations in
the stock price that are not directly in proportion to changes in the affairs of
the business.
You will also find many cases in which the stock of a well-regarded, well-
managed, long-established concern, whose latest earnings report shows
increased profits, and with a long record of dividends paid, would not be a
good buy at the market price. It may be overpriced and due for a serious
depreciation. You will find other cases in which a stock, which apparently
represents no great promise of either earnings or dividends, suddenly starts
a series of spectacular moves upward, and is indicated clearly as a buy. Of
course, the answer, in each case, is the records available apply to the past,
not the future; and very often, chart action will indicate the inside
knowledge of those who are in possession of facts the public has not yet
received.
To change our example to something more easily visualized, let's assume
there are two houses for sale. One is a fine, well-built, modern home in an
attractive part of town at, say, $200,000—and the other property, a
somewhat shabby six-family tenement in a less attractive section, at the
same price of $200,000. There is no question which is the “better” house,
but in a case like this, the market for well-built single homes at this price
may be poor, whereas the demand for apartments may be good. The six-
family house may be the better investment.
Then again, we have the question of what is conservative and what is highly
speculative. It is not always enough to judge from the type of business of
the company itself. You may have a highly conservative concern, carrying
on a stable volume of business, with a long record of successful operation.
Yet, if there are bonds, debentures, preferred stocks, and other senior
obligations, the common stock may be subject to wide fluctuations. Also, if
the issue is small, or if a large part of it is closely held, you will have a
“leverage” effect that results in wide swings in the stock.
Therefore, in choosing your stock to chart, you will want to consider the
kind of stock and its character and habits in the market, rather than the
business of the concern it represents. We will come back to this point and
show you how you can shape up a list that will give you the kind of stocks
you want for trading.
Meanwhile, the question “How many charts?” has been left hanging. One
answer to this is that the more stocks you chart, the more good
opportunities you will have. Many stocks, even of active issues, will go
through long periods when, indeed, there is nothing much to tell. In a period
of stability, the chart simply indicates it is a period of stability, and the only
possible trading activity would be purchases and sales at the Bottoms and
Tops of its undulations. The charts are more informative when a change in
the situation occurs; they will signal a change of trend as soon as (and
usually before) the news of the changed conditions has come out. If you
have enough charts, you will always have some stocks making decisive and
clear-cut moves either up or down, at any time.
You should, therefore, keep as many charts as you can. Do not bite off more
than you can chew, however. A man with only 15 minutes to half an hour a
day for this work might have to confine himself to 20 or 30 charts. It would
be much better if he could have 100. If he is in a position to give a major
part of his time to the work, he could very well run as many as 300 charts. A
most important word of caution is indicated here: Do not start anything you
cannot finish. It is better to have too few at the beginning than too many.
Then, if you find you can add others, you will be in a better position, from
your experience, to pick out the ones you want to include. However, if you
start with too many charts or begin to run behind with your analyses, you
will not be getting the best use from your portfolio and it would be better to
cut down at once. (EN: Magee's admonitions are still in effect for the
manual chartist. The modern computer-equipped investor has a different
problem. He can chart every issue in the market every day. The question
becomes how many can he effectively study and analyze? There is even a
computer answer to this question. Namely, the cyber trader can program
the computer to report stocks on an exception basis. For example,
“Computer, show me all the stocks which are above their 50-day moving
average and which have unusual volume.”)
From what we have already been over, you know it is possible to chart
anything that is sold in identical units in a free competitive market. This
includes all kinds of commodities, bonds, debentures, when-issued
contracts, and so on, as well as stocks. You may have some special interest
that will call for charting something outside the field of stocks—well and
good.
In general, however, you will want to chart active, listed stocks of well-
established corporations. There is no reason an unlisted stock cannot be
charted, but ordinarily, the only figures you can obtain on it are the bid and
offer prices. On these stocks, you do not have a published statement of the
volume of sales each day or any record of prices at which sales actually
took place, and those are essential to the charting of daily technical action.
Therefore, you will usually be charting stocks listed on some exchange.
This is also an advantage because concerns listed on the larger exchanges
are required to meet certain conditions, publish certain information, and
comply with definite rules and practices.
In this book, most of the examples have been taken from stocks listed on
the New York Stock Exchange (NYSE). There are thousands of issues
traded on the NYSE, and these stocks represent every type of security, from
the most conservative to the most speculative, from the cheapest to the most
expensive, and they include every principal type of industry and business.
There is no reason, however, that stocks should not be chosen from the
American Stock Exchange, the NASDAQ, or from any other exchange in
this country, or for that matter, in some other country. (EN: So far as the
chart action is concerned, the patterns and their meanings will be the
same).
(EN9: In general the stocks to watch, or chart, will tend to leap out of the
haystack of stocks. For stock pickers Investor's Business Daily is in the
constant process of sifting the markets for nuggets with its CANSLIM
system. (Not a recommendation to use that system, only a recommendation
to examine every tool that might be of use.) Stocks that appear suddenly on
the most active lists of http://www.stockcharts.com might bear examination
by the chart analyst. These include optionable stocks that suddenly show a
radical change in implied volatility,; stocks that pop up with suspicious
Chapter twenty-one: Selection of stocks to chart 317
volume spikes compared with average volume, and those with internet and
software packages one might construct a filter to be informed by the
computer of stocks breaking their 14-, 44-, 150-, and 200-day moving
averages: 14 because some professionals think the public thinks in this time
frame; 44 because some think funds think in 44-day time frames. The others
because everyone thinks they are important.
In reality, if the investor aim is to beat the market, he may choose just to
confine his activities to the ETFs that represent the indices—DIAMONDS™
(DIA), Standard & Poor's Depository Receipts (SPY), and QQQ. ETFs are
inherently less risky than any individual stock.)
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter twenty-two
Selection of stocks to chart: continued
In choosing your stocks, you will probably look for the greatest diversity in
the kind of industry. As you are not specializing in the detailed study of a
single group, you will try to get stocks from as many different groups as
possible. You will want to include mines and oils, rails and chemicals,
liquors and amusements, airlines, utilities, techs, internets, biotechs, ad
infinitum. The reason for this is simply that, very often, many stocks in a
particular industrial group will show the same or similar patterns, as the
entire industry is affected by certain Major conditions. You will often find,
for instance, when Allis-Chalmers (EN: or Dell) makes a Triangle or other
Area Pattern, followed by a sharp upward move, Deere (EN: or Compaq),
Minneapolis-Moline, Harvester, and Case will make similar Triangles, or
possibly Rectangles or some other Consolidation Pattern, followed by a
similar upward move. When Schenley is moving in a long downtrend, you
will very likely find that Distillers—Seagram's, National Distillers,
Publicker, and American Distilling—are also moving in a long downtrend.
(EN: Metaphorical names, like the names of Greek gods or Ulysses and
Leopold Bloom. The present-day reader may read Intel, Fairchild, and
National Semiconductor or 3COM. The idea is the same.) (For an
illustration in this chapter, see Figure 22.1.)
Therefore, unless you plan to keep enough charts to include several stocks
of each important group, it is best to pick your stocks to make up as widely
diversified a list as possible. In this way, during times when certain groups
are moving indecisively, or are inactive, you will have some representation
in other groups that may be active. (Do not infer from this that all stocks of
a group move together at all times. Individual concerns will frequently
move according to special influences that bear on a single company. Where
the Major influence is some industry-wide condition, the group will move
more or less as a unit.)
We, therefore, choose stocks representing a wide variety of groups or basic
industries. Nevertheless, suppose we are limited as to the number of charts
and we must choose one stock from a group; which stock to choose? For
instance, we must choose one stock from the transportation group (EN: or
Biotech, or internets.) As a matter of fact, you would probably want more
than one because this particular group is so important and so large, but for
the moment, let us choose just one. (EN9: Or, even better, why not one of
the indexes—for example, an ETF—for the desired group. An example of
betting on all the horses rather than trying to pick the winner, and there is
no conflict between making both bets.)
Should it be a high-priced stock or a low-priced stock? Let us examine that
point first. If you examine the past records of stocks, you will generally find
the lower priced issues make much larger percentage moves than the higher
priced stocks. It is not unusual for a stock selling around 5 to make a rise of
100%, moving up to 10 sometimes within a few weeks. On the other hand,
you do not find 100% moves in days or weeks among the stocks selling at
100 or 200. The same industry-wide move that carries your $5.00 stock
from 5 to 10 might carry your $100 stock from 100 to 140. Obviously, if
you had put $1,000 into outright purchase of the stock at 5, the move would
have increased the value of your stock 100% or $1,000. In the other case, if
you had put the same amount into a stock at 100,
136
128
120
112
104
96
88
80
Figure 22.1 Low-priced stocks move faster than high-priced stocks. Here
are weekly charts of two rail stocks, charted on ratio scale over the same
six-month period. Baltimore and Ohio during this time advanced from 12
3/8 to 28 7/8, a gain of 16 1/2 points, while Union Pacific moved up from
109 to 137, a gain of 28 points. The advance in “UP,” however, compared
with its price, is much less than the advance in “BO.” A thousand dollars
used for outright purchase of “UP” would show you a capital increase of
25%. On the other hand, if you had put a thousand dollars into outright
purchase of “BO,” your increase would have been 133%, or more than five
times as much.
Bear in mind low-priced stocks not only go up much faster, but also come
down much faster than high-priced stocks. When you own a low-priced
stock, you cannot safely “put it away in the box and forget it.” For security
and stability, you would do better to buy a few shares of a high-priced, gilt-
edge security. For trading purposes, you will want to strike a compromise
between the rather sluggish “blue chips” and the extremely erratic “cats and
dogs” in the lowest price bracket.
the move to 140 (although many more points) would have increased your
capital to only $1,400. The gain in the lower priced stock would be about
two and one-half times as great.
The authors have worked out and tabulated the percentage moves of large
groups of stocks over long periods of time (see Appendix A, ninth edition)
and have set up a table that shows the relative average sensitivity of stocks
at different price levels. This table pertains only to the price level of stocks;
thus, the same stock that today sells at 5 and makes wide percentage swings
will not swing so widely when it has moved up to a price level of 20-30.
(EN10: These concepts replaced by beta and volatility.)
Several questions may come to your mind at this point. Do not the costs of
trading low-priced stocks relative to high-priced issues have to be taken into
account? (EN: Yes, they do. Given the extreme changeability in these costs
in the internet economy, calculation of those costs here would be
tantamount to wasting trees. This cost question may be researched quickly
and easily given the availability of search engines such as Google and
access to the internet.)
In selecting the price level of the stocks you prefer to trade in, you cannot
set too arbitrary a limit because there are other factors to consider and you
may have to make some compromises on one score to get what you want in
some other direction. Stocks from 20 to 30 are in a good trading price
range. Very often, you will find stocks in the 10-20 range that are so
interesting you will want to chart and trade in them. You will find good
situations in stocks selling at 30-40. Furthermore, you will understand, of
course, the stocks that are now selling at 10 may be selling next year at 40,
or vice versa. Considering you cannot be changing your portfolio of charts
all the time, you must not be too “choosy” in picking the price range of
your stocks. You would not ordinarily pick out a stock that was selling far
above the price range of most stocks of its group, say at 150, when several
others in the same industry were selling at 15, 28, or 37. For the high-priced
stock, as we have said, is likely to be sluggish as a trading medium. On the
other hand, you would not take the very lowest priced issues of the group,
selling at, say, 4 or 2 when others were in the 10-30 bracket. You would not
only be faced with erratic and tricky chart action, and much higher
percentage costs for commissions, but also you might not be able to operate
on margin at all. There are, from time to time, limitations on the amount of
margin on stocks at all levels. In the lower priced issues, these limits are
often more stringent. Plus, in the lowest priced stocks, you are sometimes
not permitted to trade on margin. (EN: As these requirements are subject to
the vagaries of the Federal Reserve Board, the investor must inform himself
at his personal broker or ECN. For quite some years, the general margin
requirement has been 50%. The Fed came in for some sharp criticism for
not dampening speculation in the fin de siecle bubble by raising margin
rates to 100%, and its lack of action exacerbated the blow off of 2000. A
change in margin rates should get the immediate attention of the technical
analyst. Something will be up.)
Ordinarily, you will get the greatest effective leverage at some point in the
20s, considering all these factors, and your trading can run down through
the teens and up through the 40s. Above 40 and below 10, you will have to
have strong reasons for trading, which might be, of course, ample capital. It
would therefore be best for the moderately financed investor to choose a
majority of his stocks from the middle price range (10-40), plus only those
special situations you are particularly interested in watching among the very
low and very high brackets.
If, however, you will go back to the long-time past record of any group of
stocks, you will find that even among stocks moving at nearly the same
price levels today, there are widely different behavior patterns. You will find
some stocks respond to a severe market setback by reacting, let us say, 20%
—that is, if they were selling at 30, they would move down to around 24.
Others will respond to the same setback in the general market by a reaction
of 50%—that is, if they were selling at 30, they would end up at around 15.
Additionally, if you examine the records, the same stocks that make these
relatively different reactions in one setback will make about the same
moves, relative to each other, in other setbacks. Furthermore, the same ones
that make only moderate corrections on declines will make only moderate
advances on rises. The ones that go down sharply on setbacks will also
skyrocket in a Bullish Market. This has nothing to do with the phenomenon
we discussed earlier, by which we saw that cheap stocks move faster than
expensive stocks. This is due to the habits of particular stocks, and these
habits seem to be quite stable over periods of many years.
We will find, for instance, volatile and speculative issues that make larger
percentage swings than most other stocks at their price level. On the other
hand, we will find a stock, selling for much less, that has smaller percentage
swings than most stocks at its price level. This fact may be obscured, as the
comparatively low-priced stock may actually make larger swings than the
higher priced. It is only when we have taken the price level into account
that we can see the individual habit of the stock. Knowing this, we can
project that habit to other price levels.
We are not too interested, as we have said before, in stocks that do not
ordinarily make substantial moves. We are very much interested in those
that make the wider moves. We can compute the basic swing power of a
stock, which we call the Sensitivity Index, and will outline the method for
doing this in Appendix A, ninth edition. (EN: The procedure Magee speaks
of here, of computing a “Sensitivity Index,” may be regarded as the
historical predecessor of what are now called “betas.” The beta of a stock
compares its relative volatility with that of the market as a whole, so if the
beta of the market is 1.00 and the beta of the stock in question is 1.50, a
move of 1.00 in the market will probably be matched by a move of 1.50 in
the higher beta stock. The formula for beta will be found in Appendix B,
Resources, and calculated betas at finance.yahoo.com.)
Therefore, you will have eliminated from your list stocks at the wrong price
level and stocks without enough swing power (for you want to chart only
those stocks in which you can trade profitably). Of the ones left, you will
eliminate others and find that some stocks, which make wide price moves
and apparently offer large opportunities for profit, may be very “thin.” The
charts will be spotty, filled with gaps, days of “no sale,” and moves of
several points on only a few hundred shares of business. These stocks are
thin because of a small issue, because of ownership of a large block of
shares by some corporation or by insiders, or for other reasons. They are
difficult to trade in because they are hard to buy and hard to sell; you stand
to lose heavily on the “spread” between bid and offer. It might be hard to
liquidate even 500 shares without driving the price down badly, to your
loss, and sometimes you will see changes of 1 or 2 full points between sales
of single hundreds. These you will want to eliminate, and if you do not
know the habits before you choose your portfolio, you will probably find it
worthwhile to drop any stocks that prove too thin, substituting new and
more dependable choices.
After you have culled the list from all these angles you will find you have
left a choice of a number of stocks, all of them selling in a price range that
is attractive, all of them sufficiently active and responsive to market trends,
and all of them available in sufficient supply to provide a good trading
medium. The final choice of any one (or several) of these stocks is then a
matter of personal preference.
After you pick out your stocks from one group, study the other groups—the
motors group, the amusements, the computers (EN: the internets) and so
forth, until you have finally made up your selection of stocks to follow. Try
to get as complete and balanced a representation of groups as the number of
your charts will allow. (EN: In this context, the process described here is
made infinitely simpler by available software and by the proliferation of
group indexes, ETFs, and indicators. In fact, if the investor desires, rather
than trading an individual stock in an industry group, he may often choose
to trade the average or index itself and cushion his risks. This will almost
never be as profitable as a well-chosen individual issue but will always be
better than a badly chosen individual issue. And ETFs never go broke (so
far).)
In this connection, if you are not planning to represent all groups, there are
some groups more likely to provide good trading stocks than others. Foods
and tobaccos, for example, are generally less responsive to market swings
than the rails, liquors, and airlines, which are very responsive. Do not worry
too much, however, about exactly which stocks to choose for even if you
took the first 50 or 100 stocks in the listed issues, you would have among
them at least 25 good trading stocks. You can start with almost any list, and,
as time goes on, you will drop some and add others, improving your
portfolio and tailoring it to your own needs.
(EN: As additional commentary here it is worth noting that “techs,”
“biotechs” (or whatever the mania of the moment is—probably space hotels
and intergalactic travel in this millennium) will present areas of risk and
reward sufficient to excite the seventeenth-century tulip trader. The centered
investor and trader will consider vogues and manias as he chooses his
active portfolio and choose to participate (or not) depending on his appetite
for risk and excitement. Or, as the popular maxim has it, one man's
champagne is another man's poison. This question is pursued in greater
detail in Chapter 23.)
By way of further simplification, the investor may choose to follow only one
or two issues— Standard & Poor's Depositary Receipts (SPY) or
DIAMONDS™ (DIA). If it were not only bought, but also sold or hedged,
the market would be outperformed. This would be a simple investor's life
indeed.
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter twenty-three
Choosing and managing high-risk stocks: tulip
stocks, Internet sector, and speculative frenzies
Nothing could more vividly illustrate the timeless nature of chart patterns
and situations than the internet stocks that bloomed at the turn of the
century. These stocks repeated that eternal pattern—the Tulipomania, the
Gold Rush, the can't-fail-opportunity-to-get-rich-quick. (For illustrations in
this chapter, see Figures 23.1 through 23.17.)
It is almost impossible to resist comparing the speculative frenzy that took
place in the internet and technology issues to the famous seventeenth-
century mania that Holland experienced in the famous Tulipomania. In
MacKay's undying classic account (Extraordinary Popular Delusions and
the Madness of Crowds), the trading of tulip bulbs replaced sober
commerce and business as the occupation of the country, and enormous
fortunes were made trading the tubers. Blocks of real estate, breweries,
assets of real and large value were traded for one tulip bulb. MacKay
produced my favorite paragraph in the literature of finance: “A golden bait
hung temptingly out before the people, and one after the other, they rushed
to tulip-marts, like flies around a honey pot. Every one imagined that the
passion for tulips would last forever, and that the wealthy from every part of
the world would send to Holland, and pay whatever prices were asked for
them.”
That mania ended in ruin. A better long-term prospect may be in store for
the internet, as there is a basis of technology and economic substance to the
sector. You could not, after all, use your tulip to check the market for prices.
In fact, there were those, admittedly a small number, who struck it rich in
the California Gold Rush of 1849. It is an ill wind, etc.
As an exercise in rueful perspective, the seventh edition of this book
remarked, in the words of Richard McDermott,
Companies like Lotus or Microsoft went public and grew into business
giants in a short period of time... A significant theme stock for the 1990s has
been Internet stocks. Names like America Online, CompuServe, and
Netscape have provided important products and services that allow
individuals to “surf the net” for information around the world.
Young students of the market will search in vain for Lotus, CompuServe,
and Netscape in the lists of stock symbols. The giant Lotus was swallowed
by IBM, in part because Microsoft, a ruthless competitor, disemboweled it.
CompuServe and Netscape disappeared into the belly of a larger fish, AOL,
with some of the same factors involved. Later Microsoft got its
comeuppance—halving in value as the U.S. Justice Department brought
successful antitrust action against it.
There are those who fault the great Wall Street investment banks for having
brought half-baked potatoes (or unblooming tulips) to market. The Street
firms, cashing in on the mania, were willing to sell the public every
immature profitless idea and company named

Figure 23.1 Multitudinous lessons in Microsoft. However, short-lived joy.
The top rounds over, price makes another attempt, and then the momentum
is clearly, if puzzlingly, down. The cancellation of the runaway day in
January definitely marked this move as a bull trap, and the short-term
trendline from October would also have taken the trader out of the trap. Use
of the Basing Points technique (see Chapter 28) would also have allowed
escape from the trap. Failed signals, as this one, often are excellent signals
for a trade in the other direction.
“dot.com Inc.” that venture capitalists floated on a sea of seed money.
Mining engineers will recognize the phenomenon of “salting the mine.” It
was the finest moment for the great old firms of the Street since the
investment trusts of the 1920s. The reader is most recommended to look
into The Great Crash, 1929 by John Kenneth Galbraith to compare the
Street firms' behavior from one mania to the next. It will be found most
edifying. At the pinnacle of great manias, no one can be trusted.
Managing tulipomanias and Internet frenzies and.. .Bitcoin
In a time of excess, the centered investor maintains his composure and
focus. Probably easier said than done. Nonetheless, many investors and
traders profited from the internet boom or were not severely damaged.
Many managers and traders watched with envy from the sidelines, and with
schadenfreude when the bubble burst.
For technical analysts speculating and trading according to the principles of
this book, important opportunities arise in speculative frenzies and buying
panics—namely, important profits may be made by remaining calm and
methodical while the uninformed and naive cause speculative blow-offs,
which have some things in common with the ends of great bull trends in
substantive issues.
The question becomes that of realizing some of the profits to be made in
these exciting times. Of course, the first thing to do is not get excited. These
manias come and go— sometimes they are called biotechs, sometimes
computers, sometimes internets, and probably, at some point, human
genome miracle drugs or Martian real estate. It should be emphasized these
profits are made on both sides, long and short. The crowd will only
Figure 23.2 MSFT monthly. It is easy to lose perspective when looking at a
daily chart of a bull trap in which one has lost a leg. A monthly long-term
look at Microsoft can help restore perspective. Unfortunately, the Dow-
Jones Company was looking at this chart, not the nearby, when they added
Microsoft to the Dow 30 in 2000. Expert timing? At the time, the John
Magee Newsletter observed it was a negative indicator of a major top in the
Industrials.
think of the riches to be made long. Professionals and skilled technicians,
professional or not, will take the profits on the short side.
Here is the most important concept in trading these runaway issues: all of
the techniques and methods described in this book remain valid for dealing
with these kinds of stocks. In addition, here are some other points that
should be taken into consideration. The best way to control risk in the
Bitcoin market is by trading a position so small (like a roulette bet) that a
100% loss will cause no distress or discomfort. The sector in question, tech-
tech, web-tech, biotech, internet, space travel, whatever, will be a market
unto itself, and special technical factors will apply to it. The phases of
market lives, accumulation, attraction, markup, mania, and blow-off will
occur in compressed time spans—much shorter than the cyclical life of an
issue with fundamental data to attach it to reality (see Figure 23.4 of Palm
Computing).
By the time the IPO occurs, the insiders are already prepared to begin the
distribution phase. For example, when Palm Computing was spun off from
3Com in 2000, only 3% of the shares were sold—creating an artificial
scarcity and propelling it to absurd heights—Palm attained an instant
market value greater than that of 3Com, which owned most of its stock.
(EN9: We have, since The Fall, learned of “laddering.” To let their inside
clients in on the IPO, some of the underwriters required the clients to buy
more of the stock in the open market after the IPO at higher prices. A clever
way to throw gasoline on a raging bonfire. Whether Palm was laddered or
not is not known.)
Figure 23.3 The editor learns a lesson. Never leave a chart unanalyzed,
even if the implications are obvious. Also, never be afraid to belabor the
obvious. Obviously, this figure should have had a longterm trendline drawn
on it. No monumental bull market should be ignored. Why give the market
its money back? It should have been obvious from this figure that the
Microsoft party was over and not just the fat lady but the entire chorus was
beating on anvils. Plus, the protective line must be drawn. Here the broken
line at A is the most important and saves a bit of capital rather than waiting
for the plaintive signal at C. Given the robust Bull Market in Microsoft, the
long-term investor might have been justified in waiting until the C trendline
was broken. A matter of investing style and philosophy. There appears to be
some long-term support at 18. The five-year sideways market appears to be
resolving itself into a macro triangle that might break out one way or the
other in 2005. This is a case in which an investor might make a fundamental
analysis to guide his position (always confirming with the chart analysis).
Microsoft is beset with howling wolves on all sides. Linux, Unix, sales of
only one copy of Windows in China, hackers playing hob with security
holes in its software. Can it rise again? Only the chart knows for sure, and it
is silent at this recording. In 2011, MSFT was in an 11-year sidewave.
These issues must be traded with the utmost care and attention. For
example, it is the height of foolishness to enter a market order to buy on the
issue of the IPO. An issue going public at 12 might trade on the opening at
50 in these frenzies—a sign to the savvy technician the sheep are headed for
the shearing shed.
Certain factors must be kept in mind. Some IPOs collapse shortly after
going public. Others rocket off before distribution is complete. So stops
must be carefully computed. Once it is clear the rocket is taking off, as
indicated by price and volume, some discreet pyramiding might be possible
for the experienced and skilled speculator.
Detailed techniques for management of the runaway issues
The technique described in Chapter 28 for tight progressive stops is
certainly one way of dealing with these stocks. There, the method for
finding Basing Points and raising stops based on the three-days-away rule is
detailed. Also, especially in the case of these rocket stocks, the practice of
raising stops based on new percentage highs should be
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Created with MetaStock www.equis.com
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Figure 23.4 PALM. Fool's gold. Fool's gold with naivete writ large on it.
Here is a spike reversal day on the initial day of trading. The accumulation,
markup, and most of the distribution occurred behind closed doors before
this trick was perpetrated. After the matanza, the continuation takes on
Figure 23.5 Dealers palmed all the missing capital in PALM? Somebody
made the money disappear up a shirtsleeve. What makes you think the deck
was stacked? Or that the initial public offering (IPO) was laddered? Maybe
it was just fools chasing tulips. Those investors (gamblers) playing the shell
game with PALM found themselves playing with six shells instead of three
as like an insidious amoeba PALM divided into two tulips, PLMO and
PSRC. Keep your eye on the magician closely. For the analyst, all the
smoke and mirrors could not hide the fact gravity took PALM in all its
manifestations down. The downtrend lines are broken in 2003 and 2004 and
a respectable Kilroy Bottom is made. Nevertheless, the implications of the
bottom may have already been carried out. A continuing story for
speculators or astute (very astute) investors who know something
fundamental and have very long-term vision.
Figure 23.6 PSRC in its amoeba-like glory. The failure of what might have
been a rounding bottom, especially with the breakdown gap in October and
the failure to rally back to the neckline left no doubt as to the fate of PALM
by any other symbol. Broken trendlines are also indicative. Remember that
any large pattern can be broken down into smaller patterns susceptible to
short trendline analysis, as in this case. Sooner or later a palm-size
computer, PDA, widget device is going to be the wave of the future. (EN10:
A visionary prediction of the iPhone.) The canny investor will not mistake
the company for the stock and will also not venture capital until there is a
better chart story.
implemented. Since these are “game” situations, and irrational, one may
employ tactics he might not ordinarily use with his serious capital—some
light pyramiding and some scaling out of the position based on continuous
new highs. Additionally, in the blow-off phase when close monitoring is
necessary, one might want to exit on a long reversal day, or on a key
reversal pattern, and then go to the beach; or, if from Texas, one might want
to short the issue.
Essentially, I view these stocks as interesting aberrations in the early part of
their lives. So I would not look for long-term investment-type trades. Take
the money and run. In all likelihood, these stocks will explode like
fireworks and then expire. There will be the companies like Microsoft and
—it remains to be seen—Yahoo!. After the fireworks show, the patient
technician may return to the scene of the crime to see whether there are any
burning embers. Once they have blown off, crashed, and made reasonable
bottoms, then one begins to look for investment possibilities, which there
definitely will be. There is too much potential in the technology of the
internet—and biotech and the human genome—for some phoenix not to rise
from the ashes.
In the beginning it behooves the trader to regard them as speculative
instruments of exceptional risk and opportunity.
Several caveats are in order:
• The prudent speculator does not commit too much of his capital to such
enterprises. Probably no more than 5%-10%.
3com Corporation-(Nasdaq NM) 3.71 0.10 2.77%
Apr Jul Oct 97 Apr Jul Oct 98 Apr Jul Oct99 Apr Jul Oct 00 AprJul Oct 01
Apr Jul Oct
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Figure 23.7 COMS. Underwriters cleverly doled out only 3% of 3Com-
owned Palm stock onto the market at the IPO. Palm wound up “worth”
more than 3Com for a short time. Here the lesson of tulipomania is vivid.
The contrast in before and after volume. The necessity of analysis to deal
with tulips in bloom. The fatal lesson of heeding (or not heeding) gaps
across horizontal trendlines. Impossible to manage for the buy-and-hold
investor.
• When selling them short, one should not be early. A definite top should be
seen because there might be a second stage of the rocket.
• Emotional involvement with tulips and internet stocks—or stocks of any
kind actually—can lead to a broken heart. In the charts, note the success in
a number of cases of trading the key reversal day.
(EN9: Reviewing charts from the apocalypse is a sobering experience. So
many rash and mad adventures. So much capital sucked into the black hole
of underwriters and 21-year-old huckster CEO wallets. Better than the
South Seas Bubble. And, as definite proof that man is directly descended
from geese and sees no farther ahead than the next feeding bowl, the ghost
of the mania oozes from the closet in 2005, reborn as Google mania. Man
(or goose if you will) never learns. That is why he is so much fun to watch.)
Google—what a creature is man! What a game is the market! Google, a
wonderful company, and a great concept goes public in 2004 after world-
class hype (world class? intergalactic class!). Floated as a red herring at
135, it eventually goes IPO at 85 in an innovative public offering. Then the
fun starts. Future readers of this book may observe the markup made as of
the date of this writing (November 2004) and judge whether the method
worked. A company on roller blades, impossible to dislike as a company.
Remember, unless you are Warren Buffet, you are buying the stock, not the
company.
45
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Figure 23.8 ORCL. True to the character of stocks during the Tulipomania,
Oracle was difficult to handle without careful analysis. Stock splits
preceded a number of the sell-offs (note gaps post splits). Bullish gaps are
also frequent here, and the tulip top is obvious, and was at the time. An
excellent trading vehicle though a wreck for the casual investor.
Hope springs eternal and there is one born every second
One might have thought the age of the tulip was over as we moved into the
second decade of the new millennium—but what naivete! Not over at all.
Investors rushed into the LinkedIn and Groupon IPOs and stood quivering
on the sideline begging for Facebook to go public. But Facebook, the
ultimate practitioner of chutzpah, satisfied itself by feeding on the venture
capital community, demanding ever higher valuations from venture
capitalists desperate to own a sliver of the deal at whatever cost. The public
will have to wait to be shorn. But have faith, it will be. Remember Palm.
You can buy these things, but you have to remain glued to the screen and
the ride will be rough. Unless you have your professional speculator's
license and have lost money on these deals before, watch the snake pit from
the sidelines—and do not buy any snake oil.
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Figure 23.9 INKT. The pleasures and delights (and disappointments) of
internet stocks. The last trendline, in conjunction with the second horizontal
trendline, clearly marks the end of the party (AND WILL FOR ANY
STOCK WHATSOEVER). The break of the long-term trendline is the last
exit signal, as if the previous signals were not clear enough. Is it not
obvious that this issue was (and is) manageable with technical analysis?
Figure 23.10 EMULEX (ELX). The message of 2000, a severe drubbing,
and precipitous at that, would have been lost on the non-technician. Those
who continued to ride the roller coaster relearned a lesson some technicians
know—stocks often repeat the same behavior (or misbehavior). The lesson
of monster breakaway gaps (or air gaps) may have needed relearning also.
Oh well, after such a gap the damage is done, the unenlightened investor
says, only to see the damage continue down to 10 (from 110!). These are
signals of such magnitude that disaster awaits the trader who denies its
significance. The air gap here nicely complements those of Figures 12.9 and
37.43.
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Figure 23.11 Amazon weekly. Amazing Amazon dances in the internet
follies. The breathtaking plunges are the direct result of the breathtaking
speculative excess. See the daily chart (Figure 23.12) for a closer look at the
details of the blow-off.
AMZN (Amazon.com, Inc.)
Figure 23.12 Amazon daily. In cases of speculative blow-off, trendlines are
of little use. A dozing trader (presumably it was obvious this was not an
investment issue) would have been mauled in the plunge. An alert trader,
knowing that in blow-offs the procedure is to sell strength, might have
avoided it. Other techniques include recognition of the second exhaustion
gap and exit. Also, a trader using the techniques described in Chapter 28,
setting progressively tight stops, might have avoided the fall.
Figure 23.13 The wild frontier of the internet and of the gunslinger
speculators (gamblers?). Amazon bucks on. Give us a slug of rotgut
whiskey and get out the ruler. A clear top for the rational analyst with clear
broken trendlines and broken horizontal lines and then a clear Bear Market
with a clear bottom resembling a Kilroy Bottom and then a clear breakout
and another Bull Market and then another downtrend. Talk about your
fearless bull riders down at the rodeo. But this Bull-Bear is ridable with a
little technical analysis. Without technical analysis it is like being the target
in a shooting gallery—a sitting duck.
Figure 23.14 CISCO (CSCO). Although the first long-term trendline
beautifully intercepts the downtrend in progress at a gap (a coincidence of
indicators that occurs too often to be a coincidence), the trendlines drawn
later are of such strength that even the novice analyst should know how to
exit. In fact, one of my students, an employee of Cisco, did just that, saving
himself thousands of paper dollars in this very case.
Created with TradeStation 2000i by Omega Research '.s'-1999
Figure 23.15 Is there any way the trader (investors keep away) could avoid
stepping off this cliff? Extreme paranoia is one way. Another way is by
being acutely conscious of the pattern of behavior manifested by Cisco in
Figure 23.14.
Figure 23.16 You thought all the tulips and Bulls had been exhausted in the
Tulipomania in 2000? Silly you. There is an inexhaustible supply. All you
need is a company and a story and an underwriter to peddle it. Sometimes
there are even earnings. Sometimes the earnings are even real. Sometimes
the earnings are skating uphill on roller blades. Then sometimes the
characters are so appealing that you are almost willing to buy the IPO at
face value, but not if you are a cynic, as are all technical analysts. Google
was rumored at $200 or more on the IPO. The editor offered to sell all of it
at that price and throw in the Brooklyn Bridge for free. This offer (well,
there may have been other factors also) knocked the IPO down to $85 (still
an errant speculation), but only insane, not unreasonable. The
oversubscription in an innovative offering revealed that the tulip virus was
not dead, but very much alive and infecting not just the same old suspects,
but many new ones. We love a horse race, and this is a great one. Notice the
obvious defensive lines and support and resistance. How long Google can
defy gravity (a galactic price-earnings ratio) remains to be seen. Prudent
gamblers will have a stop identified. On this chart, for the long-term
gambler, it might be in the 182 area. For the more agile gambler, it might be
failure of the support around 204, or closing of the breakaway gap there. No
opprobrium is attached to the term gambler. In fact, bolder investors
(competent readers of this book) should take a flyer from time to time with
about 5% of their capital. This is the flyer that should have been taken. The
breakaway gaps in October and April, operating against disbelief, were
signals of enormous technical strength. And Google went to 475! The
lesson here, which must be learned and relearned and ... ad infinitum ... is
this: trust the chart. Ignore the story. In 2008, GOOG went to 700, halved in
the Bush Bear Market, recovered to 600, and entered a two-year sidewave.
Figure 23.17 Google, 2011. Google turned out to be the real thing and had
a herd of cash cows that produced and produced and produced. Mother's
milk? Or America's love affair with advertising? Whatever, the reader can
see the simple-minded management of the issue with trendlines. Using
trendlines would have avoided bungee-like equity, which is never pleasant.
Basing Points might have been used the same way with the same effect.
GOOG has essentially been in a large sidewave (very large) since 2010. The
exit from this sidewave should have dramatic consequences—up or down.
chapter twenty-four
The probable moves of your stocks
At first glance, all stocks appear to move helter-skelter without rhyme or
reason, all over the lot. All stocks go up at times, and all go down at times
—and not always at the same time. We already have seen in these rises and
falls stocks do follow trends, make various typical patterns, and behave in a
not completely disorderly manner. (For illustrations in this chapter, see
Figures 24.1 and 24.2.)
It is also true that each stock has its own habits and characteristics, which
are more or less stable from year to year. Certain stocks normally respond
to a Bullish Phase of the market with a very large upsurge, whereas others,
perhaps in the same price class, will make only moderate moves. You will
find that the same stocks that make wide upward swings are also the ones
that make large declines in Bear Markets, whereas the ones that make less
spectacular up-moves are more resistant to downside breaks in the market.
There are stocks that ordinarily move many, many times faster than others.
We do not know, for example, whether a year from now Glenn Martin (EN:
read, Microsoft, eBay) will be moving up or down, but we do know, and it
is one of the most dependable things we know, whichever way it is going, it
will be covering ground much faster than American Telephone and
Telegraph. (EN9: Even T accelerated into hyperspace after its unfortunate
divestment of local Bells. And, unlike the leopard, completely changed its
spots.) These differences of habit, of course, are due to the size of issue,
floating supply, nature of business, and leverage in the capital structure,
matters we have touched on briefly before. As a matter of fact, we are not
especially concerned with why the differences exist. We are interested
mainly in what the differences are, and how we can determine them.
This is important: stocks that habitually move in a narrow range, although
excellent for investment purposes in cases in which stability and income
(dividends) are the chief desiderata, are not good trading stocks. A fairly
high degree of sensitivity (EN: volatility), with wide percentage moves, is
necessary to make possible profitable commitments that will cover costs
and leave a net gain. To be in a position to make a profit, you should see the
probability of at least a 15% move in your stock.
How then are you going to tell which stocks are most sensitive and
potentially most profitable?
By examining the record of a certain stock for a number of years back, and
comparing the percentage moves it has made with the percentage moves of
the market as a whole, you can obtain a fair picture of that stock's habits.
You will not be able to say, at any particular moment, “This stock is now
going to move up 25%,” but you can say, with a good deal of confidence,
“If the market as a whole makes an advance of 10%, this stock will
probably advance about 25%.” Or, conversely, “If the market goes down
10%, this stock will very likely go down at least 25%.” (EN10: The concept
of beta.)
Many methods have been used for measuring and checking these
percentage-move habits, differing only in detail. (EN10: With the ready
availability of desktop and internet software, the investor may call up a
two- or five-year chart and see the potential range of the stock at hand.)
Indexes on several hundred important stocks listed on the New York Stock
Exchange have been computed by the authors and are presented in
Appendix A, ninth edition.
44

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Figure 24.1 Some stocks move faster than others. We have already noticed
that low-priced stocks have much larger percentage moves than high-priced
issues. Yet, even between two stocks that may, at a particular time, be
selling at the same price, there are enormous differences in their habits.
Furthermore, these habits change very little from year to year.
Here we have a weekly chart of Corn Products Refining Company (left),
covering an 18-month period in the years 1945 and 1946. We also have a
chart of Schenley Distillers (right) for the same period. The average price
between the high and low on these charts is about 64 1/2, the same for both
stocks.
However, during this period, we see “CFG” moving between a low of 58
1/2 and a high of 71, a range of 12 1/2 points, while at the same time, “SH”
has moved between 28 1/2 and 100, a range of 71 1/2. A thousand dollars
put into an outright purchase of “CFG” at its extreme low would have
grown to $1,210 at its extreme high, whereas the same amount used for
outright purchase of “SH” at its low would have grown to $3,510. Your gain
of $2,510 in “SH” would be more than 10 times the gain of $210 in “CFG,”
and this without using margin.
It is not likely you would actually purchase either stock at the extreme low,
nor sell at the extreme high. The point we are bringing out here is there are
enormous differences in the swing habits of stocks.
(EN10: Magee's concept of “sensitivity” appears to combine some aspects
of our modern concept of beta and modern computation of volatility. The
replacement for Magee's Sensitivity Index is readily available at
finance.yahoo.com and http://www.abg-analytics.com as well as any
number of other sites findable by Google.)
Individual stocks have their characteristic habits, as do some entire
industries. In general, the food stocks, of which “CFG” is one, are stable
and slow-moving. On the other hand, liquor stocks make wide moves on
any general advance or decline of the market. At this time “CFG” had a
Sensitivity Index (EN9: or beta equivalent) of 0.58, whereas Schenley's was
2.05.
(EN: Current-day betas or volatilities may be compared with these and/or
substituted for them in other computations suggested in this book, for
example, in Composite Leverage formulas. The reader
CUBAN - AMERICANSUGAR CSU
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Figure 24.2 Another example of the difference in swings between stocks. In
this case also, the stocks show the same average price between the high and
low of the period, and both stocks are plotted for the same 18 months in
1945 and 1946. Although in a lower price range and even though the
disparity in their Sensitivity Indexes is less, there is a considerable
difference in their actions. Cuban-American Sugar (left), a food stock,
shows a range of 76% from its low of 16 1/2 to its high of 29, whereas
Electric Boat (right), a shipbuilding concern, advances more than 140%.
may read in the following text “beta” for “Sensitivity Index” and avoid the
annoyance of excessive notation by the editor.)
The Indexes are relative. They show stocks with a high Sensitivity Index
(EN: beta) will move much faster in either Bull Markets or Bear Markets
than stocks with low Indexes, and about how much faster, relative to the
other stocks.
(EN: As is obvious to the experienced reader, and new to the inexperienced,
Magee's method predates the modern compilation of betas and volatilities.
Beta measures the systematic risk of a stock, or for those who are not into
financial industry jargon, the sensitivity of a stock to the market. Volatility
measures the dispersion of returns in the stock itself. Thus, if the market
moves 1 point, a stock with beta of 1.5 will move 1.5 points. A stock with a
beta of 0.5 will move 0.5 points, approximately or more or less. Not
surprisingly, high beta stocks are volatile. For readers who like to roll their
own, I offer here the formula for computing the beta of a stock, which is
somewhat more sophisticated than Magee's method:
((N)(Sum of XY)) - ((Sum of X)(Sum of Y))
where
N = the number of observations,
X = rate of return for the S&P 500 Index,
Y = rate of return for stock or fund.
The general investor may not be avidly interested in this calculation,
especially when the beta is readily available at Value Line and
finance.yahoo.com and is published regularly by Merrill Lynch. Betas litter
the internet, found by searching Google; seekingalpha.com has lists; and
finance.yahoo. com displays the stock beta in “Key Statistics” for each
stock covered.
Of equal or greater importance is the individual risk of a stock that
professionals like to determine by computing its volatility. Somewhat akin to
Magee's “normal range for price,” volatility measures the variability of a
stock's returns (price movement). The general investor should be informed
the study of volatility is an extremely sophisticated subject, and
professionals expend enormous resources dealing with the question.
Numerous methods are used to derive volatilities, but these mainly come
into play in options arbitrage and professional trading on exchange floors.
For the private investor, it is sufficient to know of the dangers of this arcane
area. Before venturing into “volatility plays,” the newcomer should take a
postgraduate course. For the general investor who wants to know enough
to calculate his own volatilities (not recommended or necessary), I note the
formula here:
To calculate volatility, first find the difference between each return and the
average. Then square each difference and add them together. Divide the
sum by the number of returns minus one. This result is known as the
variance. Finally, take the square root of the variance to get the volatility.
Combining these steps into a formula:
^(Ri -|i)2
• Step 1: Calculate the average return.
• Step 2: Calculate the deviation of each return.
• Step 3: Square each period's deviation.
• Step 4: Add them together.
• Step 5: Divide the sum by the number of periods - 1. This is the
variance.
• Step 6: Take the square root.
The less punctilious (or more practical) investor may find volatilities at ht
tp://www . optionstrategist.com, ht tp: // www .cboe.com, and
finance.yahoo.com, as well as other locations that can be located by
searching on Google.)
chapter twenty-five
Two touchy questions
This chapter is directed largely to the new trader, to the investor who has
followed other analytical methods, and to the investor type who is now, for
the first time, taking up the technical trading of stocks for the shorter term.
The use of margin
The first question here is the use of margin. There are many people who,
knowing of the disastrous margin calls of 1929 and the staggering way
losses can be multiplied against one in a margined account during a sharp
break in the market, take the attitude that the use of margin is intrinsically
bad, dangerous, foolish, and unsound. They will tell you they are willing to
risk their own money, but they never speculate on borrowed funds. They
will tell you that by buying securities outright, they are safe against any
kind of break in the market.
There is something to this line of argument, although very often you will
find the arguer has not really thought the case through all the way. If he had,
he might realize that, in buying outright stocks that are sensitive or highly
leveraged, he is accomplishing almost exactly the same thing as someone
else who buys more conservative stocks on a margin basis. Very often,
despite his feeling that outright purchase is more conservative than margin
buying, he is a speculator at heart. He is not really interested in dividends
and a stable investment. Rather, he is looking for “something with
appreciation opportunity.” Considering he is not facing the issue squarely,
he may fall into expensive errors.
To be thoroughly consistent here, a man who shuns the risks inherent in
margin trading should shun the risks of leverage and volatility. He should
avoid risk, forget “opportunity for appreciation,” and confine himself to
sound, income-producing stocks of a sort that will not fluctuate widely.
If we are looking for stability, we do not want excessive fluctuation and
there are securities that provide stability. In this work, however, we are
looking for “swing power.” We want the highest degree of fluctuation we
can handle safely. We can secure this by buying outright a stock that is
normally subject to fairly broad swings—that is, a stock with a high
Sensitivity Index (EN: beta). We can get the same effect by trading in a
stock of more conservative habits but increasing the Composite Leverage
(EN: or simply leverage) by using margin. (The method of computing and
comparing Composite Leverages in various situations is covered in
Appendix A, ninth edition and may be studied in Chapter 42.)
Let us assume, for example, we will buy 100 shares of a rather speculative
stock, which we will call UVW, on an outright basis. It has a Sensitivity
Index of 1.50, and now sells (let us say) at 20. At the same time, we buy a
somewhat less speculative stock, XYZ, also selling at 20; but in this case,
we buy on 70% margin, putting up only three-quarters of the value of the
stock. In a general advance affecting both of these stocks, the probabilities
would favor a somewhat greater percentage move in UVW than in XYZ. If
such a general rise should bring UVW to 30, we might expect XYZ to rise
to a lesser degree, say to 28. Now the advance of 10 points on the $2,000
invested in outright purchase of UVW will represent a gain of $1,000 or
50%. The advance of XYZ to 28 on the $1,400 invested at 70% margin will
mean a gain of $800 or 57%. In other words, we have, by the use of margin,
increased the effective leverage of XYZ; we have made it, in fact, slightly
more speculative than UVW.
The effect of margin use is simply to accentuate or increase the sensitivity
of a situation. It is a mechanism for assuming more risks and, therefore,
more opportunities for faster gains. Assuming you are willing to assume
risk (as you must be if you intend to make speculative commitments), it is
simply a matter of knowing approximately what risks you are taking and
whether you can afford to take them. The danger in margin lies in cases in
which the customer grossly overextends himself, taking on a risk far
beyond his ability to protect himself. This will not happen if he sets a
reasonable limit to his total leverage (EN: put another way, his portfolio
risk).
The margin transaction is simply a matter of buying (or selling short) more
stock than you have money to pay for in full. The purchase of a home on a
mortgage is essentially a margin transaction. The financing of business
operations, using borrowed money for part of the capital, is the same. The
buying of anything for which the purchaser puts up part of the capital and
borrows the rest, using the value of the purchased property as security for
the loan, is exactly similar to the trading of stocks on margin. In each case,
any change in the value of the property will cause a larger net change in the
value of the margin capital. Thus, if a man buys a home for $100,000,
paying $50,000 cash, and later sells it for $150,000 (an increase of 50% in
the value of his property), he will benefit to the extent of $50,000 profit, or
100% on his invested capital.
The question of margin calls, being “wiped out” on margin transactions,
will seldom, if ever, come up if you protect yourself properly by
maintaining stops at all times or by closing out the transaction when it has
violated certain predetermined danger points. Needless to say, if you have
allowed a trade to go so bad it reaches the minimum margin maintenance
range, the best thing is to take your loss and forget it; not try to meet the
margin call. Yet again—this need not ever happen.
As we will see in discussions of sensitivity and leverage, stop levels, and so
on, there are certain limits that can be fairly well defined, beyond which
you cannot safely venture. If you could buy stock on a 10% margin, as you
could at one time, you might have visions of highballing $1,000 up to $1
million in one Bull Market; that is not a reasonable hope and it is not safe to
risk your capital on a 10% margin because, in many cases, your perfectly
logical purchase would sag enough to wipe you out entirely before going
ahead to the normal advance you expected. (EN: In a nutshell, the risk of
trading commodities and futures.) In judging how much margin you can or
should use within the limits of margin trading laid down by law, you must
take into account the method of trading you are using, the amount of
adverse fluctuation you must expect in the normal operation of your
method, and the nature of the stock you are dealing with, that is, its
Sensitivity Index and Normal Range-for-Price (EN: at the risk of being
repetitive, beta and volatility), at the time you make the original
commitment.
Short selling
The other touchy question is that of short sales. A majority of traders avoid
the short side of the market. Six out of seven investors you meet, who have
bought or sold stocks, will tell you they would never sell a stock short under
any conditions, at any time. In fact, short selling is limited, very largely, to
skilled professionals. (EN: The private investor, because of his fears and
prejudices, voluntarily grants this “edge” or advantage to professionals.
Magee dealt with this subject at length in Winning the Mental Game on
Wall Street, which I wholeheartedly recommend to the reader. EN9: The
widespread proliferation of hedge funds in the new century attests to the
frustration of professional managers with mutual fund rules requiring them
to maintain only long positions. Even with this development, short selling
by the general investor remains a limited technique—to the disadvantage of
the nonprofessional.)
Now, if you have studied long-term charts (weekly and monthly), and the
daily charts in this book, you will recognize several facts about the action of
markets. Most stocks go up most of the time. There are almost always more
advances than declines in the list of the most active stocks published each
day. Stocks, in general, advance about two-thirds of the time, and go down
only about one-third of the time. (EN9: Probably a truth over the long term,
but in the modern context, ample short opportunities exist.)
Furthermore, most of the news releases, rumors, and comments in the press
related to stocks and corporate affairs have to do with the brighter side of
industry. It is only natural that executives, public relations people, and the
reporters themselves should be interested in forward-looking developments,
new processes, expansion of facilities, increased earnings, and the like, and
that such items should prove more newsworthy than less optimistic reports.
These various factors may explain why “the public” is always Bullish. The
public is always hoping and expecting stocks to go up all the time. If stocks
are rising and in a Bullish Phase, the public expects them to still go higher.
If stocks have declined sharply, the public will argue they are now better
buys than before and must surely go up soon. It is up, up, UP, always up, in
the mind of the public.
Yet, examination of the long-term charts covering the action of the
Averages over many years will show you that, through these long periods,
the levels rise and fall about the same amount. This being the case, it must
follow that stocks come down as far as they go up and because they go up
about two-thirds of the time, they must come down much faster than they
go up. This you will find is true. The angles of decline in the Averages and
also in individual stocks are usually steeper in Bear Market Moves than the
advances are in Bull Market Moves. A corollary to that is that profits can be
made faster on the downside of the market than on the upside.
Such profits are made by selling short. It is important if you are a trader to
understand the meaning of a short sale. When you sell a stock short, you
borrow that stock from someone who owns it, and then you turn around and
sell it to someone else, agreeing with the original owner to replace his
shares at some unspecified time in the future. All of the details of this
transaction is handled by your broker. Shares of most stocks of large
outstanding issue are available for loan at all times in the hands of brokers,
and your broker has access to them. The mechanics of this borrowing and
sale are interesting; you may wish to get from your broker the whole story
of how these operations are carried out. For all practical purposes, however,
all you need to do is tell your broker what you wish to sell and leave the rest
to him.
He will advise you if, by any chance, the stock you have selected for short
sale is not available for loan. Another practical point, although of minor
consequence, is that a slight additional tax is assessed against short sales.
(EN: In that gains on short sales are not eligible for long-term capital gains
tax.)
It is important also, if you are a trader, to accept opportunities to sell short
as readily as you go long stock. Unfortunately, there are psychological
barriers to short selling. There are, for example, the unintelligent and
entirely irrelevant slogans about “selling America short.” There is the
feeling on the part of many who are poorly informed that short selling is the
somewhat unethical trick of the manipulator. Others have the impression
that, in selling short, one is hoping to profit by the misfortunes of others at
times of disaster and Panic. It is not the purpose of this book to persuade
anyone to sell stocks short, any more than it is our purpose to advise anyone
who should not to speculate on the long side of the market. Nevertheless, so
many questions are constantly raised, even by fairly sophisticated investors,
about the ethics, as well as the practical procedure of short selling, that we
may perhaps be pardoned for saying a few more words in its defense.
All of the popular ideas about short selling mentioned in the preceding
paragraph may be branded as so much nonsense. There is nothing more
reprehensible about selling short than buying long. Each is a speculation in
relative values. The truth is money is a commodity, just as much as a share
of stock. There is no moral or practical difference between borrowing
money to buy stock because you believe the latter will go up in value in
terms of the former and borrowing stock to “buy” money because you
believe the latter is going to go up in value in terms of the former. In each
case, you are obligated eventually to repay the loan whether it be money or
stock. In each case, you are taking a risk on the basis of your considered
forecast as to the future trend of relative values.
There are, in fact, many common business practices that are more or less
analogous to selling stocks short. For example, every time the publisher of a
magazine accepts cash in advance for a subscription, he is making
something like a short sale. His ultimate profit or loss will depend on what
the magazines he will eventually supply have cost him by the time the
subscription runs out.
When you sell stocks short, you (or rather your broker) receive the proceeds
of the sale at once but you are obligated to turn back an equal number of the
same shares at some future date to the man from whom the stock
certificates were borrowed. (EN: One of the advantages or edges that
professionals enjoy over private investors is the credit of short sales to their
accounts and the payment of interest thereon. Although the proceeds are
credited to the private investor, no interest is generally paid on it, unless the
investor has influence with the broker. A favorable situation is created,
however, if a short sale of $100,000 were made on, say, 50% margin, a
credit of $150,000 would be made to his account, and no interest would be
charged. Any dividends the trader paid on the transaction would be
expensable.) Consequently, sooner or later, you have to go into the market
again and buy those shares. When you buy them, you (or rather your
broker) return the shares to the original lender, thus discharging your
obligation. If the cost of your purchase was less than the proceeds of the
earlier sale, the difference is your profit. If it costs you more to buy in the
shares—or as it is termed, cover your short—the difference represents a
loss. You do not enter into a short-side transaction unless you expect the
price of the stock to go down; hence, showing you a profit.
One of the little-appreciated results of a large volume of short selling is
actually to strengthen the market. Every short seller is a potential buyer.
Most short sellers are glad to cover and take their profits on a relatively
Minor Decline. Consequently, if there is a big short interest at any given
time in a particular issue, it means there are many people waiting to buy
that stock when it goes down. This situation tends to “cushion” bad breaks.
Some astute operators will actually buy a stock when they learn there is a
very large short interest in it, meaning a great many shares of it have been
sold short and not yet covered, because they realize competition among the
short sellers to buy the stock whenever it has a small decline may result in a
very fast and profitable Short-Covering Rally. Any stock is stronger,
technically, if there is a good-size short interest in it.
There is one further objection raised against short selling. It will be pointed
out when you buy stock that your loss, if worse comes to worst, can be no
more than the total amount you paid for it. In the case of a short sale, the
price of your stock could, theoretically, rise against you to $50.00, $100,
$1,000, $10,000 a share; in other words, it could rise without limit. This
argument sounds much more alarming than it really is. Certainly there is no
occasion to lose sleep over it. Stocks do not go up without limit all of a
sudden. It is just
as easy to set a stop on the loss you are willing to take on a short-side
transaction as it is on a long purchase. Such situations as the famous 1901
corner in Northern Pacific are not likely ever to occur again under present
regulations. (EN: The famous “short squeeze.” Short squeezes still occur
but are extremely rare in big liquid issues. A famous short squeeze occurred
in the silver markets of the 1980s when the Hunt brothers trapped Exchange
members and almost bankrupted them. The members, being in control,
retaliated by quintupling margin requirements and bankrupted the Hunts.)
The authors realize nothing said, and probably no amount of cold-blooded
analysis on the part of the reader himself, will remove entirely the
trepidation that most nonprofessional traders experience when they sell
short. The mental hazards will always be slightly greater than in buying
long. Nevertheless, from every practical angle, a short sale is exactly the
same thing (although in a reverse direction) as a long purchase, with no
greater risk, with actually somewhat greater chance of quick profit, and
differing only in details of execution.
A commitment in commodity futures contracts, whether long or short,
although quite different in theory, has some similarities to a short sale of
stock. In making a contract, no actual sale takes place, and no loan of either
cash or the commodity is involved. Such a contract is simply a binding
legal agreement to accept delivery or to deliver a certain commodity at a
certain price at a certain time. In this respect, it is different from a short sale
of stock. It is also different in that it must be closed out on or before a
definite date. Although, the purchase or sale of a commodity contract is
similar to a stock short sale in that (1) it is necessarily a margin transaction,
and (2) it creates an “open” or incomplete transaction that eventually must
be liquidated.
A short sale of stock must always and necessarily be a margin transaction.
Thus, if you buy 100 shares of stock outright at 20, it can sink to 15 and you
cannot be called for more margin. You have lost $500, but the stock is still
yours. If you sell, you get back $1,500, disregarding commissions. On the
other hand, if you sell a stock short at 20, putting up a margin of 100%, and
the stock rises to 25, you will also have lost $500. The broker, under certain
conditions, such as the 100% margin requirements in effect at one time,
might call on you for $500 additional margin. Or, if the transaction were to
be closed out at that point, you would receive back $1,500 less
commissions, the same as in the long transaction. In the case of this short
sale, had the price dropped to 15, your profit would have been $500.
On short-term moves, the effect of short selling is exactly the same as the
buying of long stock, but in the opposite direction. You simply apply the
same methods here in reverse, during a Bear Market, that you would use in
a Bull Market. As we have already seen, the various technical indications
that point to upward moves in a Bullish Phase have their counterparts in
downside signals during a Bearish Phase.
Execution of short sales cannot be made at any time and at any price you
wish. A short sale must be made in a rising market. You are not permitted to
sell a stock short on the New York Stock Exchange during a market break
when each regular sale is at a lower price than the one before it (EN9: the
uptick rule). However, this need not bother you much because, ordinarily,
you would make such a sale on the rally as it reached your price, and this
would naturally fill the requirement of a rising market. Your broker can give
you, in detail, the special rules and regulations that apply to short sales. It
will pay for you to study these so you can place your orders correctly when
the proper time comes to make such sales. (EN9: At the AMEX, short sales
on ETFs and some HOLDRS are exempt from the uptick rule as are futures
contracts on the futures exchanges. EN10: In 2007, the uptick rule was
removed in an ill-considered bow by the Securities and Exchange
Commission to large speculative interests. The reader may judge for himself
whether subsequent markets have been more volatile on the downside. It is
our observation that the loss of this rule results in accelerating slides in fast
downside markets. Since 2009, there has been wide debate about
reinstatement of the uptick rule, so far to no avail.
In the current context, short selling has been institutionalized. The public
may buy ETFs, which take the short side of almost any instrument, as, for
instance, QID for the Qs is a short bet, as is DOG for the DIAMONDS™
(DIA). There are even leveraged [two times, three times] ETFs [long and
short].)
chapter twenty-six
Round lots or odd lots?
(EN: Or, put another way, size?)
One of the minor tactical questions bound to plague you is whether to trade
in round lots of 100 shares or odd lots (less than 100 shares in active
stocks).
(EN: In Internet-age markets, this question has virtually lost its relevancy.
In Magee's time, there was a distinct disadvantage to trading odd lots, and
one traded odd lots only if hampered by limited capital. Now that an
investor can achieve full diversification in an odd lot position by buying
odd lots of Standard & Poor's Depositary Receipts (SPYs) and
DIAMONDs™ (DIA), there seems little point in discussing it. There is, of
course, always the question of broker commission—if the broker has a fixed
commission rate, regardless of the size of the trade, then the small investor
gets nicked. It would seem this follows the old adage that the rich get richer.
Nevertheless, now the small investor can strike back by finding a broker
who does not charge commissions. At first I thought commission-free
brokers were making up their profit on volume; in fact, there are other ways
to make a profit on trades than charging a commission—for example,
directing the execution of the orders to a trader who needs “order flow.”
In the Internet age, the question of what size a trade or investment should
be is different from the question that confronted traders of, as it were,
ancient times. Now, it is not so much a matter of cost disadvantage in
trading odd lots as it is a much deeper question—that of risk and portfolio
management. So how does the aware investor determine the size of any
individual trade?
I am indebted to a longtime friend, colleague, broker, and fellow trader,
William Scott, for articulating the common-sense procedure here for
calculating trade size and controlling risk.
First, we determine the percentage of our capital we want to risk on any
given trade. Among many professional traders of our acquaintance, this
figure is often 2% or 3%. For the sake of illustration, using round numbers,
if we have $100,000 capital this means we will be risking $3,000 on a trade.
Let us say we are going to buy a $20.00 stock and defend our position with
a stop-loss order $5.00 away. Our formula for computing position size is as
follows:
3,000/5 = n number of shares (600 shares)
If we were going to accept a $10.00 risk, our trade size would be 3,000/10
= 300 shares. Thus, we adjust our trade size to fit our risk parameters.
This is a simple, practical, and elegant way to implement risk control at the
individual trade level.
Trade size is, without doubt, one of the most crucial factors in success for
the general investor. Ignorance, or denial, of its importance is a major
reason for the failure of many traders. In short, overtrading. Other
perspectives on risk and trade size are found in Chapter 42 and in Appendix
B, where the Leverage Space Model is explained.)
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter twenty-seven
Stop orders
We are going to take up two kinds of stop orders, or, rather, two entirely
different uses of the mechanism of stop orders.
First, let us look at the protective stop order. At best, it is not a happy
subject. Stop orders of this type are like fire extinguishers; the occasions
when they are put into operation are not times of rejoicing. Stop orders are
used for emergency rescue when things get so bad there seems no
reasonable hope for a situation.
Wherever you set your protective stop, it is likely to be touched off at what
seems to be the worst possible moment. You will set it at a safe distance
under a certain bottom; the stock will break through, catch your stop, and
then proceed to build a new bottom at this level for the next rise, or to rally
at once and make new highs. No matter, you had your reasons for setting
the stop. The stock did not act the way it should have. The situation is not
working out according to Hoyle and certainly not the way you hoped it
would. Better to be out of it, even at a loss, rather than face a period of
uncertainty and worry. If the stock has started to act badly, you cannot tell
how much worse it is going to behave. If you fail to set a stop, you may go
on day after day hoping for a rally that never comes while your stock sinks
lower and lower until, eventually, you find (as millions have found) that
what started to be a small reaction, and an annoying but trivial loss, has
turned out to be a ruinous catastrophe. Stop orders cannot always be placed;
in certain cases in active stocks, the exchanges may even restrict the use of
stop orders.
The question is where and when to set the stop, realizing there is no perfect
and absolutely satisfactory rule. If the stop is too close, you will take
unnecessary losses; you will lose your holdings of stocks that eventually
forge ahead and complete the profitable rise you hoped for. If stops are too
wide (too far away), you will take larger losses than necessary in those
cases in which your stock definitely has broken out of pattern.
Now, it will be obvious, as the setting of stop orders depends on the price of
the stock and its habits. You would not place your stop level at the same
percentage distance under a Bottom in a conservative, high-priced stock
when it is selling at 80 that you would to protect a speculative issue at a
time when it is selling at 8.
The higher priced stocks, as we have already seen, make smaller percentage
moves. Conversely, the lower-priced stocks make wider percentage moves.
Therefore, the lower-priced stocks should have more leeway for their
gyrations. We will need a wider stop for them than we will for the less
volatile “blue chips.”
Similarly, we can take our Sensitivity Indexes (EN: betas in considering a
stock relative to the market, and volatilities for absolute measure of one
stock against another) to give us a picture of the individual habits of the
stock. Although two stocks may be selling at the same price at a given
moment, you would expect a high-beta, high-volatility stock to make wider
swings than a low-beta, low-volatility stock; therefore, you will set your
stops wider on the higher volatility stock.
We must take these factors into account and work out some sort of simple
rule of thumb to follow. Let us arbitrarily assume an imaginary stock of
“average” habits and a price of 25 and further assume we will be satisfied,
in this particular case, with stop protection 5% below the last established
Minor Bottom.
For a stock of the same sensitivity selling at 5, we would need about half
again as much stop leeway (on a percentage basis). That is, the stop would
be placed 7.5% below the last Bottom (EN9: significant low).
(EN10: Here Magee gave an account of how, using his Sensitivity Index and
his normal range for price, he computed stop positions. The process is too
convoluted for modern investors—and unnecessary because Magee boiled
the procedure down to a table I have modernized below. The Procedure is
intact in the eighth and ninth editions for the scholarly (or obsessed)
investor or academic.)
For most ordinary purposes, a simplified table of stop distances will be
sufficient. Table 27.1 gives you the approximate stop distance you would
get by the method outlined above, for stocks in various price classifications
and of various degrees of sensitivity (volatility).
(EN10: Magee originally constructed this table based on his Sensitivity
Index. The informed reader may consider an alternative to Magee's
Sensitivity Index, which I have conjectured here for the modern context—
that is, basing the stop distance on volatility, which would present a
dynamic method of adjustment.)
The stop level should be marked on your chart as a horizontal line as soon
as an actual or theoretical transaction has been entered into, and it should be
maintained until the transaction is closed, or until progressive stops (which
we will explain in a moment) have been started to close it out. In the case of
purchases, the stop level ordinarily will be at the indicated distance below
the last previous Minor Bottom. In the case of short sales, it ordinarily
would be at the indicated distance above the last Minor Top.
To determine the position of this stop level, simply figure what the
percentage distance would amount to at the price of the stock. If you are
dealing with a stock selling at 30 and the stop distance comes out 10%, then
allow 3 points under your last Minor Bottom.
In no case would we ever set a protective stop level at less than a 5%
interval, even for the most conservative, high-priced stocks.
These questions remain: What constitutes a Minor Bottom? What makes an
established Minor Top? How do we know how to choose the Basing Point
(EN9: see Chapter 28) from which to measure off our stop level interval?
The constitution of a Bottom or a Top (EN10: wave high, wave low) will be
taken up in the next chapter. For the present, let us accept the proposition
we will determine the correct Basing Point and will always, always set our
stop level at the moment we make the commitment.
Table 27.1 Table of stop distances (expressed in percent of the price of the
stock)
Price Conservative
sensitivity
Median
sensitivity
Speculative
sensitivity
Volatility
under 0.40
Volatility
0.41-0.79
Volatility
over 0.79
Over
100 5% 5% 5%
40-1005% 5% 6%
20-40 5% 5% 8%
10-20 5% 6% 10%
5-10 5%a 7% 12%
Under 55%a 10% 15%
a Ordinarily, stocks in these price ranges would not be in the conservative
group.
It is understood protective stops under long stock are never moved down,
nor are protective stops over shorts ever moved up. As soon as the stock has
moved in the right direction far enough to establish a new Basing Point, the
stop level is moved up (on longs) or down (on shorts), using the same rules
for determining the new stop level as were used in fixing the original level.
The progressive stop
There is another use of a stop that is properly considered here. This is the
progressive stop, which is used to close out a stock that has made a
profitable move, or in some cases, where a stock has given a danger signal
before either completing a profitable move or violating a previous Minor
Bottom.
You will find on many moves, the stock will progress in the primary
direction for several days and then may develop exceptional volume. Often,
this occurs just as the stock reaches an important trendline or pattern border
or Resistance Area. This heavy volume means one of two things: usually,
that the Minor Move has come to an end, being this is the top of the rise for
the moment; occasionally, the volume may signal the start of a breakaway
move that may run up several (and perhaps many) points, almost vertically.
(The reverse situation may develop on downside moves.)
If, noticing the heavy volume following a good rise, and assuming this day
marks the end of the move, you sell the stock at the market or at a limit, you
are going to be dreadfully disappointed if this should be one of those rare
cases in which the stock opens the next day on an upside gap and continues
3, 5, or 20 points up in the following days. On the other hand, experience
will have shown you it will not pay to expect that sort of move very often.
You will know that, 9 times out of 10, you will be better off out of the
stock.
After such a day when volume is exceptionally high (provided this is not
the first day of breakout into new high ground beyond the last previous
Minor Top), cancel your protective stop and set a stop order, for the day
only, just 1/8 (0.125) point under the closing price. For example, you have
bought a stock at 21; it goes up on moderate volume, smashes through the
old Minor Top one day at 23 on very heavy volume, the next day continues
to 23 3/4 on moderate volume, the third day advances on moderate volume
to 24 1/4, and, finally, the fourth day makes a rise to 25 on much heavier
volume than it has shown on any day of the rise except the day it broke
through 23. The morning after this close at 25, you will notice the volume
signal. You will cancel your protective stop, which may be at 18, and you
will place a stop order, for the day only, to sell on stop at 24 7/8. In most
cases, this will mean your stock will be stopped out on the first sale of the
day. Plus, you may get a slightly lower price than you would get with a
straight market order. On the other hand, after a day of high volume
activity, you are not likely to be left in a thin market; there should be bids
enough, near the top, to get you out at or near your stop price.
Meanwhile, you are protected against losing the stock if there should be a
continued move in the right direction. Suppose the opening the morning
after you set your stop at 24 7/8 should be a gap at 25 1/4, and that prices
then move up further, closing at 26. (On “runaway” moves of this sort, the
closing for the day during the move is likely to be at the top.) You will then
set your stop, again for a single day only, at 25 7/8. If the stock then opens
at 26 3/8 and moves up to 28, you will set another day stop at 27 7/8,
which, let us assume, is caught at the opening the following day at 27 5/8.
In this example, you risked only 1/8 point on the first day, and eventually
netted an extra gain of 2 5/8 points. This, it should be pointed out, is all net
gain because your commissions are approximately the same in either case.
A progressive stop of this sort can be indicated on the chart by any mark
you choose to use—for example, a band of short diagonal lines. When a
stock moves for several days in a runaway move, you may repeat this mark
each day, indicating a tight stop 1/8 point under the close for each
successive day, until finally, one of these stops is caught. In the case of
short sales, a buy stop is used in precisely the same way as the selling stop,
by following the stock down on a sharp runaway dive.
This use of tight progressive stop orders is indicated wherever a stock has
reached its reasonable objective on high volume, or where it has exceeded
its objective and is moving out of the Trend Channel in free air, so to speak,
and in some cases, where the stock has failed to reach its objective.
If your stock, for instance, is rising in a Trend Channel, and, about halfway
between the lower and upper trendlines, suddenly develops great volume,
then a progressive tight stop will protect you against the threatened failure
of the move. Extreme volume in such a case, before there has been a
breakout to a new high above the last Minor High, is definitely a warning
and a threat. This would be especially true if there were also a gap or a One-
Day Reversal at this point.
The one day on which a tight stop would not be applied after heavy volume
had appeared would be the day the stock made a new high, running entirely
through the previous Minor Top and closing above it. This action generally
means the move is not yet completed. Should the move continue higher and
again show heavy volume, even if it is the very next day, we would then
protect with a progressive stop.
In this chapter, as throughout the book, the expression “heavy volume”
means heavy only with respect to the recent volume of sale in the stock you
are watching. A thousand shares may be significantly heavy volume in
some thin issues, whereas 10,000 shares would be no more than a normal
turnover in more actively traded stocks. The volume chart itself will show,
by a market peak, when a day of abnormally heavy volume occurs.
It should be understood the progressive stops we have been discussing are
intended to take short-term gains, or to close out an exceptionally profitable
runaway move terminating in an Intermediate Climax. Although the
extreme conditions that call for this type of operation are by no means rare,
they are not the usual, everyday action of the market. In the case of ordinary
Minor Tops, even when they are fairly apparent on the basis of Trend
Channels, volume peak, and other indications, many traders and investors
will prefer to wait out the expected reaction rather than pay additional
commissions and lose a position that is still presumably in a favorable
Major Trend.
In short, the progressive stop is a device that may be very useful on
occasion, but it is intended to cope with a special and somewhat unusual
move.
The protective stops, on the other hand, offer the average trader, the man
who is not able to spend his entire time studying the market, or who has not
had long experience, a device by which he can limit his possible loss. He
will be protected from his own reluctance to close out the bad holding, and
he will avoid the ruinous condition of becoming frozen into a hopeless
situation. Since he will be taken out automatically, regardless of whether he
has an ultimate gain or loss, he will have the capital to use in better-looking
issues and will not have to worry about the prospects of recovery in his
stock after it has gone many points against him.
If one has sufficient knowledge and sufficient determination to get out as
soon as the trend has shown convincing evidence on a turn, there is less
need for the stop orders. (EN: This editor believes that only the proven
trader-investor should trade without a stop in the market. The reader may
determine whether he meets this criterion by examining his portfolio to see
whether he has ever let a loss run or allowed a significant profit to slip
away. If so he, or she, or they, or it, is not proven.) It is possible for such a
person to operate successfully without them; and there are some advantages
in doing this because a stop order will occasionally be caught by a false
move or an extended dull reaction. There are also advantages in not using
stop orders for the experienced technician who is looking toward a possible
long-term gain and who is willing to wait out a Secondary Reaction. Yet it
is a thousand times better for the person who is not sure of his methods to
be stopped out early, than to be left holding a stock bought at, say 60, when
it has declined to 29—or to 5!
Stop systems and methods
The two most important concepts in investing and trading are trends and
stops. Being right, the trend immeasurably diminishes risk and increases
our probability of profit. However, without skillful setting of stops, all our
work and study can easily result in nothing as the markets dodge and
weave, deceive, and throw off false signals. If our analysis has not resulted
in skillful stop setting, we will be no better off than that unfortunate fellow
who is acting on a tip from his brother-in-law—or his bootblack.
Consequently, let us first attack this question from the viewpoint of the
trend-following investor and deal with trading stops thereafter. In Magee's
systems for the trend follower, there are two basic stop methods. One is
based on trendlines (sloped and horizontal), and the other is rooted in
Basing Points. Chart patterns interact with these two methods. This entire
book treats the former at length in too many chapters to mention here. The
second, Basing Points, is discussed exhaustively in Chapter 28.
The breaking of trendlines is always significant. Magee tested the validity
of the break by requiring that prices penetrate the line by 2%-3%. This may
not be perfect, but it serves for the majority of situations. The longer the
trendline the more important the break, as illustrated in the market breaks of
2008 and 2011 (a trendline of more than 700 days). The downwaves
(crashes?) resulting from these trendline breaks were recognized and
commented on at the time at http://www/edwards-magee.com. Figure 5.1
illustrates the serendipitous convergence of all three methods combining to
exit longs and short the market in 2008. Trendline analysis, pattern analysis,
and Basing Points analysis by their very nature are complementary and lead
to similar conclusions, as, for example, in August 2011 when the long-term
trendline from March 2009 was broken, a Head-and-Shoulders Top was
identified, and the Basing Point stops were taken out.
Therefore, we have three ways of setting stops in extended trends—
trendlines, patterns, and Basing Points. Are there other stop methods for
trend following? Indeed. A multitude. A plethora. A cornucopia. An excess.
First, let us remark on the crucial question of stop setting in trends.
Stops set too close to the market result in the trader losing his position. The
stop must be set to give the market room to move against his position, thus
(crocodile tears) apparently surrendering precious profits. As the market
advances in waves (truism)—wave up, wave down—stops must be, as in
the Basing Points Procedure, set sufficiently below wave-low points to
avoid being exercised. In an interview in Market Wizards, Jack Schwager
asked a major trader, Bruce Kovner, where he set his stops. “Where they're
hard to get to,” replied Kovner.
This is the principle at work in Basing Point stops. Knowing that locals and
market mischief-makers probe for stops at wave lows and support zones,
the stop is set with a filter, thus some distance below the wave low (or wave
high). This stop is hard to access.
The same thing is true if using a moving average. Magee used a 2% or 3%
stop for trendlines and a stop of this type is probably good for a moving
average, too. At the same time, if volatility and excitement are running
high, the trader must adjust the size of his filter. In a rising market tracked
with a moving average, the trailing stop would be moving every day the
dotted line moved up. Naturally, with a filter that might be enlarged if
market volatility became excessive.
A brief survey of stop methods
Here we are going to deal primarily in exit stops. (EN: My book Signals
[available on Amazon's Kindle platform] analyzes at length methods for
entering trades and trends.) Many traders use stops to enter positions, but
that is not our interest at this moment. We want to know how to protect our
initial entry and how to advance our stops so as to lock in our profits when
the trade has gone our direction. The initial stop may be set as with Basing
Points (as described in Chapter 28), or it may be set above or below a
Support-Resistance zone, or as a percentage (William O'Neil says a stop
should be set 8% below the entry), or even as a percentage of capital—for
example, 2% risk per trade—a $2,000 stop ($100,000 capital) is a common
money management system.
If the market moves against our trade, the protective stop limits the loss. If
the market moves with us and begins to accumulate profits for us, we have
a different, and happy, problem. It is only a matter of time until the market
throws us a downwave to test our mettle—or to dislodge us altogether. We
are trend followers, so we buy strength and sell weakness, but our
antagonists are contrarians—they do the opposite. Thus, after a reasonable
upwave, contrarians will be taking profits and driving prices down. Swing
traders will be doing the same thing. We want to stick to the trend until it
changes, even taking these “corrective” waves against our position. Basing
Point stops will do this, and the inevitable result is fluctuation in equity.
Long experience has shown that fleeing from downwaves and exiting
invariably results in smaller long-range profits. Accepting downwaves and
fluctuations in profit leads to greater long-range profits. Look at the tables
of Dow and Basing Points performance. It is not unusual to see downwaves
of 10%-30% without a change of trend occurring. We have seen how we
can stop these trends with trend analysis and Basing Points analysis—and
there are other philosophies and other methods.
Some other stop methods
Average True Range
Average True Range (ATR) is an interesting concept and tool. It is a
measure of volatility, in actuality, and tracking it gives us some interesting
information. True Range is defined as the largest of the following:
Today's high minus today's low.
Today's high minus yesterday's close.
Today's low minus yesterday's close.
ATR is the average of True Range over some defined period. Twenty days is
a not uncommon parameter, as is 14. Five days is very sensitive, which has
advantages and disadvantages.
ATR may be used to set stops. For example, we might set our initial
protective stop 2 (or x) ATRs below our entry. We might set our trailing
profit protection stop in the same way: x ATRs below the recent high—or
the low of the recent high.
Stops set this close are typical of trading situations. There is at least one
practitioner of my knowledge (Eric Crittenden,
http://www.blackstarfunds.com) who judges if prices take out the stop 10
ATRs below the most recent high, the trend has changed. This is sometimes
called a Chandelier Exit. This kind of concept can be examined using
trendlines and reversal formations. ATR is a natural way of measuring
market volatility and it rhythmically adjusts to market behavior. This makes
a system more flexible than fixed percentages or fixed dollar amounts. An
interesting paper on Crittenden's method is found at http://www.
trendfollowing.com/whitepaper/Does_trendfollowing_work_on_stocks.pdf.
Feature this, relevant to my point, that the market must be given room to
work: Crittenden found that a 10-ATR filter averaged a space of 27%. So
what we have here is an inherent stop system that posits a 27% reversal to
indicate a change of trend.
Parabolic stop and reverse
Welles Wilder's (1978) parabolic stop and reverse (SAR) technique uses an
“acceleration factor.” Consequently, the stop rises parabolically, which has
its strengths and weaknesses as the reader can imagine. Chuck LeBeau has
conjectured a Modified Parabolic Exit, which tweaks the acceleration factor
at http://lcchong.files.wordpress.com/2011/05/precise-exits-entries-
manual.pdf. This presentation includes other interesting comments on stop
methods.
Target stops
I am not a great proponent of target stops, but many traders analyze a
formation or market situation and compute a possible target and exit the
market when their target is reached. Other target criteria may be used—a
dollar or point amount, or as in Bill Scott's method, five days down causes
liquidation of half the position, six days the other half.
Similar to the target method, the trailing stop is raised when x% of profits
are achieved and raised again as prices advance. An old Japanese saying has
it as follows: “Sell half at 8 new prices, half again at 10 new prices, and the
rest at 12 new prices.”
Of a similar nature, some traders will close the trade when an extreme move
occurs in their direction.
A natural method used by the Turtles
The Turtles used the breakdown from a 10-day channel to exit their long
trades. This can be modified to as little as three days, in which case the
trader would set a very tight stop based on the three-day low if a market
were running away. Such a situation might also be managed with Magee's
tight progressive stops—raising the stop each day to just under the low of
the day to be in effect for the next day.
In the end, as the reader can see, there are as many stop methods as there
are traders. For our purposes, the more natural and less algorithmic the
method, the better—so it comes back down to trendlines, formations, and
Basing Points, which can be tweaked to the individual taste.
If there is a truism about the markets it is this: a trader without stops will
soon be a trader without capital.
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter twenty-eight
What is a Bottom and what is a Top?
(EN9: In this extremely important chapter, I have left intact Magee's usage
of “Tops and Bottoms.” It will be less potentially confusing for the reader
to think of “highs and lows” as that terminology is commonly used in the
business in the modern era. Also, thinking in terms of highs and lows is an
important concept in itself. Thus, for a Bull trend, higher highs, higher
lows. When this pattern is broken in an important way, the trader should be
alert for a trend change. Also, as the use of eighths is of the essence in
Figure 28.1, I have left the discussion in eighths, although the reader knows
decimals are now used in the markets.)
In this chapter, we are not talking about what makes a Major Top or Bottom
or what makes an Intermediate Top or Bottom. We are speaking of the
Minor Tops and Bottoms that give us important hooks on which to hang our
technical operations. Stop-order levels, trendlines, objectives, and Supports
and Resistances are determined by these Minor Tops and Bottoms. They are
of prime importance to us as traders. (For illustrations in this chapter, see
Figures 28.1 through 28.4.)
Usually, these Minor Tops and Bottoms are well marked and perfectly clear,
though often they are not. Sometimes, it is not possible to say definitely that
this or that place is or is not a Top or Bottom, but it is possible to set certain
standards and practical working rules that will help us in making these
points, and these rules will not fail us too often.
A good rule for setting stop levels is to consider a Bottom has been made
when the stock has moved “three days away” from the day marking the
suspected low of the Bottom. If a stock reacts for some days and finally
makes a low at 24, with a high for that day at 25, then we will not have an
established Bottom until we have had three days in which the stock sells at
no lower than 25 1/8. The entire price range for three full days must be
entirely above the top price for the day making the low. This is the three-
days-away rule, and it would apply in reverse in declining markets, in
which the range for three days must be entirely below the entire range of
the day making the high.
This gives a rule for setting an original stop order. It also gives a rule for
changing the stop order. As soon as the stock has moved three days away
from a new Bottom, we move the stop order to a position below that
Bottom. (We have already explained in Chapter 27 how we determine the
distance this stop level should be below the Bottom.)
Protective stops for long stocks can move only up. A stop level, once
established, is never to be moved down except when the stock goes ex-
dividend or ex-rights; then, the stop may be dropped the amount of the
dividend or rights. Similarly, protective stops for short sales are to be
moved only down and may not be raised. (In the case of ex-dividends and
ex-rights, the short-sale stop would be dropped the amount of the dividend
or rights.)
There are certain situations in which it is difficult to determine Bottoms and
Tops; where, indeed, it seems as though a Consolidation or Correction had
been made without any significant move in the Secondary Direction. In
such cases (as contrasted to the obvious situation in which the stock moves
up or down in series of well-marked steps and reactions, like a staircase),
you will need all your judgment and experience to determine the point at
which the Minor Basing Points actually occur.
17
16
15
14
JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER
7 14 21 28 4 11 18 25 1'8 15 22 29 6 13 20 29 3 :10 17:24' 1 8 15 22 29 5 ’
Figure 28.1 Advance of a protective stop order in a long commitment. The
daily chart of American Cable and Radio in the summer of 1945 made a
Rounded Bottom, part of a long period of Consolidation following the
advance that ended in July 1944. A breakout on heavy volume occurred
September 12, and purchases were then possible on any Minor Reactions.
13
12
11
10
Sales
100's
250
200
150
100
50

The first protective stop would immediately be placed 6% below the
previous Minor Bottom of August 21, using Table 27.1 in Chapter 27. This
would put the stop level at 9 7/8. On September 19 and 20, we would have
two days of market action entirely “away” from the September 17 Minor
Bottom, and, on September 28, a third day. We would then move the stop
up to 6% under the September 17 Bottom, or to 10 5/8. The next move
would come after the new high closing of October 11, which is more than
3% higher than the October 1 Minor Peak. The stop would now be placed at
11 7/8. On November 2, a new high close was registered more than 3% over
the October 15 Minor Peak; the stop would be raised to 12 3/4. On
November 15, another high closing topped by more than 3% the Minor
Peak made on November 7. The stop would be moved up again, this time to
13 1/2. November 29 made the third day the entire range was “three days
away” from the November 26 Bottom, and the stop was upped to 13 3/4.
The closing on December 5 gave us a 3% advance over the November 17
high, and again we moved the stop, raising it to 14 7/8. Finally, on January
3, 1946, this stop was caught as shown on the chart. In a Bear Market,
protective stops would be moved down in exactly the same manner to
protect a short sale. (EN9: A number of inconsistencies exist in this figure
and caption that are clarified later in the text.)
Basing Points
Let us call the levels that determine where stops should be placed Basing
Points. In a Bull Market Move, we will consider the Bottom of each Minor
Reaction as a Basing Point, from which we will figure our stop-order level
as soon as the stock has moved up to “three days away.” We will also use
each Minor Top as a Basing Point in a Bull Move. In a Bear Market, we
will consider the Tops of each rally and also each Minor Bottom as Basing
Points for the protective stops in the same way.
Where a stock makes a substantial move in the Primary Direction, say a
move of 15% or more, and then moves back at least 40% of the distance
covered from the previous Basing Point to the end of the Primary Move,
that surely gives us a Basing Point as soon as the stock again starts off in
the Primary Direction. If the stock reacts less than 40%, however, perhaps
even marks time at the same level for a week or more, that should also be
considered a Basing Point as soon as the move in the Primary Direction is
continued (provided the volume indications are right).
The daily volume, as we have seen, is like the trained nurse's clinical
thermometer; it tells a great deal about what is happening in a stock, more
than the superficial symptoms of price alone. There are three times at which
you may look for exceptionally heavy volume: (1) on the day of breakout
from a pattern or a period of inaction, especially if the breakout is on the
upside; (2) on the day on which the stock goes into new ground in the
Primary or Intermediate Direction, that is, goes above the last Minor Top in
a Bull Market or below the last Minor Bottom in a Bear Market; and (3) on
the day on which the Minor Move is completed or nearly completed, that is,
the new Minor Top in a Bull Market and the Minor Bottom in a Bear
Market. To this we might add that extra heavy volume on any other day
during a move in the Primary Direction is likely to indicate the move is at
an end and will not complete the hoped-for advance or decline.
Now, after a Minor Top has occurred, the stock now being in new high
ground, and the Top having been made on very heavy volume, we may look
for the corrective move. Ordinarily, that would be a decline of several days,
a week, sometimes longer. Occasionally, the correction, as we said a few
paragraphs back, will take the form of a horizontal hesitation lasting a week
or more without any particular corrective move in the downward direction.
Where there is a downward correction, it is likely to come down to or near
the Top of the last previous Minor High (support). Also, and often at the
same time, the corrective move will carry down to the Basic Trendline
drawn through two or more previous Minor Bottoms; or to the “parallel”; or
to a trendline drawn through the last two or more previous Minor Tops. If
the corrective move is horizontal, it is likely to run out until it meets one of
these lines.
In any case, the thing to watch for is the decline of volume. If the trading
shrinks, perhaps irregularly, but on the whole, steadily, for some days after a
new Top has been made, during which time the stock either reacts or, at any
rate, makes no progress in the Primary Direction, then you are justified in
considering this as a Minor Correction. If the stock now continues the
Primary Move and gets to a point that is “three days away,” you can
consider the Bottom (i.e., the point you draw your trendline through, not
necessarily the extreme low point in the case of horizontal moves) as a new
Basing Point.
Where a stock is starting what appears to be a new move or a breakout from
a period of vacillating moves, it is sometimes hard to say precisely what
point should be considered the Bottom. There may be several small and
indecisive moves on low volume preceding the real breakout. In such a
case, we would consider the appearance of high volume as the breakout
signal and set our Basing Point at the low point immediately preceding this
signal. There usually will be such a point on one of the low-volume days in
the three or four days just before the breakout.
All that has been said about Basing Points in a Bull Market would also be
true, in reverse, in a Bear Market, except that heavy volume does not
always accompany a downside breakout.
Now comes the difficult and distressing situation in which the stock, having
made a long runaway move (let us assume it is an upward move), starts out
to make a Flag; is bought after a sufficient correction of 40% with a decline
of volume; and then continues to go down steadily, without any rallies and
without any clear volume indications. This is an unusual situation, but it
does happen on both the upside and the downside, from time to time. In the
case we have just mentioned, we would look for Support Levels
(Consolidation Patterns, Multiple Tops, and so on) formed on the way down
in the previous trend and lying below the level at which we purchased the
stock. We would use these supports as Basing Points rather than hold a stop
under the extreme Bottom of the vertical move.
In many cases of this type, you will not be able to find adequate Basing
Points. Therefore, it seems unwise to try to get in on corrections after long
runaway moves except in the following cases: (1) the stock has risen well
above good Support that can serve as a Basing Point, or (2) the stock is
completely above all prices for several years and is moving “in the clear.”
(And the reverse: in Bear Markets, the stock should have fallen below a
strong Resistance Area or must be in new low ground for the past several
months before you consider a short sale.) In any case of this sort in which
you are thinking of a trade in a stock that appears to be making a
Consolidation after a fast, long, vertical move, you must have pronounced
and conspicuous drying up of volume throughout the formation of the Flag
or Pennant Correction.
There is one more word of caution needed here regarding trading in an
Intermediate Trend. A series of moves in a trend will often take place in
very regular form. There may be a good trendline, and the reactions may be
about 40%-50% and may come back to the previous Minor Tops. The
volume on the Corrections may shrink with increasing volume on the new
Tops. It is easy to start trading on such a “staircase” in the expectation the
moves will continue to be regular and consistent, but trends do not go on
forever. Any Minor Top may be the last. The importance of finding your
Basing Points is to enable you to get out, at best, on any closing violation of
one of these points, and at worst, on your protective stop order. The volume
may again come to your aid in this question of when to stop trading on a
trend. Although you look for high volume on the Tops, you will be
exceedingly suspicious of volume that is much higher than on any of the
preceding Minor Tops (or Bottoms in a Bear Market). The final, or the next-
to-final, “blow-off” of a trend usually will show more volume than any of
the Minor blow-offs along the way. When you see such climactic volume,
you should prepare to retire into your shell and wait for a full Correction of
the entire series of moves making up your Intermediate Trend. Later, weeks
later, or perhaps months later, you may find the stock has corrected 40% or
more of the whole Intermediate Move and is resting quietly with very little
activity. Then is the time to watch it for new opportunities and a new trend
in the Primary Direction.
(EN9: In a book composed of nothing but important chapters, this Chapter
28 might not get the emphasis it deserves from the unwary reader. In fact,
the procedure outlined here is of absolutely basic importance in analyzing
and trading trends. I have added to this chapter material that has been of
great importance to my trading and to the trading of my students.)
Basing Points: a case analyzed
The longer one thinks about the chart so casually tossed off in Figure 28.1,
the more he realizes it embodies a profound and natural understanding of
trends and the market. Consider—wave up, wave recedes, wave up, wave
recedes, and so on. As long as the trader or investor is not chased from his
position by the corrective wave, he will, under normal circumstances, ride
the trend to its natural end. Nevertheless, locals and hedge funds and those
who profit from volatility know the previous low is where investors and
traders set their stops. So in the ordinary flow of trading, if they see an
opportunity to take out an important low, they will do it—if possible.
Indeed, it is sometimes possible and the low sometimes falls from the
natural flow of trading.
Bruce Kovner, on being interviewed by Jack Schwager (Market Wizards),
was asked where he set his stops. “Where they're hard to get to,” he said. A
twice told tale for its importance a stop set on a Basing Point with a
prudently calculated filter is hard to get to unless the market has truly
reversed direction. In fact, what is a long-term moving average but a
lagging stop with a filter built in?
Basing Points are merely the marking of highs and lows in full realization
that a pattern of higher highs and higher lows is a Bull trend, and when that
pattern changes to one of lower highs and lower lows the trend is changing
or has changed. This is the principle behind Dow Theory, and it is the
principle behind trading trends of lesser duration than Dow trends.
Moreover, as is quickly realized, a pattern of lower highs and lower lows
means inevitably the trendline has been broken.
As for Figure 28.1, Mark Twain had some cogent comments on it. He said
anyone trying to make sense of it would go crazy, and anyone trying to
justify the prices with the chart would be shot. Figure 28.1 preserves
unexplainable conundrums and conflicts carefully preserved since the
earliest editions. The reader is urged to take it as a concept rather than using
it as a lesson (See Figure 28.2). Let me codify the rules implicitly presented
in the figure:
• A high is made, being recognized by no higher prices occurring for the
moment.
• Prices recede and a low is made. This low is found by watching each day
after the previous high until no lower prices are made. As prices begin to
rise again, we note each day on which prices are completely outside the
range of our low day candidate.
• When three such days are observed (three days away) before a new low is
made, we mark the candidate day as a Basing Point and raise our stop to 6%
(or x%) under the low of the Basing Point day (see Chapter 27).
• If a new high is 3% greater than the previous high, a new Basing Point is
found at the low of the new high day.
The Basing Points paradigm
By no means will every issue be amenable to this kind of analysis.
However, the method is so paradigmatic, it is worth examining at greater
length. Similar to virtually every other method of classical chart analysis, it
must be used with caution and good, thoughtful judgment. Sometimes some
stocks will seem to work as smooth as silicon lubricant, while other issues
will appear to be useless. Even on recalcitrant issues, however, the
principles underlying the method will be of use, if not the actual method
itself. With this in mind, Figure 28.2 is presented; the careful reader will see
the chart in this example uses only bottoms or lows in stop setting and does
not advance stops on the making of new highs as in Figure 28.1. This is
done for instructional purposes and to keep the example simple for the
general investor. More advanced traders will want to study and perhaps
utilize the new high techniques in Figure 28.1.
Figure 28.2 actually serves more than one instructional purpose. It
illustrates a pictureperfect case of the use of Basing Points, as well as a
complete analysis of a Bull Market from entry to exit with keys marking
events in the life of the market. Thus, the observation of Basing Points, the
setting of the stops, the tracking of potentially false turns are all noted. The
chart is accompanied by the keys. Originally the marked and keyed chart
was used in graduate seminars at Golden Gate University for instructional
purposes. Shortly, it became obvious that marking the chart in this manner
was extremely useful in trading. Thus, it is suggested to the reader as a way
of making his charts more communicative and more useful.
Key to Figure 28.2 analysis
1. A rounding bottom, or perhaps a scallop.
2. Resistance or breakout line.
3. Wake-up call on volume.
4. Run day, big volume. Breakout through line 2. Sure entry signal.
5. First Basing Point (BP). Notice prior volume fall-off in
consolidation and surge on run day. A stop was entered before this BP
using the low of the formation before the entry.
6. BP.
7. A weak BP (because of shallowness of retracement).
8. BP.
9. Test of BP at 8.
10. A trendline drawn after point 9.
11. BP.
12. BP candidate that fails the three-day-away rule.
13. BP.
14. A potential BP, but not a very good one because a new high has not
been made from 13.
15. A Support-Resistance line.
16. A test of 16 BP.
17. BP.
18. A Resistance-Support line.

Figure 28.2 Apple Computer, Bull Market of 1987. A near-perfect
example of the use of Basing Points for trading of a reasonably regular
and smooth Bull Market. Only wave-low Basing Points are illustrated.
19. Flag that becomes BP.
20. Trendline, but too steep to last.
21. Trendline.
22. BP.
23. Trendline.
24. BP.
25. BP.
26. Horizontal trendline.
27. BP at 26.75 (stop 25.41). Stopped out at 25.41.
A narrative of the events in the chart
1-3. Had we been asleep, the event at number 3 should have awakened us; a
volume day like this should catch our attention. We begin paying attention
to the stock and note the pattern that has been developing—the rounding
bottom, or scallop.
4. At number 4 we see a run day on heavy volume. A good signal for
entry with the breaking of the horizontal line at number 2. When we
enter, we set our stop 5% under the recent low. After entering on
strength, there is every possibility that some profit-taking will occur as
well as probing by locals to chase out arrivistes.
5. We watch with interest for the first reaction. Each day we observe as
a candidate for a possible Basing Point. This occurs at 5, and we now
begin to count “days away” from the Basing Point—days whose range
is entirely outside the range of the candidate day and occur before a
lower low is made. When the Basing Point at 5 is confirmed, we raise
our stop to 5% under the low of 5.
6. A higher high is made after 5 with a subsequent reaction to 6, which
proves to be another Basing Point. Therefore, we raise our stop to 5%
under 6.
7. Prices continue to climb and another Basing Point is made at 7. The
procedure is becoming clear: find a Basing Point and establish a stop a
prudent distance under it. If a new Basing Point is made, raise the stop.
Watch with interest the reactions against the trend. Either they allow
you to establish a new higher Basing Point, or they end your trade.
8-10. We find a new Basing Point at 9, raise our stop and draw the trendline
at 10. At 9 we have a lower low than 8, but our “filter,” our 5% padding,
keeps our position intact. We do not lower our stops using 9 as a new
Basing Point. One of the inviolable rules is stops are never lowered. The
filter is important because traders try to take out nearby lows and
exacerbate volatility. It is called the running of the sheep.
11. At 11 we find a new, if tenuous, Basing Point. An advance with a
thin higher high.
12. At 12 we have a candidate for a Basing Point that fails the three-
day-away rule.
13. At 13 we find the Basing Point that is good and raise our stop.
14. At 14 we are confronted with a marginal situation. It is a potential
Basing Point, but a marginal one because a higher high was not made
after 13.
15. At 15 we are able to draw a line defining resistance—a line that
will become a support line.
16. At 16 we have a new Basing Point that would have tested a point at
14.
17-21. At 17 we find a new Basing Point, and at 18, we can identify a
resistance line. The spurt across this line is both gratifying and a warning
because it becomes a flagpole from which the flag at 19 flies. Flags and
flagpoles are messages the market has heated up and now wants close
watching. A flag can serve as a Basing Point, so we move our stop again,
fully aware the end may be approaching. The trendline at 20 is further
confirmation of this environment because of its steepness, but we see two
good anchor points in 16 and 17 and draw trendline 21—a better line to
defend.
22, 23. A good reaction finally occurs at 22, giving a strong Basing
Point and good rationale for raising the stop. Notice the interesting fact
that points 22 and 24 have come back to rest on the trendline we drew
at 10.
24. As the tempo has increased and the volatility 24 furnishes us
another valid Basing Point.
25, 26. Even 25 is a valid point, and we can now see the clear support
line at 26.
27. When this line is pierced at 27 upon extraordinary volume, and in the
process takes out our Basing Point stop from 25, it is clearly time to exit the
train. The Basing Points concept is even more thoroughly explored in the
book entitled, StairStops, which is available on the John Magee Technical
Analysis website at http://www.edwards-magee.com and on
http://www.amazon.com, including Kindle edition.
The complete Basing Points Procedure: taking into consideration the
setting of Basing Points on both wave lows and new highs As previously
discussed by Magee, the Basing Points Procedure may set Basing Points on
both wave lows and on new highs. We find the wave-low Basing Point by
the three-days-away rule; we find the new high Basing Point, by marking
wave highs and subsequent new highs so when price exceeds by 3% the old
wave high, or recent high, whether or not an intervening wave low has
occurred, we may set the new Basing Point at the low of the new high day.
If a new high were made subsequent to this new high, we would reset the
Basing Point again if we were using this variant of the procedure, which I
call Variant 2.
Once again, the one-armed economist rules. On the one hand, raising the
stops like this on new highs may easily result in being ejected from the
position by a price dip; then you watch the train leaving the station on the
way to incredible new highs amid much teeth gnashing and irritation.
(Incidentally, if emotional distress occurs in this or other like situations it is
a message to you are too emotionally attached to the market. Complete
market maturity is not achieved until such situations can be viewed with
relative equanimity so the event is viewed with detached interest and a plan
to set things right.)
On the other hand, after having accumulated large paper profits, the issue
collapses and snatches back from you a third (or more) of your hard-earned
profits. (If you had only advanced stops based on new highs!) Remember,
the problem with Dow Theory (and trend following) is you give up the first
third of the move and the last third of the move and sometimes there is not a
middle third, as conventional market wisdom has it.
What essentially occurs when using Variant 2 of the procedure is as follows:
when blow-off or runaway conditions occur, the procedure changes from
selling weakness to selling strength. I believe very strongly in the variation
of tactics, generally. Also, I am intimately familiar with the pitfalls of
varying tactics, but I like the procedure in general and also think knowing
when to use it and when not to use it can require a great deal of experience
and emotional coolness in potentially high-stress conditions. If the entire
(Variant 2) procedure is executed and also combined with a scale-in/scale-
out plan, the user may succeed in shooting the moon.
The phlegmatic Marc Antony (who sleeps well of night and is sleek and
well fed) follows the conservative wave-low method (Variant 1) and
probably wins in the long run. The Variant 1 procedure is simpler and
naturally expands to accommodate the high-volatility market that ejects the
trader attempting to escape the inevitable collapse before going on to new
completely unexpected heights.
As it goes, damned if you do, damned if you don't, unless you are charmed
or kissed by the market fairy—or lucky.
The complete Basing Points procedure
1. A wave high is made, recognized by no higher prices coming for the
moment. If this high is 3% (Magee's number, but could be a parameter)
higher than the previous wave high (or the recent high in a run or blow
off), the Basing Point is raised to the low of the new high day.
Obviously, this comes into effect for the next trading day.
2. Prices recede and a low is made. This low is found by watching each
day after the previous high until no lower prices are made (a potential
wave low or Basing Points candidate). As prices begin to rise again,
we note each day on which prices are completely out of the range of
(away from) our low-day candidate, or a “day away.”
3. When three such days are observed (the three-days-away rule)
before a new low is made, we mark the candidate day as a Basing
Point and raise our stop to 6% (or x% as this is a parameter) under the
low of the Basing Point day. Obviously, the new stop is established the
day after the three days away have occurred.
4. If a new high is made without an intervening wave low Basing
Point, the process starts over from the new high.
5. If the new high is 3% (or x%) higher than the previous high
(whether made from a wave low or wave high), or from surging prices
continually making new highs, a new Basing Point is found at the low
of the new high day. Thus, a price move that went from 10 to 10.3 to
10.61 to 10.93 would create new Basing Points at the low of each new
high day.
11
14
13.5
13
12.5
12
11.5
Figure 28.3 Basing Points candlestick version. This chart is a
candlestick version of Figure 28.2. It illustrates the complete
procedure, showing establishment of Basing Points made by wave
lows and by higher highs. This is a blow up of the period in the chart
during which higher high conditions exist. As might be obvious, the
higher high rules begin to come into play late in the life of a trend, in
the runaway and blow-off stages.
10.5
10
Figure 28.4 Apple Variant 2 of the Basing Points Procedure. This chart
shows the trend from beginning to end as in Figure 28.2, with the
addition of dotted lines to show where stops fell when computed from
higher highs. The previous candlestick chart is used for the close-up
analysis. This chart puts into broad perspective the relative level of
stops using the Variant 2 method. As can be seen, setting stops from
new higher highs results in stops closer to the market prices. This can
be good or bad, depending on what the market does to you.
Two charts giving a long-view perspective on
the complete (Variant 2) procedure
There is another method Magee advocated for surging and blow-off
markets. He called this alternative method “progressive stops,” which is
explained in the ninth edition. Strictly speaking, although there is a
variation in tactics involved in using new highs for stop calculation, this
method is a twist on selling on strength. Variant 2 is still lagging stops
behind prices. A pure strength selling method would attempt to time exit on
a blow-off day, or a key reversal day or a one-day reversal, or even on a
strong long running day up. This is perhaps a little easier to visualize on the
downside. A panic selling day (which tends to finish at the lows) would
provoke an exit on the close.
The representative case fully analyzed using wave lows and new
highs
The case will not be unfamiliar to readers, and its use will fully highlight
the differences found in the procedure. The same materials will be used,
and the differences will be boldfaced in the text.
1. A rounding bottom, or perhaps a scallop.
2. Resistance or breakout line.
3. Wake-up call on volume.
4. Run day, big volume; breakout through line 2; sure entry signal.
5. First Basing Point (BP). Notice prior volume fall-off in
consolidation, and surge on run day.
6. BP.
7. A weak BP (because of shallow retracement).
8. BP.
9. Test of BP at 8.
10. A trendline drawn after point 9.
11. BP.
12. BP candidate that fails the three-day-away rule.
13. BP.
14. A potential BP but not a very good one because new high has not
been made from 13.
15. A Support-Resistance line.
16. BP.
16A. New High: 10.35.
17. BP.
17A. New Higher High 10.81; Low BP 9.89 (+3% 11.13); Stop 9.30.
17B. New Higher High 11.16; Low BP 10.58 (+3% 11.49); Stop 10.49.
17C. New Higher High 11.62; Low BP 11.22 (+3% 11.96); Stop 10.55.
18. A Resistance-Support line.
19. Flag that becomes BP. High 11.62.
19A. New Higher High 12.55; Low BP 11.91 (+3% 12.93); Stop 11.19.
20. Trendline, but too steep to last.
21. Trendline.
22. BP.
23. Trendline.
24. BP.
24A. New Higher High 12.93; Low BP 12.43 (+3% 13.34); Stop 11.68.
24B. New Higher High 13.41; Low BP 13.07 (+3% 13.81); Stop 12.29.
25. BP.
25A. New Higher High 13.82; Low BP 13.36 (+3% 14.23); Stop 12.56.
25B. Stopped out at 12.56.
26. Horizontal trendline.
27. BP at 25 (stop 11.80); Stopped out at 11.80.
A narrative of the events in the chart
1-3. Had we been asleep, the event at number 3 should have awakened us; a
volume day like this (Cf. chart 28.2) should catch the attention. We begin
paying attention to the stock and note the pattern that has been developing
—the rounding bottom, or scallop.
4. At number 4 we see a run day on heavy volume. A good signal for
entry with the breaking of the horizontal line at 2. When we enter, we
set our stop 6% under the recent low. After entering on strength, there
is every possibility that some profittaking will occur as well as probing
by locals to chase out arrivistes.
5. We watch with interest for the first reaction. Each day we observe as
a candidate for a possible Basing Point. This occurs at 5 and we now
begin to count “days away” from the Basing Point, that is, days whose
range is entirely outside the range of the candidate day, and that occur
before a lower low is made. When the Basing Point at 5 is confirmed,
we raise our stop to 6% under 5.
6. A higher high is made after 5 with a subsequent reaction to 6, which
proves to be another Basing Point, so we raise our stop to 6% under 6.
7. Prices continue to climb and another Basing Point is made at 7. The
procedure is becoming clear: find a Basing Point and establish a stop a
prudent distance under it. If a new Basing Point is made, raise the stop.
Watch with interest the reactions against the trend. Either they allow
you to establish a new higher Basing Point, or they end your trade.
8-10. We find a new Basing Point at 8, raise our stop, and draw the
trendline at 10. At 9 we have a lower low than 8, but our “filter,” our 6%
padding, keeps our position intact. We do not lower our stops using 9 as a
new Basing Point. One of the inviolable rules is that stops are never
lowered. The filter is important, because traders try to take out nearby lows
and exacerbate volatility. It is called the running of the lambs.
11. At 11 we find a new, if tenuous, Basing Point. An advance with a
thin higher high.
12. At 12 we have a candidate for a Basing Point that fails the three-
day-away rule.
13. At 13 we find the Basing Point that is good and raise our stop.
14. At 14 we are confronted with a marginal situation. It is potential
Basing Point, but a marginal one because a higher high was not made
after 13.
15. At 15 we are able to draw a line defining resistance—a line that
will become a support line.
16. At 16 we get a Basing Point.
16A. New High: 10.35 (a benchmark).
17. At 17 we find a new Basing Point and at 18 we can identify a
resistance line. The spurt across this line is both gratifying and a
warning because it becomes a flagpole from which the flag at 19 flies.
Flags and flagpoles are messages that the market has heated up and
now wants close watching. A flag can serve as a Basing Point, so we
move our stop again, fully aware the end may be approaching. The
trendline at 20 is further confirmation of this environment due to its
steepness. However, we see two good trendline anchor points in 16
and 17 and draw trendline 21—a better line to defend.
17A. New Higher High 10.81; Low BP 9.89 (+3% 11.13).
17B. New Higher High 11.16; Low BP 10.58 (+3% 11.49).
17C. New Higher High 11.62; Low BP 11.22 (+3% 11.96).
18. Support-resistance line.
19. Flag that becomes BP. High 11.62.
19A. New Higher High 12.55; Low BP 11.91 (+3% 12.93); Stop 11.19.
22-24. A good reaction finally occurs at 22 giving a strong Basing Point and
good rationale for raising the stop. Notice the interesting fact that points 22
and 24 have come back to rest on the trendline we drew at 10. As the tempo
has increased, and the volatility, 24 furnishes us another valid Basing Point.
24A. New Higher High 12.93; Low BP 12.43 (+3% 13.34); Stop 11.68.
24B. New Higher High 13.41; Low BP 13.07 (+3% 13.81); Stop 12.29.
25. Even 25 is a valid point and we can now see the clear support line
at 26.
25A. New Higher High 13.82; Low BP 13.36 (+3% 14.23); Stop 12.56.
25B. Stopped out at 12.56.
26. Support-resistance line.
27. When this line is pierced at 27 upon extraordinary volume, and in
the process takes out our Basing Point stop from 25, it is clearly time
to exit the train.
chapter twenty-nine
Trendlines in action
From what has already been said in Section I of this book, you will be
familiar with the characteristic single-line trends of stocks and the
numerous exceptions and deviations that come into the picture from time to
time. We know stocks often move in parallel trends, sometimes for months,
occasionally even for years. We also know they may, and do, break out of
trend or change the direction of their trends without notice.
Most of the pattern formations we have studied can be considered as
manifestations of trend action, or Continuations or Reversals of a trend.
Thus, a Symmetrical Triangle is simply the meeting of two trends. During
the formation of the Triangle, the stock is following both trends in a
narrowing pattern until, finally, the dominant trend asserts itself. An
Ascending Triangle is following an upward trend but has encountered a
Resistance Level at the Top. A Head-and-Shoulders Formation shows the
end of an upward trend and the beginning of a downward trend. A
Rectangle is a Parallel Trend Channel running in a horizontal direction, and
so on.
We can project a Parallel Trend and, in the case of stocks continuing to
move in that trend, we can buy and sell at almost the precise points of
contact with the trendline. Unfortunately, long and perfect straight-line
trends of this sort are the exception rather than the rule. For actual trading
purposes, we will project our trends more or less continuously on the basis
of the most recently established data.
From the standpoint of tactics, let us consider the trends as they are
indicated by the successive Minor Tops and Minor Bottoms. For illustration
of this, and as a guide to what we are leading up to, we will consider
simplified, ideal situations (see the examples in Diagrams 29.1 through
29.6).
To avoid confusion, mark the top trendline in blue pencil and the bottom
trendline in red pencil. We will refer to the upper trendline as the Blue
Trend, and the lower trendline as the Red Trend. From time to time, we will
also want to draw a line parallel to a Blue Trend across the Bottom of the
trend so as to include a segment of the Trend Channel between two Tops
within parallel lines. This we will call the Blue Parallel, and we will mark it
with a dotted or broken blue line. Conversely, we may wish to draw a
parallel to the Red Trend so as to include the segment of the Trend Channel
between two Bottoms, and this dotted red line we will call the Red Parallel.
Ordinarily, a Top (wave high) will be formed after a Bottom (wave low) and
a Bottom after a Top; thus, we will expect to draw, alternately, a Blue
Trendline and a Red Trendline with these lines being drawn as soon as the
new Top or Bottom is established. (In some cases, a light pencil line may be
drawn to indicate suspected Tops or Bottoms, until developments confirm
their validity.)
We have already taken up the important and rather difficult question of
determining the Minor Tops and Bottoms. Very often, these points will be
clear and obvious. Sometimes they will be obscure, and you will be able to
draw trendlines with confidence, in such cases, only after considerable
experience covering many types of actions. The most difficult times to
determine Minor Trends are during Reversals, especially in cases in which
these are of
Diagram 29.1 Here is a rising trend showing the Basic Trendline across two
Bottoms, which we call the Red Trendline, and its parallel (indicated by a
broken line) through the Top of the intervening peak. The parallel suggests
the approximate objective of the next move if the stock continues in trend.
Diagram 29.2 The same rising trend with the Return Line, which we call
the Blue Trendline, drawn through two Tops. The broken line represents its
parallel through the intervening Bottom. This Blue Parallel is useful in
determining a buying point, especially in trends of rapidly changing form
when the stock may not react to its Basic Trendline.
Diagram 29.3 This is a declining trend showing the Basic Trendline across
two Tops, which we call the Blue Trendline, and its parallel (indicated by a
broken line) through the Bottom of the intervening decline. The parallel
suggests the approximate objective of the next move if the stock continues
in trend.
the rounded and irregular types. In these cases (of Reversal), however, we
will not depend much on the trendlines to determine buying and selling
points.
As long as a stock persists in a Parallel Trend Channel, it is perfectly clear
to buy near the Bottom of the channel and sell near the Top. From the
geometry of the situation (see examples), you will see at a glance it is not
likely to be profitable to sell short in an

Diagram 29.4 The same declining trend with the Return Line, which we
call the Red Trendline, drawn through two Bottoms. The broken line
represents its parallel through the intervening Top. This Red Parallel is
useful in determining a point at which to make short sales, especially in
trends of rapidly changing form when the stock may not rally to its Basic
Trendline.
Diagram 29.5 Simplified diagram of a stock chart showing trend action.
Basic Trendlines are marked with heavy lines; Return Lines are marked
lightly.
upward-moving trend (because the reactions are necessarily smaller than
the advances), or to buy stock in a downward-moving trend.
Therefore, a trend must show it is presumably an uptrend before you are
justified in buying stock. Plus, you must have what is presumably a
downtrend to justify a short sale.
You will notice from the simplified examples shown here that pattern
formations indicate trends. The breaking of a Rectangle on the upside
results in an upward slope of the Blue Trend. The move up out of an
Ascending Triangle confirms the rising Red Trend and creates a rising Blue
Trend. The downside breaking of a Head-and-Shoulders neckline confirms
a descending Blue Trend and sets up a descending Red Trend, and so on.
From studies of these patterns and various trend actions, we arrive at a
compact set of trading rules based on these Red and Blue trendlines. These
rules are summarized below.
Buying stock, “going long”
• Preparatory buying signals (indicating a buying opportunity may be in
the making). Penetration of Blue Trend to a new high closing (in most
cases). The simple breaking of a descending Blue Trendline, in cases in
which no other pattern or indication is present, is not sufficiently conclusive
evidence of Reversal to justify commitments.
b

g
h
Diagram 29.6 Preparatory buying signals shown by trend action.
a. Penetration of an ascending Blue Trendline.
b. Penetration of a horizontal Blue Trendline.
c. The penetration of a descending Blue Trendline without other
technical indications is not conclusive evidence of a change in trend
and does not justify long commitments.
d. Contact with the Blue Trendline of an Ascending Parallel Trend
Pattern.
e. Contact with the Blue Trendline of an Ascending Divergent Trend
Pattern.
f. In this case, contact with the Blue Trendline does not suggest a buy
on the next reaction, because the trend appears to be converging; a
possible Wedge in the making, with Bearish implications.
g. Contact with the Blue Trendline of a Rectangle at its fifth point of
Reversal.
h. Contact with the Blue Trendline of an Ascending Triangle.
i. Penetration on volume of descending Blue Trendline when Red
Trendline is ascending (Symmetrical Triangle).
• Contact with the ascending Blue Trend if the Red Trend is also ascending,
provided the trends do not converge (Parallel or Divergent Trend Channel).
• Contact with the horizontal Blue Trend if the Red Trend is also horizontal
or ascending (Rectangle, Ascending Triangle).
• Penetration of the descending Blue Trend on volume if the Red Trend is
ascending (Symmetrical Triangle).
• Execution of buys (after preparatory buying signal).
• In case the previous Blue Trend has been ascending, draw the Blue
Parallel and buy at or near this line.


Diagram 29.6 (Continued) Preparatory signals for short sales shown by
trend action.
j. Penetration of a descending Red Trendline.
k. Penetration of a horizontal Red Trendline.
l. The penetration of an ascending Red Trendline without other
technical indications is not conclusive evidence of a change in trend
and does not justify short commitments.
m. Line of a Descending Parallel Trend Channel.
n. Contact with the Red Trendline of a Descending Divergent Trend
Pattern.
o. In this case, contact with the Red Trendline does not suggest a short
sale on the next rally, because the trend appears to be converging; a
possible Wedge in the making, with Bullish implications.
p. Contact with the Red Trendline of a Rectangle at its fifth point of
Reversal.
q. Contact with the Red Trendline of a Descending Triangle.
r. Penetration of ascending Red Trendline (with or without volume)
when Blue Trendline is descending (Symmetrical Triangle).
In descending trends, the Red Trendline is a return Line, and short sales will
be made on rallies to a line parallel to the new Red Trendline established at
the Bottom of the signal move and drawn through the intervening peak.
Note in the case of decisive breakouts from patterns such as Rectangles and
Triangles, a short sale might also be made on the basis of a computed
40%-50% correction of the breakout move, or on a return to Resistance.
• In case the previous Blue Trend has been horizontal or descending (that is
to say, emerging from Rectangles, Triangles, and various Reversal
Patterns), buy on a reaction of 40%-45% of the distance from the last
previous Minor Bottom to the extreme Top of the most recent move.
Liquidating, or selling a long position
Immediately on execution of the buy order, determine the stop level (see
Chapter 27, Stop Orders) and place your protective stop. Penetration of this
stop level will automatically close out your transaction. The stop level may
be moved up according to the “three-days-away” rule but may never be
moved down (except to adjust for ex-dividend or ex-rights). If the stock
closes below a previous Minor Bottom (thus setting up a descending Red
Trend), sell on tight (EN: or hair-trigger) progressive stops.
At the start, the stock declines in a Parallel Trend Channel. The Blue
Trendline is basic here. A short sale on a rally to the Red Parallel at point A
will find its objective on the Blue Parallel at B. Another short sale on the
Red Parallel at C would be followed by failure to reach the objective.
Chances are good, however, that increased volume would develop at the
Double Bottom and give warning to get out of short commitments. The
upside penetration of the basic Blue Trendline at E, alone, is not sufficient
reason to reverse position and go long. Trendlines set up during formation
of the Rectangle would be marked in the regular way, but they are indicated
here by broken lines to emphasize the pattern. Another short sale, if tried on
the sixth point of contact with the Rectangle at F, would be stopped out on
the breakout.
The trend is now rising, although we cannot yet draw a Basic (Red)
Trendline. The first buy would be made on a 40%-50% correction of the
breakout move from the Rectangle, or on a return to the Top (Support) level
at H.
A trendline would be drawn to the first Bottom established in the Triangle.
This is not shown, as it would ultimately be replaced by the line shown
through the outermost point in the Triangle. We have indicated by broken
lines the trendlines set up during the formation of the pattern.
The objective of the breakout move from the Triangle would be the Red
Parallel to our now rising Basic Trendline; this objective is reached at J. A
Return Line (Blue) would be drawn from the first Reversal Top of the
Triangle at G through the Top of the breakout move at J, and the parallel to
this through point I would indicate about where to make the next purchase.
As a matter of fact, the stock does not actually get back to that point; in
practice, the purchase would probably be made at K on the basis of a
40%-50% correction, or on a reaction to the Support Level G.
The subsequent upward move would not carry through to the Red Parallel
marked W; however, the alarm would probably be sounded clearly by a day
of heavy volume, a One-Day Reversal, or a gap. Since the trend is now
obviously convergent, no further purchases would be considered. The next
move fails to make such headway and falls far short of the objective set by
the Red Parallel marked Y. Soon after, the Wedge breaks out downside.
If the stock advances on moderate volume and then develops unusually high
volume on any day during the advance before either the Blue Trend is
broken (with a close above that trendline) or before the stock has made a
new high closing over the last Minor Top, close out the transaction on tight
progressive stops.
If the stock develops high volume on the day on which it either tops and
closes above the Blue Trend or makes a new high closing over the previous
Minor Top, hold it. If heavy volume again occurs on the following day or
any subsequent day, however, sell on tight progressive stops.
In rising trends, the Blue Trendline is a Return Line, and purchases will be
made on reactions to a line parallel to the new Blue Trendline established at
the Top of the signal move and drawn through the intervening Bottom. Note
in the case of decisive breakouts from patterns such as Rectangles and
Triangles, a purchase may also be made on the basis of a computed
40%-50% correction of the breakout move, or on a return to Support.
You will find in many cases the heavy volume signal will develop
(sometimes with also a One-Day Reversal or an Exhaustion Gap) on or near
the Red Parallel; watch especially for this volume indication as a sign of a
good profit-taking point. If the volume signal does not show up, your
selling objective is this Red Parallel, at a limit or on tight progressive stops.
In case there is no such volume signal at the top of the move and the move
does not reach the Blue Trend or make a new high, you are very likely
running into a Triangle situation. In that case, you will have to wait for a
breakout one way or another. Meanwhile, maintain your stop protection
underneath.
Selling stock short
• Preparatory selling signals (indicating an opportunity for short sales may
be in the making).
• Penetration of Red Trend to a new low closing (in most cases). The simple
breaking of an ascending Red Trendline where no other pattern or
indication is present is not sufficiently conclusive evidence of Reversal to
justify commitments.
• Contact with descending Red Trend if Blue Trend is also descending,
provided the trends do not converge (Parallel or Divergent Trend Channel).
• Contact with horizontal Red Trend if Blue Trend is also horizontal or
descending (Rectangle, Descending Triangle).
• Penetration of ascending Red Trend (with or without volume increase) if
Blue Trend is descending (Symmetrical Triangle).
• Execution of short sales (after preparatory selling signal).
• In case the previous Red Trend has been descending, draw the Red
Parallel and sell at or near this line.
• In case the previous Red Trend has been horizontal or ascending (that is to
say, emerging from Rectangles, Triangles, and various Reversal Patterns),
sell on a rally of 40%-45% of the distance from the last previous Minor Top
to the extreme Bottom of the most recent move.
Covering short sales
Immediately on execution of the short sale, determine the stop level (see
Chapter 27, Stop Orders) and place your protective stop. Penetration of this
stop level will automatically close out your transaction. The stop level may
be moved down according to the three-days-away rule, but it may never be
moved up.
If the stock closes above a previous Minor Top (thus setting up an
ascending Blue Trend), buy to cover on tight progressive stops.
If the stock declines on moderate volume and then develops unusually high
volume on any day during the decline before either the Red Trend is broken
(with a close below that trendline), or before the stock has made a new low
closing under the last Minor Bottom, close out the transaction on tight
progressive stops.
If the stock develops high volume on the day on which it either breaks and
closes below the Red Trend or makes a new low closing under the previous
Minor Bottom, hold it short. If heavy volume again occurs on the following
day or any subsequent day, however, buy to cover on tight progressive
stops.
You will find in many cases the heavy volume signal will develop
(sometimes with also a One-Day Reversal or an Exhaustion Gap) on or near
the Blue Parallel; watch especially for this volume indication as a sign of a
good profit-taking point. If the volume signal does not show up, your
buying objective is the Blue Parallel, at a limit or on tight progressive stops.
In case there is no such volume signal at the bottom of the move and the
move does not reach the Red Trend or make a new low, you are very likely
running into a Triangle situation. In that case, you will have to wait for a
breakout one way or another, meanwhile maintaining your stop protection
overhead.
Additional suggestions
When a level is reached that appears to be either a Minor Bottom on a
reaction or a Minor Top on a rally, and when the stock continues to stall and
remain at this point, moving in a very narrow range for three weeks or more
without giving any signal either by way of price change or volume action as
to its next move, it is wise to assume this congestion is definitely a key area
and should be considered a Minor Top or Bottom; protective stops should
be adjusted to it as a Basing Point, instead of the previously established Top
or Bottom, as against the possibility that the move out of this area, when it
comes, may be in the wrong direction.
After a series of moves in a trend, with each move in the Primary Direction
marked by heavier volume than the retreats or Corrective Moves against the
trend, you are likely to have a move in the Primary Direction, which is
marked by extraordinary volume (much larger volume than the normal
increase for a Primary Move). On such a move, after taking your profits on
previous commitments, you would ordinarily begin to plan the next
commitment on the Correction. In this particular case, noting the extreme
volume, you would cancel any immediate plans for further commitments in
the Primary Direction.
The reason for this is such climactic volume normally indicates the final
“blow-off” of the Intermediate Trend, to be followed either by a Reversal,
or at least by a period of stagnation, or by formation of Consolidation
Patterns, or by Intermediate Correction. In such a case, it is not safe to make
any further commitments on this trend pending further developments and
the positive reassertion of the trend.
If you examine daily charts of various stocks, covering long and important
trends, you will find the series of Minor Moves making up the Intermediate
Trend is likely to culminate in a Minor Move marked by tremendous
volume. This is truer of Tops than Bottoms, although at the end of the Panic
Phase of a Bear Market, we very often see climactic volume. The climax
indicates, on the other hand, the sale of large amounts of stock by strong
investors to weak traders, near the top; on the other hand, the liquidation of
holdings by weak traders occurs near the bottom, into the hands of strong
investors who will hold them for the next Major Move.
One of the most common errors, and easiest to fall into, is to mistake a
Climactic Top or Bottom for a normal confirmation or preparatory signal
for a new commitment in line with the preceding trend.
It is similar in nature to the error often made by novices in the market of
buying on the Minor Tops (becoming dazzled with the rapid price advance
and the great volume of activity). However, in the case of these final “blow-
off” moves, the volume is greater and the adverse portent far more serious.
General outline of policy for trading in the Major Trend
A. Always trade in the direction of the Major or Primary Dow Trend
(EN: see the editor's comments in Chapter 3) as it is indicated at the
time.
B. If the two component Averages of the Dow Theory (Industrials and
Rails; EN9: Transportations) are not in agreement, trade in the
direction of the last established Primary Trend but only in the
component that is still following that trend.
C. Examine charts of group Averages covering groups of businesses in
the same or related lines; trade in the Primary Direction when the trend
of the group corresponds.
D. Trade in any particular stock when its own individual chart
indicates a trend in the same direction as the Primary Trend, and when
the technical picture has indicated a probable move in that direction.
Make all new commitments on the reactions or rallies following the
signaling move in the Primary direction, except in the case of Primary
Reversals from Bull Market to Bear Market, when short sales may be made
at the market immediately following the Reversal.
Exception: after an extended move or a series of moves in the Primary
Direction, when signs of exhaustion and Reversal appear in individual
charts, commitments in the opposite direction may be made with objectives
limited to a correction of the preceding Intermediate Move in the Primary
Direction.
(EN9: Now the reader's head is spinning and the color blind are completely
confused. As this book is unfortunately printed in black and white, the
reader without colored pencils will be at sea. This is what I recommend:
take out your colored pencils and color the lines yourself. The principles
articulated here by Magee are of great value to a trader and are worth
studying.)
Taylor & Francis
Taylor & Francis Group
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chapter thirty
Use of Support and Resistance
We know that after many breakouts from well-defined Reversal and Consolidation Patterns, we get ashort countermove back to the edge of the pattern and the checking of this move at that point is anexample of Support or Resistance, as the case may be. Also, we should be familiar by now with thetendency of stocks to move up or down in a series of zigzag steps (EN10: i.e., waves and wavelets). If themove is upward, the reaction after each advance tends to stop at the level of the preceding peak. If themove is downward, the rally after each decline tends to stop at the level of the preceding bottom. This isagain a matter of Support and Resistance and provides the basis for buying on reactions or selling onrallies. It has also been pointed out Intermediate Secondary Moves will frequently stop at or close to theprevious Intermediate Top or Bottom.
It is necessary to evaluate the importance of these phenomena of Support and Resistance and apply themin market practice, for they are among the most important tools we have. Unfortunately, it is not easy toreduce this particular subject to a neat formula or body of rules. (EN9: And the effort will be made. Seeendnote of this chapter for an interesting effort to do just that.) Here you will depend very largely onexperience and observation. You will have to be alert in spotting the levels at which Resistance or Supportis likely to be encountered, and some judgment is needed in balancing the various factors that will affectthe situation.
For example, there is a stock that has broken up out of a well-defined Rectangle of considerable duration.Should the heavy volume of the breakout move give way to a dull reaction, you will look for anopportunity to buy this stock at a point a little above the top level of the Rectangle. It will probably notpenetrate very far below that level and, indeed, will often fail to react all the way to the Support. If thestock should then advance to a new high, and once more decline on low volume, you may look foranother buying point at about the level of the peak reached on the original breakout. Another advancemay be followed by reaction to the second peak, and this process may be repeated a number of times,each reaction carrying back to the level of the preceding high.
Now we all know this sort of thing does not continue indefinitely. When the stock first breaks out,moving from, say, 15 to 19, we may buy rather confidently on the reaction to 17, if that is the SupportLevel. If we did not buy on this move, we may buy with considerable assurance on the reaction toSupport after the next advance. This advance might have carried the price to 21 and our buying pointwould be at the previous peak of 19. As the stock moves up to 25, 30, 40, it must be clear we areapproaching a real Top; although we cannot say where that Top will be reached, we can be sure it isbecoming increasingly tempting to long-time holders of this stock to sell and take their substantial gains.The series of steps is bound to come to an end. To be sure, the Major course of the stock and of themarket may continue up for months or years, but after a series of sharp rises, we may reasonably expect aReversal and a rather substantial Intermediate Decline before the upward move is continued.
Therefore, we must regard each successive step of advance with increasing suspicion; after a stock hasmade three such moves in the Primary Direction, it is time to look for an Intermediate Correction or atleast for an important period of Consolidation. Thus, we have the rough shape of a rule. Buy on thereaction to Support after the first breakout; buy on the reaction to the first Minor Peak after the nextmove, but do not buy on the reaction to the second Minor Peak.
Let us say, then, we have been successful in two short-term moves, buying on the reaction to Support andselling on the climax after a new Top has been made. Nevertheless, we have decided not to attempt a thirdsuch trade. What, then, may we expect next? We may see a period of Consolidation, we may see thebeginning of an Intermediate Decline, or we may see the stock actually go right on moving up. No matter—we will wait for the Intermediate Reaction. We will wait until the stock makes a very substantial
decline, and this may take many weeks. Then, if the Major Trend has not reversed itself, we will againlook for a buying opportunity at (or somewhat above) the Intermediate Support, which will usually be thetop level of the advance preceding the one just completed, for this is the level from which the nextPrimary Advance is likely to proceed and is a good buying point.
We find the same situation in Bear Markets. A breakout is likely to be followed by one, two, three, ormore steps of decline, with intervening rallies to Minor Resistance. Sooner or later (and we would counton no more than three such steps in a series), we will get a turn and an Intermediate Recovery. We willthen wait for this rally, which may itself be made up of several Minor steps, to reach or approach closelythe preceding Intermediate Bottom, at which point we may look for substantial Resistance. Here is theplace again to put out shorts.
Questions will come to your mind. One of them, and one of the most important: how do we decide whenan expected Support or Resistance has failed us, and at what point do we then abandon our position?
It will be clear this question can be a very painful one. Let us suppose you have seen a stock rise to 25and have placed an order to buy it at 23 1/2 on the basis of expected Support at 23, the level of a previousMinor Peak. The order is executed during a dull reaction. The next day, the stock slips down to 22 1/2, onperhaps only two or three sales. The next day, it continues down to 21 1/2, still on low volume. Plus,during the next week, it goes down steadily, without much volume, nearly every sale being at a lowerprice, as though no new bids were being received, and as though no substantial number of bids werestanding on the book at any point. A decline of this sort can eventually assume the magnitude of anIntermediate Reaction. The move may carry down to 15 before it turns. Obviously, this was not what youexpected, and you should be out of the stock.
The painful part of these drifting moves is you do not want to sell your stock (which you bought at 231/2) on just a slight move down, say to 22 3/4, because the probability is strong it will shoot up at anymoment to new high levels. Yet, at some point during a continued decline, you must decide, “This hasgone through the Support; I should sell and take a small loss now, rather than risk a more serious loss.”The most painful part of all is, sometimes, the moment you have sold and taken your loss, the stock willcome to life and complete what would have been an extremely profitable move.
You might just as well prepare yourself for this sort of disappointment, for it will happen to you. To avoidnights of pacing the floor and days of worry, you should decide, at the time you make the originalcommitment, just how much leeway you are prepared to give the stock. Then you will not be tempted toput off a decision from day to day if things are not going the way you hoped.
In the case of purchases or short sales made against Minor Peaks or Bottoms, as the case may be, youmight set up the following rule. Measuring from the extreme high of the previous (Supporting) MinorTop, or the extreme low of the previous (resisting) Minor Bottom, set a stop using the method we haveoutlined in Chapter 27. (EN9: See also Chapter 28 and consider the risk limitation procedures in Chapter42.) This often would be the intraday high or low, not necessarily the closing price. Penetration to thatextent should be presumptive evidence that your expected Support or Resistance is not going to function.
Where you are buying against Major or Intermediate Support, or selling short against Major orIntermediate Resistance, you can allow a little more leeway for penetration. In such cases, examine theSupport or Resistance Area, and estimate visually its core or axis; in other words, try to gauge the “centerof gravity” of this area, the point is most nearly the mean price of sales occurring there, taking intoaccount the volume, because the important thing is to determine the approximate price level at which agreat many shares changed hands. Having determined this point, set your stop beyond it, according to themethods specified in Chapter 27.
Up to this point we have concerned ourselves (reversing the usual order) with how to get out of situationsthat have gone bad. We have said nothing about where, precisely, to get in, nor where, precisely, to takeprofits.
In the matter of getting in, that is, making the original commitment, you might feel there is a conflictbetween acting on Support or Resistance and acting on either trendline action or a computed reaction of40% to 50% after a previous move. At times, these conflicts might arise and it is not possible to state anyexact rule that will reconcile these three different trading indications. In a great number of cases,however, you will be delighted to observe a reaction of about 45% will bring your stock to the trendlineand will also bring it near to the Support or Resistance Level. After a move to a new Minor Top, a stockmay be expected to react (1) about 40% to 50% of that move, (2) to the Basic Trendline, and (3) to theprevious supporting Minor Top. Your purchase, then, will be based on a consideration of all three factors.If you have bought “early,” on the basis of one factor alone, you may expect the stock to react a bitfurther without spoiling the triple indications to the extent of catching your stop. It would be best to makeyour purchases on the basis of whichever factor indicates the smallest reaction and to place your stopbeyond the greatest reaction indicated by any of the three. Ordinarily, there will not be too muchdifference between these three factors. As usual, the method applies in reverse to short sales.
In cases in which you are buying after an Intermediate Decline or selling after an Intermediate Rally, youwill lean somewhat more heavily on Support and Resistance than on either a computed percentage for theSecondary Move or a trendline. You will examine the history of the stock, preferably on weekly ormonthly charts first, to see its Major Trend, to locate important Support or Resistance Areas, and toestimate roughly the extent of the Corrective Move, the termination of which you are trying to gauge. Youwill then check these data in the more detailed picture you can get from your daily charts. As theIntermediate Corrective Move approaches within 4% or 5% of the Support or Resistance Level, you maycome to a day of extremely heavy volume, and this day may also be a One-Day Reversal. If so, yourcommitment should be made at once and protected by a stop. Otherwise, you may make yourcommitment whenever the chart begins to hesitate or flatten out, or, lacking other indications, when it hascome to within 3% of the Support or Resistance.
In this case, your problem in taking profits is a bit more difficult than in the case of Minor Moves. Youare expecting a Reversal of the Intermediate Corrective Move and the establishment of a newIntermediate Trend in the Primary Direction. You are at a point at which the course of the market isuncertain. You must realize prices may stay at the Support (or Resistance) Level, forming a Line orRectangle, and finally penetrate that level, establishing Reversal of the Major Trend. However, they maybe stopped and turned at the Support or Resistance Level, only to make a small move away and thenreturn for another, and possibly successful, attempt at penetration. Then again (and this is what you hope),a continuation of the Major Trend may develop with a sharp move on increased volume in the favorabledirection, to be followed by a Minor Corrective Move and another thrust in the Primary direction—perhaps a new series of Minor Moves carrying the entire Primary Trend into new ground.
Taking these cases one by one, if the stock remains at the Support or Resistance Level for many days orseveral weeks and then penetrates that level, closing at a price that is clearly through it, get out at once. Ifthe stock makes a small move in the right direction and returns to the Support or Resistance, prepare toget out if there is a definite penetration. If, however, the move is in the right direction, watch for volumeindications, and prepare to set tight stops to take your profits as soon as heavy volume appears (except ona day of breakout). Once such a signal has appeared, you are then justified in continuing to make newcommitments on the following Minor Correction, and the one following that, for you are again moving inthe Major Trend.
One other situation should be mentioned; up to this point, we have assumed all of your commitmentshave been made to take advantage of a move in the direction of the Major Trend. Let us suppose a move
that has carried a stock up to new high levels in a series of Minor steps proceeds to form and then breaksout of a Reversal Pattern. We must now look for a Secondary Move of Intermediate extent. We may sellshort on the rally to the Minor Resistance, and, if the move continues down, we may make a second andeven (more cautiously) a third commitment against successive Minor Bottoms. In this case, we will belooking for the decline to end somewhere in the vicinity of the last previous Intermediate Top, which isnow a Support Level. Similarly, following a recognized Reversal Pattern and upward breakout on volumeduring a Bear Market, we may expect an Intermediate Rally that can be used for trading up to theprevious Intermediate Bottom where strong Resistance is likely to show up. A skillful trader can turnthese Secondary Moves into profits during periods when it is not possible to trade along the indicatedPrimary Trend; however, it should be remembered, ordinarily, such moves cannot be expected to go as faras will those in the Primary Direction.
We might close this chapter by reminding you again that, although Support and Resistance action in theMinor Trend is shown clearly in daily charts, the Intermediate and Major Supports and Resistances aremost easily recognized on weekly or monthly charts.
(EN9: It seems to this editor that Magee's discussion here of the use of Support and Resistance is reallymost pertinent to position building and pyramiding. Alternatively, the method applies to an issue that hasjust caught the analyst's attention, and he has missed the breakout, which is usually obvious (at least inhindsight). I feel strongly that the serious trader should not miss the original breakout. Chasing movingtrains is never a healthy activity. Does this appear an impossible occupation, to watch thousands ofstocks? Impossible for your average analyst, but not for your average computer. For example, thecomputer may be programmed to alert you when a stock is gapping on volume or trading at volumes thatare suspiciously large. And given the plethora of services and user groups, the trader stands a goodchance of spotting an issue to put on his watch list before it takes off.
Investors should, in theory, never miss a breakout, because they should be watching a much more limitedgroup of issues. In my opinion, these are primarily indexes and iShares. An investor's portfolio mightinclude a few well-chosen individual issues, but these would be of obvious visibility to the individual, forexample, biotechs for an investor with some knowledge of the area, or Internets for an engineer, and soon.
The unending effort to remove ambiguity from market interpretation extends to identifying areas ofSupport and Resistance. Metastock (http://www.metastock.com), an excellent software package, has anumber of value-added packages. One of the more interesting of these, Powerstrike™ by John Slauson ofAdaptick, Inc. (http://www.adaptick.com) attempts to mathematically define Support and Resistancezones. Slauson's package is interesting, and the reasoning and observation behind it are interesting aswell. Market analysis is rooted in one thing: the intelligent observation of the operation of the market.Dow watched the markets for years and came to the understanding of waves that led to Dow Theory.Schabacker and Edwards, equipped with these observations and comments, collated and observed moredata and recognized the persistent patterns that occurred over and over in the markets, and added Mageefor his practical engineer's approach to solving the tactical and strategic questions. In the 1980s, one ofmy friends, a Chicago market maker in the options pit, noticed that there was a 90-second delay on datacoming out of the futures pits to the options pit. He set up a “human ticker” with a direct phoneconnection to his pit and enjoyed a 90-second advantage over other market makers until the glitch wasnoticed and corrected.
Slauson (among others) noticed that important trading and Support and Resistance in optionable stockstended to cluster around important option strike price levels. In fact, these levels influence stock pricesand may be said to determine where “important” buying and selling occur. Obviously, Support andResistance Levels are set by concentrated face-offs between buyers and sellers. A battleground metaphoris appropriate: since the time of the Greeks, battles have occurred time and again in the same physical
locations. The reason is obvious. You need physical space to deploy an army. So commanders will beattracted to the plain or open ground for face-offs and to the high ground for defensive purposes. Optionstrike prices have the same attractiveness for traders that a good battleground has for a militarycommander. A good place to test the enemy.
Powerstrike™ analyzes the instrument price and volume around the nearby option strike prices anddetermines whether Support or Resistance is stronger. All in all, this is a clever application of number-driven analysis to the Support and Resistance question. The chart analyst may supplement his analysiswith a routine like this.)
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Taylor & Francis Group
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chapter thirty-one
Not all in one basket
(EN: As diversification for the general investor is nowadays infinitely easier, an important endnotefollows Magee's text.)
Diversification is important because technical patterns do not always carry out their original promise. Ifall your capital is tied up in one stock, or in a few stocks of the same group or line of business, you maybe hurt by a false move affecting only your holdings, even though the rest of the market may continue tohold firm or even to move farther along the Primary Trend. By diversifying, you are protected by the lawof averages against all of your holdings going the wrong way, except in the case of some Reversalaffecting the entire market or a large segment of it.
Intelligent diversification calls for study of the costs of buying and selling stocks, especially in smallquantities. You might wish to have a portfolio of stocks representing the entire Dow-Jones Averages, or aselection that includes at least one stock of every major group. However, if your capital is limited, thismight mean buying only a half-dozen shares of each stock, and the minimum commission charges wouldmake this an expensive operation, entirely too costly for short-term trading. The short-term trader mustalways think of these costs. They are more important to him than to the long-term investor who mayintend to hold the same stock for many months or years. To you as a trader, a quarter point or a half pointmay amount to serious proportions when it is multiplied through a number of transactions.
Your broker can give you a schedule showing commission and tax costs, and in case there are anyimportant changes in the rates, which you should study to see what effect they will have on your costs oftrading in stocks at various prices. (EN: You may also evaluate these charges at http://www.gomez.comand by checking websites of http://www.scottrade.com, http:// www.etrade.com, and
http://www.tdameritrade.com. Google is, as ever, an important price-checking resource, and Barron'spublishes a yearly edition evaluating brokerage houses. In general, this editor believes the investor whodoes it the “old-fashioned way,” that is, by phone and human broker, operates at a disadvantage unlessthe broker's value added can be quantified and proven.)
You will find your round-trip costs are a higher percentage of the capital invested in low-priced stocksthan in high-priced stocks. Also, the percentage costs will be higher on a smaller number of shares thanon a round lot and increasing as the number of shares decreases. Additionally, the percentage costs rise asthe total amount of capital used is less.
If your capital is, say $1,000 or $2,000, you might do well to divide it into units of about $500 each andconfine your trading to odd lots of stocks selling at 40 or higher. With larger capital, you could use largertrading units and extend the range of trading into somewhat lower priced stock. In any case, it isimportant to diversify your holdings. By dividing your capital and using it in such a way as to avoidunnecessary penalties in high costs, you will have greater protection against freak moves and suddenchanges that might affect a single stock very seriously.
On the other hand, if you have sufficient capital to secure plenty of diversification (8 or 10 stocks shouldbe a maximum for an active trading account), you can increase the size of the trading units. The wholequestion here is as to the minimum amounts to be invested in a single commitment and, if these amountswere doubled or tripled, it would not increase costs, but would, in many cases, reduce them.
EN: diversification and costs
In this original chapter, Magee discussed the necessity for considering costs while striving fordiversification. In present-day markets, diversification may be achieved through the use of Standard &Poor's Depository Receipts (SPDRs; SPY) and DIAMONDS™ (DIA) and similar instruments (ETFs) atcomparatively reasonable costs. Index funds and mutual funds also represent diversification and costcontrol for the general investor. Mutual funds will not control costs and expenses as efficiently as theIndex Shares and ETFs. This is because mutual funds create costs that the Index Shares do not:management fees and expenses, slippage, the spread, turnover, and taxes resulting from realized gains.These costs may be avoided by the careful independent investor.
An internationally prominent trader has told me, on more than one occasion, his considerable tradingfortune amounts to what brokers and specialists would have made off of him if he had been a member ofthe general public instead of a member of the Exchanges. The most important weapons in his quiver wereseats in Chicago, New York, and San Francisco.
The message is extremely clear. The general investor must control his costs. The more frequently hetrades, the greater his chances of having his capital ground to hamburger meat by brokers, specialists,floor traders, market makers, tax authorities, Exchanges, etc., etc., because there is undoubtedly anotherparty out there taking a chunk as the capital changes hands. The phone company maybe.
Trading costs are the last item brokerage firms want to focus on (see the book Where Are the Customers'Yachts?). For years, the Street firms and Exchanges controlled commission costs, keeping them high, butentering the Internet age a different ethos rules—cutthroat (and cut fees) competition, reluctantly broughtto the old-line exchanges and brokers by upstart competitors, and not suppressed by the Securities andExchange Commission (SEC) and the Commodities Futures Trading Commission.
It would be misleading to attempt to analyze costs in this book because of the mercurial nature of costfigures as firms compete in the Internet age.
The SEC runs a mutual fund calculator for computing costs of mutual funds. Mutual funds are amongthose that manage somehow to not be overly punctilious in estimating (read, disclosing) their costs toinvestors. Another good resource for researching mutual funds is http://www.morningstar. com.
But let me emphasize once again that iShares and ETFs have really made mutual funds obsolete if theinvestor uses the simple procedures outlined in this book.
chapter thirty-two
Measuring implications in technical chart patterns
If you show one of your charts to a friend and tell him it looks Bullish, he will reply immediately, “Howfar do you think it will go?” This is an automatic response; you can count on it.
The question is a good one. How far is this expected move likely to go? You do not know, nor doesanyone. Very often you can say, with a fair degree of assurance, “This stock, which has just made such-and-such an advance, is likely to react to around such-and-such a price.” That you can estimate fairlyclosely 7 or 8 times out of 10, by referring to the Basic Trendline, the parallel projection of the toptrendline, or the Support Level.
These rules work out fairly well as applied to reactions in the Bull Trend, and similarly, we can estimaterallies in a Bear Trend. Not so with the move in the direction of the trend itself. A Bullish Move may, andoften does, overrun the upper trendline by running up as far again as the move to the trendline. A BearishMove may exceed the downtrend, dropping apparently without limit. (That is one reason we haveprotective stops—to prevent disaster in case the trend suddenly reverses itself.) Additionally, it is why weprefer the use of nearby progressive stops as a method of taking profits, rather than using limit ordersplaced at a trendline, Resistance Level, or at some other definite point. Very often, to be sure, a stock willcheck its advance at one of these indicated points, but the cases in which a move carries beyond itsobjectives are fairly common, and in such cases, no one can make even a reasonable guess as to whatlimit the stock will reach on the move.
This follows because the move itself is an unreasonable one. It is an example of public participation, thesurge of uncontrolled speculation (and, very often, it is the final surge of that particular trend).
In exactly the same way, and often more violently, the uncontrolled falling out of trend in a downwardmove is an example of Panic, and being completely beyond reason, it follows no rule and knows nopredetermined limits.
There are, however, certain patterns and certain situations in which we can make some estimate of theprobable extent of a move in the Primary Direction—usually an estimate of its minimum extent. In thesecases, we have a guide to help us in making the decision as to whether the situation offers enoughpotential gain to be worth the risks involved. Also, the indicated measurement gives us at least a hint ofabout where we might reasonably begin to look for the volume that will indicate the Top.
For example, a decisive breakout from a Symmetrical Triangle is likely to carry at least as far as theheight of the Triangle measured along its first reaction. This is a conservative measurement. The movemay go much farther. In fact, the trend implications of the Triangle would suggest a continuation equal tothe move preceding the Triangle and leading into it, for if the trend continues valid, the move should runup to the upper limit of the channel. In the case of a Reversal, we would also use the height of the firstreaction as a minimum measure. With Right-Angle Triangles, we also can take the long side (formed bythe first reaction) as a rough measure of the minimum expected move.
What is more, with Rectangles the minimum we may reasonably expect after a breakout is a distanceequal to the height of the Rectangle. The Head-and-Shoulders Pattern carries a good measuring stick. Theheight of the formation from the extreme Top of the head down to the point directly beneath where theneckline crosses represents the minimum probable move from the neckline down. Again, this is a matterof Trend Channels, and most emphatically, this is only a minimum move. Some Head-and-ShouldersPatterns, representing an implied move of no more than 3 or 4 points, have marked the start of a declineeventually running to hundreds of points.
The rather unusual breakout that takes the form of an almost vertical “mast” running up (or down) manypoints before arriving at a stopping point, where some Consolidation Pattern is made, carries with it amost explicit measuring rule, and one that works out with amazing accuracy. The Flag or PennantConsolidation will occur at the halfway point—“the Flag flies at half-mast.” The speculation moveleading up to the Flag very likely will be duplicated by another rise, at least equal to the first, in the nearfuture. Following this rise, there may be another Consolidation and other rises, or there may not. Aftertwo surges of this sort, it is best to stand back and let someone else carry the ball. If you keep enoughcharts, and for a long enough time, you will see many perfect examples of this beautiful formation. Youwill also see some imperfect examples and some failures. And because the move is so spectacularlyprofitable when it works out, you will be tempted to buy on every Consolidation Pattern formed after asharp rise. It would be best to wait until the example is clear—a nearly vertical, almost unbelievable rise,followed by several days of congestion with practically no volume. If the congestion continues or sags offfor more than about three weeks, sell the stock; it is probably not the real thing.
Needless to say, this same pattern appears in reverse in downtrends and can be traded on accordingly.
The questions relating to the measuring attributes of gaps have been reviewed in detail in Chapter 12. Theonly type of gap that carries substantial implications as to the extent of the move to follow is theRunaway or Continuation Gap. The appearance of such a gap during a rapid price move is likely to markapproximately the halfway point; two or more such gaps can be weighed, in connection with volume andtotal extent of the move, to estimate the probable midpoint of the move and thus to predict a probableultimate objective.
Measuring properties have been ascribed to other patterns and occasionally work out according to plan. Ingeneral, the best measuring devices are your trendlines, Support-and-Resistance Levels, and the all-important signals of increased volume.
Other tools exist for measuring moves. Arthur Sklarew (see Bibliography) describes the-rule-of-seven,which I have often found effective. In addition, Wyckoff used PnF charts to measure moves and I haveseen some impressive analyses produced by Professor Hank Pruden using PnF charts.
(EN9: I have always been extremely chary of measuring moves. If the measurement does not lead thetrader to indulge in expectations that distract him from the crucial nature of the moment at hand, it mightbe quite all right. So, as an off-hand casual tool, it might serve some use. Always better to observe closelywhat the situation is when the price arrives at the measured point. Decisions should always be made inthe here and now, and not in the “I measured it then.”)
chapter thirty-three
Tactical review of chart action
The Dow Theory
(EN: In this chapter, multiple references are made to the tight stop - 1/8 point which decimalizes to .125.Readers should read this as decimal.13 to.25, depending on the habits of the issue. Issues greater than adollar are quoted at two decimal places. Penny stocks can go to 4 decimal places.)
The record shows an investor who had bought a representative group of stocks on every Major BullMarket signal according to the Dow Theory, as outlined in Chapters 3 through 5, and sold all his stockson every Major Bear Market signal, since the start of the Dow Averages, would have come out very wellindeed over the years. (EN: see tables in Chapter 4.) Although this tabulation does not take short salesinto account (EN9: now taken into account in the ninth edition), it would be perfectly consistent to add arepresentative group of stocks might be sold short on every Major Bear Market signal and covered at thenext Bull Market signal. Additionally, if the figures for such short sales, based on the level of theIndustrial Average, were included, the total profits on these theoretical transactions, both long and short,would be enormous. (EN9: Buy and Hold to 2018: $55,411.83. Dow Theory, long only: $795,592.01.Dow Theory, long and short: $5,757,390.17.) (For illustrations in this chapter, see Figures 33.1 through33.16.)
We believe this record carries some weighty implications that have a bearing on the operations of everytrader and investor. We will comment on these shortly, but before doing so, it should be pointed out thatfew, if any, investors have actually followed the long-time Dow signals, buying or selling 100% on everyMajor signal.
In the first place, to do so would require a long market lifetime and would presuppose the investor hadaccepted the Dow Theory in its classic form in toto from the start and he had never wavered, never alteredthe definitions nor his method of trading, and never withdrew any of his capital during the entire period.
In the second place, we would have to assume our ideal investor had an extraordinary degree of courageto stand firm in periods during which the Major Trend appeared to be making dangerous threats againsthis position and an extraordinary degree of patience to wait out the many months of stagnation when thetrend seemed to be getting nowhere at all.
Finally, we would have to make the assumption the group of stocks actually bought or sold reallyrepresented a fair cross-section of the Averages in that they would make about the same moves as theAverage itself. As a matter of fact, if the group were well diversified, the chances are good its movesmight approximate those of the Averages.
However, it is taking a lot for granted to suppose an investor could meet all of these conditions over aperiod of years, which he would have to do to operate strictly as a “Dow Theory” trader. It is not seriouslysuggested anyone try to follow any such plan literally. (EN: Well, in retrospect, why not? Given, in theInternet age, the availability of trading instruments and markets [DIAMOND™—DIA, Standard &Poor's Depositary Receipts—SPY] it might not
Figure 33.1 Head-and-Shoulders Top. The Bull Market that carried Southern Pacific from 8 to 70 in theyears 1941 through 1946 culminated in June 1946 with this formation. Notice the heavy volume on theleft shoulder, lower volume on the head, and small volume on the right shoulder. The breakout signal,which was decisive on July 15, served notice on holders of long commitments to sell at the market thenext day (at about 63) instead of waiting for the protective stop, which would have been set at 61, to becaught. Volume eventually developed at the Bottom of the breakout move at about 58 1/2, which move,incidentally, carried out the minimum measure of the Head-and-Shoulders prediction.
From this point, however, a weak rally on low volume started and continued up for four weeks. Theweakness of this picture would justify a short sale on a rally of 40% to 50% of the move from the leftshoulder to the bottom or on a return to the neckline, say, at 63. The rally actually extended to theneckline at 64, broke away on a gap with volume, and continued down in a move that led, in the nextthree months, to prices below 40, and later even lower.
An extraordinary feature of Head-and-Shoulders Tops is the frequency with which a comparatively smallformation, such as the one shown here, will herald a Major Move, changing the course of the stock formonths or even years to come. Not all patterns of this type will lead to such big moves as this, but noHead-and-Shoulders should be regarded lightly, ever.
be such a bad idea. The implementation of such a plan in Magee's time would have been extremelycumbersome and expensive, but it is eminently practicable in modern markets.)
The important implications of which we spoke are these: if the record of the Averages shows on theseMajor Signals it is possible to take substantial theoretical profits over the long term, and if the Averagesare composed of the prices of individual stocks, then the probabilities favor buying or selling a majorityof stocks in line with the Major Trend of the Averages. The evidence shows Major Trends normallycontinue for months or years. The line of “most probable gain,” therefore, is the line of the Major Trend.
On this basis, we would be on safe ground to say when a trend of sufficient importance gives a MajorSignal, the Averages are under way and there will be a greater likelihood of finding profitable situationsamong individual stocks moving in that trend than among those moving in the reverse trend.
Figure 33.2 Head-and-Shoulders (or Kilroy) Bottom in Braniff Airways, 1945. Strictly speaking, aContinuation Head-and-Shoulders after a Secondary Correction in the Bull Market. A Major Bottom,reversing a long Bear Market, would normally take much longer to form.
Here we see heavy volume on the left shoulder, somewhat less on the head, and very little on the rightshoulder, with a sharp increase, as required, on the breakout move of September 21. The breakout wasfollowed by a Throwback to the neckline on diminishing volume, providing a good opportunity forpurchases at 23. The upward move was resumed, and again there was a reaction to the neckline Support.A second reaction of this sort is not unusual. The closing at 22 3/4 on October 19, below the previousMinor Bottom, and on increased volume, was mildly disturbing. But in view of the strength of the patternand breakout, we would not have sold the stock, and the protective stop at 21 7/8 was not eventhreatened. On October 25, the advance was resumed with a Breakaway Gap and continued up to 29 1/2,where the move was signed off with a One-Day Reversal and Exhaustion Gap.
Notice on reaching 29 1/2, “BNF” went into a Consolidation Pattern for more than three weeks, makingan Ascending Triangle, before leaping to 37 1/2. Notice also (we might as well get all we can out of theseexamples) the Ascending Triangle takes shape at approximately the halfway point of the whole advance.We are already familiar with this tendency of stocks in fast moves to form “halfway” patterns.
It is suggested you read this preceding paragraph again, carefully. It means we do not try to sell stocks “atthe Top” in a Bull Market. We do not try to “pick up bargains at the Bottom” in a Bear Market. We do notdeliberately buck the kind of trend that history shows is likely to continue for an undetermined andpossibly long time.
What we have said here is stated with a little different emphasis than in previous editions of this book.You will notice we have not said you will never sell a stock short during a Major Bull Market or buy astock in a Bear Market. There will be, and often are, cases of stocks moving against the Major Trend and,on the basis of their individual technical behavior, may justify a commitment against the trend of theAverages.
ASSOCIATED DRY GOODS DG
•••••••••••
44 Sales 100's
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JANUARY FEBRUARY MARCH APRIL
5 12 19 26 2 9 16 23 2 9 16'23 30'6 13 20 :
13'20 27 4
MAY
11 18 25 1
8 15 22
Figure 33.3 Associated Dry Goods winds up its Bull Market Trend with a Rounding Top. This is a dailychart for the first six months of 1946.
The advance in “DG” from 4 to above 72 in just 3 1/2 years, when seen on monthly charts, is a smooth,accelerating curve that emerged from a long Bottom Formation that had lasted five years from 1938through 1942.
As we enter the final six months leading up to the ultimate peak, note first the action during January andFebruary. “DG” had just completed a fast run-up in the last quarter of 1945 and was about due for aConsolidation or a Secondary Correction. On reaching 48, it turned back to 45, advanced to 50 1/2, to 51,and finally to 52, and then reacted to 44 at the end of February. Had the move on January 22 gone a littlelower and closed below the January 3 low, followed by an even lower closing on February 26, we wouldhave had to consider this January-February pattern a completed Broadening Top, a definite Reversalsignal. However, the pattern was not perfect, and, therefore, not valid, but the erratic price action showsincipient weakness.
It is not unusual in these last stages, when public participation is running high, for the climactic advancesto be spectacular and fast; that is what we see here. A five-point Breakaway Gap occurred on March 25,followed by an advance that petered off at 63 1/2 reacted, and then ran up to more than 68.
From here on the move advanced slowly with suggestions of a Convergent Trend and a succession of“heads” and “shoulders,” and volume dropped off as the Top was reached. The drop on June 4 to belowthe May 7 Minor Bottom on increased volume would complete the Rounding Top and call for immediatesale if we were still long; and the penetration of the “neckline” on June 18 was a conclusive break.
We feel such trades should be made cautiously and with a full realization the majority of stocks aremoving in a contrary manner. Such trades might be made, for example, in particular cases as indicated bythe charts of the stocks involved, as partial hedges to reduce overall risk. For example, if a Bull Markethad persisted for several years and was still presumably in effect, but certain stocks had broken badly andshowed individual weakness, a trader might continue to hold three-quarters of his capital in good longpositions but might make a limited number of short sales in the weaker stocks. If, then, the
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Figure 33.4 Greyhound: a Rounding Bottom in 1945. A Continuation Pattern after the May run-up tomore than 29 and reaction to Support at 24, the 1944 high.
In July, volume ran fairly high on downside days, drying up as we entered August. August 10 showed aspurt of volume on the upside, and then more dullness.
The various small moves through August and September would not give us any basis for tradingoperations. The move to a new high in the pattern on August 31 suggested an upturn, and again onSeptember 19-20, we see another little push up to the 26 level—still not conclusive, however.
The move that got under way in the week ending October 13 is more definite. This decisive move withgood volume carries right out of the “Bowl” in an almost vertical ascent; not a big move, but a clearindication of the probable trend. We would look for a point to buy “G” on a correction of 40-50% of theentire move up from the Bottom, or on a return to near the Support Level around 26. The purchase wouldprobably be made around 26 1/2. Notice the drying up of volume on this reaction.
The advance from here to 30, marking an entirely new Bull Market high, came almost immediately. OnNovember 3, with very heavy volume for a Saturday, “G” closed at 30; since this volume was not on theday of breakout, we would have closed out the transaction on a tight stop at 29 7/8 on Monday (unless wehad elected to wait out the next Minor Reaction for a further advance).
Two weeks later, on the basis of the reaction to good Support, we would have bought “G” again at about29 (you cannot figure on getting the extreme low price on any reaction). The following advance carriedup to 34 1/4 in two days. At that point, profits could have been taken or the stock held for the longer term.“G,” it might be noted, continued up eventually to 54.
Bull Market continued, he might eventually have to close out the shorts for losses, which could beregarded as the reasonable cost of “insurance.” On the other hand, if the general weakness became greaterand eventually reversed the Major Trend, then the short sales would cushion the depreciation of the longsup to the time of the Reversal signal. (EN9: An extremely wise observation the present editor hasdeveloped at greater length in the theory of “natural hedging.” Given the complexity of modern markets,profits may be made on both sides of the hedge, and this should be the objective.)
By using an Evaluative Index (see Chapter 38) instead of, or in addition to, the Averages, it is possible tosay, “The market appears to be about 60% Bullish,” or “55% Bullish,” instead of merely Bullish orBearish. This takes account of the fact that some markets are more
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48
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32 Sales 100's 125 100
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Figure 33.5 Symmetrical Triangle in Allied Stores, a Consolidation in the 1946 decline. Notice heavyvolume as “LS” crashed to the first Reversal point of the pattern on September 10, and the drying up ofvolume during the successive swings of the Triangle. In Point-and-Figure charts, this type of pattern isknown as a Pendulum Swing because it does seem to come to rest like a pendulum. Often, volume willpick up somewhat at each Reversal point, but a valid Triangle must show some overall decrease ofvolume.
If, by some unhappy chance, you were then long “LS,” you should have had your protective stop at 331/8, 8% below the Bottom reached at 36. However, the move down out of the Triangle on Friday andSaturday, October 4 and 5, although on slight volume, was a true breakout (remember that downsidebreakouts do not require volume confirmation), and you would have been justified in selling your longcommitment at the market on Monday. You would have received about 38 1/2. To justify a short sale,however, the breakout would have had to close at least 3% outside the Triangle. The return to the borderof the pattern at 40 was interesting, and you will notice volume increased characteristically as the declinereally got under way on October 9 and 10.
No question about the validity of this breakout. Short sales were in order on a return to the border of theTriangle, or a 40-50% Correction of the breakout move, say, at 38 1/2 to 39. The rally carried to the apexof the Triangle and then broke away fast for the decline to 33, where, on October 30, a Selling Climaxand One-Day Reversal occurred—a signal to take profits.
Notice the small Head-and-Shoulders in August. This was a Continuation Pattern marking the top of therally before the September-November crack-up.
Bullish or more Bearish than others, and it enables the investor to “roll with the punch” instead of havingto take an all-out position one way or the other. (EN9: I have called this “Rhythmic Trading.”)
It should be noted, however, while he may take such a partial position against the (presumed) MajorTrend, he will continue to use the bulk of his capital in situations that accord with the main trend. He willnever risk the larger part of his assets in opposition to the trend, and he will make any countermoves witha clear understanding they are of the nature of insurance and serve this purpose even though theyultimately may be closed out as small losses.
Summarizing all these implications of the Dow Theory: do not make a majority of your commitmentsagainst the Major Trend. During periods of potential Reversal, gradually reduce your long holdings, andmake short sales to a limited amount in weak stocks; but do not attempt to anticipate either a Major Topor Major Bottom in the Averages by making an all-out commitment counter to the main trend.
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11
Figure 33.6 An Ascending Triangle. “CMR,” after emerging from the doldrums in 1943, forged up toabout 12 early in 1945. The first eight months of the year on a monthly chart showed an AscendingTriangle with Top at 12 1/4. On daily charts, however, we see the more detailed aspects of this largepattern. For instance, the final reaction of the whole (monthly) formation in August became here aSymmetrical Triangle. The breakout from this pattern carried out the minimum measuring requirements,bringing the price again to the 12 1/4 Top, from which point there was a reaction that was stopped cold at11, the apex of the Triangle. A purchase on the reaction after the powerful breakout from the Triangle, sayaround 11 1/2, would have been closed out on progressive stops, starting September 28 when “CMR”reached 14, the sale being consummated October 2 at 14 1/2, a highly profitable move.
Profit-taking of this sort would largely explain the stopping of the rise and the formation of aConsolidation Pattern that turned out to be the Ascending Triangle with Top at 16 1/4, lasting eightweeks. Notice the November 7 volume when price went through the 16 1/4 level, but failed to closeoutside the pattern, and the volume on November 30 when a clean, decisive breakout move closed at 17.This move ran to 20, and purchases would have been made at 18 or less on the reaction. The next wavetook “CMR” to its ultimate Bull Market Top at 24 in January. On the ratio scale, the Top of the AscendingTriangle was exactly halfway between the September Bottom at 11, and the extreme high of 24. This typeof halfway consolidation is typical of Flags and Pennants, and this is a very similar case.
Head-and-Shoulders Top
A. If you are long a stock, should a breakout down through the neckline occur, with a closing at least 3%below the neckline, next morning place a stop 1/8 point below the last close. Continue to place such“tight stops” if not caught the first day, 1/8 point under each day's close until one is caught.
B. Short sales may be made after a breakout, on a recovery of 40% of the distance from the top of theright shoulder to the bottom of the breakout move, or on a recovery to a line drawn down across the topof the head and right shoulder, or on a Pullback to
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Figure 33.7 A Broadening Top. This somewhat rare but beautiful and highly dependable formationdeveloped as CertainTeed made its Bull Market Peak in 1946. A quick glance at the volume scale in thisdaily chart shows the high volume on the final stages of the advance, the dullness during the developmentof the Top Pattern, and the increased volume after the breakout.
As we all know by now (or go back to Chapter 10 and review the specifications), a Broadening Top is aFive-Point Reversal, differing from the Head-and-Shoulders, Triangles, Rectangles, and so on, in thateach Reversal must be at a new high or low for the pattern. It is, if you wish, a sort of reversed Trianglewith its apex to the left, the swings becoming continually wider.
In the second week of May, “CT” (the symbol has since been changed to “CRT”) made a new BullMarket high at 25 1/4 (marked “1”). The reaction carried back to Support at the previous Minor Peak(point “2”) and the following week, “CT” advanced to another new high at 3, closing 1/8 point above theprevious Top.
Another week had brought “CT” down to point “4” with a closing at 22 1/2, three-quarters of a pointbelow point “2.” This, in itself, is not sufficient reason for making short commitments. Three weeks later,“CT” closed at 25 5/8, another new high, at point “5.” Finally, the stock dropped to 21 1/2 on July 23, andat this point (marked “B”), the pattern was completed. Notice the tendency of volume to rise at eachReversal point of the pattern.
Long holdings would be sold at the market the day after the breakout, but short sellers should wait for acorrection of 40-50% of the move from point "5" to point "B." If shorts were put out at 23, we would notworry if the stock advanced for a time, as it did, without making a new high. The downside move in "CT"went quickly to 15 1/2, and within 12 months to 11 1/2.
26
22
24
Figure 33.8 Rectangles in Remington Rand. This is part of a long Bull Market rise that carried “RR”from under 10 to above 50 in the period from 1942 to 1946. The last three years of this advance werealmost continuous, as seen on monthly charts, without any extensive reactions. When we put the chart ona daily basis, such as this section covering the end of 1944 and the early months of 1945, right in themiddle of the advance, we see that the rise was not actually continuous but rather was built up of steps inan ascending “staircase” of Accumulation Patterns. Each sharp advance on increased volume is followedby a period of dullness and slight recession.
A picture of this type suggests the methodical campaign of buyers who intended to purchase large blocksof the stock for large long-term advances without creating a “skyrocket” market by their own buyingoperations. Presumably, each advance was checked by the temporary distribution of part of the stock heldby such buyers, and accumulation restarted on reactions.
In October and November, there is a well-marked Rectangle between 20 3/4 and 22. A purchase couldhave been made at or near the bottom limit, say at 21, on the fifth Reversal on November 14. The moveout of pattern in the week of December 2 did not carry 3% out of pattern, but about two weeks later, amove got under way that qualified as a valid breakout, with volume confirmation as required on upsidemoves. Notice the volume increase and One-Day Reversal on December 20 as this move neared its Top.Purchases would have been made at about 22 1/2 on the basis of a normal correction, and you would have
expected Support at the 22 level. This Support was respected, but the move did not advance beyond 233/4 (made this same Top three times in a period of two weeks) and returned again to 22 1/4.
There was no question about the breakout on January 25. Extent and volume were decisive. Notice thegap and One-Day Reversal on the following day as this Minor Move reached its end.
In mid-March, as you will see, “RR” plunged down from its high of 27, but the decline was stopped in itstracks at the top level of the January Rectangle, a good Support shelf. Never again during the Bull Marketdid “RR” even threaten this level because it moved up in April and continued its long march to the 1946Top.
the neckline, whichever point is reached first. If the breakout move continues down another day, or forseveral days, the 40% recovery would be based on the entire move from the top of the right shoulder tothe lowest point reached.
Head-and-Shoulders Bottom
(EN: The editor, long distressed by the paradox of the term “Head-and-Shoulders Bottom,” proposes thisformation be renamed in technician's nomenclature to “the Kilroy Bottom” [see Figure 7.4.])
A. If you are short a stock, should a breakout on increased volume occur, penetrating the neckline andclosing at least 3% above it, place a stop next morning to cover at 1/8 point higher than the close. If sucha stop is not caught, continue each day to place a stop 1/8 point higher than the previous day's close untilone is caught.
B. New purchases may be made after a breakout, on a reaction of 40% of the distance from the bottom ofthe right shoulder to the top of the breakout move (which reaction must be on decreasing volume), or on areaction to a line drawn across the bottom of the head and the right shoulder, or on a Throwback to theneckline, whichever is reached first. As in the case of the Top Formation, this 40% reaction is figured onthe entire distance of the breakout move if it should continue up for several days.
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Figure 33.9 A Double Bottom in Paramount Pictures. Double Tops and Double Bottoms are not ascommon as many traders like to think. They require considerable time to develop and must conform tospecifications as to price range and time, and also (on upside breakouts from Double Bottoms) as tovolume. They are easier to spot on weekly charts than on dailies.
This is a weekly chart of “PX” from September 1941 through March 1943. A Bottom was made onclimactic volume at 11 3/4 during the “Pearl Harbor Panic” Move. Then came a rise lasting eight weeksthat brought “PX” back to 15 5/8—a rise, incidentally, on feeble volume, strongly suggesting thepossibility of another crack-up to even lower levels. This rise, you will notice, was a considerable one,amounting to 35% of the price at the December low.
The downward move, however, which lasted to mid-April, was on low volume and ended precisely at theDecember low of 11 3/4. (Note: it is not necessary moves of this sort end at exactly the same level; thesecond Bottom could have been a bit higher or lower without spoiling the pattern.)
The second week in July shows the first sign of a possible Reversal when the price advanced on increasedvolume, but it did not close above 15 5/8 and, therefore, was not a breakout. Two weeks later, on heavyvolume, “PX” had moved up to 16 1/2, closing the week at 16. This is a true breakout and purchaseswould have been in order on reactions from this point on.
The move continued up for three years to an ultimate Top at 85.
Figure 33.10 A Right-Angled Broadening Formation in Associated Dry Goods. A beautiful example of abreakout through Multiple Tops, followed by an important move. This is, however, a pattern that is morefun to observe in retrospect than to follow as an active trader. The stock had moved up from an importantBottom around 4, established in 1938, 1940, and 1942. At the time of this chart in 1945, “DG” wasstarting the accelerating climb that eventually ended with the 1946 Rounding Top at more than 70 (seeFigure 33.3).
If you had been holding the stock, you would have been watching for a substantial corrective move afterthe advance from 12 to 20. In late February and the first week of March, “DG” went into a new BullMarket high-ground, reacted to Support around 19 to 19 1/2, and then advanced again in the week ofMarch 17, failing in this move to make a new high. Ten days later, “DG” had reacted to 18 1/2, closingbelow the previous Minor Bottom. An inexperienced observer, at this point, might have commented“Double Top” and planned to sell “DG” at once or even to make a short sale. The pattern, however, wasnot large enough in duration or extent of price movement to qualify as a Double Top, nor did it conformto any other recognizable pattern of Reversal. Nor was the volume as high as one would expect on animportant Top.
The rally in early April carried through to a decisive breakout of more than 3% in the move that reached22 7/8 on April 18. This move was a near penetration of the middle Top and confirmed the uptrend. If youstill held your long stock, you would not rest easier, and in any case, you would have looked for a chanceto buy on a reaction after the breakout. If you had tried to buy at the 21 1/2 Support Level, you wouldhave been left behind, but if you had put your order in a little higher, say at 22, you would have had a niceprofit on the advance to 25 7/8, where you would have sold on a tight stop at 25 3/4.
Complex or multiple Head-and-Shoulders
The same tactical suggestions apply to these as to the simple Head-and-Shoulders. Definitions and specialfeatures of these formations are covered in Chapter 7.
Rounding Tops and Bottoms
It is difficult to set precise rules for trading on these gradual changes of trend. In the case of RoundingTops, if one is long the stock, the general appearance of a Rounding Formation, extending over a periodof several weeks, leveling off from the rise and then turning down, very likely with a tapering off ofvolume nearing the top of the rise and a pick-up of volume as the turn starts down, would suggest gettingout of the stock at the market as soon as the picture looks more or less definite. A short sale of a RoundingTop could be very profitable; but no exact rule could be stated except, in the absence of fixed BasingPoints, one would want to be very certain the formation was unmistakably a Rounding Top. It would needto be well formed and following a long rise and extending over a period of some weeks in its formation. Itwould also need to be protected with a stop above the Top of the curve, as explained in the chapter onstops.
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Sales
100's
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Figure 33.11 A Diamond Pattern in American Can. The daily chart covers the period from December 3,1946, through May 1947, inclusive. For background on this situation, keep in mind that “AC” made itsBull Market Peak in October 1945 when it reached 112. The tendency of high-grade, high-priced stocksto top out early at the end of a Bull Market has already been noted. The first decline carried nearly to 90and was followed by a rally to 106. The stock then dropped to below 80 and a second rally brought us tothe situation we see here.
You will notice at once the moves have a gradual “rounding” appearance, due to the fact, at this price,conservative stocks do not make large percentage moves. If charted on a scale having larger verticalintervals, the patterns would look very much like those in more speculative stocks.
The first part of the pattern is similar to a Broadening Top. The first Minor Peak at 96 is followed by areaction to 92. The second peak carries even higher, to 98; and the reaction this time goes down to 91 1/4.A third rally takes “AC” to 99. So far, we have the five Reversal points of a Broadening Top, needingonly a close below 91 1/4 to confirm the Bearish indications. The next decline fails to break out of thepattern, however, and for several weeks, we have a narrowing picture like a Symmetrical Triangle.
Eventually, the stock makes a clean breakout to 89, which is the signal to get out of longs and to considershort sales on the next rally. As a matter of fact, the three-week rally that started never made an upsidepenetration of the Resistance Level at 94, the level of the apex of the converging lines bounding the latterpart of the Diamond.
American Can did not make a spectacular move down from this point, which is not surprising consideringthe markdown that had already taken place in “AC,” the habits and price of the stock, and the generalcondition of the market. It did not, however, again rise to the level shown here and, in fact, retreated tothe 80 level.
To review the nature of the Diamond—it is not a common pattern. It is somewhat like a Complex Head-and-Shoulders with a bent neckline. It resembles, at the start, a Broadening Top, and its latter phasenarrows like a Symmetrical Triangle.
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15 Sales 100's 250 200 150 100
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GULF MOBILE & OHIO RR.
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Figure 33.12 Gulf, Mobile, and Ohio builds a beautiful Wedge, as shown on this daily chart for the firsthalf of 1945. This was the move that terminated the spectacular rise of “GFO,” its final Bull Market Top.
Immediately after the downside breakdown from the Wedge, “GFO” came down to 18 3/4, and from thisIntermediate low, which was reached in August, rallied into a long Rectangle between 23 3/4 and 26 3/4from which it eventually broke down in a series of crashes that found it, in May 1947, selling for 6 1/8!
It is rather hard, with a formation of this sort, to say at what precise point the convergence of the trends isestablished. The breakout move late in April was normal; the stock was a buy on the next reaction. Thefollowing advance in May, which reached 23 1/2, did not carry out a Parallel Trend Channel, and we sawa tendency to converge as prices retreated on the reaction. The next three advances all repeated andconfirmed the Wedge picture, and at the top, we see a sort of “bunching up” as prices make little or noheadway. The chances are at 11 an alert trader would have taken profits on long commitments after thehigh volume appeared at the top of the Minor Move ending June 4 and 5. In any case, he would havemaintained a protective stop at all times to take him out if and when a downside breakout occurred.
You would not be likely to be short a stock on a Rounding Bottom. The long and gradual roundingappearance with dull volume, followed by a sudden revival on greatly increased volume, would be signalenough to cover if you should find yourself in this uncomfortable position. Purchases would be justifiedin a stock whose chart showed a Rounded Bottom or Saucer, after the first spasm of activity following along, dull period of dormancy. You would buy, according to the rules we have given for purchases onreactions, not on the breakout, but on the reaction following it, which would almost surely come.
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Figure 33.13 A Pennant in Martin-Parry. This type of pattern is fairly common in fast-moving markets.The extraordinary point about Flags and Pennants (and sometimes other Consolidation Patterns in fastmoves) is their tendency to form almost exactly halfway between Bottom and Top.
Just before this move, “MRT” had built a Rectangle between 10 and 12 lasting seven months, whichfollowed the 1944 rise from around 4 to 12. The May breakout on heavy volume carried “MRT” right tothe top of the Pennant without any adequate reaction. Note the increase of volume at the top of that rise.For three weeks prices drifted off with a drying up of volume that is clearly shown in the chart. Thepattern did not correct the entire first phase but found Support at the Minor Peak at 14 1/2.
Suddenly, on high volume, the move was resumed and this time went right up to 24 3/4. The chances aretraders who were still long their original stock or who had bought in around 15 on the Pennant wouldhave sold after the high volume of June 6 when “MRT” reached 19 7/8.
Symmetrical Triangles
A. If you already have a position in the stock. During the formation of
a Symmetrical Triangle, you may be unable to make any change in
your holdings. Let us say you have bought the stock on a reaction after
a Bullish Move. The next upsurge fails to make a new high and gives
no sufficient volume signal to cause you to sell out. The next reaction
fails to carry below the previous one. You are “locked” into the
Triangle, and you cannot safely sell, because the Triangle that has
formed may eventually break out in the original direction and show
you a good profit (in fact, the odds favor that it will break out in that
direction). In case of a breakout move (which must be on increased
volume on the upside), you can close it out for a profit (according to
the rules for trading we have already given) and immediately mark it
as a rebuy on the next reaction. If the breakout is down (whether or not
on increased volume), with a closing outside the Triangle, you should
protect yourself with a tight (1/8 point) stop the next day and continue
to set such tight progressive stops under each day's close until it is
sold.
If you are short the stock, the same rules would apply in reverse, except the
breakout in the right direction (down) would require no volume
confirmation while the adverse breakout (up) would need such increased
volume.
Figure 33.14 This daily chart of Lehigh Valley R.R. through late 1945 and
early 1946 shows a variety of gaps. At this particular time, “LV” was
completing a Secondary Corrective Move before making one more (and as
it turned out, final) effort to exceed the 1945 Top just above 17. This long-
term situation could be used for a discussion of Double Tops because the
Bottom of the intervening move was violated in the summer of 1946 and
the stock continued a downward course to below the 5 level.
Not all gaps are significant, as displayed in the first gap on October 3, when
the stock was moving in a narrow range on low volume. The gap on
Saturday, November 3, however, is important because the Saturday volume
(when doubled) is high. The move failed to qualify by a 3% new high
closing as a true breakout, but the implications of the move were Bullish
and might well have justified purchases on Minor Reactions. The low-
volume gaps on these reactions were of no particular interest.
It is not until the third week of January that we see another gap that looks
like a real breakaway. On January 14, with high volume, “LV” moved up
and out in a rush that took it to 15 7/8 on January 16, closing at 15 1/2. The
second appearance of volume here would have suggested application of
progressive stops, and long trades would have been closed out at 15 3/8.
New purchases could have been made on the reaction at 14 1/2. A second
advance accompanied by a Breakaway Gap developed on January 23. If we
consider the second gap (of January 24) a Runaway or Measuring Gap, we
would estimate the probable top of this move at around 17 3/4. When a
third gap appeared on January 28 with a One-Day Reversal and climactic
volume, it would be clear this move was about finished and progressive
stops would be used to clear out longs at 16 3/4.
Note the attempt to rally after the sharp drop and the One-Day Island
formed by two gaps as “LV” fails to hold at the 15 level.
B. If you do not have a position in the stock. Stay away from any
stocks making Symmetrical Triangles until a clear and definite
breakout close has been made. After such a breakout, if on the upside,
buy on the next reaction if the Major Trend is up; on the downside, sell
short on the next rally if the Major Trend is down. Rules for making
such commitments have already been given.
Note: Avoid breakouts from Symmetrical Triangles of the type that have
continued to narrow until the breakout point comes far out toward the apex.
The most reliable breakouts occur about two-thirds along the Triangle.
Right-Angle Triangles
The same rules would apply to Right-Angle Triangles as to Symmetrical
Triangles (see Chapter 8, Important reversal patterns: the triangles). Early
breakouts are more dependable here, as in the case of Symmetrical
Triangles. Volume confirmation is more important on upside breakouts from
Ascending Triangles and is not strictly required on downside breakouts
from Descending Triangles. Commitments already made are retained until
the breakout and then closed out in the same way as any transaction that
shows a gain.
As the Ascending and Descending Triangles carry a directional forecasting
implication that the Symmetrical Triangles do not have, it is possible to
make new commitments on reactions within an Ascending Triangle or
rallies within a Descending one. Since the flat horizontal side of one of
these Triangles represents a supply or demand area of unknown magnitude,
and because such a Triangle can be (and sometimes is) turned back before
the horizontal line has been decisively penetrated, it might be better policy
to note such formations in the making and wait until the decisive breakout
before making the new commitment.
Broadening Tops
Presumably, you would not be long a Broadening Top. The early Reversals
in the pattern would have taken you out of the stock, if you follow the
tactical rules based on trendlines, as previously outlined, long before
completion of the pattern. Neither would you be tempted to buy into such a
pattern because the trend indications would be clearly against a move.
On the other hand, a Broadening Top, after its completion, offers excellent
opportunities for a short sale. After downside penetration and a close below
the fourth point of Reversal in the pattern, you are justified in selling short
on a rally of about 40% of the distance covered from the extreme top (fifth
point of Reversal) and the lowest point reached on the breakout move. The
stop would be placed at the proper distance above the fifth Reversal, that is,
the extreme top of the pattern.
Rectangles
A. If you already have a commitment in the stock. The early moves of a
Rectangle may provide no volume signals to permit you to get out. There
will be no “breakout” moves during the formation of a Rectangle that will
allow you to take a profit. However, as soon as the character of the
Rectangle is well established (which requires at least four Reversals to set
up a clear Top and Bottom), you may trade on the Tops and Bottoms— that
is, sell at or near the Top, or buy at or near the bottom. For, as in the case of
Symmetrical Triangles, there is a definite presumption in such formations
that they are more likely to lead to continuous moves than to Reversals, this
would mean you would probably pass up your first opportunity to get out
(on the fifth Reversal) and would indeed probably decide to “ride along” in
the expectation of a continuation of the original move, which will be in the
“right” direction for your commitment. In the case of a breakout in the right
direction, you would dispose of your commitment according to the rules for
trading already stated. If in the wrong direction, use the tight (1/8 point)
progressive stops, the same as with the Triangles.
B. If you are not committed in the stock. Trades can be made within the
Rectangle on the fifth and subsequent Reversals. Due to the slight
probability, the move will eventually continue in the same direction as the
preceding move leading up or down to the Rectangle; thus, it might be best
to wait until the sixth Reversal for new commitments, which would set your
interests in the same direction as a continuation. Also, short sales can be
made after any downside breakout close from a Rectangle or purchases
after an upside breakout close with increased volume. Both the short sales
and the long purchases would be made on the Corrective Move following
the breakout.
Double Tops and Bottoms
Double and Multiple Tops or Bottoms are not valid unless they conform to
the requirements for such formations. Chapter 9 on these patterns should be
read carefully in this context.
A. If you are long a stock. On penetration and close at a price lower than the
extreme Bottom of the pattern between the Multiple Tops, dispose of the
stock on tight (1/8 point) progressive stops.
B. If you are short a stock. On penetration of the highest point of the
Inverted Bowl or rise between the Bottoms, with a close above that point,
close out the short sale on tight stops.
C. If you are not committed in the stock. Consider a penetration and
close beyond the limit of the correction between the Tops (or Bottoms)
as a signal of Reversal and make new commitments on rallies or
reactions.
Right-Angled Broadening Formations
The handling of these on breakouts through the horizontal side would be
similar to what has been said about Multiple Tops and Bottoms, and Right-
Angle Triangles.
The Diamond
If you are sure what you have is a valid Diamond Pattern, the rules for
trading will be the same as those we have already covered in connection
with breakouts from Symmetrical Triangles. As in the case of such
Triangles, new commitments should wait for a definite breakout.
Commitments already in force would have to remain until such a breakout
had occurred, either declaring a Reversal or indicating a probable
continuation of the original trend.
Wedges
There is no need to set forth detailed rules for policy within a Wedge and
during its formation because the general principles taken up in connection
with trendlines and Support and Resistance would take you out of such a
situation at the first opportunity after the convergent nature of the pattern
became clear. At the very worst, your stops (which we hope you maintain
faithfully in all situations) will take you out before the consequences
become serious.
Regarding new purchases (from a Falling Wedge breakout) or short sales
(from a Rising Wedge), the same volume characteristics would be expected:
notably increased volume on an upside breakout from a Falling Wedge and
less pronounced volume action on the first stages of breakout from a Rising
Wedge. New commitments, in line with the implications of the breakout,
may be placed on rallies or reactions after a clear breakout closing occurs,
carrying beyond the trendlines forming the Wedge.
One-Day Reversals
One-Day Reversals are not technical patterns suitable for trading in the
same sense as the important Reversal and Consolidation pictures we have
examined. They are mainly useful as a gauge in helping to find the precise
Top or Bottom of a Minor Move to protect profits on commitments
previously made. The One-Day Reversal, the Exhaustion Gap, and the day
of exceptionally heavy volume following several days of movement in a
Minor Trend are strong indications that the move may have run out. Any of
these three signals is worth watching for; any two of them together carry
more weight than one alone; and the appearance of all three carries very
strong implications of a Minor (EN: or even a Major) Top or Bottom.
Regarding trading on movements signaled by One-Day Reversals, this type
of trading would lie almost in the field of gambling, or at least trading for
quick, small profits on short moves. It would not be the same kind of
trading at all that we have been studying in the greater part of this book.
The indications and some suggestions for trading on those one-day moves
are covered in their discussion in Chapter 10.
Flags and Pennants
In many cases, the total decline from a Flag in an uptrend will bring the
price back to a point at which the stock may be bought according to our
regular trading tactics, namely, the decline may carry down to the Basic
(Red) Trendline, to the Blue Parallel, or make a 40% to 50% correction of
the rising “mast” preceding the Flag. If the “mast” move is the first such
move out of a level or only moderately rising trend, and if the Major Trend
of the market is Bullish, we would be justified in buying at the first
opportunity, which would be on the Blue Parallel. In such a case we would
expect, and ordinarily get, some further reaction, but it is important to get in
early because sometimes the reaction is very brief and does not meet either
of the other requirements for the correction. It is most important in a
situation like this that the volume drop off sharply. Volume must decrease
and remain slight; any increase of volume during the formation of the Flag
should be reviewed as casting suspicion on the entire pattern, except the
increasing volume that characteristically attends the start of the breakout
drive. This drive is usually so virile that we would be safe in placing a tight
(1/8 point) stop under the close of any day during formation of a Flag or
Pennant that showed notably increased volume. Hence, if the volume
indicated failure of the pattern, we would be taken out at once; but if the
breakout was under way, we would probably be left in because the stock
would ordinarily move up then without a reaction, very often making a
Breakaway Gap.
In downward movements, when the Major Trend of the market is Bearish,
the same suggestions would apply, with one difference. The final high day
of the Flag type of rally may be on high volume and also may show the
Exhaustion Gap or One-Day Reversal. If a short sale has been made into
such a day showing high volume, gap, or One-Day Reversal, a stop order
placed above the peak of the Flag will protect you should the advance be
resumed unexpectedly.
In either the up-moving or down-moving manifestations of this type of
action, there may be Flags having horizontal Tops and Bottoms, which are
Rectangles. If the drying-up of volume and other aspects of the picture,
including the sharp upward or downward move preceding it, suggest a Flag-
type Consolidation, you would be justified in making a commitment on the
sixth Reversal point, or for that matter, at almost any point in the pattern
(because you cannot expect this pattern to continue very long).
Flags and Pennants continuing too long (more than three weeks) are open to
question. Stops should then be set at the usual computed distance above or
below their extreme Tops or Bottoms (as the case may be). The fairly
frequent appearance of Flag-like Formations that eventually fail is
unfortunate because it is particularly hard to give up hoping with this kind
of pattern, and it is necessary to set the three-week time limit to prevent the
stock from drifting all the way back to previously established stop levels.
On the other hand, breakout moves from these patterns, when completed
normally, are among the fastest and most profitable forms of market action.
The question remains what to do in the case of stocks you may be holding
as they go into Flag or Pennant Formation. Obviously, they should be held
if you are long and the move leading to the Flag is up; or short positions
should be retained if the move is down. This would not happen ordinarily,
however, if you had followed the trading rules strictly. In most cases, your
signals calling for tight (1/8 point) progressive stops would have appeared
during the formation of the “mast.” You would have been taken out of the
picture somewhere along the way, possibly at the extreme top of the mast
(although ordinarily, you could not count on being so fortunate).
If no signal should appear and you still are holding a position as the Flag
starts to make its appearance, by all means hold your position. The odds
favor a continuation of the original move.
Now, if you have been holding the stock long (in a Bull Market) and have
seen it break out and start leaping to new highs, say from 20 to 32, and you
have been stopped out at 30, and then you see the price advance, halt, and
during the next several days retreat, with the rather high previous volume
drying up to practically nothing (it must be a drastic drying-up, and no
mistake about it), then you are justified in buying right back in again, even
at a higher price than you received only a few days before.
Gaps
If you are long a stock that is in a well-marked pattern formation, or in an
area of dull movement within fairly narrow limits, and the stock suddenly
breaks out on the upside with high volume and a gap, that is a Bullish
indication. You will hold the stock until signs of exhaustion appear as the
rise continues, or reappearance of high volume, or another gap or One-Day
Reversal. Then, particularly if two or all three of these indications show up
at the same time, you can protect your commitment with tight progressive
stops. You will have to consider whether a second gap should be considered
an exhaustion gap or a continuation gap, depending on the volume and the
speed of the rise, as discussed in the chapters on gaps and their measuring
implications.
19
18
16
15
14
17
Figure 33.15 This daily chart in Northern Pacific, covering six months
during 1944, shows several examples of Support and Resistance. The entire
chart covers only part of the series of Consolidations that took place in 1943
and 1944 preceding the 1945-1946 advance that carried beyond 38.
Support and Resistance phenomena appear on many, in fact, on most of the
charts in this book, and you will find them on the charts you set up for
yourself. There is nothing unique or even unusual about the Support-
Resistance action in “NP.”
Starting at the left in April, after the downside move on volume to 14 1/4,
notice the recovery to 15 5/8 where the move stops at the Resistance Level
of the preceding two weeks. After the formation of the Symmetrical
Triangle, there is a breakaway move with a gap that runs right on up to
above 17, where a small Rectangle is built during the next three weeks. The
stock ultimately breaks down from this pattern on considerable volume. It is
doubtful whether one would want to trade on this as a normal reaction after
the breakout from the Triangle because of the downside volume and the
implications of the Rectangle.
Note, however, how the reaction stops cold at the 15 line, the apex level of
the Triangle, and then moves right on up. Rather surprisingly, there is only a
three-day hesitation at the Bottom of the Rectangle, but a little setback
occurs at the Top of that pattern.
The July Top might be classed as a Head-and-Shoulders or Complex or
Rounding Top; in fact, it is almost a Rectangle, and after the downside
breakout, prices hesitate at the level of the Top of the May Rectangle,
continue down, find temporary Support again at the April Support Shelf
around 16, and ultimately wind up a bit under 15. Although “NP” actually
did penetrate and close slightly below the apex of the Triangle, the violation
was barely 3%, and it is interesting to note this September Bottom was the
lowest point reached. From here, the stock started its climb to the 38 level,
which was reached in December 1945.
Ordinarily, after a Breakaway Gap, regardless of whether you sell on the
next Minor Top, you would consider the move Bullish and would prepare to
make a purchase on the next reaction.
Now if you are long a stock and during the course of a sharp rise it develops
a gap after several days of the move, you must make your decision as to
whether or not it is a Continuation (Runaway) Gap. If so, you would
prepare to hold the stock for a further rise approximately equal to the rise
up to the gap. You would watch the approach to the ultimate objective
indicated very closely; on the appearance then of Reversal signals, you
could protect your holding with tight stops.
If you are satisfied a gap following a good rise is actually an Exhaustion
Gap, then you should protect your stock with a tight progressive stop at
once.
In Bear Markets, you would apply these same rules in reverse to your short
sales, remembering a downside breakaway is not necessarily accompanied
by the high volume you expect on an upside breakaway.
Where you are long or short a stock that is moving in a Pattern Formation
and the stock then makes a Breakaway Gap in the adverse direction, the
commitment should be closed out immediately at the market, or on tight
progressive stops.
38
36
34
30
28
26
32

Figure 33.16 Trendlines in American Steel Foundries. This daily chart
shows the tendency of trendlines to develop along straight channels. We
have already pointed out that these channels are frequently easier to see in
retrospect than during their formation, that stocks move in perfect channels
only occasionally, and that all channels come to an end, frequently without
warning. In this case, the long trend channel does give a warning of
Reversal.
In 1946, “FJ” had declined from 48 to a Support Level of 30. From here it
rallied for three months in a Trend Channel that brought us to the February
Top at 37. The next decline broke the previous trend, and volume developed
at the bottom of this break. If you will follow the entire chart, you will
notice volume nearly always shows an increase at the points of Reversal,
which are also usually points of contact with the Trend Channel. Notice also
the way the Corrective Rallies tend to stop at or near the previous Minor
Bottoms in the downward trend, and how reactions tend to stop at the
previous Minor Tops in the upward trend.
Trading on this situation would have been profitable. The Secondary
Intermediate Rally up to February approached the Resistance Level marked
by a 1946 Bottom around 40, and a correction of the drop from 48 to 30
would indicate short sales around 37 (which objective was just barely
reached). Such sales, if made, would have been covered after the first drop
(week of March 1) around 33 1/4. New shorts at 34 1/2 would have been
closed in the week of March 15 at about 31 1/2. Shorts made on the rally of
the March 22 week around 33 would be covered in the week of April 19 at
30. If shorted again, the same week at 31, the sale would have been covered
after the Climactic Bottom in the week of May 24. The combination, here,
of great volume and a One-Day Reversal would have warned against further
shorts.
The Rising Channel, being a Secondary, presumably of limited extent,
would not offer any great inducement to long-side trading in the absence of
other good reasons.
Support and Resistance
When you are long a stock, you do not want to see it violate any Minor
Bottoms previously made. Neither do you want to see it violate any of the
preceding Minor Tops that it has surpassed. Therefore, your stop orders will
be placed at a computed distance, as explained in Chapter 27 on stop orders,
using both the Minor Bottoms and the Minor Tops as Basing Points.
Normally, the Minor Bottom most recently formed will be at the
approximate level of the preceding Minor Top, so that these Basing Points
often will coincide. Ordinarily, therefore, in a rising trend, we look to the
most recently formed Minor Bottom. When the stock has, for three days,
made a price range that is entirely above the entire range of the day marking
this Bottom, you may move up your stop protection to a place indicated by
this new Basing Point.
The same procedure will apply in Bear Markets; the “three-days-away” rule
being used to confirm Basing Points established by Minor Peaks and also
by the preceding Minor Bottoms. Ordinarily, it will be sufficient to use the
Minor Peaks as Basing Points.
Intermediate Tops and Bottoms are used in determining the probable
objectives of Intermediate Moves because previous Tops constitute Support
under Intermediate Reactions, and previous Bottoms indicate Resistance
over Intermediate Rallies.
Multiple Tops are Support Levels. Multiple Bottoms are Resistance Levels.
The neckline of a Head-and-Shoulders Pattern is a Support or Resistance
Level, as the case may be. The apex of a Symmetrical Triangle is a strong
Support and Resistance point that may show its effect again on a subsequent
move. Any congestion or area at a certain price level or within narrow price
limits may provide Support or Resistance when a stock moves again to that
price or range.
Trendlines
We have already gone into the methods of following trends in stocks, and
the use of the Top and Bottom Trendlines (Basic and Return Lines) as
indicators of Bullish and Bearish opportunities, and as price determinants
for executing purchases or short sales.
There remains the tactical problem of the stock in which you are
committed, which is acting badly, but which has neither broken out of a
recognized pattern nor violated an established Minor Peak. This is not a
common situation, but it can present a very difficult problem when it does
come up. Let us say the Major Trend is Bullish, and a certain stock that has
been moving up irregularly in a Parallel Trend Channel confirms its uptrend
by a long, more or less continuous advance and calls for repurchase on the
next reaction. You buy on the reaction, and the stock continues down;
namely, the reaction continues with prices sagging for days and weeks,
without any rallies, Consolidations, or Corrections that are sufficiently well-
defined to serve as Basing Points for stop orders.
In the absence of clear indications during the reaction, and also during the
preceding large upward move, your stop would be placed at a computed
distance below the top of the preceding rise. Plus, if the reaction continues
down until that level is reached, you will have sustained an abnormally
large loss.
In a case like this, you should examine the trendlines making up the long
advance in the Trend Channel. The points of contact with the Basic
Trendline can serve as a fair emergency substitute for Minor Bottoms. Your
stop level, therefore (in the absence of more definite Basing Points), should
be placed at the computed distance below the last point at which the stock
made contact with the bottom trendline and moved decisively up away from
it. If a penetration and close below this point occurs without catching the
stop, sell on tight progressive stops. (EN: The editor feels that such
situations should occur only in positionbuilding or pyramiding cases. Every
effort should be made to join trends on breakout or origination, whatever
the source. There is no excuse for “chasing stocks” in the modern
environment in which literally monitoring all stocks and instructing the
system to alert one to the conditions attending breakouts is possible with a
computer. EN9: On the other hand, human frailty being what it is, we will
all find ourselves chasing a train at some time or other.)
The reverse of this rule would apply to the same type of situation in a Bear
Market, where stops for short sales would be placed at the computed
distance above the point at which the stock made contact with and fell away
from the upper trendline.
The changes of angularity and direction in Intermediate trendlines are
helpful in showing the gradual turning of a Major Trend.
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter thirty-four
A quick summation of tactical methods
There are three types of tactical operations: (1) getting into new
commitments; (2) getting out of commitments that have moved as expected
and show a profit; and (3) getting out of commitments that have not moved
as expected, whether the transaction shows a profit or a loss.
The principles of taking profits based on trends, Resistance and Support
Levels, measuring implications of patterns, and most especially, on the
daily technical and volume action of the stock, already have been covered.
These profit-taking operations seldom present very difficult problems
because the picture has developed normally and in the way you hoped and
expected it would. The “stepping off” point is usually easy to determine.
The more difficult problems arise in making new commitments correctly,
and in the very important defensive operations of getting out of losing
commitments with the least possible loss.
It should be emphasized that a stock ceasing to act in a Bullish manner
should, therefore, be sold and is not necessarily a short sale on the next
rally. In other words, the signal that shows weakness or failure of a move in
one trend is not always a signal to make new commitments on the opposite
side of the market. More often than not, in fact, it is nothing of the kind.
We know certain moves, such as adverse breakouts from Symmetrical
Triangles or Rectangles, advise us simultaneously to get out of
commitments in what is now clearly the “wrong” direction and to make
new commitments in the “right” direction. The simple failure of a trendline,
however, where the stock merely penetrates an old Minor Bottom without
completing a Head-and-Shoulders or other Reversal Pattern, although
reason enough to get out of commitments that are showing losses, is not
sufficiently conclusive by itself to justify reversing policy and making new
commitments in the opposite direction. Therefore we separate the two types
of signals as follows:
Get out of present commitments
• On adverse breakout from Head-and-Shoulders Formation.
• On adverse breakout from Symmetrical Triangle.
• On adverse breakout from Rectangle.
• On establishment of new Minor low or new Minor high in adverse
direction.
• On adverse breakout from Diamond.
• On adverse breakout from Wedge.
• On One-Day Reversal if marked by heavy volume or a gap.
• On adverse breakout from Flag or Pennant.
• On clear penetration of any Resistance or Support Level in the adverse
direction.
• On an adverse Breakaway Gap.
• On the appearance of an Island after a move in the favorable direction.
• On penetration of basic trendline in the absence of pattern or other
favorable criteria.
Note: It is understood all breakouts must close in the breakout area. A
closing 3% beyond the Support, trend, or pattern is sufficient to give the
danger signal. All takeouts are performed by the use of 1/8-point
progressive stops.
Make new commitments
• In line with the Major Dow Trend, or to a limited extent in countertrend,
moves as insurance to reduce overall risk.
• On breakout from Head-and-Shoulders Pattern.
• On breakout from Symmetrical Triangle, provided it is not working into
the final third of its length toward the apex.
• On breakout from Right-Angle Triangle.
• On breakout from Rectangle, or (possibly) on points of contact, beginning
with the sixth Reversal.
• On breakout from a Broadening Top.
• On breakout from Double or Multiple Top or Bottom. (Namely breakout
through the Bottom of the valley between Tops, or upside penetration of the
“dome” between Bottoms.)
• On breakout from Wedge, or (possibly) commitments within the Wedge in
the last third of its length as it approaches its apex.
• On Flags and Pennants, after sufficient Secondary or Corrective Move by
the pattern, or (possibly) within the pattern, provided volume and all other
indications tend strongly to confirm the pattern.
• On clear penetration of a well-defined Support or Resistance Area.
• On Breakaway Gap (possibly).
• After formation of an important and well-defined Island following a
considerable move.
• On contact with, or penetration of, the “favorable” trendline if both
trendlines are moving in the Major Trend direction. (Blue Top Trendline in
a Bull Market, Red Bottom Trendline in a Bear Market.) Note: Breakouts
and penetrations must show a closing in the breakout area and must
conform to volume requirements. Breakout closings should conform to the
3% rule.
New commitments (marked “possibly”) may be made in certain cases
within some patterns: Rectangles, Wedges, Flags, and Pennants.
Exceptional care should be used in such cases.
It is extremely difficult to catch Breakaway Gaps; we would not
recommend this as a general practice. (EN: This is not so difficult as it was
in Magee's time thanks to modern communications, computers, and access
to the internet.)
All commitments, except those just noted, are made on the next following
reaction or rally, to rules previously stated.
All commitments are protected by stops from the moment they are made.
Stops are moved, as conditions justify moving them, but always in the
favorable direction, never in the adverse direction.
chapter thirty-five
Effect of technical trading on market action
The question often is asked whether the very fact that traders are studying
methods and patterns tends to create those very patterns and trends—in
other words, whether the technical method sets up, to some extent, an
artificial market in which the market action is merely the reflection of chart
action instead of the reverse.
This does not seem to be true. The charts we make today seem to follow the
old patterns; the presumption is very strong that markets have followed
these patterns long before there were any technicians to chart them. The
differences mentioned briefly in Section I, due to changed margin
requirements, restraining of manipulative practices, and so on, seem to have
changed these habits, if at all, only in degree and not in their fundamental
nature.
The market is big, too big for any person, corporation, or combine to
control as a speculative unit. (EN9: And even beyond big in the twenty-first
century. Gargantuan.) Its operation is extremely free and extremely
democratic in the sense it represents the integration of the hopes and fears
of many kinds of buyers and sellers. Not all are shortterm traders; there are
investors, industrialists, employees of corporations, those who buy to keep,
those who buy to sell years later—all grades and types of buyers and
sellers.
What is more, not all short-term traders are technicians by any manner of
means. There are those who trade on fundamentals for the short term, and
those who rely on tips, hunches, on reading the stars, or on personal
knowledge of the company. They are all part of the competitive market and
all use methods different from yours—and sometimes they will be right and
you will be wrong.
The technician using the various tools of technical analysis, Dow Theory,
Point-and-Figure charts, oscillators, scale order systems, and monthly,
weekly, and daily charts is in the minority. The cold attempt to analyze a
situation on the basis of the market record alone does not appeal to many
people. Technical analysis leaves out the warmth and human interest of the
boardroom, the trading room, the fascinating rumors of fat extra dividends
to come, the whispered information on new patents, and the thrilling study
of the quarterly earnings reports. (EN9: Unless I am mistaken the only
appearance of irony in Magee's work.)
It is the influence of all these rumors, facts, and statistics that causes people
to buy and sell their stocks. It is their actions that build the familiar chart
patterns. You are not interested in why they are doing what they are doing.
So far as your trading is concerned, you are interested only in the results of
their actions.
The habits and evaluative methods of people are deeply ingrained. The
same kinds of events produce the same kinds of emotional responses,
hence, the same kinds of market action. These characteristic approaches are
extremely durable. It is not quite true that “you can't change human nature,”
but it is true it is very difficult to change the perceptive habits of a lifetime.
Considering the “orthodox” investors greatly outnumber the technicians, we
may confidently assume technical trading will have little or no effect on the
typical behavior of free markets.
(EN: This statement by Magee is still true in principle and it should be
noted in modern markets professional investors attempt to learn (or
perhaps it is “the mysterious and anomalous market”) what makes systems
and other investors successful. They then take action to frustrate those
methods, which are inimical to their self-interest. For example, locals and
professionals will search for stops above a congestion zone in an attempt to
cause the market to break away. This might be in an attempt to create a
trend or it might be in an attempt to create a Bull trap.
The proliferation of systems trend traders in the futures markets has, some
of those traders feel, created conditions hostile to systems traders as a
group. The moral of the story is the trader-investor must be ever alert for
the false move and the changing rhythm of the markets.
No one has been able to quantify chart analysis or to disguise his own
activities from the x-ray of the charts. Nor has anyone changed human
nature to eliminate treachery and perfidy and truculent defense of self-
interest.)
(EN9: And—dramatic drum roll—in 2005, Smith-Barney fires its entire
technical analysis staff. What to make of this is left to the imagination of the
reader. Some commentators attribute it to the Bearish outlook of the
technical staff as opposed to the need of the firm to sell long positions to its
customers. In my view, an unintended validation of the craft. When you
have to shoot the messenger, it says something about the state of the market,
as well as something about the industry.
Also, in conversation at a meeting of the Technical Securities Analysts
Association of San Francisco (http://www.tsaasf.org), Larry Williams said,
“I hate technical analysis.” I am reasonably certain the “technical
analysis” referred to is number-driven analysis.)
chapter thirty-six
Automated trendline: the
Moving Average
In 1941, we were still filled with starry-eyed ignorance and felt if only we worked hard enough and lookedshrewdly enough, we would discover the sure, unbeatable formula or system that would solve all our problems inthe stock market, and all we would have to do for the rest of life was apply the magic and telegraph our brokerperiodically from Nassau, or Tahiti, or Switzerland, or wherever we happened to be enjoying life at the time.
We have learned (we hope) quite a bit since then. We have learned most particularly a number of things not to doand by not repeating the same errors over and over, we have been able to improve our performance substantially.We have also learned (to date) (EN: still true in the twenty-first century) there are no sure, unbeatable formulas orsystems in the market, even the most useful and generally dependable forecasting methods must be regarded asstatements of probability only, subject to revision and vulnerable to failure at all times.
One of the useful tools, and one of the first many students of market action adopt, is the trendline. Whether a stockis moving generally up or down or sideways, there seems to be a tendency for the Major Trend to persist. It is trueevery trend is broken sooner or later, and the fact that it has been broken is often significant. But given a well-established trend, the probabilities certainly appear to favor its continuance rather than its Reversal.
As with all other market studies, however, there are times and conditions in which the simple trendline actionseems “not quite good enough.” One feels there should be some mechanical or mathematical way of determiningthe trend that might avoid some of the perplexities of choosing the right point through which to draw a trendline. Itwas back in 1941 when we delightedly made the discovery (although many others had made it before) that byaveraging the data for a stated number of days, weeks, or months, one could derive a sort of Automated Trendlinethat would definitely interpret the changes of trend over the past 30 days, or 200 days, or 12 months, or whateverperiod was chosen. It seemed almost too good to be true. As a matter of fact, it was too good to be true.
The Moving Average is a fascinating tool and has real value in showing the trend of an irregular series of figures(like a fluctuating market) more clearly. It also has value in the fact it can be used to cancel out the effect of anyregular cyclical variation, such as a normal seasonal range of temperatures, to get a better picture of the truesecular trend.
The trouble with a Moving Average (which we discovered long since but keep bumping into from time to time) isit cannot entirely escape from its past. The smoother the curve (longer cycle) one has, the more “inhibited” it is inresponding to recent important changes of trend. Plus, there is a very bad fault of Moving Averages in that “the tailtends to wag the dog”; the figures back to the first date of the current tabulation, perhaps six months ago, or a yearago, if they are large, may unduly affect the present average, and may conceal or mask some important feature bydistorting the curve. We feel the Moving Averages trendlines are useful, but they should be understood and usedwith discretion and with a full perception of their limitations.
After going through some of the caveats of Moving Averages, let us give you some of the ways to construct them.Moving Averages can be classified as Simple Moving Averages, Weighted or Exponential Moving Averages, andLinear Moving Averages. We have found over the years, and prefer, the simple methods that work just as well andsometimes better than the more complicated Moving Averages, while the others are more useful when usingcomputers.
For this reason, we will concentrate on Simple Moving Averages. The most common are the 50-day and the 200-day Moving Averages. If you want to increase the sensitivity of a Moving Average, shorten the Moving Average byusing 10 or 20 days. Another way is to increase the lead time by starting on the third day for the 10-day MovingAverage, or on the 20th day for a 50-day Moving Average, and so on.
To construct a Simple Moving Average, whether it is 5 days, 10 days, 50 days, or 200 days, add the price of 5 daysand divide by 5, or the 10 days and divide by 10, or the 50 days and divide by 50, or 200 days and divide by 200. Asimple way of doing the five-day Moving Average, instead of adding all five prices each time, is to drop day one
and add day six. A similar method can be used in calculating the 50-day Moving Average or the 200-day MovingAverage. Instead of adding the 50-day Moving Average each time, just drop the first day of the previous averageand add the 51st day. The same with the 200-day Moving Average; drop the first day of the previous 200 and addthe 201st day. Another way of calculating the 200-day Moving Average is to take one day of the week of 30 weeks,such as Wednesday or Thursday, add them, and divide by 30. This will give you the same Moving Averages as youwould have doing 200. Another way to put it is, on the second day, take the total, add the new day's price, andsubtract the oldest day's price from your 5-day, 10-day, 50-day, or 200-day Moving Average, whichever way youare doing it. Repeat the process on a daily basis and divide by the representative day—for the 5 day, you woulddivide by 5; for the 10 day, you would divide by 10; for the 50 day, divide by 50; and for the 200 day, you woulddivide by 200.
Sensitizing Moving Averages
The shorter the time period, the greater the sensitivity you will develop in your Moving Average. The 5-dayMoving Average will be much more sensitive than a 10-day. The problem with short-term Moving Averages is youcan have a greater number of false moves. Shorter Moving Averages are more suitable for commodities. Oncommodities, we would even advise using a 30-hour, a three-day, and a six-day Moving Average.
It is often better to use two Moving Averages, one of shorter duration and one of longer duration. In addition, youcan use channels, a Moving Average of lows and a Moving Average of highs. (EN10: In the markets of the 2000s,the most watched Moving Averages are the 50-day and the 200-day. In fact, these two have gained almost iconicstatus.)
Crossovers and penetrations
As a general rule, consider the crossing of two lines (EN10: as 50 and 200) by the price line as a sell or buy signalin the direction of the crossover or penetration.
1. Uptrends—Long positions are retained as long as the price trend remains above the Moving Average Line.
a. When the price line intersects or penetrates the Moving Average Line on the upside, it activates a buysignal.
b. When the price line goes above the 200-day Moving Average, but falls sharply toward it withoutpenetration, it is a possible buy signal. Additionally, conditions at the time must be closely observed.
c. When the price line falls below the Moving Average Line while the line is still rising, it could be a buysignal.
d. When the price line spikes down too fast and far below a declining Moving Average Line, a short-termrebound toward the line may be expected: a possible whipsaw trap.
2. Downtrends—Short positions are held as long as the price trend remains below the Moving Average. Whenthe price trend reaches a bottom and turns upward, a penetration of the Moving Average is a possible buysignal.
a. When the price line moves above the average line while the average line is still falling, it is a sell signal.
b. When the stock price line moves below the average line and rises toward it, but fails to penetrate andbreaks down again, it is a possible sell signal.
c. If the price line rises too fast above the rising average line, a short-term reaction may be expected: could bea whipsaw.
d. Occasionally, penetration of the Moving Average Line will occur in close conjunction with the penetrationof a trendline, and then according to its direction, it is a buy or sell signal.
3. Horizontal, Diagonal, or Sideways Movements—If the fluctuations are broad in comparison to the lengthof the Moving Averages being used, the price trend will fluctuate back and forth as the Moving Average, trueto its character or purpose, moves horizontally. The trader must be alert to the need to change tactics.
4. Gaps—Moving Averages, depending on their length, may have a tendency to be penetrated in proximity toa Breakaway Gap, particularly at the beginning of a Major Phase of an Intermediate cycle, and also in suchcases in which Breakaway Gaps occur at the beginning of correction phases.
Area Patterns can be a pitfall for the Moving Averages. Normally, the Moving Average oscillates through thecenter of these areas, producing buy and sell signals in rapid succession. In Area Patterns, the Moving Average is aheadache to the trader because he never knows which penetration is the one preceding either the renewal of thetrend or the Confirmation of a Reversal.
When trading areas develop in the form of Triangles—Descending, Declining, or Symmetrical—the MovingAverage will trend through the center of the Triangle. The technician has some small advantage in judging whichof the series of penetrations of a Moving Average is the important one. When the Triangle reaches its apex and thestock breaks out in one direction or another and penetrates the Moving Average, the penetration is likely to be themost important one during the sideways movement of the Triangle's development. Penetrations occur many timesin close conjunction with the penetration of a trendline.
As a price derivative product, the Moving Average can be a trend indicator by the way it fits a trendline.Nevertheless, it should be considered an adjunctive tool to everything else you have learned in relation to technicalanalysis.
(EN10: Magee had, and I have, an instinctive aversion to mechanical systems. We want to see and feel the analysisand the moment and consider the context and the subtle variables. A mechanical system of any type—and aMoving Average system is not bad in broadly trending markets—is blind. It will throw your capital in front of anon-rushing train and merrily hum along while the
Figure 36.1 150-day Moving Average (dotted line). Up to the 1980s (the period during which Ronald Reagantripled the national debt) trading the 150-day Moving Average (buying on an up crossover and selling on a downcrossover) gave a trader somewhat the same advantage that trading the Dow Theory afforded. In the 1980s, thesystem stopped working. Here in 1929 it would have been a lifesaver, as can be seen. Not illustrated here is whatthe Moving Average does in a Dow Line, or rectangle or congestion pattern. If taking signals on crossovers onecould find his capital ground to hamburger meat.
market is eating your lunch. I have called these “unnatural” systems—they interpose an algorithm between thetrader and the facts. This reduces decision-making stress but can go badly awry in some types of markets.)
A 150-day Moving Average is charted in Figure 36.1.
The PENTAD Moving Average system from Formula Research
One of the solid and prestigious technical research firms in the country is Ned Davis Research, Inc. (NDR). NelsonFreeburg of Formula Research has taken one of NDR's systems and tweaked it to yield what may be an effectivelong-range approach to the market. It is presented here because Magee was interested in Moving Average systems,as well as investors who are graphically challenged, meaning they can relate to numbers but not to pictures.
Freeburg took an NDR Moving Average system and a 20-week Moving Average, added a filter, and produced asystem that reportedly has an 80% profitability on signals and generated returns in the 15% range going back to1942. Since 1980, returns averaged 19%. We all know (or the reader can quickly demonstrate to himself with asoftware package) that a Moving Average tends to create whipsaws in a sideways market. As the market movessideways, the Moving Average moves through the pattern creating buy and sell
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Figure 36.2 Looking at the top chart, we can see the deleterious effects of using a Moving Average system in asideways market. Of course, at the end in January 1995, the system gets ready to cash in big time. You will nevermiss a big market with a Moving Average system—if you have any capital left after the whipsaws. Yet when a 1%filter is added, the number of trades is dramatically reduced and the accuracy improved. Something systems tradersnever think of is a qualitative filter—looking at the context when price crosses the average. What is the volumeand what is the price action? Also, the trader can experiment with different-size filters and filtering conditions.
signals as price oscillates about it. In a common-sense move, Freeburg added a filter to the system thatimmeasurably improved it. Readers should be aware we include this method because experience tells us this kindof system can be effective, but we have not validated the research. Also, any system including the 1990s isguaranteed to have good, if not spectacular, results. Diagrams illustrating the idea are shown in Figure 36.2.
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter thirty-seven
The same old patterns
To the newcomer, the market appears filled with wonders and mysteries as the landscape of Mars will appear to thefirst space travelers to land there. There are strange rumblings, apparently unexplainable upheavals, weird growths.An unknown stock will suddenly emerge from a morass of debt and deficit and proceed to soar to great heights. Anold and trusted issue will paradoxically sag and droop, although apparently rooted in the soil of economic stability.All will seem peaceful and secure, and, suddenly, the ground opens up and swallows values in a sensational marketbreak. (For illustrations in this chapter, see Figures 37.1 through 37.54.)
Such a newcomer, perhaps not realizing what appears unusual and alarming is only the normal fluctuation andadjustment that goes on continually in the market according to the changing evaluations of millions of investors,will feel frightened, insecure, and indecisive. He may scurry from boardroom to boardroom, personally or on thetelephone, scan the financial pages, talk with friends, accumulate a mass of conflicting information, and end upshutting his eyes and making a blind stab in the hope he may come up with the right answer.
Some never, even after years of contact with the market, achieve a tranquil and assured approach.
However, it is possible to learn something about the basic nature of stock trends. It is possible to know, withinreasonable limits, about what might be expected in certain situations. It is also possible to find ways of coping withthese situations, including the exceptional cases that persist in doing the unexpected. To repeat: it is possible todeal successfully with the unexpected and with what cannot be precisely predicted.
To put it another way, it is possible to be wrong part of the time and still to be successful on the balance. To dothis, it is only necessary to have a background of experience sufficient to know what will usually happen underparticular conditions, about how often the unexpected will occur, and how to deal with the unexpected when itdoes happen. These are the same general problems that would confront the space traveler, the chemist, thephysician, or almost anyone else in his daily affairs.
There are men who have observed the market long enough and carefully enough to discover there are not quite somany unexpected events as the newcomer might be led to believe.
The charts in this book are, in the main, the same as those used for examples in the first edition in 1947. Some ofthem show situations from 1928 and 1929, others from the 1930s and 1940s. (EN: And still others from the 1980s,1990s, and 2000s.) The reader can hardly overlook the similarities that occur in various stocks at different timesduring corresponding phases of their trends or turning points.
We have said that these same patterns, trends, and Support/Resistance phenomena repeat themselves over and overagain, and that they may be observed by anyone in his own current charts for any period of time, in any normallyactive stocks, and on any exchange or market.
By way of demonstration, there were included in this chapter of the fifth edition a number of typical technicalexamples, similar to those already discussed, but taken from
Figure 37.1 A 1952 Major Head-and-Shoulders Top in U.S. Smelting, Refining and Mining. This stock had movedup from a bottom at 33 in 1950 to the peak at nearly 88 shown here. The decline carried down to 37. This chartshows the typical high volume on the left shoulder. The volume at the head is a little higher than in the “ideal”pattern. Light volume on the right shoulder is a definite warning. Notice the Pullback Rally to the neckline in thelast week of August. Also, the Secondary Recovery in November and December. There also appears, at the left sideof this chart in 1951, a beautiful example of an Ascending Triangle, indicating the resumption of the previousinterrupted advance.
the period 1947-1966. (EN: The eighth edition includes examples taken up through the turn of the millennium.) Itwould be possible to include ten times the number of good examples, for almost every situation that has beenpreviously illustrated has appeared again and again in recent years.
Not all the same
Although a majority of stocks will participate in a big market trend, they will not all move at the same time or tothe same degree. Some will move quite independently and contrary to the Averages. There was a “boom” in the1920s and there was a Panic in October 1929, but these are inadequate statements, half-truths if you will, and canbe very misleading if they are swallowed whole. A technician, following the individual behavior of stocks, wouldhave been able, through a balanced and diversified portfolio, to protect himself against irreparable loss.
The facts are that of 676 stocks we have studied through the period 1924-1935, only 184 made a Bull Market Topin August-September-October 1929 and suffered Major Declines in October and November of that year. Therewere 262 stocks actually in Major Downtrends before the year 1929. Another 181 stocks made their Bull MarketTops in the first nine months of the year and were already moving down before the end of the summer. Five stocksdid not start their decline until after 1929 and 44 stocks continued to make new highs after 1929. In Figures 37.9through 37.11, there are three stocks showing very different trends during the years 1927-1930.
Figure 37.2 Downtrends seldom show the perfect and regular trendlines we often see in uptrends, but in spite ofthe irregular, ragged rallies and spotty volume action, the basic principles are about the same as for advances.Notice in this six-month period, Inspiration Copper had no rally that carried above the Top of a preceding rally. Awell-marked downtrend of this sort must be presumed to continue until there is a marked change in the pattern andvolume action. Notice the volume on the day “IC” broke the historically important 52 level, and subsequent action.

Figure 37.3 Part of the Major Advance in Granite City Steel. Here we see the familiar phenomenon of Support andResistance in almost every move through the period shown.
The August-September Rectangle held for six weeks between the top limit of 47, which was reached on threeoccasions, and the bottom at 44. Like most Rectangles, it was marked by heavy volume at the start on July 19, andgradually declining volume as the pattern progressed. The breakout move on August 29 was on enormous volume.
After this breakout, there was a typical Flag-like reaction on sharply diminished volume, and although this movepenetrated the top border of the Rectangle, the penetration was not decisive or significant, and the lower borderwas never violated. Now, see how volume appears on October 15 as the old high is reached, and again at the top ofthe move on November 14. The decline returns to the level of the September high on a low-volume reaction. It isinteresting how, on five occasions in this chart, the 52 level served as a Support or Resistance point: twice asResistance on the way up, and three times after the new October high, as Support.
On the next rise, we see almost the same type of advance. In this case, the Support-Resistance Level is about 57.Notice the approach to the critical level, the backing away, the aggressive move into new high ground (in mid-December), and the recession to the Support at 57.
Advances of this sort seem to represent the ebb and flow of the Minor Moves during a Major Trend when there areno great “news developments” to change the normal progress of the trend. Where there are frequent and importantchanges in the market or in news affecting the industry, we may see long Consolidations or Secondary Reactions,but the Major Trend is durable. We must not assume a Major Reversal prematurely.
48
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Figure 37.4 During the same period that Granite City Steel was making the series of steps upward, as shown inFigure 37.3, Masonite was doing almost the same thing in reverse.
To have continued to hope for a change in trend with a stock that was acting as “MNC” did through the latter partof 1956 would have required an unusual amount of optimism or innocence about the habits of stocks. Actually,there would be good reason for optimism if the stock had been sold short early in the trend.
This is almost a perfect counterpart to the “GRC” chart. We have not only a series of declines with rallies that failto establish even Minor highs above the previous Tops, but we are also able to draw a trendline with a number ofpoints of contact on the way down, which is somewhat unusual in a downtrending situation. Notice the tendency ofthe rallies to stop short at the level of previous bottoms in a series of Support-Resistance Levels. We see suchaction at 44, at 41, at 38, and at 36.
We would certainly not consider the breaking of the trendline on the upside in late December as evidence of aReversal. Such a break after a trend of this sort probably means no more than a Secondary Recovery. To be ofgreater significance, it would certainly call for some volume showing, which was utterly lacking here, and beforewe would consider the stock again strong enough to buy, there would have to be some sort of Reversal Pattern. Afaltering rally back to around 40 would, in fact, suggest the advisability of further short sales.
DELAWARE, LACKAWANNA AND WESTERN
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Figure 37.5 Very often you will hear the question, “But how can you tell whether a technical formation or abreakout is valid?” In many cases, and in a great majority of upside patterns, the volume gives such a decisiveanswer that all doubts are removed. Not always is the volume confirmation as clear as in this chart of Delaware,
Lackawanna and Western, but this is typical of a good many breakouts in uptrends. You will see the volume wasgenerally light during the Rectangle, in which we see five plainly marked Tops and Bottoms.
On Thursday, November 4, the volume increased sharply as the price moved up to the top of the Rectangle andclosed at that point. The following day, Friday, we see good volume again with a close beyond the top border.From this point on, the move is obviously upward.
There was no indication of Reversal at any time after the breakout. A Top was reached in March at 25 1/2.
This was an especially vigorous move as it came out of the Rectangle. Normally, we would look for MinorSetbacks such as the series of reactions in “GRC,” Figure 37.3. If these had occurred, it would in no way haveweakened the Bullish Pattern.
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Figure 37.6 The situation, somewhat similar to “DL” in Figure 37.5, presents a little complication. The problemwould have been whether to sell or continue to hold “LA” after the late October break down through the Bottom ofthe Rectangle. There was no important volume on this drift move, and on only one day did the price close barely3% below the bottom of the pattern. A holder of the stock might well have sold it, might even have executed ashort sale.
Suppose now, you had actually sold the stock short; observe the volume and the price action on Thursday,November 4, and Friday, November 5. Notice the volume and the price on the following Monday and Tuesday as itreacted slightly. Then see the quick pick up in volume as the price advanced on Wednesday, the week and a half ofdull Consolidation, and the larger volume on the move up on Friday. Surely by the middle of the first week ofDecember, if not before, you would have seen the danger signals and closed out your short.
Such a turnabout does not need to be a tragedy nor even a discouragement. Some easily discouraged traders wouldbe so concerned about the small loss realized on their unsuccessful short sale they would not be ready to seize theopportunity to reverse position and buy the stock after the strong up signals. This move carried to 26 3/4 in March1955.
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At the time this Triangle started, in early 1955, it was not possible to identify it as such—particularly since theFebruary high ran a little higher than the horizontal Tops that eventually formed. However, during the sevenmonths preceding the first breakout move, it became increasingly clear each rally to the neighborhood of 32 1/2was followed by a reaction on low volume, and these reactions were forming a series of Rising Bottoms.
In the first week of September we see a clean penetration upside, and from here on, the advances and declines fitinto the typical pattern of a Major Advance. Notice the Breakaway Gap in November and the low volumethroughout the December-January-February reaction.
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Figure 37.8 Here, in a daily chart, we see once again the dramatic sequel to a Descending Triangle. Here is thetypical series of declining Tops on rather low volume with retreats between the rallies to a horizontal line.
Notice the important Support here was violated with heavy volume on Friday, January 25. Although the degree ofpenetration was not great, in view of the generally Bearish reaction to this point we would sell at once. ADescending Triangle has Bearish implications even before the breakout. There was no substantial Pullback afterthe breakout. Since it is not possible to count on such a recovery after a break through Support, it is safest to selllong holdings immediately or to place a very near stop on them as soon as a close outside pattern occurs (in thiscase, outside the pattern as adjusted for ex-dividend).
Notice the pickup of volume as the price drops into a tailspin at the end of January. Heavy volume is notnecessarily a feature of important downside moves, but it may, and often does, accompany them, and when it does,it simply underscores the significance of the move.
Question: does Textron look like a “bargain” to you at the end of January on this chart? Would you be tempted tobuy this stock because “it can't go down any more,” or because it is “due for a rally,” or because it is “sellingbelow its true value”?
Suppose “TXT” did have a technical rally, which seems quite likely after the move shown. How far would youlook for it to go? Would you expect it to penetrate the 20 level in the near future? Would you call this a BullishSituation at the end of January 1957?
LIBBY, McNEILL
AND LIBBY
1927 1928 1929 1930

Figure 37.9 (a) Libby, McNeill and Libby showed no serious effects at the time of the October 1929 panic, andwent on to new highs in March and April 1930. (b) Chrysler, one of the great market leaders, made its Bull MarketTop in 1928, more than a year before the Panic, and had already lost 60% of its value before October 1929. (c)Eagle-Picher Lead never enjoyed any Bull Market at all. Aside from an unimpressive rally in 1928, it was in adowntrend all the way.
The examples given are not rare exceptions; there are many others involving important stocks that did not followthe pattern set by the Averages. This variety of behavior is typical of the market. It is to be seen today. They are not“all the same,” and each stock must be studied individually. In Figure 37.10, there are a few examples showingdisparate action during the years 1953-1956. There are hundreds of others that would illustrate the point equallywell.
(a)
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Figure 37.10 (a) West Indies Sugar broke out of its “Scalloping” Pattern in late 1956 to make its own Bull Marketat a time when action in the Averages was apathetic and generally weak. (b) Although the Averages continued tomake new highs through the spring of 1956, Westinghouse Electric made its top and went into a Major Declinemore than a year earlier. (c) Here is a companion piece to Eagle-Picher's chart of more than 25 years ago, shownabove it. Kresge, like a number of other “blue chips,” did not participate in the Bull Market Moves of 1953-1956.
These six charts were adapted from “Graphic Stocks” (F.W. Stephens, New York). The 1927-1930 charts are froma Special Edition covering nearly 700 stocks through the period 1924-1935. The 1953-1956 charts are from a lateredition of “Graphic Stocks.”
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NORTHROP AIRCRAFT
NOC
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' 4 ;11 18 25
J ANUARY  FEB R UARY  MAR CH
4 41 18 2^ 1 8 45 22 2^ 5 12 19 26 5 12 19 26 2 9 16 23 30 7 14 21 28 ’
Figure 37.11 A beautiful Top Formation in Northrop Aircraft, 1954-1955. The move, which ended here at 39 3/4 inJanuary 1955, emerged from a Bottom in 1953 at 6 1/4.
The Descending Triangle is marked by rather unusual volume at the peaks of rallies in February and March.Otherwise it is typical of this sort of Reversal Pattern. As so frequently happens, there was a Pullback effort afterthe March 14 breakout, but this rally lasted only two days.
You will notice the volume on the breakout and throughout the downside move was not so spectacularly heavy, notnearly as heavy, in fact, as on the Minor Rallies within the Triangle. As pointed out previously, however, we do notneed or expect so much volume on a decline as we look for in an advance.
Volume did not develop until the end of the first stage of the decline. It is quite usual for heavy volume to show upat the end of a Minor Move whether on the upside or the downside.
Notice the Flag formed on the subsequent rally in mid-April. The measuring implications of this Flag wereapproximately carried out a month later.
During the following year and a half, “NOC” never reached 31 again.
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Figure 37.12 Bearing in mind the 1954-1955 chart of Northrop in Figure 37.11, we now turn to the action in thissame stock in the latter part of 1956 and the beginning of 1957. The question is whether the Major Downtrend isstill in effect or whether an important upturn has taken place.
As usual, it is the volume that must be watched and studied. Notice the Minor Peak on August 14, then the veryheavy volume on August 24. See how the activity dries up during September but resumes briskly as a new MinorTop is established in October. Observe the drying-up of volume on declines and the activity on rallies to the 25 1/2level, which, by the middle of December, has become the horizontal Top of an Ascending Triangle.
There was no question about the validity of the breakout move on December 10, and the subsequent reaction in thenext two weeks confirmed this by the lack of activity on the decline. Again, in early February, we see volume pickup notably as a new high is registered.
At the time this is written (EN: 1957), it is not possible to say whether or not “NOC” will continue this upwardcourse and eventually smash the “31 barrier.” We feel there will be no doubt in the reader's mind at the beginning
of February, Northrop was presumably moving in an uptrend and must be presumed to be in that trend until adefinite change in its market action has taken place. It seems quite probable if “NOC” should advance to the 30-31level, there is likely to be a period of Consolidation with the formation of an Area Pattern before a successfuladvance above 31 is accomplished.
As a sidelight on this chart, it might be mentioned that during the period of advance shown above, many aircraftstocks were moving lower.
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B.;
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Figure 37.13 The 1954-1955 advance in Chicago, Milwaukee, St. Paul and Pacific is an object lesson in BullMarket techniques. Where would such a trend (of which there are many similar cases) leave the man who sells just“because he has a good profit,” say at 15, or who feels “17 is too high a price”?
Here is a chart worth considerable study because it exemplifies a great many features of the “ideal” uptrend. In thisfull year of advance, there is no point at which even a tyro technician could find reasonable cause for anxiety orjustification for selling the stock. What is more, we should not overlook the tax advantages of long-term gains.
In August and September, we have a perfect example of the Symmetrical Triangle as a Consolidation. The volumeis typically heavy at the start of the pattern and shrinks to almost nothing as it progresses. The breakout volume isdecisive. The reaction after the breakout, also on lower volume, as it should be, runs right back to the apex, the“cradle point” that is nearly always a strong Support on such a reaction.
Now follow the action from here; the two days of higher volume in the early November rally represent thepenetration of the previous Minor Top, and the end of the rally, respectively. The reaction comes back to theprevious top.
The December rally is marked by heavier volume when the November top is exceeded, and again, to a lesserdegree, at the end of the move. Once more there is a reaction, this time to the November top.
A fast move near the end of December repeats the same price and volume action, and it is followed by a typicallow-volume reaction to the early December top. (This is becoming monotonous, but it is important. You are seeinghere a long-term demonstration of Bullish technical action.)
Next, we have the January breakout. How far would you expect its Minor Reaction to go? Would you be surprisedif it found Support at the level of the three little Tops formed early in the month at 17 1/2?
The following advance drives through the 20 level, and, in a series of small fluctuations, forms an AscendingTriangle. By the end of February, another new high has been established. Can you estimate where to look forsupport on the reaction?
Figure 37.13 (Continued) Now we see the formation of the second Ascending Triangle (notice the relatively lowvolume), which is broken on the upside in a burst of trading activity toward the end of April. The next reactioncomes back to the support of the former Tops as you would expect. Once again, an Ascending Triangle is formed,and you will see how the volume dries up throughout this pattern, coming to life emphatically on the breakout onWednesday, June 8.
Many students, on first seeing this chart, remark, “Well, the trend wasn't broken until Tuesday, June 21.” Actually,no break occurred on that day. The stock simply went ex-dividend $1.50, which, as you will see if you adjust theprice by that amount, merely brings it back to the Support at the top level of the April-May Ascending Triangle.
It is inconceivable that any such regular series of Bullish Patterns could appear throughout a full year of trading ina stock “by accident.” This is part of the normal mechanism of the market, representing the judgments, opinions,fears, hopes, and trading tactics of thousands of traders and investors. It should be added, however, that it is notoften that one sees such a long and “perfect” Major Advance as this. Normally, there are interruptions, distortions,or Secondary Reactions from time to time.
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WESTINGHOUSE ELECTRIC AND MANUFACTURING CO.
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FEBRUARY MARCH i . ApR1^ , , MAY . , JUNE JULY. ,
5 12 19 26 5 12 19 26 2 9 16'23 30 7 14 21 28 4 11 18 25 29 16 23 30'
Figure 37.14 Does it require second sight to perceive this is a Bearish stock? If you were keeping a chart onWestinghouse Electric and Manufacturing, wouldn't you have recognized, long before the end of the period shownabove, that the trend was down, not up?
It is one of the great delusions of the market that the stock we own must be “good.” As prices decline, the price-dividend ratio, based on past history, will improve. Additionally, the priceearnings ratio likewise will lookcontinually better. Investors will begin to speak of “averaging their cost” by putting more money into a tumblingstock (instead of looking for something going their way). They will talk endlessly about improved outlook, newproducts, and a forward-looking management; they will prove to you it is selling “below its true value,” whateverthat may mean. They will bend every effort to establish what is going on before their eyes is not true; that the veryweak-looking stock is actually strong; that the American public is making a great mistake and is misjudging thisstock; that the tape is wrong because they must be right.
Nevertheless, values in the market are determined democratically and, by and large, probably represent the bestcomposite appraisal you can find. A move like this is not meaningless, and it is not possible today to attribute it tothe machinations of a few manipulators. In the chart, we are seeing the reflection of a collective evaluation thatcannot be lightly disregarded. Westinghouse reached 50 7/8 in November 1956.
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Chapter thirty-seven: The same old patterns
Figure 37.15 A typical stock chart on TEKNIPLAT™ charting paper. Allowing for ex-dividends, "OT" neversignificantly violated the apex of the Triangle. The advance ultimately added 60% to the value of the stock. Thischart, in its long, mostly sideways movement, is a good example of the importance of making allowance for theex-dividend drop in the price. During the first five months shown, we see an almost perfect Symmetrical Triangle.The first critical point would be on the slight breakdown in the middle of May. The lower border of the Trianglewas violated just a trifle, even if we had allowed for the 62 1/2(2 March dividend. If one had sold the stock here,who could blame him? No great or immediate harm would have been done. However, an experienced technicianmight have taken into account the insignificant volume at this point and waited a bit, with a stop at, say, 60. (Seethe somewhatsimilar situation in the chart of "LA," Figure 37.6.) If "OT" had been held, the volume pickup on therally would have shown the trend had not yet reversed itself. The second critical point came in late September andearly October, at the time of President Eisenhower's illness. However, if we allow for the two dividends that wentex in July and October, the break did not violate the May Bottom. Furthermore, it was on relatively light volume.If the stock was still held, there was no valid reason for selling on this decline. From here on, breaking upwardsharply from the October-November Island, "OT" resumed the Major Advance interrupted by this long period ofConsolidation, and advanced to the equivalent of over 100 (adjusted for two-for-one split) in 1956.
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Figure 37.16 The Broadening Top in the Dow-Jones Industrial Average that formed in May, June, July, and August1957. Although Broadening Tops have appeared many times in individual stocks, and, as a rule, have carried outtheir Bearish implications, such a chart pattern has never before been completed in the Industrial Average. In 1929,on two occasions, there were patterns that began to show Broadening tendencies, but because these wereinterrupted by continuation moves, about all one can say of them is they may have indicated a growing technicalweakness in the market.
The 1957 situation, on the other hand, was very definite and was fully completed. During the early stages of thepattern, several of our friends wrote, calling attention to the possible Broadening Top, among them Charles E.Carden of Fort Worth, TX, who has handled Dow Theory comment and analysis for the Fort Worth Star Telegram.The chart shown in Figure 37.16 is adapted from one of Mr. Carden's charts and is reproduced with his permission.
The first significant point after the February 12 Bottom was the Minor Peak of Tuesday May 21, marked (1). TheMinor Decline from this point on Tuesday, May 28 (2), was quite normal, as was the renewed advance to Monday,June 17 (3).
The first sign of a broadening tendency was when the Average closed on Monday, June 24 (4), below the May 28bottom. However, this by itself did not indicate a Reversal. The advance was resumed, and surmounted the May 21and June 17 Minor Tops, reaching a high closing figure of 520.77 on Friday, July 12 (5). The Broadening picturewas now quite evident, and the completion of a Broadening Top required only a close below the June 24 Bottom.
On Tuesday, August 6, the Industrial Average closed decisively below the June 24 Bottom, signaling thecompletion of the Broadening Top. This was an indication of Major weakness, a warning not to be taken lightly.
The Broadening Top, as we have pointed out previously, is an indication of a wildly gyrating market, a marketwithout leadership or definite trend. The presumption is that heavy distribution is going on under cover of therallies and the breakout move is seldom a false one.
Figure 37.16 (Continued) Since we are dealing with an Average rather than a single stock, we would consider anyclosing below point (4) after the peak at (5), regardless of how slight the margin might be, would constitute a validbreakout, because Averages are less sensitive than individual stocks, and it is customary to consider even slightpenetrations at signal points (as in Dow Theory) as perfectly satisfactory. You will notice also that, although itwould be possible to draw the Broadening Top through the extreme ranges of the price, as we have done with thewide-dashed line, we have used the closing prices as marked by the narrow-dashed line. This, too, is in line withDow Theory practice, where only closing prices are considered.
The implication of the pattern here was Bearish for the “market-as-a-whole.” As might be expected, a majority ofstocks showed weak patterns of trends at this time. As always, however, it was necessary to examine each stockseparately on its merits, because, as we will show in the following pages, not all stocks behaved alike even in thisextremely weak market situation. Compare the broadening top from 1999 to 2000 (Figure 37.17).
Figure 37.17 The Broadening Top in the Dow in 1999-2000. If repetition is the heart of pedagogy, the reader maydie of heart disease with looking at the Dow Broadening Top, especially if he was long at the time and eitherdisregarded the signs or was not educated as to their significance. The lesson is always the same: bad news is on
the way. The numerous technical aspects of this historic market top are discussed at length in other views of theDow taken at this time. Remember, this time it is different. The market paradigm has changed, and so on and soon. ... Those who listen to fools will be fooled.
Figure 37.18 1957 Bearish Trend in Industrial Rayon. At no time did this stock show significant strength.
Averages do not tell the whole story. Each stock has to be considered on its own merits. Long before the formationof the 1957 Broadening Top in the Industrial Average, Industrial Rayon was moving down in a Major Decline. Youwill find many cases in which it is difficult to "see" what a stock is doing or to determine its Major Trend, but insuch a situation as this (and this is not a rare case), it is perfectly obvious that the trend is down. Although therewere a number of Minor Rallies and Consolidations during the decline, the entire pattern was so obviously part andparcel of the same big decline that no one who was even slightly familiar with typical stock behavior would havebeen tempted to buy the stock, even to cover shorts.
On Monday, July 29, there was a sharp downward break with a gap on climactic volume. This would havesuggested the probability of a Minor Bottom, and for three and a half weeks, the stock did stabilize at around 24.But even during this Consolidation, the continuing weakness showed up on the small Descending Triangle that wasformed, and ultimately on Wednesday, August 21, the price broke sharply to continue the Major Decline.
446 Technical Analysis of Stock Trends
Figure 37.19 1957 Bullish Trend in Lorillard. Although most stocks declined in 1957, there were a number ofstrong issues like this one that appeared to be totally unaffected by the general pessimism.
Averages do not tell the whole story. It will come as a shock to many readers, who rightly regard the latter half of1957 as a Major Bear Market, to see Lorillard making a typical Bull Market Advance. Lorillard moved up from15L to 34 during the year—and reached 54J during the first three months of 1958. It is hard to believe this chartand the Industrial Rayon chart we just looked at cover the same period, the year 1957.
The majority of stocks did suffer severe depreciation, but there were a good many issues, like Lorillard, whichenjoyed a generally Bullish Trend all year. Among the important stocks that moved up consistently in 1957 wereAmerican Chicle, Anchor Hocking Glass, Colgate-Palmolive, General Foods, General Cigar, Grand Union,National Biscuit, Parke Davis, Penick and Ford, Plough, Inc., Proctor and Gamble, Ruberoid, Vick Chemical,Winn-Dixie Stores, and Zenith Radio.
Whatever theories we may have as to the condition of the "market-as-a-whole," we must always realize we arebuying and selling individual stocks. (EN: Unless we are trading Index Shares.) We may get a picture of extremeBullishness or extreme Bearishness in the "general market," but if this picture conflicts with the clear evidence in aparticular stock, we must recognize it is the stock, not the Average, with which we have to deal. We cannot assumea stock "must" follow the Average. Often, it is possible to obtain greater stability and safety by buying a few strongstocks in a Bear Market or by selling short a few weak stocks in a Bull Market, than by attempting to maximizeprofits with an "all-out" position one way or the other.
Chapter thirty-seven: The same old patterns 447
448
Technical Analysis of Stock Trends
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Figure 37.20 During the latter nine months of 1961, some well-known market Averages continued to show newall-time highs. However, the Evaluative Index (see Chapter 38), in this period did not indicate any such overallstrength; many stocks were in almost continuous decline for the nine months. These included such important issuesas Air Reduction, Allied Chemical, Allis-Chalmers, Aluminum, Ltd., Fansteel Metallurgical, Flintkote, HeydenNewport Chemical, Sperry Rand, Texas Instruments, Trans World Airlines, Universal Match, and many others. Atsuch times, it is best to choose stocks selectively and maintain adequate liquid reserves.
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Figure 37.21 A familiar Top Pattern. From the end of 1957 to the spring of 1961, Burndy Corporation moved frombelow 10 to 37 in a generally Bullish Trend. The advance accelerated sharply on the postelection rally of late 1960and early 1961. However, with Burndy, as with many other stocks, the rally ended in the early months of 1961.Here, we have not only a perfect example of the Head-and-Shoulders Top in the price action, but we also have thetypical volume confirmation. The early April rally was on heavy volume. The rally in the last week of April was onsomewhat-disappointing volume, although a new high was made at that time. We have a definite increase ofvolume on the retreat from this peak, and practically no enthusiasm in the final rally of the first week of June. Thebreakdown on Monday, June 19, accompanied by heavier volume and a definite gap in the price track, confirmedthe Top Formation. Although Burndy held around the 30 level for a time, and after a further drop recovered to 31,the Major Trend had definitely been reversed. By June 1962, Burndy was selling at 11 3/4.
Figure 37.22 Weekly chart of Brunswick Corporation showing the final stages of the long Bull Market in "BC,"the Climactic Top in March 1961, the distributive phase through December 1961, and the ultimate breakdown.
For five years, from 1956 into early 1961, Brunswick advanced in a great Bull Market surge. During this period,the stock was split four times. In the first week of March 1961, terminating the postelection rally, "BC" made anew high on extraordinary volume, but closed the week nearly at the bottom of the weekly range. The One-WeekReversal might well have served as a warning to the market trader.
Assuming, however, the owner of shares in Brunswick was not a trader and was interested in the stock from along-term point of view, he might have held the stock through the breakdown from the Symmetrical Triangle
formed in March and early April. He might have continued to keep his shares through the summer and fall of 1961and the rally of September and October. If so, and if he had been watching the action of the stock, he would realizethe 50-52 level was a critical area. A break through this previous Bottom would represent a serious failure ofSupport and, certainly, the decisive violation of the 50 level in the first week of January 1962 (with heavy volume)could be recognized as a very dangerous Reversal Signal, calling for immediate sale of the stock regardless ofcapital gains tax or anything else. Although this move preceded the general collapse of the market by severalmonths, it was a clear technical indication of extreme weakness and extreme danger in Brunswick, regardless ofthe action of other stocks at that time. If an investor had noted the break but decided to "wait for a rally" to sell hisstock, he would have had no chance to get out. Brunswick never recovered, never rallied, and by October 1962 itwas selling at 17.
Technical Analysis of Stock Trends
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Figure 37.23 A beautiful example of a Rectangle in Polaroid. Notice the low-volume fluctuations between(approximately) 178 and 202. On Thursday, May 10, on the highest volume of that year to date, Polaroid brokeSupport and plunged to 168. This was a clearly Bearish Move. It would have been fatal to “hold for a rally,” forthere was no rally. It can be very expensive to hold onto a stock wishfully when the situation has changed radically,no matter how good it may have looked previously. Note this break came more than two weeks before the “near-panic” of May 28. By that time, “PRD” had dropped 50 points and was headed for still lower levels.
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Figure 37.24 At a time when a majority of stocks were already showing signs of serious weakness, early in 1962,Copper Range was making vigorous new highs. Actually, the move did not get far; it never substantially brokeabove the 1961 Top.
The evidence of weakness in “CPX” did not become apparent until, after the relatively weak April rally, the stockbroke through 19 on Monday, April 30, and closed at 17. This was the completion of a well-marked Head-and-Shoulders Top. In this case, there were three days of rally before the downward move really got under way, but itmight have been dangerous to count on a rally after the clearly Bearish signal.
Incidentally, this Top Formation was completed well before the precipitous drop of May and June.
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Figure 37.25 Like practically all stocks, “UV” went into a tailspin in the spring of 1962. After the “bad day,” May28, it continued to slide throughout the month of June. At this point, there started what could be considered nomore than a technical rally in a Bear Market. This rally stopped at 29 and was followed by a dull decline lastingabout two weeks.
The next move, in the second week of August, was marked by considerable volume, and although there was noobvious, clear-cut pattern, it seemed significant that the 29 level, briefly touched on May 23, May 28, and July 12,was penetrated on August 6.
Whether to regard this August 6 closing as an immediate buy signal, or to wait for the completion of the breakoutmove and look for an opportunity to buy on a reaction, would be a problem. In this case, it would have paid towait. Notice the late August reaction came back to the 29 level, where it found Support, and then continued itsupward move.
Considering the weakness of most stocks in this period, the action of “UV” is remarkable. The important thing torecognize is individual stocks do not necessarily follow “the main trend” of the Averages.

Figure 37.26 Weekly, July 1961 through June 1962. This chart shows the Head-and-Shoulders Top Formation inthe Industrial Average that preceded the collapse of April, May, and June 1962. Normally, especially in the chartsof individual stocks, there would tend to be heavier volume on the left shoulder. The price pattern alone issufficient to mark the pattern as a dangerously toppy situation. During the entire period in which this formationtook shape, many individual stocks representing important companies were showing Top Reversal symptoms, asmight be expected. Note, so far as this Head-and-Shoulders Pattern is concerned, the Reversal Signal is notdefinite until the neckline has been penetrated.

Figure 37.27 Daily, April through September 1961. Here is a rather confusing and complicated chart, but one thatcontains several points of interest worth a bit of analysis. Notice the beautiful little Head-and-Shoulders Top inApril and May, especially the volume weakness on the final rally before the downside breakout. Notice also thisstock was split two-for-one in June, but such a split does not materially affect the technical action of the stock,except because there are now two shares of stock (at half the market value) for each share of old stock, there maybe some increase in the average number of shares traded per day. Notice also that once the downtrend wasestablished, the rallies (especially the mid-July rally) do not penetrate the trendline drawn through the April andMay peaks. This trend continued down for more than a year after this, reaching a low of 11 1/4 in October 1962.
Figure 37.28 Daily, January through June 1963. Here is a good example of a Symmetrical Triangle as aContinuation Pattern. Triangles of this (Symmetrical) type may mark Consolidations in a Major Trend, or they mayconstitute a Reversal Formation. The characteristics in either case are an active move to the first turning point ofthe Triangle, and then, generally diminishing volume as the price fluctuates in a narrowing pattern. During thisperiod, it could be said the stock was in both an uptrend, marked by the lower boundary of the formation, and adowntrend, indicated by the upper boundary. Notice the increase of volume on the breakout, which, in this case,was on the upside. Also, notice the reaction to the “cradle point” defined by the intersection of the two boundarytrends of the Triangle. The advance of the stock from April to June measures just a little more than the height ofthe open side of the Triangle. The attainment of this “objective” does not necessarily mean the termination of theMajor Trend, however, and by August 1963, Cerro had reached 33 1/4.
M CRUCIBLE STEEL CO. OF AME
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Figure 37.29 XA. Daily, March through August 1963. Here is a good example of an Ascending Triangle, in whichthe rallies advance repeatedly to a given level; the reactions find Support at gradually higher points. Such a patternnormally indicates a potentially Bullish situation in the making, just as the reverse (Descending Triangle) implies aBearish tendency. Notice the higher volume on the various peaks near 22, and the very high volume on thebreakout move in August. If any further evidence of the strength of this move was needed, the Breakaway Gap atthe opening, Monday, August 12, would supply it. After a breakout of this sort, it would be quite normal for thestock to suffer some profit-taking reaction, usually on light volume, and such a reaction might run back to 22 oreven a little below this without altering the essentially Bullish nature of this picture.
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JUNE JULY AUGUST SIPIIMBI^ OCTOBER NOVEMBER
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Figure 37.30 SOC. Daily, June through November 1962. Before commenting on the November breakout here, weshould call attention to the fact “SOC” was one of the stocks that held up fairly well during the Cuban crisis inOctober 1961 and did not make a new low under the June bottoms. This chart picture is an excellent example of aDouble Bottom. It is not necessary for the two Bottoms to be at exactly the same level if they are reasonably close.The important thing is the stock has found Support once, has rallied, then declined again, and has found Support atnearly the same point. The Bottoms should be some distance apart; there should be at least six weeks betweenthem, preferably more. Also, the rally between them should be definite and should amount to at least a 15% gain atits peak. The formation does not acquire significance as a Major Bottom Pattern until the level of the top of therally is penetrated on substantial volume. This penetration took place on Tuesday, November 13, and from thattime continued in a Major Bullish Trend, reaching 1559 in May 1963, an advance of more than 500 points from theclose on the day of breakout.
Double Tops have an opposite significance; they are similar to the Double Bottoms, but they consist of two tops atapproximately the same level, separated by some weeks or months, and with a decline between them, which mustbe penetrated to validate the Top Formation.
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Figure 37.31 Daily, November 1962 to April 1963. To the average person unfamiliar with the usual behavior ofstocks in the market, the price fluctuations appear meaningless and entirely fortuitous. If they are aware of generaltrends lasting months or years, they are often inclined to consider only the trend of “the Averages,” and are notconscious of the fact many stocks may be making large advances at the very same time that others are slidinglower and lower. It is not always possible to lay a straight-edge ruler along the trend and show \ it makes a perfectstraight line (although this does sometimes happen); however, as in the case of General Steel Industries, there is noquestion the advance is fairly consistent over a long period of time, barring the relatively unimportant reactions,Consolidations, and so on, along the way. You will notice, too, the two-for-one split in early March did notmaterially affect the upward trend except to show somewhat more volume, as might be expected with a greaternumber of (new) shares. For a contrasting (downside) trend, see the chart of Avnet Electronics, Figure 37.20.
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Figure 37.32 Daily, February to August 1963. This is an interesting study of Support and Resistance phenomena.Incidentally, it is also an example of a Bearish Stock (and not the only one by any means) in what was generallyconsidered a Bullish Market, during the spring and summer of 1963. We would point out several rallies to 31 inMarch and April, and the breakdown in early May. In May and June, the stock rallied, but it stalled at about the
level of the March low. Then there was another drop, and in the rally, this time came back to the late April low. Thenext drop, in July, was followed by a little rally to the June Bottom at 25. This is fairly typical Support-Resistancebehavior. The price level that has been a Support tends to become a Resistance once the Support has beensubstantially broken. Vice versa, as regards overhead Resistance; after it has been broken, it tends to serve as aSupport level.
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Figure 37.33 January through June 1963. Sometimes a move happens all of a sudden and does not result in acontinuing long trend. In this case, it is not possible to say whether the long-term trend will be up or not. Thepurpose of showing this chart is to point up the remarkable action that can follow a break through an importantSupport or Resistance Level. You will notice that the entire period from mid-January to Tuesday, May 14, can beregarded as a Rectangle on the chart with Bottoms at about 10 1/8 or 10 1/4, and Tops at about 11 3/4. Notice theincrease of activity on the several rallies during the formation. The move, which was a “situational” thing insugars, affected all sugars in May, and turned out to be somewhat of a flash in the pan. Nevertheless, it was aspectacular one, and a trader with courage and acuity might have picked up this stock as a speculation after theclose of Tuesday, May 14. The next five trading days advanced the price from Wednesday's opening at 12 to theTuesday, May 21, close at 17 1/2, an advance of 46%. This is a type of market trading we would not recommendgenerally; it calls for courage, experience, and the willingness to take a number of small losses to secure onesubstantial gain. However, the in-and-out trader who observed the action on May 21 and noticed the One-DayReversal with abnormal volume and a gap could have secured maximum quick profits either by selling his stock atthe opening of the next day or by placing a stoploss order just under the close, say, at 17 3/8.
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::::::::::::::
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Figure 37.34 There are some warning signs in “CDA” in the Minor Breakdowns of late March and early May.What seems especially significant, however, is the nature of the recovery move in May and early June 1965. Thetwo convergent boundaries of the Recovery Trend form an up-sloping Wedge, which has rather definite Bearishimplications. If the Wedge had been pointed down, it would strongly suggest the possibility of a decisive upwardbreakout. Notice on the two days during which the highest prices were attained during this Wedge Pattern, thestock closed near the Bottom of the day's range. The subsequent history here, the collapse on heavy volume, showsclearly how dramatic a break from this not-too-common formation can be.
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Figure 37.35 Here is a chart that shows several interesting technical features. In July, August, and most ofSeptember, “W” was in a period of dormancy. The breakout of September 27 was followed by a week of inactionand then a strong continuation of the move on big volume. Notice the October-November Consolidation, whichtook the form of a large Symmetrical Triangle. If we draw the upper boundary of this Triangle, and the lower, wesee the breakout signaling a continuation of the move, on Wednesday, December 1, was decisive both in price andvolume action. At no time during the advance from 28 1/2 to more than 62 was there any indication of potentialweakness.
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Figure 37.37 Here is a beautiful picture of technical market action in Packard-Bell Electronics from August 1965into January 1966. The first point of interest is the Flag Consolidation in September and October, a classic example(“The Flag flies at half-mast”) and on the resumption of the up-move, the stock did duplicate the earlier move, anda bit more. (Compare with the 1945 chart of Martin-Parry, Figure 33.13.) Notice the nearly flat Tops and the risingBottoms from October to January, with generally declining volume (Ascending Triangle), and the magnificentbreakout move in the second week of January 1966. In this case, we can see no evidence calling for selling thestock all the way from September into January.
1969 197
N OVEMBER . D ECEMBER  J ANUARY
PARKE, DAVIS AND COMPANY PDC
AUGUST
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Figure 37.38 This could be regarded as a very flat Head-and-Shoulders Top or as a long Rounding Top. Thebreakdown through 66 was a warning, and certainly the sharp break below 60 in February was a definitely Bearishsignal.
ASTRODATA INC.
ADA
125 . ..
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75
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25
OCTOBER NOVEMBER DECEMBER JANUARY FEBRUARY
4 11118 25 1 8 15 22 29 6 13 20 27 I 3 10 17 24 31 7 14 21 28 >
Figure 37.39 A complete collapse in one day, Astrodata in January 1970. Not the sort of action you see every day,or even every month, but it is “normal” in the sense it is a phenomenon we have seen many times in the past andundoubtedly will be seen many times in years to come. When it does happen, it should be heeded—it meanstrouble. “ADA” was doing well in what appeared to be a typical and perfectly healthy uptrend. After a one-daysuspension on January 15, it reopened many points lower and never recovered. Trading was halted in lateSeptember. Some readers may remember other downside moves of this nature in the past. In Mack Trucks, in FifthAvenue Coach, and some may even recall, many years ago, a break like this in American Woolen. Such a break isdue to some sudden development or change in company affairs, but it is not necessary “to know the reasons”: thechart speaks for itself. As Lady Macbeth put it (in another connection), “Stand not upon the order of your going,but go at once.” There was a good example of this type of a “Gap Move” in Villager Industries on April 30, 1971,when the stock dropped 42%, from 7 3/8 to 4 1/4 in one day. Such moves as we are discussing here are nearlyalways on the downside; we do not often see comparable upside gap moves. After this type of break, althoughthere may be brief rallies, the stock nearly always resumes the downtrend, and in many cases, is delisted from theExchange. Anyone caught holding such a stock should not feel he had made a mistake in buying it, nor should helook for evidence of weakness before the big breakdown, for ordinarily, there is none, however, he should get outimmediately to avoid further loss. By way of reassurance, it can be repeated though this kind of collapse is a ratherrare occurrence.

Figure 37.40 Oracle Corporation. Lest one think the air pocket gap does not still exist, here is an example from theturn of the century (third millennium). These gaps, caused by disappointing earnings, were so prevalent at the endof the century at the top of that Bull Market that one could short vulnerable stocks before earnings reports withlittle upside risk and often collect nice scalps like this one.
EARN.
DIV.
. SHARE  S
PUBLIC SERVICE ELECTRIC AND G A S  PE G
THOUSANDS OF
, 1
ElLJ
Figure 37.41 A typical electric and gas utility stock. There are a great many stocks in this group, serving variousmunicipalities or regions. They tend to show similar market behavior because they are basically similar in nature.
There is a relation between the earnings of a company and the dividends paid, and the market price of the shares.Neither earnings nor dividends alone, however, are sufficient to constitute a complete determination of “value”because there are many other factors that can affect the “value” considered from different angles, such asdependability of earnings, future prospects, taxability, research and development investment by the company, andso forth.
The electric and gas companies, enjoying a regulated monopoly position in most communities, have a sure andsteady income. They are also in a definite “growth” situation because of the constantly increasing demands forpower by users. Most utilities will show a record and pattern of trading over a period of years very similar to thatof “PEG.” You will notice reported earnings have been larger each year from 1959 through 1970. Also, thedividend rate has been increased each year except in 1970, when it was unchanged from the year before. Anyonebasing his estimate of “value” on a simple index such as “price-earnings ratio” would conclude the stock was 2 1/2times as good a buy in 1970 as it had been in early 1965.
Obviously, there is more to it; the big funds and other large holders of stock are not giving up “bargains” of thatsort lightly and for no reason. The depressed chart is undoubtedly reflecting the whole thorny outlook facing theutility industry, including costly new facilities, anti-pollution devices, and other problems including deregulation.
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JANUARY
AUGUST
[ARCH APRIL MAY
MEMOREX CORP. MRX
SEPTEMBER OCTOBER NOVEMBER DECEMB
FEBRUARY
Figure 37.42 Although 1969 was Bearish for most stocks, “MRX” was enjoying the final fling of a dramatic four-year advance. Notice the Island-like Top in November, December, and January, and the low volume all throughthis period. The Breakaway Gap in early February speaks for itself. See also Figure 37.39.
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FLYING TIGER CORP
1969, 1970, 1971
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M T A T M ^L J A T S J P T N J-. D J J J F
Figure 37.43 From a 1967 high of 48 1/2, “FLY” started a downtrend that lasted two years and took the stockdown to 11 1/4; but during the spring and summer of 1970, the stock found bottom, made a Head-and-ShouldersReversal, and took off in a skyrocket move that, by February 1971, had recovered nearly all of the two-year drop.
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Figure 37.44 Here is a familiar pattern you have seen many times before in the pages of this book or in your owncharts—a large Ascending Triangle in the daily chart of Action Industries, formed in December of 1971 andJanuary of 1972. Notice the typical breakout and reaction moves and the continued uptrend into April of 1972.
Figure 37.45 Two things are remarkable here: (1) the amazing story of a business emerging from a college dormroom—a computer business, of course—and (2) the regular occurrence of air pockets, which will be seen better onthe next chart. Not a stock for those who dislike carnival rides and surprises. One should fit his portfolio to hisdigestion. Dell broke its long-term trendline, which the reader may easily draw here with a ruler, and after setting abull trap, went to 20, displaying several major warning downside gaps (see next chart). The out-of-proportionvolume at the chart end is a forewarning.
Figure 37.46 DELL. The breakaway or air pocket gap continues to astound, so frequently choosing to occur athorizontal lines. An exceptionally alert trader might have avoided the air pocket, observing the broken trendlines.
The average technician would have got out and shorted the breakaway gap. Seen one tulip, seen them all.
Figure 37.47 The benefits of the “Wintel” partnership are reflected in Intel's chart. The trader might have been inand out of Intel several times based on tightening trendlines, whereas the long-term investor would have patientlywaited out the—call it a “rectangular wedge”—that never was violated on the downside. The steeper the trendlinethe more likely—even the more certainly—it will be broken.
Figure 37.48 NOKIA (NOK). Not enough is made of the marking of zones of Support and Resistance (highs andlows) with horizontal trendlines. These benchmarks help the technician to mark the running of the tide, just likeDow's stakes on the beach. Notice how the high of 1999 influences the high of 2004. The breaking of horizontallines here after the breaking of the steepest trendline once again tells the tale for the technician.
Figure 37.49 AMD. Reflecting the vagaries of the semiconductor business, including the felicity (or infelicity) ofbeing a competitor of Intel, AMD shows trading opportunities both up and down. Here the intermediate-termtrader would respond to the vigorous breaking of short-term downtrend lines to get long.
JulOct 97 Apr Jul Oct 98 Apr Jul Oct 99 Apr Jul Oct 00 Apr JulOct 01 Apr
Figure 37.50 Yahoo! (YHOO). A superb trendline that should have kept the technician long until April of 2000—and then got him out, especially when combined with the top horizontal trendline. The extravagant volume at the
very top is the exclamation point on the warning.
Figure 37.51 Any resemblance between this chart and Amazon (see Figure 23.13) is not strictly coincidental.Readers will remember Magee's principle that birds of a feather flock together. Internet goony birds certainly do—or did. Yahoo! looks in this guise somewhat stronger than Amazon, but then selling books and mortar is a harderrow to hoe than selling electronic images (best business in the world). Again, such an attractive fundamental story.Gooks (or geeks) on skates helping revolutionize the wild frontier—we love these stories, but not enough to stopdrawing lines on the chart and selling them when they violate our lines. Even love must obey the rule of the ruler.
Figure 37.52 Apple (APPL). Apple is a remarkable delight because it illustrates vividly one of the centralprinciples of technical analysis: ignore (or take with a cellar of salt) the news. Any time the media swarms on acompany, be skeptical. If we believed the media, Apple would have more lives than a cat, considering how manytimes the media has written it off as dead. It is also a chartist's delight as illustrated in my Basing Point studies(Chapter 28), and here, by trendlines (horizontal and sloped) and a large fan. Readers years from now will want toobserve how the trendlines here forecast Apple's future. Figure 37.53 vividly illustrates the technical signal thatkicked off Apple's run, complete with Triangle and run day, and wake up volume. We constantly deprecated thepress disrespect of Apple—hounds of the press are appropriate—and they paid the price for their disrespect asApple went to 425 in 2011. It is satisfying to see the know-nothings of the financial press exposed for how littlethey know.
Figure 37.53 The file of press clippings predicting the death of Apple weighs as much as the daily output of theAugean Stables, and it is worth as much. One wonders why the press likes to beat on Apple so, especially when thewizard was up to his never-ending tricks; the wizard (Steve Jobs) had millions of fanatics ready to support his nexttrick. Although the Beatles are mad at Jobs and Apple, Apple is now a music company as well as a computercompany. The smooth-as-silicon lubricant iPod made music to investor's ears and Apple took off on another run.The start of the latest trick is pictured here. The volume in April is the wake-up call. Of course, what is thatvolume? A shakeout. The breakout across the Descending Triangle line after the false signal (Remember? Thosefalse signals are often followed by valid signals), the volume, and the surging run days—all good grist for theanalyst's mill. Furthermore, the surge across the downtrend line on big volume should be recognized as animportant technical pattern regardless of what proceeds it.

Figure 37.54 $NDX, THE NASDAQ 100. Following the Basing Points Procedure in Chapter 28, an almostcompletely objective procedure may be devised for the very long-term investor to replace or augment Dow Theory.In this chart, the Basing Points Procedure is applied to weekly bars. Thus, instead of three days away, we look forthree bars away. The result is a trade that lasts around 10 years! The method gets long in 1991 at the arrow, holdsthe trade until about 2001, and reverses. Observes the bottom of 2002 and reverses again and is long into the BullMarkets of 2006. Arrows show the signals; numbers mark the Basing Points, and Stops, which would be about 5%under the Basing Points, are not illustrated.
chapter thirty-eight
Balanced and diversified
The average investor wants a clear-cut, simple, easy answer to his question,
“What do you think of the market?” To him, it must be at all times either a
Bull Market or a Bear Market. If, in answer to his insistent demand, you
reply with the question, “What particular stocks are you interested in?” he
will avoid that issue and say, “Oh, I mean in general.” (For illustrations in
this chapter see Diagrams 38.1 and 38.2.)
If you will examine the pages of any magazine or newspaper carrying a
great deal of financial advertising, you will find many advisers and advisory
services make a great point of giving unhedged opinions as to the future
course of the market, and these opinions are most frequently couched in
terms of what the market as a whole is going to do.
Now, there is just enough truth in the common belief that they all move
together to make this an exceedingly dangerous assumption. It is true, for
example, we can set up definitions of what we feel constitutes a Bull
Market or a Bear Market, such as the Dow Theory, and if a given set of
conditions meets the rules we have laid down (i.e., our definitions), then we
can say accurately, “according to my premises this is now a Bull Market”
(or a Bear Market, as the case may be). It is also true that over the years, if
we had treated the Dow Industrial Average (DIA) as if it were a stock and
had theoretically bought it and sold it according to classic Dow Theory, we
would have done very well. (EN: As is vividly illustrated in Chapter 4,
where buying and selling by the Theory netted one $795,592.01 as opposed
to $55,411.83 [as of December 29, 201]) through buying and holding. Of
course, now it is the same as a stock [ETF], DIA.)
It is also true in the great inflationary and deflationary movements, which
reflect the changes in the relative values of dollars to equities, there is a
tendency for the majority of stocks to move with the tide. Furthermore, it is
true in the day-to-day movement of stock prices that most stocks move up
or move down together.
We should never lose sight of the fact the Averages themselves are
abstractions, not railroads, manufacturing companies, airlines, and so on. If
the Averages move, it is because the individual stocks making up the
Averages have moved; although, it is true during a time when the Averages
are advancing, a majority of stocks are also advancing, it is not quite
possible to reverse this and make it absolute by saying because the
Averages are advancing, therefore, all stocks must advance. If we carried
this to its logical conclusion, we would arrive at the point (that some have
arrived at) at which the fact that a stock has not advanced, but rather has
declined in a Bull Market, is considered sufficient reason to make the stock
attractive for purchase on the basis it must catch up with the others.
If we examine the facts, namely, the long-term records of what stocks have
actually done, we find there are periods when most stocks go up in value
and other times when most of them go down. We find, sometimes, laggard
stocks eventually will join the procession in an upward trend.
However, this does not always happen and it can be extremely
uncomfortable to have bought stocks in a presumably Bullish Market
because they are behind the market or they are all going to go up, and then
wait for months as we watch other stocks climbing to new highs, whereas
our own securities continue to languish or decline further.
From what you already know of the market, you will surely agree it is not a
wise policy to put all your capital into buying stocks in what is clearly a
Bear Market in the Averages and in most stocks. You will agree, too, it is
not a safe thing to sell stocks short to the limit of your resources in a
skyrocketing Bull Market.
If you have to be 100% on one side or the other, it is much better to go with
the trend. In that way, you will be in line with the probabilities as shown by
a majority of stocks and by the Averages.
Nevertheless, you should realize going with the trend is not always as easy
as it sounds. We can set up definitions, as we have, of what constitutes the
Major Trend. Then the question is whether you have the patience and the
courage to maintain a position in line with these definitions through months
of uncertainty and possible adverse moves. During turning periods, it is
often hard to make the decision whether to buy or sell.
Most especially, there is the difficulty of knowing what to buy or what to
sell and when. The simple patterns and signals of the Averages do not tell
the whole story. There is a certain usefulness in regarding the market as a
whole in studying Dow Theory, just so long as we keep in mind the
Averages we are studying are generalities (high-order abstractions) and the
rules for determining their trend apply to these generalities and not
necessarily to each and every stock listed on the Stock Exchange.
In many cases, for example, a group of stocks will top out and start an
important Bearish Trend, whereas other groups of stocks are continuing to
make new highs. This occurred in 1946, when we saw a large number of
stocks topping out in January and February, and others continuing strong
until the end of May.
We think of 1929 as the year the market made its great peak and crashed in
October to start the series of breaks that continued into 1932. There is some
truth in this, but it is not the whole truth. There were some important stocks
that made their highs long before the 1929 Top. Chrysler, for example,
made its high in October 1928, and had dropped from 140 to 60 before the
Panic of 1929. There were stocks that never enjoyed a Bull Market at all in
the whole period from 1924 to 1929. By actual count of nearly 700 listed
stocks, 262 issues made their Bull Market highs before 1929, and 181
topped in 1929, but before August of that year. There were several stocks
that did not have their first downside break until after 1929. Forty-four
stocks went into new Bull Market high ground after 1929 and before mid-
1932. Only 184 of the 676 stocks studied made their Bull Market highs in
August, September, or October of 1929 and crashed in October and
November.
In other words, only 27% of the stocks acted the way everybody knows all
stocks acted. (EN: As the Dow and S&P 500 made all-time highs in 1999
and were near those highs in 2000, the same condition held true again.
Many stocks had topped and were in long downtrends. EN9: And as stocks
crashed after the top of March 2000, Dow stocks held up well compared
with NASDAQ stocks and Standard & Poor's (S&P) 500, which saw
declines of around 50% [see Figure 20.3].)
It is all right to accept the general trend as a useful device, as long as we
know it is a device only, and not a picture of the detailed reality. We have to
face the problem that continually confronts every student of the market:
how to protect ourselves from uncertainties in interpretation of the
Averages, and how to protect ourselves against stocks that are not moving
with the majority. The problem can be met, first of all, by not taking an
unreasonable amount of risk at any time (see Chapter 41).
It can also be met by using an Evaluative Index instead of switching from
all-out Bullish to all-out Bearish. By this we mean using an indicator that
will show not merely whether it is a Bull Market or a Bear Market, but how
Bullish or how Bearish it seems to be at a given time.

10
20
Diagram 38.1 The Evaluative Index shows the percentage of stocks that
appear in Bullish or Bearish Major Trends. In 1961, this Index conflicted
with “stock Averages,” suggesting a possible Major Turn.

30
40
50
60
70
80
90
At first glance, this may seem not too different a conception from that of the
classic Dow Theory; the same technical methods apply. Also, during a
strongly Bullish Market, an Evaluative Index will also indicate
approximately the degree of strength. As the market begins to develop weak
spots, as did the market in 1928 and 1929, the degree of Bullishness will
gradually decline.
Before considering the use of this Index, let us outline what it is and how it
may be constructed. You will understand it is not a precise tool; it gives
only an approximate picture of the state of the market; it gives no positive
signals; and, in the final analysis, it is a reflection of the judgment and
opinion of the person who is maintaining it.
Suppose you are keeping daily charts of 100 stocks; at the end of each
week, you can mark these along the bottom of the chart with a small plus or
minus, indicating your opinion as to whether each particular stock is
moving in a Bullish Major Trend or is Bearish. In some cases, you will find
it hard to make a decision. This is not too important, however, because
these cases will not be numerous, and in the majority of stocks, you
normally will be able to mark them plus or minus on the basis of their
obvious action. If you now total the plus stocks and also the minus stocks,
including those in which you have had to make a tentative decision, you
will have two figures totaling the number of your charts. If 75 of these are
plus, you can say the market looks 75% Bullish to you. If next week the
percentage is higher, say 80%, it indicates a stronger or more Bullish
condition. If it is lower, say 70%, it shows that, on balance, fewer of your
stocks look strong; hence, the market is presumably weaker.
(EN10: A quick way to construct an Index of this sort is to run Moving
Average studies on the market, examining how many stocks are above their
50-day Moving Average, how many above and below their 200-day Moving
Average, and so on. Obviously, you can also do it as Magee did, by
examining each chart of the Dow to see whether it looks strong or not.)
As we have said before, if the Averages are making new highs, you will
expect (and find) the Evaluative Index will range well above 50%. In an
obvious Bear Market, the Index will stand considerably lower than 50%.
However, notice we do not speak, here, of signals. There is no point at
which we need to say, “Sell everything.” Neither is there a point at which
we can say, “Buy now,” in an all-out sense. The Index will float and adjust
itself continually to the shifting conditions.
It must be clear that a market in which only 53% of a large group of
representative stocks are moving Bullishly is not as strong as one in which
80% of these stocks are acting Bullish.
Therefore, you would be justified in making larger commitments on the
long side in this second case.
You would still have the problem of selection of the individual stocks to
buy, but you would be justified in making larger total commitments or in
assuming total greater risk (see again Chapter 41), than in a market that was
barely qualifying as a Bull Market.
By bringing the total of one's investment program in line with this Index, it
is possible to roll with the punches, and one would almost automatically be
withdrawn from a deteriorating market before things became too dangerous.
Furthermore, this would be accomplished without the need for torturing
decisions as to whether to sell now or wait a while.
There is a further extension of this method. If an investor were to follow the
Evaluative Index only by increasing or decreasing his long commitments
with the rise and fall of the Index, he might be better off than if he had only
the two alternatives of complete optimism or complete pessimism. In this
case, he would still be pointed always in one direction and would stand to
lose to some degree on his long commitments if the market did eventually
reverse and go into a Panic Move.
The extension of the method is to proportion capital, or a certain portion of
capital, between the long side and the short side of the market. Assuming
your interpretation of your own charts is reasonably correct in a majority of
cases, you can, at any particular time, select several stronger-than-average
stocks, and similarly, several weaker-than-average issues.
With the Index standing in the vicinity of 50% (as it did for a number of
months in mid-1956), you can then select several strong stocks to buy, and
several candidates for short sale, making commitments that will
approximately balance your total risk. In the case of an upward surge that
sweeps all before it, you will accrue losses on the short sales and eventually
may have to reverse your classification of them from minus to plus, closing
them out for a loss. In such a case, the gains on your good long positions
will more than offset the loss, assuming your choices were well made, and
the loss realized can be absorbed as insurance, namely, the price you have
paid to be in a protected position.
On the other hand, should the market collapse suddenly (as it did, for
example, at the time of President Eisenhower's illness in 1955) (EN: and as
it did on rumors of Reagan's incompetence in October 1987, and the Asian
Flu of 1998, and so on and so on), the accrual of loss in the long positions
will be offset by accrual of gains in the short positions. If the decline should
continue to a point calling for sale of the long stock, the losses here could
be considered the price of the insurance protection to the shorts provided by
the longs. (EN: In the tradition of the Texas Hedge, I take a somewhat
different view of shorts. Although they would be viewed in Pragmatic
Portfolio Theory as reducing risk, I like to view shorts as another profit
opportunity with the added benefit of reducing total risk. Being short a
stock in a confirmed Uptrend is simply feckless, and vice versa.)
It is also quite possible, in a more normal market, for both the long
positions and the short positions to show gains. What we are proposing is a
systematic and continuous arbitrage or hedge. As the Evaluative Index
advances, the proportion of short positions would gradually be reduced, and
the long positions increased. As the Index declines, the reverse would
happen. (EN9: I have suggested the method outlined here be called a
“Natural Hedge,” and the implementation of the hedge be called
“Rhythmic Trading.” A Natural Hedge of the Dow would consist of a long
commitment to, for example, the DIA in a Bull Market and short positions
in Bear stocks within the Dow. Or, even better, short positions in stocks
positively correlated to the weak Dow stocks. This last because even weak
members of the Dow will tend to be cushioned by the large holdings of
passive indexers.)
This method is essentially conservative. Those who have always feared the
short sale as a purely speculative gamble might well reexamine short selling
from the standpoint of using the short sale as a regular part of their
investment program as counterbalance to the long holdings.
The result to be looked for in this conservative balanced and diversified
program is primarily protection of capital. By its very nature, it eliminates
the possibility of plunging for spectacular profits, but it also provides the
mechanism by which the technical method can stand on its merits, largely
independent of the changes and chances of the market. It makes it possible
to eliminate a large part of the anxiety and uncertainty so many traders and
investors carry every day and often late into the night.
(EN: Many modern readers are probably unaware that John Magee wrote a
weekly advisory letter for four decades. These wise and practical letters
comprise the John Magee Market Letter
Diagram 38.2 From Collected Market Letters, September 28, 1985. Magee
Evaluative Index computed on the Dow-Jones Industrials illustrating the
use of the Index to identify Tops and Bottoms in the market. A sort of
“oversold-overbought” indicator.
Archive. From this Archive, I append here the letter of September 28, 1985,
relative to the Magee Evaluative Index (MEI). It speaks very strongly for
itself.)
September 28, 1985: an oversold market
This week, the MEI fell to 9% Strong, its deepest penetration into the
oversold quadrant this year. Not since June of 1984 has this index been
lower (see Diagram 38.1). Shortly after its June low of 8% Strong, the MEI
headed steadily higher, giving an Aggressive Buy signal throughout late
June and July.
The June 1984 MEI low of 8% Strong, together with the 8% level reached
on February 25, 1984, constituted a Double Bottom oversold reading for
this index. It corresponded to the 1,079 Bottom recorded by the Dow-Jones
Industrial Average (DJIA) on June 18, 1984, after which that Index
advanced steadily to its recent July peak of 1,372.
For more than 20 years, all major stock market Bottoms have corresponded
with extremely low MEI readings. During the “turbulent period” when the
stock market oscillated violently but showed no gain at all, MEI readings of
5% Strong or less corresponded with all Major DJIA Bottoms until the June
1982 low of 9% Strong, which immediately preceded the stock market's
upward explosion.
That slightly higher than “5% Strong or less” Bottom was an important clue
that a reinvigorated stock market was at hand; the straight-line DJIA
advance from 770 to nearly 1,300 ended a 17-year “do-nothing” period for
stock prices and ushered in the “renewed upswing” period shown on the
chart.
In this context, the “8% Strong Bottom” of June 1984, and the current MEI
reading of 9% Strong, take on added meaning. If, in fact, we are in a period
of Renewed (or major secular) Upswing, stock market Bottoms will tend to
be less severe and Tops more extremely overbought than would otherwise
be the case. Both the June 1982 DJIA low and that of June 1984 fit this
model. Because secular stock market waves tend to last for many years,
even decades, the likelihood is that the current MEI reading of 9% Strong
will also define a Major DJIA low.
chapter thirty-nine
Trial and error
You will not expect to turn in a perfect record from the start. You may
indeed do poorly, which is one of the reasons we have suggested using only
a safe amount of your capital, allowing enough leeway so if you should
misread and misdirect your campaigns, or if you should encounter an
Intermediate Setback in the trend of a Major Turn, you will be able to get
back on course, undismayed, and richer in experience.
Your records of actual transactions (and notes on theoretical transactions)
will help you. As time goes on, you will discover new trading refinements.
Try these methods against your previous chart records. See whether your
improvements work out consistently to your advantage. In that way, you
can test new details of method without risking actual capital until you have
checked the operation thoroughly.
In one actual case, a trader who had shown a rather poor record of
performance through a fast-moving Bear Phase of the market, rechecked 30
of his actual trades made during that period in light of new methods he had
subsequently developed. Where the original record showed a loss at the rate
of about 40% per year on the capital for the time it was tied up, the changes
he introduced, applied to the same situations, would have resulted in a
profit at the annual rate of 156%. Such a result, although not conclusive,
would strongly suggest trying out the new method in all similar situations in
the future, and if the performance continued to show this advantage, to
adopt it as a permanent policy. It is only by continual checking and testing
that you can learn to pick up more of the profitable opportunities and
protect yourself better against the unexpected Reversals.
If you follow the suggestions of this book, those already given, and those in
the following chapters, you will proceed slowly and cautiously, not risking
all your capital on a single move in a single stock; subsequently, errors and
plain bad luck, when they hurt you, will not hurt you too seriously. You will
be prepared for false moves, wrong interpretations, and complete Reversals
of expected developments.
If you have worked thoughtfully and serenely, without permitting your
emotions to rule your judgment, the law of averages will bring you
continually greater success. You are not gambling blindly in this work; you
are intelligently using past experience as a guide— and it is a dependable
guide. Your operations are part of the competitive workings of a free
market; your purchases and sales are part of the process of interpreting the
trend, checking runaway inflation and crashes, and determining the value of
the American industrial plant.
The market will continue to go up and down in the future as it has in the
past. Your technical knowledge will save you from “buying at the Top” in
the final Climactic Blowoff, and it will save you from selling everything in
a fit of depression and disgust when the Bottom is being established. In
your studies of past market action, you have a strong shield against the
sudden thrusts that surprise and often defeat the novice trader.
(EN9: I have often told my students if their knowledge of this material does
nothing more than keep them from making stupid mistakes like buying a
Top or buying a downtrend or buying before a Bottom has completed
forming, then their time will have been well spent. The elimination of
amateur blunders such as these can immeasurably improve investment
performance.)
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter forty
How much capital to use in trading
Up to this point, we have been talking mostly in terms of points and
percentages. Little has been said about dollars. From here on we are going
to turn the spotlight on the questions revolving around money, capital, and
the dollars you will actually be using in your operations; just as an
understanding of the technical signals and patterns alone will not guarantee
your profits without a tactical method of applications, so too your tactics
alone will not ensure you profits until you have tailored your method to fit
your pocketbook, and until you have a systematic control of your trading in
terms of dollars and cents.
At the start of your charting operations, you will be using no capital. You
will be making no trades either actual or theoretical. Any commitment you
might make during the first four or five weeks on a new chart would be no
more than gambling on a hunch. It will take about two months of thankless
charting before you have any clear picture of how any of your stocks are
acting technically. From then on, your chart history will become more
valuable each week. Your first trades probably will be theoretical ones. You
will want to get the feel of the charts and learn to apply the methods you
have studied. Eventually, you will want to make an actual transaction.
(EN: The prudence of this approach can hardly be disputed. Just as markets
have changed, stock market mentality and awareness have changed. The
mere existence of this book and of the general atmosphere enable the
modern investor to progress more rapidly than the old pencil-and-paper
and slide-rule chap. The availability of computers and databases and
tutorial tools, not to mention online and offline courses in the subject, are
unparalleled resources.)
Then the question will come up, “How much of my capital shall I use for
trading purposes?” (EN: In a certain sense, this question begs the question.
It presupposes the reader has capital. If the reader does not have capital
but is gambling with the milk money or the mortgage payment, his failure is
virtually assured. Do not speculate with money whose loss will occasion
you more than passing discomfort.)
The amount will depend on your circumstances and how much of your time
and effort you plan to put into stock trading, as well as your experience in
the market. If you have been buying and selling stocks for a number of
years, you will naturally continue along the same lines, simply applying the
new techniques to your operations.
On the other hand, if stock trading is entirely a new field for you, or if it is
only a minor hobby or sideline, it would pay to make haste slowly. Some
writers have pointed out it usually takes about two years to gain enough
practical experience to operate safely in the market; during the two-year
apprenticeship period, many traders come in, gradually lose their capital,
and retire permanently from the field, leaving their money behind them.
Therefore, no matter how confident you may be or how anxious to get in
and start pitching, it would be safest to do most of your experimenting on
the theoretical basis and to use only a small amount of your actual capital,
so that after, say, two years, if you have shown some actual profits,
consistently and regularly, even though small, you will be much better
prepared to use more of your capital wisely and safely. Conversely, if
during that time you have made repeated mistakes and have registered
many unnecessary losses, you will be able to correct your methods and
continue on a sounder basis, without having lost your main capital reserve.
In no case do you want to risk everything you can scrape together on the
theory that here is the quick way to make easy money. That simply is not
true and the chances are overwhelmingly against you if you go ahead under
any such plan.
It is better to figure out how much you can spare, how much you could
afford to spend for experience, considering the amount you start with is in
the same category as money you might use for taking a special course of
instruction, or for improving property you hope to sell. Or, to take another
example, it would be similar to the salary you might lose in accepting a
lower paid position in a new kind of work that eventually should be worth
more than your present job.
In other words, you will not depend, from the start, on any returns from the
capital you use in trading. You will plan your own budget outside of these
funds, even if that calls for trimming your budget to make that possible.
Then you can go ahead and follow your trading method free from any
pressure to take unnecessary risks, free from the need to sell stock
prematurely to meet obligations, and free from heckling fears and worries.
You can start operations with as little as $500. (EN: This is especially true
in the Internet age. Free commissions in many sites and the availability of
low-cost diversified trading instruments like index ETFs [(the SPY (S&P
500), DIA (Dow Jones Industrials), and QQQ (NASDAQ 100)] offer the
small investor more opportunity than ever before in financial market
history.) Better to have $1,000 or several thousand, but it makes little
difference, so long as you have worked out what you can afford to use
during the apprenticeship period, and as long as you are sure you will have
capital to continue your operation as you develop ability. The important
thing at the start is not how many dollars you can make, but what
percentage of increase per year you can average with the capital you are
using.
If you approach the serious business of trading in this frame of mind, you
will not be afraid to take losses when it is necessary (and there are times
when that is the only wise course to adopt). You will not be straining to
make an unreasonable or impossible profit (with the usual disastrous
results). Additionally, you will be able calmly to build your trading policy
in the sure conviction the market will still be there next year, that
opportunities will still be waiting for you, and that the basic procedures you
are developing are more valuable than any “lucky break” you might pull out
of thin air or a boardroom rumor.
chapter forty-one
Application of capital in practice
(EN: Today we would refer to this as “asset allocation,” about which many
learned books and articles have been written (see Appendix B, Resources).
The modest suggestions in this chapter are, like Magee, very pragmatic and
simple—and quite possibly more effective for the general investor than
those complicated procedures spun out by supercomputers for complicated
Street portfolios.)
Let us now restate a number of ideas we have already investigated and on
which (let's hope) we are thoroughly agreed.
1. Major Trends ordinarily run for long periods of time, covering a
tremendous number of points in total advance or decline—15733.05,
2009 to 2017.
2. Almost unbelievable profits could be made by one who could buy
stocks at the extreme Bottom of a Bear Market and sell at the extreme
Top of the following Bull Market; or sell short at the extreme peak of a
Bull Market and cover at the extreme Bottom of the following Bear
Market.
3. It is not possible to accomplish either of these desirable results.
4. It is possible to avoid becoming trapped in purchases made at or
near the extreme Bull Market Top so that losses become dangerous or
ruinous in a Major Reversal. It is also possible, of course, to avoid
such losses through ill-advised short sales near the extreme Bottom of
a Bear Market.
5. It is possible to make profits by trading in line with the Major Trend,
and in some cases, by trading on the Intermediate Corrections to the
Major Trend, or, occasionally, on the individual behavior of a stock
moving contrary to the Major Trend.
6. The greatest and most dependable profits may be made along the
Major Trend during the principal period of advance (or decline, in the
case of short sales), but not during the earliest phases when the
movement first gets under way or during the rounding off or Reversal
phenomena near the end of the movement.
Therefore, to get the greatest benefits from following the Major Trends, one
would want to have a relatively small equity in the market at the very start
of the move and very little at or near the termination of the move, but a very
substantial interest during the mid-portion when the advance or decline was
making the greatest headway.
The writers have felt it should be possible to express this relation between
the amount of capital tied up and the state of the Major Trend in a neat and
definite equation. Yet, inasmuch as the idea of a Major Trend is, itself, a
matter of definition, and because the trend is an abstraction from the
individual movements of many stocks, it does not seem possible to arrive at
any such easy solution to the problem of how much capital to use at a given
time.
Nor is it necessary to have a definite and exact answer. As we have already
stated, it is possible to set up an Evaluative Index that will give an
approximate answer good enough for all practical purposes so far as
weighing the “strength” of the trend at a particular time. (EN: To clarify and
make more explicit the concept here, I would point out the Asset Allocation
implications of the Magee Evaluative Index. If the analyst's evaluation of
the market indicated 30% of stocks were Bullish, 30% Bearish, and 40%
neutral, he might so commit his capital—30% long, 30% short, and 40%
cash. This would also assume his assessment of risk also indicated the risks
of the long and short positions were balanced, or approximately equal since
infinite precision is achievable only by the writers of academic treatises
working with perfect hindsight.)
There are, however, some other questions. Most important is the question of
how much total “risk” you are assuming because some stocks are very
conservative and others are very speculative, it is not enough to determine
what part of your capital should be applied in a market trend. The
proportion of your total capital used is not necessarily the whole measure of
your participation. The price level of a stock will affect its habits (low-
priced stocks make bigger percentage moves than high-priced stocks). The
amount of margin you are using will have an effect on the degree of risk.
There is some substance to this plan (otherwise we would not be taking the
time to discuss it here at all), but there is a serious question whether the
decision as to the amount of capital to be used at any specified time can
ever be reduced to a simple mathematical operation. (EN: Still true
although there are those who attempt it.)
Let us suppose you are convinced this is a Bull Market, in a phase of such
potency that you would be justified in using 80% of your capital. However,
you will immediately realize, from what has been said in earlier chapters, if
this money is put into a high-priced (EN: and low-beta) stock, it will not
give you as much likelihood of either profit (if you are right) or loss (if you
are wrong), as it would if put into a lower priced (EN: and high-beta) stock.
In the same way, your money put into a stock having a low Sensitivity
Index, that is, a conservative stock like a Utility stock, will not give you as
much likelihood for either profit or loss as a stock of a high Sensitivity
Index (EN: volatility), namely, a speculative stock such as an internet issue.
These factors, quite as much as the amount of actual dollars, affect your
status, and are factors in answering the question, “Am I out on a limb and,
if so, how far out?”
To make this perfectly clear, we could take 80% of our capital, say $8,000
out of $10,000, and put this amount into the market by purchasing a
conservative preferred stock, outright. A great rise in the general market
might bring us an increase in value of a few points, perhaps 4% or 5%.
Conversely, a great decline might depress the issue by about the same
amount. An example of going to the other extreme might be to purchase
$8,000 worth of options on a low-priced, extremely speculative stock, in
which the probable result within 90 days would be either a profit of several
hundred percent, or a total loss of $8,000.
Obviously, we could vary our status during the progress of the market either
by increasing or decreasing the amount of the total commitment, or by
changing the nature of the account, switching part of the total into more or
less speculative stocks, higher or lower priced stocks, and also by varying
the amount of margin used.
In Appendix A, ninth edition, and Chapter 42, we will show how the
principal factors affecting a given sum of capital used (sensitivity, price,
and margin) can be combined into one figure, which we are going to call
the Composite Leverage Index. (EN: Once again, Magee demonstrates a
practical vision and intuitive understanding both of the markets and of the
basic character of investing far ahead of investment theory and
understanding of his time. What we have in this concept is nothing less than
the original glimmerings of VAR, or Value at Risk. The concepts and
practices of VAR are succinctly summarized in Chapter 42. Composite
Leverage is a complex subject and based on manual charting. For that
reason, it has been left in the ninth edition, where the truly dedicated
scholar may study it at leisure.)
It is perfectly true you must vary your Composite Leverage (EN: risk
exposure) to take advantage of the fast-moving central portions of important
moves, using a lower Composite Leverage at the beginning of such moves
and during the tapering-off or turning periods near the end.
It is one thing to express the Composite Leverage accurately, however,
another thing to write a formula for applying specific degrees of leverage at
particular times. The method suggested at the very beginning of this chapter
has some value but owing to the Secondary Reactions and the difficulty of
determining Major Trends in individual stocks, it is not possible to make
this into the neat, pat rule we are looking for.
It must be a matter of experience, or intuition based on experience. You will
not permit your Composite Leverage factor (i.e., your Portfolio Risk Factor;
see Chapter 42, Portfolio Risk Management) to run out to a dangerous point
on the limb. Neither will you allow it to become so low during times of
good market opportunity that you are not getting full benefits from the
move.
We can keep the general shape of a Major Swing in our minds as we
consider this. Bull Markets normally rise through a series of irregular
advances and declines, starting with a moderate upward trend, and
gradually accelerating as the market approaches its ultimate top. Bear
Markets are likely to move fastest at the start and to taper off gradually
toward the end. Bear Markets are steeper than Bull Markets. These
considerations will help us to judge the times when the market will offer the
best opportunities, the times when our Composite Leverage should be
increased.
There are other factors, even harder to pin down in simple figures. We
would, at times, make switches of our holdings for reasons indirectly
related to the factors making up the Composite Leverage Index of the
stocks. We know, for example, high-grade issues, the active market leaders,
and perhaps some stocks of a more conservative nature will tend to start
their moves in a Bull Market fairly early and to continue their advance at a
fairly steady pace. Eventually, they will reach their tops and make a
Reversal Pattern. They will decline from this point, probably at a steeper
average angle than the ascent. Low-priced and low-grade issues, on the
other hand, tend to be slow in getting started, will remain dormant during
the early phases of a Bull Market, and will then suddenly and spectacularly
skyrocket in a series of moves that brings them to their ultimate Top. This
Top, however, is likely to be reached at a later point (perhaps months later)
than the point at which many of the more conservative stocks topped out.
The speculative group will then drop very fast and will return to the dead
levels of inaction before the conservative group has finished its more
leisurely Major Decline.
This means you will do well to concentrate your Bull Market trading in the
early stages, in the higher grade stocks, and in the later stages, in the lower
grade stocks. In a Bear Market, you would perhaps be able to make short
sales unsuccessfully in high-grade stocks even while some of the “cats and
dogs” were still completing their final run-up; however, you would be
watching for the opportunity to cover those shorts and go short the low-
grade stocks as soon as their Reversal was signaled.
Appendix A, ninth edition, will go into the Composite Leverage Index. It
should be a useful gauge for you in your market operations, and a
protection against overtrading. Except, do not expect to use it mechanically
as an index against the market to answer all your questions involving the
nature and size of your commitments. For in gauging the condition of the
Major Trend at any time, your personal experience and judgment must be
the final arbiters.
Put and call options
Options of various sorts have a long history in commercial markets. Nearly
2,000 years ago, the merchants who operated in the Mediterranean region
used “to arrive” at agreements that amounted to option contracts, as
insurance to reduce the risks of storm and piracy. Modern commodity
futures contracts resemble stock options in their dual nature of serving
either as trading media or as insurance devices. Options are also widely
used in real estate transactions and in various other applications.
For many years, stock options were traded only on the basis of individual
agreement between a buyer or a writer, and an opposite number, directly or
through a broker or dealer. The customer and the writer were free to decide
what stock (any stock) would be optioned, at what exercise or striking
price, for what period of time, and at what premium.
In 1973, a new method of handling option contracts was inaugurated by the
Chicago Board Options Exchange and later the American Stock Exchange,
and then to other Exchanges across the country in which call options on a
selected list of actively traded stocks are offered with standard expiration
dates (like commodity contracts) and at definite exercise prices, the
premium depending on the bids and offers of buyers and writers. An
excellent guide to this rapidly expanding market is (EN) Options as a
Strategic Investment by Lawrence G. McMillan.
(EN: In the Internet age, options and derivatives markets have attained an
astounding economic importance. One amusing way of measuring this
importance is by listing some of the great debacles that have occurred to
major traders of derivatives. Bank Negara, Malaysia's central bank, lost $5
billion in 1992-1993 through bad bets on exchange rates. Showa Shell
Sekiyu, Japan, lost $1.58 billion in 1993; Metallgesellschaft, Germany, lost
$1.34 billion in the same period. Barings Bank lost $1.33 billion on stock
index futures. From 1987-1995, known losses like this totaled $16.7 billion.
As Magee would say, etc., etc., which is appropriate considering in 2012 JP
Morgan Chase lost 2 to 5 billion trading derivatives. Of course, compared
with the estimated total market in 1995 of $25 trillion, this is a mere
bagatelle. Perhaps this is sufficient to warn the general investor that the
field is strewn with financial mines even for the sophisticated.
EN9: If the investor considers stocks a complex or difficult area [although
it is hoped this book will make it less so for him] options are exponentially
more difficult. Professionals beat amateurs at that game so thoroughly and
so often as to consider it easy money. So, the general investor should be
sternly warned that much training and study should be undertaken before
becoming fodder for the pros.
EN9: Tradestation, the superlatively fine trading system and brokerage
operation, distributed at one time an intelligent little book by Charlie
Wright, Trading for a Living, which among its other fine points offered a
plan for the ongoing allocation of capital to trading.)
chapter forty-two
Portfolio risk management
As we suggested in the preceding chapter, there is some relation between
the state or stage of a Major Market and its potentialities for profit. There
are many mechanical plans and systems for coping with the problem, but
we do not believe it can be fully solved by mechanical means alone. We
mentioned one plan by which the commitments were governed according to
the consensus of trends in an entire portfolio of charts. (EN: The Magee
Evaluative Index, or MEI.) There are other plans dependent on pyramiding
the commitment as the trend proceeds, and still others based on averaging
costs by increasing the commitment working against the trend, namely, by
buying on a scale-down at progressively lower levels in a Bear Market and
selling on a scale-up in Bull Markets. (EN9: Invitations to disaster, the first,
and demanding adroit skill, the second. Avoid such methods unless you are
an expert position trader.)
None of the plans, taken by themselves, are adequate to answer the
questions of when to buy and when to sell. The primary purpose of this
book is to study the technical phenomena of individual stocks. If we can
learn from the charts at what points to buy and under what conditions to
sell, we have acquired the basic machinery for successful trading. On the
other hand, if buying and selling at points that more often than not result in
net losses, then it makes no difference how you divide up your capital or
apply it in the market, for it will be bound to shrink until, eventually, it has
all disappeared. (EN: An investor who finds himself in this situation should
set a benchmark. He should decide if he loses 50% of his capital he will
quit trading and put his money in index or mutual funds or in the hands of
an advisor. Generally speaking, an advisor is preferable to a mutual fund,
yet both are preferable to an investor with two left feet. They can certainly
do no worse than a consistently losing performer. EN10: On second
thought, from the vantage point of 2011, maybe they can.)
The first problem, then, is to learn to use the technical tools, patterns,
trends, Supports, Resistances, and so on. Then we can consider how much
money we will risk and in what way.
We have already grasped it makes a difference, sometimes a great
difference, how we apply our capital. The various factors of price level,
sensitivity, and margin enter into the concept we are going to call the
Portfolio Risk. Meanwhile, we have said enough so you will understand
what we are driving at if we use the term in connection with your market
commitments.
You realize, of course, you do not want to be so conservative to rule out
practically all opportunities for making gains. If you decide never to oppose
the Primary Trend, you will have to be inactive during long Secondary
Trends and may be left waiting, sometimes for weeks on end, for a
continuation of the Primary Move. Naturally, you will pass up all weak
signals and convergent trends and shun new commitments after very active
blow-offs or Panic Climaxes. You could, no doubt, carry your refinement of
caution so far that your percentage of success, instead of being a mere 60%,
70%, or 80%, might approach 90%; you might actually be right 95% of the
time in your decisions, but this extreme conservatism would also mean you
would trade only in the very finest possible situations, when every factor
was clean-cut and favorable. You would not have such opportunities very
often. The result might be a profit, but too small a profit to justify all the
work and study you would be
putting into your charts, for you can obtain nominally respectable returns on
your capital without very much study and without much risk, and you must
expect a much higher rate of return if your efforts are to be worthwhile.
(EN: These “nominally respectable returns” are obtained by investing in T
Bonds and similar instruments. Bond traders and investors traditionally
consider these investments “risk free,” which is another form of the denial
of reality. In reality, as David Dreman has demonstrated (Contrarian
Investment Strategy, Simon & Schuster), bonds are a kind of deteriorating
asset because of the unarrestable depreciation in the commodity-
denominated value of currency.)
To put your charts to work, you have to avail yourself of the higher
leveraged stocks that carry more opportunity for gain, hence, more risk of
loss. You have to accept, deliberately, a greater risk than the man who is
content to buy a “safe” security, put it in the box, and forget it.
By maintaining your Portfolio Risk at or near some constant level that your
experience and judgment tells you is safe for the particular state of the
market, you will be protected against overcaution and irrational exuberance.
More important, if you maintain this risk posture in your operations, you
will be protected against unconsciously overtrading. This is a fault more
common than extreme caution and can be a dangerous enemy even when
your percentage of theoretical trading gains is high. When you select a
definite Portfolio Risk Strategy and adhere to it in your trading
commitments, changing it as necessary to meet changed conditions, you
will be forced to restrain your enthusiasm within safe limits, and you will
be continually aware of the risks you are taking.
Overtrading: a paradox
A series of identical percentage gains and losses on your capital does not
give you a series of equal gains and losses in dollars and cents. This is a
serious problem, worth understanding, for a trader who is greatly
overextended is intensifying this problem (which exists in any case, but
which does not need to cause him too much worry if he has planned his
program).
You can understand the paradoxical statement that percentage gains and
losses are not equal if you take the extreme case, first, of a man, who, in
every business venture he enters, risks his entire capital with the
expectation of either a 100% gain or a 100% loss. If this first venture is a
loss, he loses 100%. He is finished, because he cannot gain by making
100% on nothing. However, if the first venture is successful and he then
uses his entire capital, including the new profits, again on the same terms,
and the second venture is a failure, he will be wiped out completely. No
matter how many successes he may have, he stands to lose everything on
his first failure.
In a lesser degree, this is the situation in which we speak; you would not
risk all of your capital on the basis of doubling your money or losing all.
Though, suppose you were extended, continually, to a point at which you
were taking the risk of a 40% net loss on each transaction, with the hope of
a 40% net gain. Should you start with $1,000 and have a succession of 10
losses, you would wind up with about $6.00. Now suppose the very next 10
transactions were all successful. You would finally come out, after 10 losses
and 10 gains, each of 40%, with capital of less than $100. It would not be
necessary either that these 10 losses and 10 gains come in the order given.
You might have the 10 gains first, or three gains, four losses, seven gains,
and then six losses. The result would be the same. After 10 gains and losses,
in any order, you would have lost more than 90% of your capital.
On the other hand, if you risked your entire capital each time on 20
ventures, in 10 of which you took an 8% net gain and in 10 an 8% net loss,
your $1,000 after the 10 gains and losses would be reduced only to $937.
You would still have about 94% of your original capital. Therefore, in this
case (and 8% is a fair average figure for short-term transactions resulting in
a loss, in fact, a rather liberal figure according to extensive tabulations of
actual transactions), you would have a handicap due to this paradox of only
about one-third of 1% on each trade.
Now it is conceivable that 10 successive trades might go wrong, although
that would be an unusual condition. There was one period of 10 months
between the actual turn of the market and the Dow Signal for a Reversal of
the Primary Trend. True, the resulting new trend, once established, ran far
and long, and it would have made up all losses and produced fine profits;
however, during the 10 hard months, allowing the fair average time of 30
days per transaction, it is possible that 10 successive wrong-way trades
might have been stopped out for losses, reducing the original $1,000 to
$434.
The important thing is that the next 10 successful trades would have
brought this $434 back to $937; in other words, you could have righted the
boat and sailed right on if you were working on the 8% basis, whereas if
you had been following the 40% basis we gave previously as an example,
you would have been sunk without a trace, a victim of overtrading.
Therefore, by maintaining a sane Portfolio Risk Strategy and letting the law
of averages work for you and with you, you will be on solid mathematical
ground. Your technical studies will have every opportunity to make you a
profit. Otherwise, you can, simply by unwise overextension of your trading,
prevent even the best technical analysis from producing a net profit.
EN: John Magee could easily be called the father of modern investment
theory but modern investment theory is so unenlightened as to technical
analysis that academics largely have not recognized his contributions—and
many probably have not read his work. If they had, he would be recognized
as having identified what theorists now call systematic risk, and what is
now called the beta (Greek letter 3) with his concept of the Sensitivity Index.
Similarly, his work on Composite Leverage precedes (and may be more
practical than) modern Portfolio Risk analysis, if cumbersome in the
modern context.
Systematic risk, simply put, is market risk in aggregate; beta relates the
individual instrument risk to the market. Thus, Magee's Sensitivity Index did
what beta calculations do—relate instrument behavior to market behavior.
A stock with a beta of 1 will move up or down 1 point for each 1 point of
market move. A 1.5 will move 1.5 for each 1 point of market move, and a
0.5 will move 0.5 for each 1 point of market move. This number tells us
immediately which stocks are more volatile and sensitive to aggregate
market behavior.
Composite Leverage was Magee's method of determining how much risk the
investor was assuming in a stock or portfolio.
The formula was (is) as follows:
CL = SNT
15.5 x C
where S = the Sensitivity Index, N = Normal Range-for-Price (an attempt to
quantify volatility), T = Total Paid, C = Capital dedicated to this
commitment, 15.5 a constant Magee called a Market Reciprocal, a sort of
proxy for market volatility. The same formula, using sums, was used for
Portfolio Composite Leverage. The number that falls out of this formula
quantifies risk for Magee and uses concepts that are extremely modern.
In his original exposition of Composite Leverage in this chapter, Magee
made use of some cumbersome manual chart procedures and tables that I
have relegated to Appendix A in the eighth and ninth editions, and deleted
in this edition. There is nothing invalid about them, even now, I feel, but
there might be simpler and more convenient ways for the present-day trader
to assess his leverage, risk, and profit exposure. One of these is certainly
utilizing Value at Risk (VAR) technology. However, there might be simpler
more pragmatic (and even more effective) ways of extracting this
information from our trading portfolios. In short, Pragmatic Portfolio
Theory and practice, which we will explore shortly.
Volatility, for example, tells us something about the risk of a stock insofar as
the dispersion of returns. Portfolio volatility gives us a way of measuring
the riskiness of a group of stocks. In researching our systems and methods,
we should be able to get some handle on “drawdown,” or the average and
largest negative swings against our equity in an account. Simple
conclusions follow: if we are willing to accept larger risks, we pick a
portfolio of volatile stocks—a portfolio of Internet (or whatever the current
frenzy is) stocks rather than a portfolio of utility stocks.
It is indispensable to maintain a regular periodic review of portfolio
statistics to assure oneself that excessive risks are not being undertaken
heedlessly. These important numbers include the following:
• Original risk per trade
• Actual realized loss
• Average (and ranges) loss and profit per trade and their relationship
(average profit divided by average loss)
• Number of winning and losing trades and their ratio
• Time in winning and losing trades (long-time trades combined with
oversize losses is an ominous sign)
• Equity swings: average drawdown, maximum drawdown
• Costs and expenses, summation, and per trade
• Daily risk, yearly risk, and catastrophic risk, as computed by Pragmatic
Portfolio Theory (as discussed below)
Risk of a single stock
The beginning of conventional, or academic, analysis of risk is the
examination of volatility.
The formula for calculating the volatility of a stock (or downloading it) was
discussed in Chapter 24. As a theoretical exercise, the formula and the
theory make certain assumptions that are not necessarily of interest to the
pragmatic practitioner. One of the assumptions is the holder chooses to
accept the inherent volatility of the stock at hand. Except the point of
technical analysis is to limit the risk accepted while attempting to realize
profit opportunities. Thus, the volatility of a stock, its (academic) risk, is
0.30% or 30%, but when we trade it, we put a stop loss on it and only risk a
move of (say arbitrarily) 5%-8% against our position (where the 5%-8%
sums to 2%-3%, or x% of total capital.) Thus, our method of risk control is
basically more dynamic than the theory. Nonetheless, volatility will give us
a measure of the stocks that make interesting trading vehicles.
It is perfectly possible to take our own experience with a stock or our
system's experience with a stock and calculate its volatility to ourselves,
using the method described in Chapter 24. If the dispersion of its returns (in
our trading) was greater than our appetite, we could then eliminate it from
our watch list. To my knowledge, the literature does not mention this
method for customizing our analysis of risk. Use of a customizing procedure
like this would give us an idea of the reliability of our methods in a
particular case. Stocks that did not behave would be banished to the
portfolios of mutual fund managers.
We subscribe to a much more pragmatic and practical concept of risk. Risk
is, to us, drawdown, or the probability of loss. Volatility qua risk is static
and non-descriptive of the “risks” we take in trading and investing. We will
choose a volatile stock or instrument because that is where the profit
opportunity is—in movement. Less risk-oriented investors will choose utility
stocks. As some carnival goers choose the Ferris wheel and others the
roller coaster. The probability of an exciting ride will be in the volatile
instruments. Our skills as traders give us the confidence to manage the
probabilities of the more “dangerous” instrument.
By measuring the drawdowns, we empirically measure the risks of trading.
Risk of a portfolio
If you have sufficient experience with a portfolio, you can calculate its
volatility the same way you calculate the volatility of a stock using the
method in Chapter 24. Note Modern Portfolio Theory (MPT) has a complex
procedure for computing portfolio volatility. (The value of MPT may be
computed by examining MPT portfolios after a market collapse.) You may
also dramatize the volatility of your portfolio by preparing a frequency
distribution. The dispersion of the returns would certainly highlight
characteristics of your trading system or style.
Academicians and investment managers use a measure called the Sharpe
Ratio to compare the performance of two systems or competing money
managers. It is discussed in Appendix B, Resources, and has deficiencies in
analyzing Portfolio Risk. I will address this question later in this chapter
after looking at some of the ways professionals treat risk.
The reader may judge for himself in the use of Composite Leverage as
presented in Appendix A of the ninth Edition by Magee, or he may consider
the following brief presentation of modern portfolio management and risk
analysis. The purpose of Magee's Composite Leverage is to measure and
control risk and profit exposure in a more or less quantitative manner.
Present-day portfolio managers might use VAR technology or do this as
follows. The editor offers this exposition only for perspective. His own
preferred method, Pragmatic Portfolio Theory, follows thereafter.
EN9: Risk and trend
Risk of a portfolio and risk of a stock are affected by being the right way in
the trend. It seems intuitive and it is observable that losses (thus risk)
expand in an Enron case in which the trader remains long while the stock
dies. The converse is also true; Risk is diminished to a portfolio and a stock
when it is with the trend. In a paper submitted to the Market Technicians
Association (http://www.mta.org), “Dissecting Dow Theory,” Bassetti and
Brooker argue (with some success in the opinion of this editor) that risk can
be proved to diminish in the Industrials when the portfolio (of Industrials) is
with the trend as identified by Dow Theory. This paper is available at the
Magee website, http://www.edwardsmagee. com. The paper was
subsequently expanded into the book, Sacred Chickens, the Holy Grail and
Dow Theory.
Value-at-Risk procedure
(EN: VAR is a method of assessing and controlling risk. Particularly, VAR
measures the worst expected loss over a given time interval under normal
market conditions at a given confidence level. This rather complex
statistical process is in use in numerous banks, American and European
regulators in Basel and at the Federal Reserve have largely accepted it as
an acceptable risk control procedure. The hole in the procedure is in the
words “normal market conditions.” The procedure is based in MPT. As
Mandelbrot has remarked, MPT ignores 5% of market data, treating market
collapse as if it did not exist. VAR and MPT both ignore trend risk, as
though it does not exist.
As a brief description of the VAR procedure, I offer the following: returns of
the individual securities are determined and, from these, returns of the
portfolio are calculated. This is done based on some time period for which
the portfolio is held. Thus, from day to day the returns, or changes in value,
of the portfolio will vary—some positive and some negative. Taking a
totality of returns, an average return will be determined. A frequency
distribution of returns may be constructed. The width of this frequency
distribution measures the riskiness of the portfolio. Thus, a portfolio with a
minimum return of 1% and a maximum return of 8% is inherently less risky
(according to investment theory) than one with returns varying from -1% to
20%. Although a frequency distribution is illustrative, it does not give us a
common measure for two different portfolios. That is done by determining
the volatility of the portfolio.)
Volatility measures the deviation of returns from the mean, known as the
standard deviation and is indicated by the Greek letter sigma (o). (EN: The
higher the volatility of a portfolio the greater its risk, according to the
academic theory. This would seem to be intuitive, in that a commodity
portfolio might range from -30% to 100% returns because of leverage,
whereas a bond portfolio would vary only by the market price of the bonds
and would return face value at maturity. In calculating bond risks,
managers ignore the deterioration of money—but that is a little secret
among us pragmatic analysts and we need not bother academicians and
bond traders with that information, as they would not want to know it
anyway.
As pointed out, portfolio volatility can be easily obtained if we have
sufficient experience with the portfolio. If we have to calculate the volatility,
the procedure gets quite complicated and the entire procedure for
determining our VAR requires some statistical sophistication as well as a
gamut of data. We must weigh the components of our portfolio, determine
their correlations, compute correlation coefficients, and on and on. As
Mandelbrot notes in Scientific American, at the end of all this, we would
still be wondering what to do in the Perfect Storm. A crystal-clear
procedure for computing VAR is presented in Philippe Jorion's excellent
book Value at Risk.
Pragmatic Portfolio Theory (and practice)
Perhaps, rather than giving ourselves headaches trying to remember
college statistics, we should look for something simpler and more
pragmatic—something just as serviceable for the general investor:
Pragmatic Portfolio Theory. The academic world, and the world of rarefied
Wall Street, strives madly to quantify everything in the world except the
risks and liabilities that they themselves create for their customers.
Let us seek simpler methods to quantify the risks of individual stocks and
the portfolios they reside in, knowing all the time that absolute precision is
impossible (namely, professional portfolio managers' performance in the
Great Panics—1929,1957,1987,1989,2008-2009; Long-Term Capital
Management, which almost brought down the world financial system in
1998; and Leland O'Brien Rubinstein Portfolio Insurance, which
contributed significantly to the Reagan Crash in 1987).
Pragmatic portfolio risk measurement
Determining the risk of one stock
The theoretical risk of a stock is commonly agreed to be its volatility, which
is determined as detailed in Chapter 24. Subsequently, we might say the
theoretical risk of our stock, Microsoft, for example, equals on 100 shares,
our position, at the market price of 120 and annualized volatility of 0.44:
Theoretical Risk = Volatility x Position x Price
V x Po x Pr = T$Risk
.44 x 100 x 120 = $5,200
where
T$Risk = Theoretical Risk (dollar)
V = Volatility
Po = Position (number of shares)
Pr = Price
Theoretically speaking, the annual risk for Microsoft should be Volatility x
Price or (in 2000) 0.44 x 120 or $52.00. In fact, those non-chart analysts
who bought Microsoft at 120 (there were some), and who did not have the
technician's ability to set a stop and discipline to stick to it, saw a risk of
50% from its top of 120 in February 2000 to its (presumed) bottom of 60 in
June 2000.
There is another measurement that might be more meaningful to us,
Operational Risk. Operational Risk refers to the specific instance of the
particular trade. For example, we have taken an initial position in
Microsoft of 100 shares. Our analysis has identified a stop point at which
we put our stop, which is 5% away from the market price. Our Operational
Risk is as follows:
Operational Risk = Market Price — Stop Price x Position
(MP — S) x Po = O$Risk
(120 — 114) x 100 = 600
where
O$Risk = Operational Risk (dollar)
MP = Market Price
Po = Position
S = Stop Price
Determining the risk for a portfolio
Computing the theoretical risk for a portfolio is quite a complex process. It
involves, in essence, finding the volatility for the portfolio as a whole, and
multiplying the portfolio market value by the portfolio volatility. This does
not sound so complex, but volatility is not determined by simply adding
together volatilities of individual securities. Rather, correlations between
instrument returns must be computed, and variance and covariance of
securities must be determined as steps along the way. This by no means
presumes to be a complete description of the process, further study of which
may be guided by entries in Appendix B, Resources.
The theoretical risk for a portfolio is, for a simple case, as follows:
Volatility x Market Value
TP$Risk = MV x V
where
TP$Risk = Portfolio Theoretical Risk (dollar)
MV = Market Value
V = Volatility
Under normal market conditions, the Operational Risk of a simple
Portfolio, PO$Risk, may be calculated by first taking the sum of the
Operational Risk figures, O$Risk, for each stock held long. Then the sum of
O$Risk for short positions is subtracted from the first figure.
PO$Risk = (sum of O$Risk longs) - (sum of O$Risk shorts)
In the situation of perfect negative correlation, the two factors would be
summed.
Measuring maximum drawdown (maximum retracement)
In the designing and testing of a system, or in actual trading experience, we
care little about standard deviations and cold statistics. What bothers us is
the flow of blood—the worst run of “luck” or experience we have. What is
the greatest sustained loss we suffer before our system or trading method
rights itself, stanches the flow of blood, and begins to accumulate profits
again? Constructing a wave chart is one way to look at this experience.
Measuring from the top of the wave to the bottom gives us our maximum
drawdown, and an idea of what amount of capital we need and how much
reserves to maintain. It also gives us a vivid depiction of our results. A chart
with many tsunamis (in the wrong direction) probably means we need to
modify our methods—unless we genuinely enjoy riding roller coasters (with
the full understanding that dreadful accidents do sometimes happen on
thrill rides). If constructing a system without actual market experience, one
should multiply maximum drawdown by 3 or 4 to get a reasonable amount
of capital with which to back the system.
Pragmatic portfolio analysis: measuring the risk
In analyzing a portfolio, we must first know what is important to measure.
To be able to control risk, we must be able to measure it. Theoreticians
identify risk with volatility. There are some real-life problems with this
concept, but we will use it for the moment anyway. In a portfolio, we want
to be able to separate our various types and weights of risk. In terms of
volatility, bonds are obviously less volatile than stocks, and unleveraged
commitments are less volatile than, say, futures. Similarly, if the portfolio is
not risk balanced, that is, if one issue represents a large proportion of the
whole, then it represents a larger portion of the risk. But, if a portfolio
consisted of only the Standard & Poor's 500, that would obviously be a
different case, because a commitment like this would be by definition
diversified. Thus, we must know what is important to measure (see Philippe
Jorion's Value at Risk. In addition, there is a piece of tutorial software
called Risk Management 101, Zoologic Corp., which is excellent in
presenting these concepts).
In operational or pragmatic terms, a trader wants to know what his
operational risk is, rather than his theoretical risk, and does not consider
upside equity volatility a negative. A trader may choose to measure risk by
the pragmatic method outlined here. In doing so, he will want to know for
his Portfolio Ordinary or Normal Risk, POR, his Risk Over Time, PRT, and
his Extraordinary or Catastrophic Risk, PCR.
Portfolio Ordinary or Operational Risk
“Ordinary” and “Operational” may be used interchangeably when
discussing daily risk. First consider we want to measure our risk today. Our
Ordinary Risk today is easily computed by taking the stop price from the
market price on each position and summing the differences, as above.
Dividing this figure by the allocated capital (Total Capital, TC) will give us
a Portfolio Risk Factor (PRF), which is the risk factor the trader is willing
to assume for one day.
POR = sum of differences
PRF = PO$Risk/TC
Portfolio risk over time
The Daily Operational Risk number can be annualized to give us a number
for risk over time—or it can be computed for a week or a month, and so on.
Or, this factor may be collected from operations. It may be collected by
taking each day's Ordinary Risk, summing and dividing for the desired time
period (and plotted). It also may be computed by taking the average return
and the variances therefrom and calculating the standard deviation. This is
Risk Over Time. Annualized risk, for example:
DR x (square root 365) where DR = Daily Risk
Portfolio extraordinary or catastrophic risk
Extraordinary Risk is the risk of market collapse or panic on any given day.
The way to look at this risk is, first of all, to assume normal behavior of the
markets, or your everyday panic. In this case, if all of one's positions
cratered, one would take his worst-case, one-day loss and be out of the
market. To extend this analysis, assume the market makes a two, then four,
then six standard deviation move. What will be the effect on your position in
this event, when stops will not be honored by specialists and market makers
and the market will be stampeding like spooked cattle for the exits? That is,
meltdown. This is Extraordinary or Catastrophic Risk. If you have no capital
reserve you are out of business.
Controlling the Risk
The most danger in these meltdown events is in the greatest leverage—so
the greatest risk is in short options—and usually short puts. You will
remember my story of my customer at Options Research Inc. who lost $57
million during the Reagan Crash of 1987; he was short puts. Some market
makers have been destroyed by shorting calls, but the case is rare and
specifically results in the case of takeovers and unwise concentration of
commitments in one issue only.
The least risk lies in being hedged. To oversimplify, long the stock, long the
put. The profit of one makes up for the loss on the other. Also, if one were
long some stocks and short others, that also is a kind of hedge. Or long the
Dow and short futures on the Dow, or some of its components.
Now, let us be pragmatic; if during the management of our portfolios we
consistently measured the market with the MEI and balanced our portfolio
accordingly, we will be at less risk, both from the Ordinary and the
Extraordinary viewpoint. In fact, we may profit from an event that
disemploys many professional money managers.
If you have been religiously raising your stops, following the market with
progressive stops, and in fact raising them on the basis of new highs as
described in Chapter 28 (the three-days-away rule), it is quite possible that
while the market is storming, you will be sailing to Byzantium in your
customer yacht.
Summary of Risk and Money Management Procedures
The procedures described above are easily reducible to simple formulas,
even for the math phobic. Trade size is the basic unit for controlling risk.
Regardless of volatility, 500 shares of anything is riskier than 100 shares.
To determine trade size, take the difference between the entry price and the
stop price, giving Dollar Risk 1 ($R1). Take the Risk Control Factor, the
percentage of total capital to be ventured on the trade, and multiply times
Total Capital—for example, 3% times TC of $100,000, giving Risk-per-
Trade. Divide Risk-per-Trade by Dollar Risk 1 to determine Trade Size.
EP - SP = $R1
RCF x TC = RpT
RpT/$R1 = TS
where
TS = Trade Size EP = Entry Price SP = Stop Price
$R1 = Dollar Risk 1 RCF = Risk Control Factor
TC = Total Capital RpT = Risk-per Trade
Measure daily Operational Risk as described above. Divide Operational
Risk by Total Capital to determine Portfolio Operational Risk Factor. If this
factor is too high, look for hedges or positions to eliminate, starting with
those that are underwater.
Recompute stops frequently (daily for a trader), raising them according to
the Basing Points Procedure, Support and Resistance, or Trendlines.
Additionally, a money management stop may be employed, where the trader
says, for instance, no more than 8% from the market price will be risked
and this 8% must represent no more than x% of total capital. Money
management stops, it should be noted, are inherently less dynamic than
technically placed stops.
As the markets proceed inevitably through their phases, track their internal
composition with the MEI, and as positions are naturally terminated, put on
new positions in accord with the general long and short strength readings
of the MEI. Remember that exceptionally high MEI readings coincide with
broad market tops, and exceptionally low MEI readings coincide with broad
market bottoms.
Professional risk managers compute daily the Extraordinary Risk potential
in the markets using the procedure described in this chapter to constrain
traders under their authority from overexposure. In fact, panics and crashes
rarely occur out of the blue. There is almost always a pre-panic phase the
truly alert trader can identify, especially with the aid of a computer; these
are marked by insider and professional selling that creates increasing
volume with Reversal Days occurring in many stocks and Gaps and
Runaway down days. Almost always, these conditions will be preceded by
many top formations among key stocks—Double and Triple Tops and
Heads-and-Shoulders and V-Tops.
Eternal vigilance is the cost of freedom. It is also the cost of investing
success.
Infinitely more sophisticated risk and money management
procedures—Ralph Vince and optimal f
Undoubtedly, one of the most sophisticated analysts now practicing is
Ralph Vince, author of The Handbook of Portfolio Mathematics and
progenitor of the Leverage Space Model. He defines risk as we do, as
drawdown, not as the variance of returns. His procedure for determining
trade size is extremely sophisticated—more so than the procedures I have
outlined here. Although I feel these procedures meet the needs of the
general investor, Vince's procedure is must reading for the more
sophisticated investor and trader. He has described the Leverage Space
Model in a short article found in Section 8 of Appendix B, Resources.
chapter forty-three
Stick to your guns
It has often been pointed out that any of several different plans of operation,
if followed consistently over a period of years, would have produced
consistently a net gain on market operations. The methods we have
discussed in this book (representing the technical approach) are a case in
point.
The fact is, however, that many traders, not having set up a basic strategy
and having no sound philosophy of what the market is doing and why, are at
the mercy of every Panic, boom, rumor, tip, in fact, of every wind that
blows. Since the market, by its very nature, is a meeting place of conflicting
and competing forces, they are constantly torn by worry, uncertainty, and
doubt. As a result, they often drop their good holdings for a loss on a
sudden dip or shakeout; they can be scared out of their short commitments
by a wave of optimistic news; they spend their days picking up gossip,
passing on rumors, trying to confirm their beliefs or alleviate their fears;
and they spend their nights weighing and balancing, checking, and
questioning, in a welter of bright hopes and dark fears.
Furthermore, a trader of this type is in continual danger of getting caught in
a situation that might be truly ruinous. Since he has no fixed guides or
danger points to tell him when a commitment has gone bad and it is time to
get out with a small loss, he is prone to let stocks run entirely past the red
light, hoping the adverse move will soon be over, and there will be a
“chance to get out even,” a chance that often never comes. What is more,
even should stocks be moving in the right direction and showing him a
profit, he is not in a much happier position because he has no guide as to the
point at which to take these profits. The result is he is likely to get out too
soon and lose most of his possible gain or overstay the market and lose part
or all of the expected profits.
If you have followed the preceding chapters carefully, you will have
realized none of the technical formations and signals is certain and
unfailing. The chart action of a stock discounts and records all presently
known information about that stock (which includes all matters of dividends
declared or expected, split-ups, and mergers that are known to be planned,
political angles as they affect the market, world affairs, management,
earning records, and so on). The chart does not and cannot forecast
unforeseeable events, matters that are completely unknown to anybody. In a
majority of cases, the charts are dependable. If you are not satisfied this is
true, you should study further, or else plan not to use charts at all.
On the other hand, if you are satisfied the charts are, for you, the most
dependable indication of the probable future course of stock prices, then
you should follow explicitly the signals given on your charts, either
according to the rules we suggest here or according to such other rules and
modifications as your experience dictates. Nevertheless, while you are
following any set of rules and policies, follow them to the letter. It is the
only way they can help you.
If you do this, you will have certain large advantages, right at the start: (1)
you will never be caught in a situation in which a single stock commitment
can wipe out your entire capital and ruin you; (2) you will not find yourself
frozen in a market that has turned against you badly, with a large
accumulated loss and your capital tied up, so that you cannot use it in the
reversed trend to make new and potentially profitable commitments; and (3)
you can make your decisions calmly, knowing exactly what you will be
looking for as a signal to take profits, and knowing also that your losses, at
the very worst, will be limited to a certain definite amount.
All of this means you will have peace of mind. You will take losses and you
will make gains. In neither case will you have to take your notebooks home
and lie awake worrying. You will have made certain decisions. If
developments prove you were right, you will, at the proper point, take your
profit. And if it turns out that you were wrong, then you can take your
comparatively small loss, and start looking for a better situation, with your
capital still largely intact, liquid, and available.
Your job, as a speculator, is to provide liquidity in the market and to
counteract the irrational excesses of market-in-motion. Part of that job is to
keep yourself free to become liquid whenever it is necessary to reverse your
position. It is part of your job to keep yourself free from irrational and
excessive emotional actions. If you do this intelligently and consistently,
you will be performing a useful and necessary service to the general
economic welfare, and you will find the market offers as good or better
returns for your efforts as any other line of endeavor.
(EN9: With the ninth edition, I expect the reader will have some powerful
new guns to stick to: new lessons in Basing Points that show what a
powerful procedure it can be; new analyses of Dow Theory that refresh and
reinforce the validity and persuasiveness not just of the Theory, but also of
long-term investing as such. EN10: And a host of new stop systems to work
with. Good trading and stick to all your guns!)
Appendix A: The Dow Theory in practice
EN10: This appendix appears as Chapter 4 in the ninth edition.
EN9: The casual and careless reader will shake his head at this chapter and ask why on earth theeditor has not excised it from the book. The editor has not deleted the chapter because, like old-fashioned cod liver oil, it is good medicine. It will appeal mainly to the serious student of not justDow Theory but also of long-term investing. If the reader has absolutely no interest in DowTheory or long-term investing, he may skip over this chapter and return to it in his old age, whenhe is wiser.
At this point, the reader, if he has little previous knowledge of the stock market, may be sufferinga mild attack of mental indigestion. The Dow Theory is a pretty big dose to swallow at onesitting. We departed deliberately in the foregoing chapter from the order in which its principlesare usually stated in an effort to make it a little easier to follow and understand. Actually, not allof the 12 tenets we named are of equal import. The essential rules are contained in 2, 3, 4, 5, 8,10, and 11. Number 1 is, of course, the basic assumption, the philosophical justification for theserules. The other points (6, 7, 9, and 12) furnish “background material,” as the news reportersmight put it, which aid in interpretation. Theoretically, one should, by strict adherence to theessential rules alone, accomplish just as much as he could with the added collateral evidence. (Forillustrations in this appendix, see Figures A.1 through A.9.)
However, the utilization of Dow Theory is, after all, a matter of interpretation. You may memorizeits principles verbatim and yet be confounded when you attempt to apply them to an actual marketsituation. We can better organize our knowledge of the theory and acquire some understanding ofits interpretation by following through a few years of market action and seeing how it looked atthe time through the eyes of a Dow theorist. For this purpose, we may well take the period fromlate 1941 to the beginning of 1947 because this covers the end of one Bear Market, an entire longBull Market, and part of another Bear Market, and includes examples of most of the marketphenomena with which the Dow Theory has to deal.
Five years of Dow interpretation
Figure A.2 is a condensed chart of the course of the two Dow-Jones Averages from January 1,1941, to December 31, 1946, on which most of the Minor Trends have been disregarded but allthe recognized Intermediate Swings (Primary and Secondary) have been indicated. Certainportions of this history will be supplemented by complete daily charts in connection with ourdetailed discussion that follows.
The year 1941 opened with the stock market in a Minor Rally. A Primary Bear Market had beensignaled when prices collapsed in the spring of 1940 and that Bear Market was
Figure A.1 “Swing” (EN: or Wave) chart showing all the Intermediate and some of the moreextensive
Minor Trends of the Dow-Jones Industrial and Rail Averages, January 1941 to December 1946.Industrial price scale left, Rails right.
still in effect. After the May Panic had ended, a Secondary Recovery swing, which lasted for morethan five months, had regained more than half of the ground previously lost by the Averages,carrying the Industrials from their closing price of 111.84 on June 10 to 138.12 on November 9and the Rails from 22.14 on May 21 to 30.29 on November 14. (During this long Bear MarketSecondary, incidentally, volume tended to increase on rallies, which encouraged many who didnot hold strictly to first principles to believe that this rise was the beginning of a new Bull Trend,illustrating the point we cited under “Volume” in Chapter 3.) From the November highs, however,the trend turned down again. Then a Minor Rally developed, as stated, at the end of the year,reaching its peak on January 10 at 133.59 in the Industrials and 29.73 in the Rails. From there,prices fell again to 117.66 and 26.54, respectively, on February 14.
The first severe test
The next few months will be particularly interesting for us to trace because they put the DowTheory to a real test. Figure A.3 shows the daily ranges and closing prices of the two Averagesand total daily market volume for the seven months from February 1 to
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August 31, 1941. Before we examine it in detail, however, let us first review the situation onFebruary 14. The Bear Market lows to date had been registered in May-June, 1940. Thereafter, anextended Intermediate Recovery had advanced the Industrial Average 26.28 points and the RailAverage 8.15 points. This had been followed by a three-month decline of 20.46 and 3.75 points,respectively, and this decline, incidentally, had consisted of three well-defined Minor Waves. Induration, and in extent of price change with respect to the previous swing—46% in the Rails andnearly 78% in the Industrials—this downswing qualified as an Intermediate Trend, and nowprices were turning up again. Dow theorists were on the alert. If both Averages could continuetheir rise to levels above their high closes of the previous November (138.12 and 30.29), thataction would constitute a signal of a new Primary Bull Market, and reinvestment of fundswithdrawn from stocks in May 1940 would be at once in order. Also, it would then be necessaryto go back and label the May-June lows of 1940 as the end of a Bear Market, the advance toNovember as the first Primary Swing in the new Bull Market, and the decline to February as itsfirst Secondary Reaction. Note Rule 12 of our preceding chapter (EN11: Chapter 3) applied here;the presumption was it was still a Bear Market until a definite signal to the contrary appeared.
Let us now turn again to Figure A.3 and see what actually did happen. The Industrials rallied forsix weeks, reaching 124.65 on April 3. The Rails got up to 29.75 on the same date, registeringdouble the percentage gain of the Industrials, but both Averages were still below their November
highs. Then the Industrials slipped off within two weeks and had broken down below theirFebruary low and drifted down to close at 115.30 on May 1. This Average was, therefore, still inan Intermediate Downtrend. The Rails, meanwhile, were staging a different sort of performance;they dropped back from their April 3 high for two weeks, but held at 27.72, rallied smartly andthen sold off again to 27.43 on May 31. The picture became at once even more
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Figure A.3 Daily closing price levels of the Dow-Jones Industrial and Rail Averages from March2 to October 31, 1942, and total daily market volume. This period saw the beginning of a 4-yearmajor bull market.
interesting. Here was a Divergence between the two Averages, a failure to confirm; the Rails,after two opportunities, were refusing to confirm the Industrials in the latter's downtrend.
Failure to confirm
When prices began to work upward in June, many commentators seized on this “failure toconfirm” as a Bullish omen and the wishful thinkers again talked Bull Market. There is anunfortunate tendency in the Street to overstress any such divergence, particularly when it can betwisted into a favorable sign. The fact is Dow Theory's refusal of one Average to confirm theother can never produce a positive signal of any sort. It has only negative connotations.Divergences sometimes occur at Reversals in the Major Trend—there have been several instancesin market history, in which, perhaps, the most remarkable occurred way back in 1901 and 1902,and we shall soon inspect another—but they also occur with equal frequency at times when noMajor Reversal is developing, and the instance we are discussing here was one of the latter.
The situation at the end of May in 1941 was precisely the same to the Dow theorist, insofar as theMajor Trend was concerned, as it had been on February 14. The June-July rally topped out in theRails at 30.88 on August 1, and in the Industrials at 130.06 on July 28 (compare these figures withtheir 1940 November highs) and prices then declined at an accelerating pace, temporarilyculminating in the Pearl Harbor Panic. This took the Industrial Average below its previous BearMarket low (111.84 on June 10, 1940), although the Rails, again, did not follow. They had,however, by this time, broken below their previous (February 14) Intermediate Bottom by aliberal margin.
The next period of importance began in April 1942. We can skip any detailed chart of the monthsbetween December and April because they posed no Dow Theory problems.
Figure A.4 Daily closing price levels of the Dow-Jones Industrial and Rail Averages fromNovember 2, 1942, to June 30, 1943, and total daily market volume.
After a Minor Rally in the Rails in January, prices simply drifted lower and lower, but it wasincreasingly evident that trading volume did not expand on the dips (Minor Declines). Liquidationwas drying up; the boardrooms were void of customers; the atmosphere was typical of the laststages of a Bear Market.
The daily action of the Averages from March 2 to October 31, 1942 is shown in Figure A.4. Newlows (since 1940) were registered both in late April, at 23.72 on April 24 in the Rails and at 92.92on April 28 in the Industrials. Shortly thereafter, a notable Divergence developed, when, afterrallying for only seven days, the Railroad Index began to slip off while the other Average keptright on going up. Trading activity remained at a low ebb (there was no sustained volumeincrease, in fact, until late September). On June 1, the Rails dropped to another new low and onthe 2nd closed at 23.31. On June 22, it looked as though the Industrials were going to be pulleddown again, but only a few days later, the best rally in months got started, taking the Industrials tonew highs and more than recovering all of the April-May loss in the Rails. Activity also speededup briefly, with one day registering a greater turnover than the market had enjoyed in any sessionsince early January. (EN9: Note this warning sign. The ringing of an alarm clock.)
Signs of Major Turn
Again, the Dow theorists were very much on the alert. An advance of Intermediate proportionswas obviously under way. Until proved otherwise, it had to be labeled a Secondary within theBear Market, which was still presumably in effect, but that Major Downtrend had by now run fornearly three years—nearly as long as any on record—and its last decline had shown no sellingpressure whatever, simply a dull drift. This presumed Secondary might turn out to be a newPrimary; hopes for such a denouement had been blighted 12 months earlier under somewhat-similar circumstances, but this time prices were lower and there was a different “feel” to themarket. The general news offered little encouragement, but the Dow Theory does not concernitself with any news other than the market itself (which discounts all other kinds of news). In anyevent, there was nothing to do but wait and see—let the market, in its own time and way, state itsown case.
In early July, the Industrials started to “mark time”; for 11 weeks, they fluctuated within a 5-pointrange, building a typical Dow Line from which they emerged on the upside in late September.The Rails pushed up to a new high for the move at the same time, and by November 2, bothAverages had surpassed their Rally Tops of the preceding January. At this stage, some Dowtheorists were willing to announce a Bull Market had been signaled. Their arguments, aside frompoints of a nontechnical nature or having nothing to do with Dow Theory, were as follows:
1. The conspicuously low level of volume at the April-June Bottom, typical of the end of aBear Swing. (True and cogent.)
2. The Rail Average had refused to follow the Industrials into new Major low ground at thattime. It had held above its closing level of May 1940. (Also true, but of questionablesignificance. More about this later.)
3. The Industrials had constructed a Line and gone up out of it. (Again true, but the Line wassomewhat short to have, beyond a doubt, major import.)

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Figure A.5 Daily closing price levels of the Dow-Jones Industrial and Rail Averages fromNovember 2, 1942, to June 30, 1943, and total daily market volume. This chart follows andshould be compared with Figure A.4. The decline in the Rail Average during November andearly December produced the first test of the Major Trend since the preceding June. Whenthis Index recovered and, on February 1, 1943, closed above its November 2 high, a PrimaryBull Market was thereby signaled according to Dow Theory.
4. The Rail Average had produced successively higher Minor Tops and Bottoms for fourmonths. (This also was true but did not permit positive differentiation from a Bear MarketSecondary.)
The more conservative Dow theorists were not yet convinced. They maintained this uptrend hadyet to undergo the test, bound to occur sooner or later, of an Intermediate Reaction. They admittedthat the picture was most encouraging, but they called attention to the fact that, except for Point 1,it was no better than that of November 1940. Let's follow along through the next five months.Figure A.5 shows the daily market action from November 1, 1942, to June 30, 1943.
The Bull signal
After reaching 29.28 at their close on November 2, the Rails declined in almost a straight line forsix weeks to 26.03 on December 14. This move indubitably rated as an Intermediate in durationand it had “given up” more than half of that Average's entire advance from the June 2 low point.The Industrial Index, however, held stoutly in another narrow Line throughout November,December, and January. From December 14, the Rails turned up, and finally, on February 1, 1943,closed at 29.55, out above their previous Intermediate Top of 29.28 recorded the previousNovember. By then, the Industrials had also moved up into new high ground. This development atlast satisfied every strictest requirement of Dow Theory; a new Primary Bull Market was in force.Trading volume had also been expanding on each Minor Advance during the fall and wintermonths, but its evidence was not needed; the price action alone was conclusive. The Rails hadproduced the necessary sequence of higher Intermediate Tops and Bottoms. In the Industrials,Lines had served the purposes of the theory as substitutes for Intermediate Reactions.
It was necessary now to relabel the up-move from April-June to November of 1942 as the firstPrimary Swing in a Bull Market. The decline of the Rails from November 2 to December 14 wasnow recognized as the first Secondary within that Major Trend.
We may turn back for a moment at this point to comment on the performance of the Rail Index inJune 1942. Since it held above its low of May 1940, some commentators have maintained theBull Market should really have been dated from that former year as representing the last“confirmed” lows. This strikes us as rather impractical hair-splitting. Regardless of the 1.17higher level in the Rail Average in June 1942, a genuine Bull Move did not start until that time.We suspect, before many years have passed, Dow theorists will have occasion greatly to regret theimportance that has since been assigned to the Rails' “failure to confirm” in the spring of 1942.Remember, such a Divergence does not and cannot produce a positive signal; at the time of itsoccurrence, it can serve merely to negate or cast in doubt the implications of the other Average;only subsequent action in the opposite direction can establish the existence of a change in trend. Ifthe Rails' decline in May 1942 had carried them below 22.14, but their subsequent action hadfollowed the course it actually did, point for point at a lower level, a Bull Market Signal wouldnevertheless have been given at the very same time, not one day later and not one day sooner.
Moreover, a Divergence does not necessarily imply a move of consequence in the oppositedirection will ensue. We have already examined one comparable instance (in the spring of 1941)that resulted otherwise. Logically, if a failure to confirm such as occurred in 1942 is to be taken asan indication of a turn in trend, then its opposite, (confirmation or reaffirmation by both Averages)should argue with equal force against a turn in trend. Yet the simple truth is that many more MajorReversals have come when the Averages were in
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FigureA.6 Daily closing prices of Dow-Jones Industrial and Rail Averages, and total marketvolume, July 1, 1943, to January 31, 1944.
agreement than when they were divergent. We have no wish to belabor the point or waste thereader's time, but we do feel he should be warned against the wishful thinking that every “failureto confirm” seems to inspire when the market is in a Bear Trend.
To return to our history, the Averages closed at 125.88 and 29.51, respectively, on the dayfollowing our conclusive Bull Market Signal in February 1943. Theoretically, that is where aninvestor who strictly followed the Dow Theory would have bought his stocks. (Those who weresatisfied the Primary Trend was up in November 1942 bought with Averages around 114.60 and29.20.) It was reasonable to assume this Bull Market, which as yet showed few of the usualcharacteristics of the second phase and none whatever of the third phase, would continue for sometime to come. The next four months produced no market developments that required interpretativeattention, and we can move on to the events of July. Figure A.6 charts the action from July 1,1943, to January 31, 1944.
The first correction
After closing at 145.82 on July 14, 1943, the Industrial Average drifted off. The Rails pushed upto a new high (38.30) 10 days later, but the Industrials refused to join in the rally and then bothindexes cracked down sharply for seven sessions. Turnover increased and the decline was thegreatest occurring in the Bull Market up to that date. However, everyone realized the market, afterseveral months of quite persistent advance, was “entitled to a correction.” In neither duration norextent could this down move be qualified as more than a Minor Trend. Next ensued three monthsof desultory fluctuation with little net progress in either Average. The Industrials pulled up to141.75 on September 20 and then drifted off again, whereas the Rails struggled back to 35.53 onOctober 27. Another quick break developed in early November, culminating in a high-volumeshakeout that cut the value of the Industrials by 3.56 points and the Rails by 1.75 on November 8.Prices rallied a little and sold off again, reaching new lows (since early spring) on November 30—Industrials 129.57 and Rails 31.50.
There was no question now that a full-fledged Secondary Reaction had developed. The problemfor Dow interpreters was whether there was more involved. If the first drop in July could beconstrued as an Intermediate Trend in itself, and the August- October action as anotherIntermediate Swing, then the November break would signal a Bear Market. As a matter of fact, noDow theorist, so far as we know, gave very serious consideration to any such interpretation. The
July break, as aforesaid, did not rate as an Intermediate in either duration or points retraced; thewhole move from July to November 1943 had to be regarded as all-of-a-piece, all one SecondaryReaction. The real Major Trend test would come on the next advance, whenever that shoulddevelop; if that failed to top the July peaks, and prices thereafter declined to new lows, a BearMarket would indeed be in effect.
The decision was long deferred. Prices began again to move up, but the advance in the Industrialswas slow and grudging. The Rails forged ahead more rapidly and pushed through their July Topon February 17, 1944, going on to a Minor Peak at 40.48 on March 21. The Industrial Averageattained 141 on March 13, but still nearly 5 points below its “signal” level, faltered and fell back.Here was another striking case of “failure to confirm.” For those who chose to assign gravesignificance to such developments, it could have only a very Bearish meaning. All it did mean, infact, was continuation of the Primary Bull Move had not as yet been confirmed. Only if bothAverages now declined and closed below their respective November 30 Bottoms would the newhigh registered by the Rails alone in February have to be disregarded and a Primary Bear Marketannounced. In brief, the situation at the end of March was no different, so far as its Major Trendimplications were concerned, from what it had been in early January before the Rails pushedthrough.
Bull Trend reaffirmed
The situation remained in doubt (but subject always to that basic presumption of the Dow Theorythat we named as Rule 12 in the preceding chapter [EN10: Chapter 3]) until June 15, 1944, whenthe Industrials finally came through to close at 145.86. It had taken them four months to confirmthe Rails, almost a full year to reaffirm the Primary Uptrend. The effect of this “signal” on traderswas electric; trading volume increased by 650,000 shares on the following day as prices jumpedanother full point.
The following 12 months need no detailed discussion as they produced nothing in the way ofmarket action to give a Dow theorist any concern. Prices drifted off irregularly for nine weeksafter mid-July, but their net loss was of minor proportions, and they then climbed with only briefinterruptions to 169.08 in the Industrial Index on May 29, 1945, and 63.06 in the Rail Index onJune 26, 1945. We should take a brief look at the period following, not because it illustratesanything new in our study, but because it takes in the surrender of Japan and the end of fighting inWorld War II.
The seven months from May 1 to November 30, 1945 are covered in Figure A.7. The Industrialsheld steady for four weeks while the Rails were making the spurt to their June 26 Top. On June28, with nothing in the newspaper headlines to account for such a radical trend change, pricesbroke sharply and turnover climbed to nearly 3 million shares, the highest day's total for the BullMarket up to that time. Nevertheless, the Industrial Average gave ground reluctantly thereafter,and by June 26, at 160.91 had given up less than 5% of its top price. The Rails shook downrapidly, however. The Hiroshima bomb was dropped on August 5, and Japan surrendered on the14th. The Industrials were now rallying up from
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Figure A.7 Daily closing price levels of the Dow-Jones Industrial and Rail Averages from May 1to November 30, 1945, and total daily market volume. This period, which saw the end of WorldWar II, produced only a moderate Secondary Correction in the Primary Bull Market, which hadalready run for three years from its beginnings in April/June, 1942.
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their July 26 low, but the Rails could not hold and plunged again, hitting bottom finally (for thismove) on August 20 at 51.48, for a loss of more than 18% of their June peak value.
The Rails falter
Before we go on with our examination of the market action here, it is interesting to note up to thispoint the Rail Average had been the “hero” of our story. Starting with its refusal to go down to anew Bear Market low in June of 1942, it was the spearhead of each important advance, had stagedthe most spectacular rallies, had gained 170% in value as compared with the Industrials' 82%. Inretrospect, the explanation is obvious: the railroads were the chief business beneficiaries of thewar. They were rolling up profits, paying off indebtedness, and reducing their fixed charges at arate unheard of in this generation (and probably never to be seen again). Although the “public's”eye was on the traditional and better publicized “war industries,” the market began, as far back asPearl Harbor, to shrewdly appraise and discount this unprecedented harvest for the Rails. Butfrom here on, the picture changes and the Rails become the laggards. As we look back now, it isjust as obvious that, with equal shrewdness, the market began in July of 1945 to discount achange in their fortunes. An illuminating demonstration of the basic assumption (Tenet Number 1)in Dow Theory!
Turning back to our chart, prices began to push up again with renewed vigor after August 20.Both Averages had experienced a Secondary Reaction and now Dow theorists had to watchclosely to see whether the Primary Uptrend would again be reaffirmed by their going to newhighs. The Industrials “made the grade” when they closed at 169.89 on August 24, but the Railshad much more ground to recover and were running into offerings as they came up in successionto each of the Minor Bottom levels of their June-August downtrend (a phenomenon to which weshall devote some attention later on in the chapter on Support and Resistance). Not until earlyNovember 1945 were they able to confirm the signal of the Industrials by closing above 63.06. Atthis point, the Averages had, once again, announced that the Primary Bull Market was still inforce. It had now lasted for three and a half years—longer than most Bull Markets, and “thirdphase” signs were rapidly appearing. The public was buying, the boardrooms were crowded,stock market news was making the front pages of even small city newspapers, the “cats and dogs”were being whooped up, business was booming.
With both Averages in new high ground and the Bull Market reaffirmed, all previous low pointscould now be disregarded. For example, the 160.91 Bottom of July 26 in the Industrials and the51.48 of August 20 in the Rails had no further significance in Dow Theory. This is a point wehave not stressed heretofore, but it is important. It might, indeed, be added to our set of rules in
the preceding chapter (EN11: Chapter 3) were it not implicit in the basic tenets. Once a PrimaryTrend has been confirmed or reconfirmed, the past is forgotten and everything hinges on futureaction. At the end of 1945, with “third phase” symptoms rife, the action of the market had to befollowed with redoubled vigilance. The third phase could last for two more years (as it did in1927 to 1929) or be concluded at any moment. Our next chart (Figure A.8) carries us throughMay 1946.
The spring of 1946
The market went through a Minor Setback in late December, a development has come to beexpected as the normal pattern for that month and is usually attributed to “tax selling”— andstormed ahead again in January 1946. Daily volume on January 18 exceeded 3 million shares forthe first time in more than five years. During the first week of February, prices “churned” withlittle net change. Extreme high closes were registered during this period by the Rail Average at68.23 on February 5, and by the Industrial Average at 206.97 on February 2. On February 9, bothstarted to slide off, pulled back sharply from the 13th to the 16th, and then broke in a selling wavethat ran to a climax on February 26 with closings at 60.53 and 186.02, respectively. The loss inthe Industrials was the greatest in points (20.95) they had suffered during the entire Bull Market;in the Rails, it was exceeded only by their July-August decline of the previous year. It amountedto a little more than 10% in the former and 11% in the latter and gave up a little less than half oftheir advances from the 1945 summer lows. The decline was three weeks old on February 26. Itwas an unqualified Intermediate—in Dow Theory a Secondary Reaction presumptively within thestill existing Major Uptrend.
Labor troubles were dogging the steel and motor industries in 1946 from early January on, with acoal strike looming. The February break was attributed to those news developments, but theruling cause was more likely the discontinuance of margin trading. In January, the FederalReserve Board announced after February 1 stocks could be bought only for full 100% cash. Thelate January up-fling was featured by the “little fellow” seizing his last chance to buy on margin.(Those who participated in this scramble will doubtless regret it for a long time yet to come.)Professionals seized the opportunity to unload their trading commitments, but the “little fellow”was now temporarily out of funds; his brokerage account was quickly “frozen.” Under thecircumstances, as we look back, it is amazing that a more extensive Panic did not then eventuate.
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Final Up-Thrust
The late February Bottoms were now the critical points on the downside; if both Averages shoulddecline below the Intermediate Low closes then recorded, before the Rails could make a new highabove 68.23 (in which event the Bullish Signal of the Industrials would be canceled), a BearMarket would thereby be signaled. Despite a miner's strike and an imminent rail workers' strike,the market turned firm again in mid-May and put forth a surprising rally that swept the IndustrialIndex up to 212.50 on May 29, 1946—a new Bull high by nearly 6 points. The Rails failed inMay by only 0.17 to equal their February high close, slid back a trifle, and then pushed through atlast on June 13 to close at 68.31, thereby confirming the Industrials in their announcement that (asof that date) the Primary Trend was still up. The February lows (186.02 and 60.53) now ceased tosignify in Dow Theory, but keep those figures in mind because they are involved in an argumentthat raged among Dow students for months thereafter.
The preceding picture is overlapped by Figure A.9, taking up the market's action on May 4 andcarrying it forward to October 19, 1946. Trading volume, it may be noted, in late May and earlyJune did not come up to the levels of either the late January to early February Top or the lateFebruary Bottom; the market appeared to be losing vitality, an ominous, although by no means,decisive manifestation. Prices began to fall off rapidly immediately after the Rail Confirmation onJune 13. The Industrials rallied for two weeks in early July, but the Rails continued to decline; theIndustrials broke again on July 15 and the two Averages continued their slide until they stood at195.22 and 60.41 at the close on July 23.
There, as it subsequently developed, was the end of that particular Intermediate Swing—one inaccord with our Rule 12 had to be labeled a Secondary Reaction in a Bull Market until provedotherwise. The market swung up again. It climbed slowly and steadily, but with turnover runningwell under a million shares, until exactly three weeks later, the Industrials at 204.52 (August 13)had regained a little more than half of their June-July loss and the Rails at 63.12 (August 14) alittle more than a third of theirs. This advance, therefore, had met the minimum requirements ofan Intermediate Trend. If prices could continue to rise and eventually push through their May-June Tops, the Major Bull Trend once again would be reaffirmed. Although, if they should turndown and fall below the July 23 closing levels, it would signal a Reversal of the Primary Trend.
The Bear Market signal
The situation was critical, as evident in the volume chart. Ever since the end of May, turnover hadtended not only to increase on the declines, but also, and more importantly, dried up on the rallies.Compare Figure A.9 with Figures A.7 and A.8, and you can see how conspicuous thisphenomenon had become by mid-August. Prices did turn down, with activity increasing on thebreaks, and on August 27, the closing prices, 191.04 for the Industrials and 58.04 for the Rails,told a sad story. The Averages had spoken: a four-year Bull Market had ended, and a Bear Marketwas under way. A Dow investor should have sold all his stocks on the following day (atapproximately 190 and 58 in terms of the two Averages).
To clear the record, it was necessary for the Dow theorist now to go back and mark the May 29and June 13 highs in the Industrials and Rails, respectively, as the end of the Bull Market. TheJune-July decline then became the first Primary Swing in the new Bear Trend, and the July 23 toAugust 14 advance became the first Secondary Recovery within the Major Downtrend. A secondPrimary Swing was now in the process of development.
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Figure A.9 Daily closing price levels of the Dow-Jones Industrial and Rail Averages from May 4to October 19, 1946, and total daily market volume. This chart overlaps Figure A.8. Compare theclosing price of the Rail Average on June 13 with its February 5 high close. This June actionnullified the previous Dow Theory importance of the February lows. Note significant change involume pattern after May, especially during the August rally.
You will have noted in the foregoing, a Bear Market was signaled as soon as both Averagespenetrated their July 23 lows. Let us return now and take up that argument we mentioned on thepreceding page. Some students of Dow Theory refused to recognize the new high of June 13 inthe Rail Average as a decisive reaffirmation of the Bull Trend. The previous close should bebettered by at least a full point (1.00), many argued, to confirm the signal previously given by theIndustrials; the margin of only 0.08 was inconclusive. Nevertheless, this opinion, if accepted, hadlogical consequences that later proved embarrassing. For, if the Bull Market had not beenreaffirmed in June, then the critical levels on the downside remained at 186.02 in the Industrialsand 60.53 in the Rails, the February 26 Bottoms. Therefore, a Bear Market could not be “called”until those prices had been penetrated downside by both Averages. This view acquired a largefollowing, especially among those who were not interested in “hair splitting” theory but wanted“to give the market every chance in view of the still improving fundamentals.”
The market did, of course, proceed to break its February lows, and by that time, the Panic (secondphase) was on. Obviously, in this case, the orthodox “any-penetration-whatever” school had allthe best of it; they had sold out at least 13 points higher up in terms of the Industrial Index (atleast 6 in the Rails). Six weeks later, on October 9, 1946, this second Primary Intermediate Swingended at Industrials 163.12, Rails 44.69, and another Intermediate Recovery Move started.
Before closing this history of six years of Dow Theory interpretation, we might note the June 13high in the Rail Average furnished a perfect illustration of the rule stating a trend can change anytime after it has been confirmed or reaffirmed, also of the diminishing odds in favor ofcontinuance with each successive reaffirmation of the Primary Trend.
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
1
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FigureA.8 Daily closing price levels of the Dow-Jones Industrial and Rail Averages fromDecember
2
1945, to May 31, 1946, and total daily market volume. Noteworthy features of this periodincluded the extremely high volume that prevailed during January and February as compared withlower turnover in April and May, and the laggard performance of the Rails when the IndustrialAverage pushed up to a new high in April and again at the end of May. At the latter date, theFebruary lows were still the critical downside “signal” levels according to the Dow Theory.
Yet the Dow theorist was not concerned with causes. The Bull Market had been reaffirmed byboth Averages in early February, canceling all previous “signal” levels. Bullish Forces were stillevidently in effect because the February 26 lows held and prices began to recover. The Industrialscame back quickly and by April 9 had closed in new high ground at 208.03. The Rails dragged;when the market showed signs of weakening at the end of April, the Rail Average was still nearly5 points below its early February high. Was this another “failure to confirm” to worry about?
Appendix B: Resources
• Section 1: Important and indispensable sites
• Section 2: References for further study
• Section 3: Investment-oriented sites
• Section 4: The Sharpe Ratio
• Section 5: Calculating volatility and examples of professional risk analysis
• Section 6: The essence of fundamental analysis
• Section 7: Software packages and Internet technical analysis sites
• Section 8: The Leverage Space Portfolio Model of Ralph Vince
Section 1: Important and indispensable sites
Contact information for John Magee:
John Magee technical analysis::Delphic options research ltd (jmta::dor)
E-mail bassetti@edwards-magee.com
bassetti@att.net
Edwards-Magee website
SEC Enforcement
http://www.www.edwards-magee.com
http://www.enforcement@sec.gov
(Whenever I receive touts or investment spam, I immediately forward it to this important branch ofthe SEC. All responsible investors should do the same.)
Volatilities and options:http://www.optionstrategist.com
Portfolio hedge computationhttp://www.cboe.com/portfoliohedge http://www.cboe.comhttp://www.abg-analytics.com
Software reviews andinformation
Software demonstrations andpackages
http://www.traders.com http://www.omegaresearch.comhttp://www.comstar.com http://www.aiqsystems.comhttp://www.tradestation.com http://www.equis.com
Web chart analysis site
Morningstar
Industry evaluations Mutualfund cost calculator Internetanalysis
http://www.stockcharts.com http://www.morningstar.nethttp://www.gomez.com http://www.sec.gov/mfcc-int.htmhttp://www.stockcharts.com
Section 2: References for further study
On Volatilities and Options:http://www.optionstrategist.com
(and futures) http://www.cboe.com
DOW futures and optionshttp://www.cbot.com
AMEX iShares (DIA, QQQ, etc.)http://www.amex.com
On betas http://www.finance.yahoo.com
On risk
Value at Risk, Phillipe Jorion, New York: John Wiley & Sons, 1996 Against the Gods, Peter Bernstein,New York: John Wiley & Sons, 1996 Risk Management 101 (software), Zoologic, Inc., 1997.
See also Chapter 42
On candlesticks
Japanese Candlestick Charting Techniques, Steve Nison, New York: NYIF, 1991 Beyond Candlesticks,Steve Nison, New York: John Wiley & Sons, 1994
On futures
Schwager on Futures, Technical Analysis, Jack Schwager, New York: John Wiley & Sons, 1996 (andother titles by Schwager in References).
On portfolio management
The Journal of Portfolio Management
Risk Management 101 (software), Zoologic, Inc., 1997
Chapter 42
Section 5, this appendix
Section 8, this appendix
Section 3: Investment-oriented sites
AARP Investment Program
Accutrade
ADR.com
American Association of Individual Investors
American Century
American Express Financial Services
American Stock Exchange
Ameritrade (has little-advertised free trade site)
Annual Report Gallery
Barron's
BigCharts
Bloomberg Financial
Bonds Online
http://www.aarp.scudder.com http://www.accutrade.com http://www.adr.com http://www.aaii.comhttp://www.americancentury.com http://www.americanexpress.com/directa http://www.amex.comhttp://www.tdameritrade.com http://www.reportgallery.com http://www.barrons.comhttp://www.bigcharts.com http://www.bloomberg.com http://www.bondsonline.com
Briefing.com
Brill's Mutual Funds Interactive
Business Week
CBS MarketWatch
Chicago Board of Options Exchange
CNNFN
DailyStocks
Excite
Federal Deposit Insurance Corporation
Federal Trade Commission
Fidelity Investments
Financial Times
Forrester Research
FundFocus
Fund Spot
Gomez Advisers
H&R Block
Hoover's StockScreener
IPO Central
Lombard
Marketplayer
Market Technician's Association
Microsoft MoneyCentral
Morningstar
National Association of Securities Dealers National Discount Brokers
Net Investor
New York Stock Exchange
Online Investor
Philadelphia Stock Exchange
Quick & Reilly
Quicken
Quicken Financial Network
Realty Stocks
Reuters
Schwab, Charles
Securities and Exchange Commission
Securities and Exchange Commission Enforcement
Securities Industry Association
Securities Investor Protection Corporation SmartMoney
Social Security Online
Standard & Poor's Fund Analyst
Standard & Poor's Ratings Services
Stock Guide
Stockpoint
Suretrade
http://www.briefing.com http://www.fundsinteractive.com http://www.businessweek.comhttp://www.marketwatch.com http://www.cboe.com http://www.cnnfn.com http://www.dailystocks.comhttp://www.excite.com http://www.fdic.gov http://www.ftc.gov http://www.fidelity.comhttp://www.ft.com http://www.forrester.com http://www.fundfocus.com http://www.fundspot.comhttp://www.gomez.com http://www.hrblock.com http://www.stockscreener.comhttp://www.ipocentral.com http://www.lombard.com http://www.marketplayer.com http://www.mta.orghttp://www.moneycentral.com http://www.morningstar.net http://www.nasd.com http://www.ndb.comhttp://www.netinvestor.com http://www.nyse.com http://www.onlineinvestor.com http://www.phlx.comhttp://www.quickwaynet.com http://www.quicken.com http://www.qfn.com http://www.realtystocks.comhttp://www.reuters.com http://www.schwab.com http://www.sec.gov http://enforcement@sec.govhttp://www.sia.com http://www.sipc.org http://www.smartmoney.com http://www.ssa.govhttp://www.micropal.com http://www.ratingsdirect.com http://www.stockguide.comhttp://www.stockpoint.com http://www.suretrade.com
1040.com http://www.1040.com
The Motley Fool http://www.fool.com
TheStreet.com http://www.thestreet.com
Technical Securities Analysis Association of San
Francisco http://www.tsaasf.org
T. Rowe Price http://www.troweprice.com
Treasury Direct http://www.publicdebt.treas.gov
Vanguard Brokerage Serviceshttp://www.vanguard.com
Wall Street Access http://www.wsaccess.com
Wall Street Journal Interactive Edhttp://www.wsj.com
Yahoo! Finance http://www.finance.yahoo.com
Zacks Investment Researchhttp://www.zacks.com
ZD Interactive Investor http://www.zdii.com
a American Express now advertises free trades for some accounts.
Brokerage houses
Waterhouse Securitieshttp://www.tdameritrade.com
800-934-4134
A. B. Watley http://www.abwatley.com
888-229-2853
Web Street Securitieshttp://www.webstreetsecurities.com
800-932-0438
Jack White http://www.jackwhiteco.com
800-753-1700
WitCapital http://www.witcapital.com
888-494-8227
Net Investor http://www.netinvestor.com
800-638-4250
Quick & Reilly http://www.quickwaynet.com
800-672-7220
Charles Schwab http://www.schwab.com
800-435-4000
Suretrade http://www.suretrade.com
401-642-6900
Vanguard Brokerage Serviceshttp://www.vanguard.com
800-992-8327
Wall Street Access http://www.wsaccess.com
888-925-5782
Empire Financial Group, Inc.http://www.lowfees.com
800-900-8101
E*TRADE http://www.etrade.com
800-786-2575
Lombard http://www.lombard.com
National Discount Brokershttp://www.ndb.com
800-888-3999
Accutrade
Ameritrade
See also
Discover Brokerage
DLJ Direct
Datek Online
DLJ Direct
Dow Jones Markets
DRIP Central
Empire Financial Group
http://www.accutrade.com
800-494-8939
http://www.tdameritrade.com
800-326-7507
http://www.freetrade.com http://www.discoverbrokerage.com 800-688-3462 http://www.dljdirect.com
800-825-5723
http://www.datek.com
http://www.dljdirect.com http://www.djmarkets.com http://www.dripcentral.com http://www.lowfees.com
Section 4: The Sharpe Ratio
Although this formula is flawed, it will not hinder the reader to know about it and understand it. Believingin it would be quite a different matter, however. The Sharpe Ratio itself is as follows:
SR = (E - I)/sd
where
E is the expected return, I is the risk-free interest rate, Sd is the standard deviation of returns.
The effect of this inflexible formula is to stick the trader with a measuring tool of little use to the practicaltrader. It assumes volatility of returns as measured by sd equals risk (the common academic problem). Inthe inflexibility of the sd calculation, it fails to measure the most important fact in trading, the maximumdrawdown, or, the inevitable fluctuations in gains and losses. Specifically, the greatest expected orexperienced loss, the retracement from greatest high to greatest low, and the sequences of theseexperiences.
Section 5: Calculating volatility
To calculate the volatility of a portfolio or of an individual instrument, first find the difference betweeneach return and the average. Then square each difference and add them together. Divide the sum by the
number of returns minus one. This result is known as the variance. Finally, take the square root of thevariance to get the volatility. Combining these steps into a formula (see Diagram B.1):
Step 1: Calculate the average return.
Step 2: Calculate the deviation of each return.
Step 3: Square each period's deviation.
Step 4: Add them together.
Step 5: Divide the sum by the number of periods minus 1.
Step 6: Take the square root.
a =
£ (Ri - M )2
i=1
n-1
Diagram B.1 Volatility formula. Illustrated is the formula for computing volatility. (1) Calculate theaverage return; (2) calculate the deviation of each return; (3) square each period's deviation; (4) add themtogether; (5) divide the sum by the number of periods minus 1 to get the variance; and (6) take the squareroot.
Note this is the formula to use when you have experience with the portfolio. There is quite a morecomplex procedure in Modern Portfolio Theory.
Section 6: The essence of fundamental analysis
From the John Magee Market Letters, December 15, 1984
by Richard McDermott
The Elliott Wave Theory: perspective and comments
We had the pleasure of attending the December meeting of the Market Technicians Association of NewYork.
Long-term subscribers will remember the MTANY as the organization that honored John Magee with its“Man of the Year” award in 1978. The speaker was Robert Prechter, publisher of “The Elliott WaveTheorist,” an investment advisory which bases its forecasts on interpretations of R. N. Elliott's work onthe stock market.
Of primary interest to SAS subscribers are Prechter's comments on technical analysis itself. The ElliottWave Theory, it must be remembered, is really no more than a “catalog” of stock market price
movements, laid one on top of the other, so to speak, until a grand, underlying, and enduring pattern isobserved; in short, pure technical analysis. Among Prechter's definitions and observations regardingfundamental analysis are the following:
1. “First let's define ‘technical' versus ‘fundamental' data .. technical data is that which is generatedby the action of the market under study.”
2. “The main problem with fundamental analysis is that its indicators are removed from the marketitself. The analyst assumes causality between external events and market movements, a conceptwhich is almost certainly false. But, just as important, and less recognized, is that fundamentalanalysis almost always requires a forecast of the fundamental data itself before conclusions about themarket are drawn. The analyst is then forced to take a second step in coming to a conclusion abouthow those forecasted events will affect the markets! Technicians only have one step to take, whichgives them an edge right off the bat. Their main advantage is that they don't have to forecast theirindicators.”
3. “What's worse, even the fundamentalists' second step is probably a process built on quicksand....The most common application of fundamental analysis is estimating companies' earnings for boththe current year and next year and recommending stocks on that basis.. And the record on that basisalone is very poor, as Barron's pointed out in a June 4 article, which showed that earnings estimatesaveraged 18% error in the thirty DJIA stocks for any year already completed and 54% error for theyear ahead. The weakest link, however, is the assumption that correct earnings estimates are a basisfor choosing stock market winners. According to a table in the same Barron's article, a purchase ofthe ten DJIA stocks with the best earnings estimates would have produced a ten-year cumulative gainof 40.5%, while choosing the ten DJIA with the worst earnings estimates would have produced awhopping 142.5% gain.”
We enjoyed Prechter's polished exposition of a technical approach, which differed from our own. As forhis observations about fundamental analysis, we simply could not agree more.
Key: portfolio risk report. The Portfolio Risk Analysis screen summarizes delta, profit, and severalmeasures of risk for a portfolio of user-specified stocks and options.
The screen displays:
STOCK SYM = The stock symbol;
STOCK POS = The stock position, or number of shares owned;
DELTAS TOTAL = The sum of the stock deltas and option deltas;
BETA = The stock beta for each stock (implementation pending);
$BETA = $The dollar risk due to movement of the general market: $Beta = (Delta x Stock Price) x Beta;
$DELT = An annualized risk figure based on Position imbalance: $Delta = (Total Delta x Stock Price) xVolatility;
Portfolio Analysis Screens
Diagrams B.2 and B.3 deal with portfolio risk and profit analysis. Illustrated are the sophisticatedquantitative portfolio Profit and Risk reports of Delphic Options Research as implemented forStandard & Poor's trading systems and Prudential Securities to give the reader an appreciation of
the depth and complexity of professional thinking about risk and portfolio analysis. The originals ofthese reports were designed by Blair Hull and Lester Loops for their own use in market making.
PORTFOLIO RISK ANALYSIS (.30 Filename)
*TOT -6900
-559 -7459 47,165
-63,9444 -141,969 93,000
166 24,7470 100.0
OMS+ .30 PORTFOLIO RISK ANALYSIS 3/24/87 10:55:28
--STOCK-- ----DELTAS
SYMPOSOPTIONTOTALPROFITBETA$BETA $DELTA $GAMMA$THETA$RISK%RISK
FDX2800-3063-26316,7341.60-32,081-7017158,136-121 18,0757.3
GE3200-3089110 12,632.95 11,3742993120,104-16 13,0005.3
HWP-62005682 -51782701.20-45,959-13,404-522,208734 56,61722.9
LIT-67000 -67000 1.40-56,9834-122,1070 0 122,10749.3
NSM3600-4080-48010,411 1.45-21,076-7267150,464-169 17,4367.0
XRX-36003991 391 -882 1.0518,1324835186,506-260 20,2328.2
AVERAGE VOLATILITY: .338
EQUIVALENT MARKET EQUITY: -419613.40
PORTFOLIO PROFIT RATIO: .191
PORTFOLIO PROFIT GAMMA RATIO: 4.815
Diagram B.2 Risk analysis.
$GAM = An annualized risk figure based on curvature of the position. A positive $Gamma indicates abackspread, and a negative $Gamma indicates a vertical position: $Gamma = Total
Gamma x (Stock Price x Volatility);
$THETA = Theoretical dollar amount a position will gain or lose in one day if the stock price remainsunchanged;
$RISK = The annualized standard deviation of the position based upon a composite of $Delta and$Gamma;
%RISK = Percent of portfolio risk in each position;
TOT = Totals for each of the above categories;
AVERAGE VOLATILITY = Average volatility for the stocks;
EQUIVALENT MARKET EQUITY = Sum of each of the stock prices multiplied by their total deltas;PORTFOLIO PROFIT RATIO = Total portfolio profit divided by the total portfolio risk; PORTFOLIOPROFIT GAMMA RATIO = Total portfolio profit divided by the portfolio $Gamma squared.
Key: portfolio profit report. The Portfolio Profit Analysis screen summarizes delta, profit, and severalmeasures of profit for a portfolio of user-specified stocks and options.
The screen displays:
STOCK SYM = The stock symbol;
STOCK POS = Stock position, or number of shares owned;
DELTAS OPTION = Total delta of the option position;
DELTAS TOTAL = Sum of the stock deltas and option deltas;
M TO M = Mark to market: Total value of stock and options positions based upon market prices;
PROFIT TOTAL = Total theoretical profit for each position;
PROFIT/DAY = Theoretical profit divided by the number of days to expiration; PROFIT/RISK = Ratio oftheoretical profit to risk;
PROFIT/DY/RISK = Ratio of theoretical profit per day to risk;
PORTFOLIO PROFIT ANALYSIS (.31 Filename )
OMS+.31 PORTFOLIO PROFIT ANALYSIS 3/24/87 10:55:28
--STOCK— ----DELTAS ---------PROFIT--------- $ $ %
SYMPOSOPTIONTOTALM TO MTOTAL/DAY/RISK/DY/RISKTHETARISKRISK
FDX2800-3063-26342,316216,734213.93 4.31 -12118,0757.3
GE 3200-3089110 704,00612,632107.97 3.01 .16 13,0005.3
HWP-62005682 -51753,7878270150.15 .97 734 56,61722.9
LIT-67000 -6700-407,0250 0 .00 .00 0 122,10749.3
NSM3600-4080-480157,29310,411 105.60 2.21 -169174367.0
XRX-36003991 391 -4431-882-18-.04-.34 -26020,2328.2
*TOT-6900-559 -7459926,79247,165557.19 .00 166 247,470100.0
AVERAGE VOLATILITY: .338
EQUIVALENT MARKET EQUITY: -419613.40
PORTFOLIO PROFIT RATIO: .191
PORTFOLIO PROFIT GAMMA RATIO: 4.815
Diagram B.3 Profit analysis.
$THETA = Theoretical dollar amount a position will gain or lose in one day if the stock price remainsunchanged;
$RISK = The annualized standard deviation of the position based upon a composite of $Delta and$Gamma;
%RISK = Percent of portfolio risk in each position;
TOT = Totals for each of the above categories;
AVERAGE VOLATILITY = Average volatility for the stocks;
EQUIVALENT MARKET EQUITY = Sum of each of the stock prices multiplied by their total deltas;
PORTFOLIO PROFIT RATIO = Total portfolio profit divided by the total portfolio risk;
PORTFOLIO PROFIT GAMMA RATIO = Total portfolio profit divided by the portfolio $Gammasquared.
Section 7: Software packages and internet technical analysis sites
The first cavemen, fighting over resources, used teeth and claws. The nature of warfare was changedforever when one of the smarter ones picked up a tree branch. Then another smart one discovered theprinciple of artillery and picked up a rock. Naive and arrogant traders laughed at Wyckoff's charts. Marketmakers on the Pacific Coast Options Exchange sniggered at Blair Hull when he started appearing on thefloor with printouts. In the days of the wooden racquet, squash players hated the arrivistes who appearedwith metal and then composite racquets.
No longer—the last to adopt the new weapons is a dead man. Charts showed their power and so did Hull'swonky printouts made with the Black Scholes Model. The losers figured out pretty quickly they needednew weapons. With that dissertation on the epistemology of warfare, I present some of my favoriteweapons in the following software and internet sites. No attempt whatsoever is made to be comprehensiveor encyclopedic. On the contrary, idiosyncrasy is my operating method and no disfavor is implied to thosenot included here.
For myself, three desktop software packages are powerful and sufficient for all the needs of a technicalanalyst: AIQ Trading Expert Pro (http://www.aiqsystems.com), Metastock 9.0 (http://www.equis.com),and TradeStation 2000i and later versions (http:// www.tradestation.com). The reader will find examplesof charts sprinkled throughout this book, supplementing the beautiful hand-drawn charts of Magee. Allthese packages have the basic requirements necessary for technical chart analysis, basic charting onreadily available data and portfolio. I have said before that all the chart analyst really needs is the abilityto draw lines on a chart ... and then perhaps to see the chart as a line chart, or a candlestick chart or ... andso on and so on. The analyst is soon seduced by the dazzling features, and the analysis is enriched andmade more powerful. Even if one says (as I do), when he looks at an oversold tool, “What do I need thatfor? I saw it on the bar chart.” The analyst finds himself wanting to know more about %R. If it worked forLarry Williams, there must be something in it.
AIQ: TRADING EXPERT PRO
AIQ's package includes an on-screen control panel and scrolling indicator boxes that are color-coded, andthis information is synthesized in an indicator barometer. Data management is smooth and easy, and theuser may use a system module to create and test his own trading ideas. A panoply of reports is available toaid the investor. For the trader, real-time alerts are a feature. A portfolio manager module aids the investorin managing not just the portfolio, but also his positions by making stop management facile. An ExpertGuru lurks behind the curtain to aid the user in analyzing situations.
METASTOCK 9.0
Metastock 9.0 boasts an impressive array of tools and indicators. “System Experts” pop up on demandand can also guide the user through systems tests and explorations. The Experts can also suggest buys andsells. A point and figure toolbox is a valuable feature. The ability to create and test trading systems, withexhaustive and critical data analysis, is a powerful tool. Metastock adapts easily to add-ons, of whichSlauson's Powerstrike (the quantitative tool for finding critical Support-Resistance zones) is a goodexample.
Tradestation 2000i and Tradestation 8
Tradestation 2000i is the standalone version of Tradestation 8. Tradestation 8 is a real-time onlinepackage that allows for trading through the Tradestation brokerage affiliate. The package is so powerfulthat online professional and semiprofessional users probably benefit by combining their softwarearrangement with a brokerage arrangement. 2000i requires the user to maintain his local database,whereas Tradestation 8 always has the data on demand. For the creatively lazy (among them the editor)this is an attractive feature. Systems building and testing has always been and remains a powerful featureof Tradestation. With “EasyLanguage,” the user may specify virtually any system and then chat about itwith the Tradestation community of traders. This community has contributed to a large database oftrading systems and ideas.
The Internet: prophet (http://www.thinkorswim.com)
For the even lazier and more casual investor, there is http://www.prophet.net (now at thinkorswim.com),an internet technical analysis site whose free features will fulfill the needs of the general charting investor.
With powerful interactive charts and portfolio reporting, the penurious investor will save many pennies athttp://www.prophet.net. As Mark Twain said, a penny saved is a penny earned. Actually, what did BenFranklin mean by a penny saved is capital when put to work? A user community and sharing are otherattractions. And no local data maintenance is necessary. Among its most valuable features,http://www.prophet.net occasionally distributes market commentary and analysis by this editor. All in all,http://www.prophet.net appears to deserve the continuing awards it has received from Barron's andForbes, as well as Technical Analysis magazine. Prophet charting is now available to customers ofhttp://www.tdameritrade.com.
The Internet: http://www.stockcharts.com
Of similar quality, and similarly honored by Forbes and Technical Analysis magazine, http://www.stockcharts.com has an additional valuable feature: point and figure (P&F) charting. I have notremarked on P&F charting here, but it is an important technical method, especially for the patientinvestor. All the other features are available at http://www.stockcharts.com, including candlesticks, barcharts, and others. Also, the distinguished analyst John Murphy makes his electronic home there. There isalso a “Voyeur” feature that allows the user to see what other traders are doing.
A brief summary
Knowledge is power. Knowing where to find knowledge is even more powerful. The inquiring investorcan keep himself up to date on these sites through the yearly evaluations in Barron's and Forbes, and thefinancial press regularly updates its evaluations of Internet resources.
Section 8: The Leverage Space Portfolio Model
No less than John Bollinger called Ralph Vince's Handbook of Portfolio Mathematics, the most importantwork on the subject. Mr. Vince has done the readers of this book, and me, the very great favor ofdescribing his work in a short article I present here verbatim.
In 1884, Charles H. Dow began his compilation of what would become known as the Dow Jones Indexes.Theories pertaining to non-confirmation of these indices, known as “Dow Theory,” would become thecornerstone of modern Technical Analysis.
It is fitting then, with Dow Jones Indexes having embraced the concepts expressed herein with thecommercial offerings of The Dow Jones LSP indexes in 2011, this explanation of Optimal f and theresultant Leverage Space Portfolio Model be included in this the foundational text on modern TechnicalAnalysis.
Let us consider a case of a simple trade with two possible outcomes. In one of the outcomes, we win 2units, and in the alternative outcome, we lose 1 unit. We can construct a spectrum ranging between avalue 0, where we risk nothing, and 1, where we risk our entire equity. We will consider this valuebetween 0 and 1 as the fraction (f) of our stake at risk, and we will refer to this interchangeably as ourleverage. Thus, on any given trade or over any given period, we are risking some fraction of our stake,and thus for any given trade or over any given period, we have a value, f, assigned to us whether we areaware of it or not.
If we consider over this hypothetical, simplistic 2-outcome, 2-1 trading situation (similar to if it were thetwo outcomes of a coin toss) we could plot what we would expect to make on our trading equity(expressed as a multiple of our initial equity) over one play at various values for f as depicted in DiagramB.4.
Diagram B.4 Expected Multiple of Starting Stake in a Single 2:1 Coin Toss.
Diagram B.5 Expected Multiple of Starting Stake after Forty Tosses in a 2:1 Coin Toss.
When there is more than 1 trade or period and what we have left to invest in the immediate play or periodis a function of what we have made or lost up to this period, the straight line becomes curved, and thepeak of the curve settles into a fixed point, migrating in from 1.0 off to the right where a positiveexpectation trade or period is growth-maximized over 1 trade or period. Thus, after many trades orperiods, it settles in to a given location, and for the simplistic case of a coin toss that pays 2-1, that peakwill settle in at .25 as depicted in Diagram B.5.
The height of the curve for any given value for f is given by the formula for Optimal f, determined as:
t1
multiple = 1 + f *| py |
'( P)
* *
\( Pn )'
number_of_expected_plays_or_trades
Thus, for n trades or periods, for a given value of f, we can determine the multiple made on our stake withsimply the outcome of each trade or period (t), probability of that outcome (p), and the worst-caseoutcome (w), the lowest of all the values for t. We raise the resultant product to the power of howevermany plays we want to determine our expected growth, obtaining the multiple on our initial tradableequity at that many trades or periods.
This represents what you would expect to make as a multiple on your starting stake for risking a givenfraction, f, of your stake.
Notice this is not the same as what is known as The Kelly Criterion, which gives a peak as a “leveragefactor,” a value between 0 and infinity representing how much to lever up one's account, rather than
a fraction (a value between 0 and 1) of an account to risk as expressed by the Optimal f formula. Undercertain conditions the two will give an equivalent value for the peak, for example, the leverage factor willequal the optimal fraction to risk, as in the 2:1 coin toss example herein, but often not, and it can be aperilous mistake to assume that the answer given by The Kelly Criterion is an optimal fraction of accountequity to risk to be expected growth optimal. The Kelly Criterion never yields a peak whose value is theexpected growth optimal fraction of an account to risk, but rather always yields the expected growthoptimal leverage factor. The two can be translated between one another, but the real benefit of theOptimal f formula is it gives us the height to this curve, expressed as an expected multiple made (or lost)on our initial equity (which is not provided by the Kelly Criterion), from which we can derive a field ofstudy.
For example, there is a point left of the peak where the curve goes from concave up to concave down.Given the vertical axis is the expected growth multiple and the horizontal axis is the risk, we can state thispoint of inflection represents that point where marginal increase in growth is occurring faster thanmarginal increases in risk, and this flips at the point of inflection.
Consider the height of the curve at both f = .l and f = .4 as equivalent yet the latter is risking four times asmuch! Clearly, there is never any reason to be beyond the peak of the curve to the right.
We have spoken that you are on this curve, somewhere, whenever you have a position in the markets,whether you acknowledge this or not. Note the point in Figure 2 where f = .5, where the multiple = 1.0. Torisk any more than this is to see a multiple less than 1.0, and therefore the more one continues to trade atthis level, multiplying his initial equity by a number less than 1, the more one insures he will go broke.
Most importantly, this is a situation created without borrowing anything at all—it occurs in a cashaccount! This is a situation created wherein one would have on one unit risked for every 2 units in equity,a situation that clearly requires no borrowing whatsoever, and yet, to continue at that level of “leverage”under these (very favorable) conditions, one will go broke with certainty as he continues to trade.
When more than one trade or play occurs simultaneously in various markets or approaches, the curvedisplayed in Figure 2 (which is a curve in 2D space since we are looking at one component), manifests inN + 1 dimensional space for N components traded simultaneously. If we consider a case of trading two ofthese issues simultaneously, of wagering on two 2:1 coin toss games simultaneously, we find ourselves inan N + 1 dimensional manifold (in this case, 2 + 1 = 3 dimensional manifold) space as depicted inDiagram B.6.
This N + 1 dimensional space is referred to as “Leverage Space,” and portfolios derived therefrom as“Leverage Space Portfolios” (“LSP” portfolios). LSP-style portfolio construction grants us insights
unavailable by more conventional portfolio constructs. For example, in Figure 3, we find the peak of thecurve at the f coordinates for both
f C o in 2
.50
f C o in 1
Diagram B.6 Expected Multiple of Starting Stake after Twenty Tosses in Two Simultaneously Played 2:1Coin Toss Games.
games at.23, .23. Yet, notice what happens if we are off on only one axis; we can be at, say .23, .6, and wefind our multiple, the height of the graph at these coordinates, to be less than 1. Thus, even though we areoff on only one component in the portfolio (and still not borrowing money to assume any positions) weinsure we will go broke as we continue to trade. The notion of diversification as one of meliorating risk isclearly challenged in an LSP-style portfolio, and this is not at all evident by more traditional perspectiveson portfolio construction.
Not only are we ineluctably in leverage space when we put on one or more positions in the markets, butwe are also very likely moving through leverage space with changes in our equity and the markets, payingthe price and reaping the consequences for the various points we traverse through the surface of leveragespace.
Thus, various paths can be constructed algorithmically through leverage space to achieve different criteriathan the conventional criterion of maximizing expected return to expected variance, or even that ofmaximizing expected growth (which would be to reside at the peak in the surface). With a path throughleverage space in an LSP-style portfolio, a path through the surface of expected growth as a multiple ofour starting stake, we are now able to seek solutions to any investment criteria.
Appendix C: Technical Analysis beyond Edwards& Magee
• Section 1: A brief general survey of number driven tools
• Section 2: The creative technician—the work of Richard Arms
• Section 3: The Point and Figure method by an eminent analyst, Mike Moody
• Section 4: One of the most famous of technical routines—Bollinger Bands
Section 1: A brief general survey of number driven tools
Here is something to contemplate: A listing of technical analysis tools.
Technical Overlays
1. Bollinger Bands: A chart overlay showing the upper and lower limits of “normal” price movementsbased on the Standard Deviation of prices 2. Chandelier Exit: An indicator used to set trailing stop-lossesfor both long and short position 3. Ichimoku Cloud: A comprehensive indicator defining support andresistance, identifies trend direction, gauges momentum and provides trading signals
4. Kaufman's Adaptive Moving Average (KAMA): A unique moving average that accounts forvolatility and automatically adjusts to price behavior
5. Keltner Channels: A chart overlay showing upper and lower limits for price movements based on theAverage True Range of prices 6. Moving Averages: Chart overlays showing the “average” value overtime. Both Simple Moving Averages (SMAs) and Exponential Moving Averages (EMAs) are explained 7.Moving Average Envelopes: A chart overlay consisting of a channel formed from simple movingaverages 8. Parabolic SAR: A chart overlay showing reversal points below prices in an uptrend andabove prices in a downtrend 9. Pivot Points: A chart overlay showing reversal points below prices in anuptrend and above prices in a downtrend 10. Price Channels: A chart overlay showing a channel madefrom the highest high and lowest low for a given period of time 11. Volume by Price: A chart overlaywith a horizontal histogram showing the amount of activity at various price levels
12. Volume-Weighted Average Price (VWAP): An intraday indicator based on total dollar value ofall trades for the current day divided by the total trading volume for the current day
13. ZigZag: A chart overlay showing filtered price movements greater than a given percentage
Technical Indicators
1. Accumulation/Distribution Line: Combines price and volume to show how money may beflowing into or out of a stock
2. Aroon: Uses Aroon Up and Aroon Down to determine whether a stock is trending or not
3. Aroon Oscillator: Measures the difference between Aroon Up and Aroon Down 4. AverageDirectional Index (ADX): Shows whether a stock is trending or oscillating
5. Average True Range (ATR): Measures a stock's volatility
6. Bandwidth: Shows the percentage difference between the upper and lower Bollinger Band
7. %B Indicator: Shows the relationship between price and standard deviation Bollinger Bands 8.Chaikin Money Flow (CMF): Combines price and volume to show how money may be flowing into orout of a stock Alternative to Accumulation/Distribution Line 9. Chaikin Oscillator: Combines price andvolume to show how money may be flowing into or out of a stock. Based on Accumulation/DistributionLine 10. Chande Trend Meter (CTM): Scores the strength of a stock's trend, based on several technicalindicators over six different timeframes 11. Commodity Channel Index (CCI): Shows a stock's variationfrom its “typical” price 12. Coppock Curve: An oscillator using rate-of-change and a weighted movingaverage to measure momentum 13. Correlation Coefficient: Shows the degree of correlation betweentwo securities over a given timeframe
14. DecisionPoint Price Momentum Oscillator (PMO): An advanced momentum indicator trackinga stock's rate of change
15. Detrended Price Oscillator (DPO): A price oscillator using a displaced moving average toidentify cycles
16. Ease of Movement (EMV): An indicator comparing volume and price to identify significantmoves
17. Force Index: A simple price-and-volume oscillator
18. Mass Index: An indicator identifying reversals when the price range widens 19. MACD (MovingAverage Convergence/Divergence Oscillator): A momentum oscillator based on the difference betweentwo EMAs 20. MACD Histogram: A momentum oscillator showing the difference between MACD andits signal line 21. Money Flow Index (MFI): A volume-weighted version of RSI showing shifts is buyingand selling pressure 22. Negative Volume Index (NVI): A cumulative volume-based indicator used toidentify trend reversals 23. On Balance Volume (OBV): Combines price and volume in a very simpleway to show how money may be flowing into or out of a stock
24. Percentage Price Oscillator (PPO): A percentage-based version of the MACD indicator
25. Percentage Volume Oscillator (PVO): The PPO indicator applied to volume instead of price
26. Price Relative/Relative Strength: Technical indicator comparing the performance of two stocksto each other by dividing their price data
27. Pring's Know Sure Thing (KST): A momentum oscillator from Martin
Pring based on the smoothed rate-of-change for four different timeframes 28. Pring's Special K: Amomentum indicator from Martin Pring combining short-term, intermediate and long-term velocity 29.Rate of Change (ROC) and Momentum: Shows the speed at which a stock's price is changing 30.Relative Strength Index (RSI): Shows how strongly a stock is moving in its current direction 31. RRGRelative Strength: Uses RS-Ratio to measure relative performance and RS-Momentum to measure themomentum of relative performance
32. StockCharts Technical Rank (SCTR): Our relative ranking system based on a stock's technicalstrength
33. Slope: Measures the rise-over-run for a linear regression
34. Standard Deviation (Volatility): A statistical measure of a stock's volatility
35. Stochastic Oscillator (Fast, Slow, and Full): Shows how a stock's price is doing relative to pastmovements. Fast, Slow and Full Stochastics are explained
36. StochRSI: Combines Stochastics with the RSI indicator to help you see RSI changes moreclearly
37. TRIX: A triple-smoothed moving average of price movements
38. True Strength Index: An indicator measuring trend direction and identifying overbought/oversoldlevels 39. Ulcer Index: An indicator designed to measure market risk or volatility 40. UltimateOscillator: Combines long-term, mid-term and short-term moving averages into one number 41. VortexIndicator: An indicator designed to identify the start of a new trend and define the current trend 42.Williams %R: Uses Stochastics to determine overbought and oversold levels Outline
This is a list of tools and indicators available at stockcharts.com. Most if not all of these tools are alsoavailable either through software packages (Tradestation, AIQ, Metastock) or online (thinkorswim andothers). I display the list so newcomers to technical analysis get an idea of the plethora of tools available.Also, I display the list so that students see the philosopher's stone nature of building systems to beat themarket. To briefly review, the philosopher's stone is a stone which allows the owner to convert lead togold. In the Middle Ages, it was the subject of much dedicated research. At present, to my knowledge,only George Soros has a philosopher's stone, but it is entirely possible for the dedicated student to find inthe list a tool or method which will allow him to reap rich rewards.
Displaying the list also prompts me to repeat what we have frequently told our graduate students over theyears: You can drive a nail with a screwdriver; so if it works for you it doesn't matter what it looks like. Tothis end I will comment on some, but not all, of the tools listed here—in some cases revealing tools andsystems which, in research, have been fiendishly effective.
Moving averages
Technical Analysis of Stock Trends is often the first book investors read when they become interested inthe technical approach to the market. This is as it should be and also new analysts need to be informed ofthe amazingly varied field of technical analysis. Chart analysis is the cornerstone of technical analysis anda required field of knowledge. If the analyst is more statistically oriented or is looking for an algorithmicmethod he must search through the numerous alternatives in the technical toolbox.
This appendix is intended not to teach the reader the details of operating a moving average or stochasticsroutine, but to place the various technical tools and systems (or methods) in context and in perspective.The first of these tools is the moving average. We personally can testify to the power of these systems,having reaped outsize profits using moving average systems. Note these profits were gained in roaring bullmarkets. In sideways markets trading a moving average can be the equivalent of producing sausage with ameat grinder. Thus, having confidence in the state of the market is an absolute necessity. The effect of amoving average is to smooth raw price behavior and clarify the trend of the market. The bells and whistlesyou can hang on a moving average are like a Christmas tree. You can use the moving average as input to asignal —buying when the price penetrates above the MA line. Using the MA line as a stop, selling whenprices fall below the MA line. Or you can construct a filter—buying or selling when prices pierce the lineby x%. The possible variations are infinite.
As is probably obvious, MA systems are in the main trend following systems. As are virtually all Edwards& Magee methods and systems. The reason for attempting to employ trending systems is, withoutexception, long-term trend following results in larger profits than any other trading method.
In general, the market makes something of a shibboleth of two moving averages—the 50-day and the 200-day. The 50-day is thought by the media and public to be a warning crack in the market and the 200-daypenetration is thought to be a bear market phenomenon. In our trading, we watch the 50 and the 200--daybut we don't use them as signals. We are usually more concerned with patterns and the character of themarket rather than using these moving averages as signals. Rather, we use them as alerts as to what thepublic is thinking and depend on Basing Point analysis for stops.
Magee's consideration of moving averages is contained in Chapter 36. It is amusing to quote a remark ofhis upon discovering moving averages: "...one could derive a sort of Automated Trendline that woulddefinitely interpret the change of trend. It seemed almost too good to be true. As a matter of fact, it was toogood to be true.”
Personally, we have experienced excellent profitability with moving average systems. While we originallythought this was a sign of genius, with time we realized that the market was the genius and my companywas trading in a roaring bull market—and indeed we were—the monstrous commodity bull markets of the‘70s—the Russian wheat market, the Hunt silver market.. Almost anything, including bonobo monkeysthrowing darts, works in a tidal market.
Nevertheless, a long moving average can keep the investor fully invested for months— if not years. In thecase of the great Bull Market of 2009-2017, it took years, as evident by the chart with a 200-period simplemoving average. (Figure C.1) A number of different types of moving averages are used by technicians:simple, exponential, triangular, variable, and weighted. The distinguishing difference amongst thesemethods is the simple method weights all prices equally. Weighted and exponential routines place a highervalue on the most recent data, enabling more sensitive and rapid reaction. Triangular averages put moreweight in the middle of the time period and variable averages adjust the weighting according to thevolatility of prices.
Does this smack of the philosopher's stone? One thing it should tell the newcomer—and grizzled veteran—is the search for a market beating method is incessant and indefatigable— it never ceases.
Figure C.1 A 200 period moving average on a weekly chart. The investor would never (virtually never)have felt the least anxiety for his position. His confidence in the trend would have been buttressed by theMA line.
Contemplating an exponential versus a simple moving average the difference is probably not worth thetrouble. Trading decisions might be moderately accelerated on trading length systems (-5-15 days for veryshort term; 15-23 days for short term; and 24-50 days for intermediate term; and 100 days and up for longterm. With recent thinking we might add super long term—that is 200 days or even longer weekly basedsystems.) The conventional way to use a moving average system is to go long when price breaks above themoving average and sell when price falls below the moving average. Probably the most usual modificationto these systems is to put a filter on them, for example requiring the penetration of the moving average lineby 1 (or x) % to assure validity. (Cf. Chapter 36, the Pentad system) We think, based on experience, thismay be the most effective way to employ this tool. Sometimes two moving averages are used. Signals arecreated by the interplay of the moving average lines, one moving above or below the other. This is acharacteristic of MACD, which will be discussed later.
Stochastics
The first thing to do when studying stochastics is stop trying to figure what “stochastics” means. Ofcourse, it has a dictionary meaning to be discussed later. Right now, the reader should put aside thequestion of actual meaning and consider what it means in the discipline of technical analysis.
Markets have two basic theoretical (and actual) states: trending or mean reverting. If the market is non-trending, swinging back and forth, up and down, traders need tools to deal with it. If they want to tradeunder these conditions they turn to oscillators. The purpose of the oscillator is to aid in identifying wavebottoms and wave tops. The stochastic algorithm is one of the more popular of these oscillators.
Stochastics establishes a “window” on the market for the analysis of prices. The default value for thiswindow is 14 bars, but different practitioners customize the value for their own use. The price highs andlows within this window are integral to the analysis. The routine establishes a line (called %K) as theessential benchmark or guide of the analysis. A second line is calculated (%D) using a simple movingaverage of %K. This moving average is quite short (3 periods default value) and thus creates a line ofgreat sensitivity. Conventionally these lines are displayed on a scale from 1 to 100. Signals are generatedby values of 20 and 80. The routine buys when the low value is 20 and sells upon a high value of 80. Inshort, selling strength and buying weakness. 20 and 80 refer to where the closing price is relative to thewindow trading range, thus placing price position at 20% or 80% of the range. Other means of generatingsignals are available, to wit the interaction of the two lines, as for example, the %K line falling below orrising above the %D line. (Figure C.2)
As with most tools, the technician can modify the routine to suit his whim.
MACD (Moving Average Convergence/Divergence)
MACD is a trend following momentum indicator that shows the relationship between two movingaverages of price. It is calculated as the difference between a 26 and a 12-day exponential moving average.Gerald Appel, who is reported to be the creator of the routine, placed a 9-day exponential moving averageon top of the MACD as a means of identifying trading signals. Generally, a sell signal occurs whenMACD falls below the signal line and a buy signal when it rises above the signal line. Trading also occursas MACD goes above and below zero. (Figure C.3) As one can well imagine with 55 indicators (andcounting), there is a tool for every occasion. One must always remember the rule of tools: To a man with ahammer everything looks like a nail. Rather than attempting to explicate every tool, I will restrict myselfto the obvious, after reminding the reader that careless and uneducated use of any tool can seriouslyendanger his capital.
Some other chosen indicators to consider: ADX, a tool which shows whether an issue is trending oroscillating. This tool is easily replaced with a ruler and the naked eye. This is the case with many of theindicators; they have been developed by their inventors to attempt to remove ambiguity from the market—a desire the experienced chart analyst doesn't possess. The chart analyst looks at a chart and most of time itis obvious. If not, it becomes obvious the moment a ruler is laid on it. Another tool which does more orless the same is the Aroon which uses Aroon Up and Aroon Down to determine whether an issue istrending or not. Once again, a question which is painfully obvious at first glance to the chart analyst. Weshould make clear that some intelligent analyst has used each of these tools to wring a profit from the
market. Accumulation /Distribution Line showing how money flows in and out
Figure C.2 Stochastic routine on a gold chart. Obviously interpreting the indicator requires someexperience and discrimination, but this is true of all number driven indicators.
of an issue may be useful to some practitioners, as may Volume by price which shows the amount ofactivity at various price levels. Pivot points—a relatively simple mechanism evidently popular with manytraders can at least give the trader unambiguous trading points.
Which brings us to a central technical and philosophical point: Almost any system is better than nomethod (or system) at all. The problem for the inexperienced trader— or investor—is what system. Thisbook answers that question for most investors and is a good method while the investor refines his ownmethods. We continue to say the trader who invents a system without thorough knowledge of this book isputting life limb and capital at risk. This statement may be a little less true now than in years past—simplybecause so much of this book's material has leaked via osmosis into general investor knowledge—usuallyunconsciously, but often through outright imitation or worse. Not a practice which outrages us, though,sometimes amuses us—but no tears. Also, as we have been in education for many years, we observe thespread of knowledge as something the enlightened and educated do as a responsibility to the communityand humanity.
Point and Figure analysis
Bar chart analysis has so dominated investor usage for so long (partly because of this book) that evenmany experienced analysts have ignored an interesting and valuable method which we will explore brieflyhere. That method is Point and Figure analysis.
$SPX S3P 500 Large Cap Index INOX
© StockCharts com
Figure C.3 MACD on a gold chart. MACD is a popular tool and deemed effective by many traders.Readers can see why from the chart.
544 Appendix C
Said by some to be an invention of Charles Dow, and by others to be created by the Russians, PnF chartinghas shown itself to be surprisingly effective in our experience. When we examine some of itscharacteristics we get an idea why. Bar charts represent price action (open high low close) with a verticalbar with cross hatches for open and close. The x axis represents time, the y, price. PnF ignores time for themost part, though there is a nod to it as we will see.
Several basic decisions are made in the construction of the chart. Since the chart is made up of boxes, thesize of the box must be determined. The analyst chooses a box style appropriate to the duration of thechart. Obviously, if one is dealing with years of data in the INDU the box must be large—50, 100 points.At shorter durations wave analysis would suggest a good size; and at any rate online routines presentreasonably sized charts. In general, one might say larger boxes furnish perspective and smaller boxesfurnish detail.
The other choice the analyst must make is reversal size. The traditional choice here is a three box reversal.Thus, if the box size is 4 and we are in an x column, 12 points down must occur to change to a column of0s and three 0s would be drawn in the next column. And although time is usually ignored, a box is markedwith a month indicator as a column rolls over to a new month.
All these options are subject to change and adjustment by the individual technician. What is more, thereare other varieties of PnF charts—one box reversal, for example, but the basic idea is the same. Using a
variety of methods, one may make forecasts from the chart. Let me emphasize: Treat this method and anyother algorithmic method with caution until you have thoroughly examined it (Figure C.4).
Next for comparison, a bar (Candlestick) chart shows the traditional picture of this period (Figure C.5).
As the reader can see, PnF charting is a fascinating and valuable method. Many investors rely on thismethod alone for their analyses.
As with all of the tools surveyed here no attempt is made to give a definitive exploration of the tool or todescribe the mechanics of its creation. Those details about PnF charts are ably discharged by the booksPoint & Figure Charting by Thomas Dorsey and The Definitive Guide to Point and Figure by Jeremy duPlessis. Later in this appendix Mike Moody will discuss the method in a much more sophisticated way.
Section 2: The creative technician—the work of Richard Arms
The Arms Index (TRIN) by Richard Arms
In 1967, when I was still an unknown in Technical Analysis and was working as a stockbroker for a majorNYSE firm, we moved into new modernized offices. Among the improvements were new quote machines,which actually had a tiny screen to display the information. Moreover, the data included some fascinatingnumbers. It was possible to see the number of stocks that were up and the number of stocks that weredown at any time, and even a total of the volume traded on the up stocks and a total of the volume tradedon the down stocks. Looking at this, I began to wonder if it could serve as an indicator, telling us if theratio of up to downs was the same as the ratio of up volume to down volume. If not, deviations fromnormality might show when the buyers or the sellers were more in control. In seconds, the Arms Index, orTRIN, came into being in my mind and then in my research. An article in Barron's was all that was neededand it took on a life of its own.
SSPX S«P 500 Large Cap Index NDX
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Figure C.4 Here from the edwards-magee.com website is a PnF chart from November 2015 which looksfor a target of 2549—this when the S&P was around 2000.
$ S P X S&P 500 Large Cap Index INDX ® StockCharts.com
Appendix C 547
The calculation
With so many sources, such as newspapers, television stations and every quotation service, providing thecalculated index most users will never need to make the calculation themselves. However, in order toappreciate the significance of the index one should be familiar with its derivation. The Formula is:(ADVANCES/DECLINES)
2---------------------- = ArmsIndex
(ADV.VOL./DECL.VOL.)
At any time, we can retrieve the numbers showing how many stocks are up for the day, how many stocksare down for the day, the volume on the advancing stocks and the volume on the declining stocks.Plugging them into the above formula we end up with a single number, the Arms Index for that instant.The above example* (footnote) has produced a somewhat bearish index. An index of 1.00 is a standoff,indicating both the advancing stocks and the declining stock received their fair share of the volume. Avalue over 1.00 is Bearish, indicating the declining stocks are receiving more than their share of thevolume. An index lower than 1.00 is Bullish since the up stocks are receiving more than their fair share ofthe volume. Normally, the index will fluctuate closely around 1.00. We have seen days end with an indexas low as .19 and other days with an index over 10.00, but these were rare occurrences, where the traderswere reacting to extremes in euphoria or fear. Normally, the index will be somewhere between .65 and1.75.
EXAMPLE THE ARMS INDEX: ADVANCES 1024 DECLINES 2030 ADVANCING VOLUME 299,790,000DECLINING VOLUME 786,830,000 1024/2030 =.504 1024/2030 =.504 299790/786830 =.381 .504/.381
= 1.32 .504/.381 = 1.32 (ADVANCES / DECLINES) (ADV. VOL. / DECL. VOL.) (ADV. VOL. / DECL.VOL.) = THE ARMS INDEX (TRIN) EXAMPLE
The reasoning
At any time, the Arms Index is telling us whether the up stocks are getting their share of the volume ornot. If the index is over 1.00 the down stocks are overpowering the up stocks. (Remember, under 1.00 forthe raw number is good, and over 1.00 is bad. It is counter-intuitive, but it is the way the index was firstcalculated, and it's late to try to change it now. If that really bothers you, invert the calculation and it willbe more intuitive, but you will be out of step with everyone else using the index. You will see the index isdealing with comparing two ratios, so it is commonplace to have a market that appears to be Bullishbecause of there being more stocks up than down, but is actually under pressure, in that those up stocksare not getting their share of the volume, and the index is Bearish. Similarly, we can have more stocksdown than up, but have a Bullish index, because the up stocks are getting more than their fair share of thevolume. The Arms Index is measuring the internal dynamics of the market—dynamics that may not beotherwise readily apparent. A Bullish Arms Index in a slumping market may be telling us there isaccumulation going on, under the guise of a down market.
Using the index
The index was originally developed as an intraday timing tool, and it still is valuable in that role. There aretwo things to look at: the actual reading and the way it is changing during the day. The actual level istending to reflect the current condition; sometimes a Bullish reading in a declining market or a Bearishreading in a rising market makes the move suspect. More often, the value will be in line with the currentmarket activity, but watch for the big extremes. Not always, of course, but often, the index will go too farin one direction, and suggest the move is overdone. It is reflecting those times when reason is beingabandoned and a blind panic or a feeding frenzy is dominating the trading. A very high or a very low indexcan be a sign it is time to be a contrarian. The other intraday use is watching for change, rather than justthe actual value of the index. Often the index will change direction before a reversal becomes apparent inthe averages. A Bearish index in a Bearish market that suddenly starts to move toward lower (less Bearish)levels may be a warning the market is about to turn up. The same is true bullish numbers that start to gethigher; suggesting a downturn may be developing. Most often, though, the index is now used on a longer-term basis. The most common use is a simple 10-day moving average of the closing daily numbers. Thistends to be a good indicator for market moves lasting a few weeks. For short-term trading, I like the 5-daymoving average. In order to get a feel for longer-term trends, I use a 21-day and a 55-day. The big marketmoves can be recognized by using very big moving averages, such as the 233-day. On each of thefollowing charts, we are looking at simple moving averages of the Arms Index on an inverted scale. Thered line is the index and the black line is the market. Since the scale has been inverted for the index, thelows on the indicator line tend to coincide with low points in the market. Similarly, peaks in the indexcoincide with the market tops. I have chosen different time intervals on each of the charts below since thelonger-term moving averages are used for longer-term predictions. I have not given any hard-and-fastnumerical levels as buy and sell signals because we need to look at the index in the context of the currentmarket. Buy signals in a Bear Market are at more oversold levels than they are in a Bull Market. Extremepeaks and troughs, compared to what has been seen recently, tell when it is time to become a buyer or aseller. These are only a few applications and examples. Not shown are Arms Indices, now available, forNASDAQ and also for a number of foreign markets, in which the index is equally effective. Immenseamounts of work, using many different methods, has been done over the years since the index was firstmade public. Anyone wishing to know more is referred to the various books by Richard W. Arms, Jr.Figure C.6 illustrates the index and shows Equivolume chart for context.
Figure C.6 Notice how on the Equivolume chart the breakaway is accentuated by the wide bars. Thetechnician is constantly in need of accents and alerts like this (cf. also Figure C.7).
Equivolume charting
Introduction
In 1971, with the Arms Index a part of Wall Street methodology, I had become more fascinated by the roleof Volume in the marketplace. I had been spending great deal of time studying an early edition of the bookyou now hold but had also been learning the ideas of Richard Wyckoff; both placed a great deal ofemphasis upon the importance of Volume in evaluating stock movements. As I was driving home fromwork one afternoon, I was thinking about stock charts and volume and suddenly realized there might be abetter way of depicting trading action. What if we could substitute volume for time on our charts? Wecould depict each day as a rectangle rather than the traditional line on a bar chart. The width of the boxwould represent the volume for that day. Unbeknownst to me, I was reinventing a method suggesteddecades earlier, but not widely popularized. I decided to call my new approach Equivolume (cf. FiguresC.7 and C.11).
Figure C.7 Once again the wide volume indicating bars alert the technician to an important surge in themarket.
The technique
In the days before the proliferation of computers, implementing the concept of Equivolume was far fromeasy. In order to lift the volume from the bottom of the chart and insert it in the posting, a scale for eachstock had to be devised based upon its normal trading. That scale could change if the stocks went into aphase of much heavier or lighter trading. I will not go into the calculations I used at the beginning, but itseemed to work. I hired a lady to draw dozens of charts for me and proceeded to learn to read what theysaid; this led to my first book. Later, each new advancement justified another book. Once people a lotsmarter than me figured out how to let a computer do the work, it became a lot easier. Now, one can getEquivolume charts on most major charting services, so there is really no need to wonder about the scaling.Suffice it to say, the rectangles on any chart are proportional to one another in reflecting the volume.
The result
An Equivolume chart does not in any way change the high and low on each entry, but when combinedwith the volume it becomes a box, the shape and size of which reflects supply and demand for that tradingperiod. All the techniques popularized by the masters who first published this book are valid when usedwith Equivolume charts.
However, for example, trendlines tend to be broken earlier if volume becomes heavier, and breakouts aremore noticeable if volume increases, thereby legitimizing them, as are levels of support and resistance.Equivolume uses all the same data, but just gives us a different picture, which includes all the data in asingle entry. Below are two charts: a bar chart and an Equivolume chart of the same stock over the sametime period. This is three months of trading in General Electric (Figure C.8).
The chart below is posted on a weekly basis (Figure C.9).
Conclusion
Equivolume represented a far better way of looking at market action because each entry told a morecomprehensive story. The shape of the box indicated how easy or hard it was for prices to move while thesize of each box showed the interest intensity. It was a method that could be used for any investmentproduct, as long as both price movement and volume numbers were available. It has become a completemethodology and is readily available on a plethora of data services.
Arms CandleVolume charting
After the introduction and wide adoption of Equivolume, the next logical step was to combine theEquivolume concept with the Japanese method known as Candlesticks. Yet, I was slow to do this becauseone or more of the major charting services had already included a partial joining of the two techniques,calling it CandleVolume, but doing it in such a way some of the visual advantages of Equivolume werelost in the process. Yet, if I did the combination of the methods in my way, completely merging the twotechniques, I found it could be another great advance in the way we looked at charts. Clumsily doubleprinting of charts, I was able to work on it and found the results to be very helpful, and since the nameCandleVolume was already taken, I started calling it Arms CandleVolume. Then, after my first speech onthe approach, to the International Federation of Technical Analysts in San Francisco a few years ago, theproblem was solved. Within minutes of completing the speech the President of Stockcharts.com, who hadbeen in the audience, showed me he had quickly adapted their software for the new technique and, withmy approval, would immediately include it in their service, which they did. The illustrations in this articleare from that source.
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Figure C.8 This is three months of trading in General Electric illustrating two different but complimentarypictures of the market. By dragging the volume off the bottom margin and including it in the price wehave made it apparent all days are not equal in importance. Moreover, the concept of eliminating time as amarket measurement led, in later studies and books, to the development of Volume Cyclicality, Ease ofMovement and of Volume Adjusted moving averages. It had become apparent the market is a volumefunction. If nothing trades, nothing happens; The more trading, the more importance.
Figure C.9 Vividly illustrating the usefulness of the Equivolume chart like signposts on a battlefield: Lotsof fighting here.
The advantages
Although the open and the close appear on some versions of bar charts, the Equivolume methodology hadignored them. The Candlestick charts did contain the opens and closes; in fact, they emphasized them. Itled to different and fascinating visual patterns using the ancient methods from their origin given
imaginative and memorable names. I have, in order to distinguish the new methods and to emphasizeadding volume changes the meanings very often, tended to use my own nomenclature. The Japanesemethods are wonderful, but the volume adds a new dimension. As one starts to use this technique itbecomes ever more apparent the open and close levels, added to high and low and volume, are providing apowerful additional tool.
The technique
All we have done is to place the Candlestick inside the Equivolume box. However, there is a vertical linethrough the box, the wick, and there are two horizontal lines across the box, the open and the close. Aboveand below these lines are the legs. If the open is lower than the close the body of the posting with be blackand if it is higher the body will be red. If color is not available, the body can be filled or unfilled. Belowwe see a comparison of the three techniques: Bar chart, Equivolume chart, and Arms CandleVolume chart.They are all daily postings of Newmont Mining over the same three-month period (Figure C.10).
To delve into the interpretation is beyond the scope of this article, but it is clear, I think that each day, eachposting, tells us a concise story of supply and demand; of conflicting pressure of buyers and sellers. Boxsizes tell us of overall enthusiasm while box shapes tell us how easy or hard it is for price movement tooccur. Moreover, the difference between the open and the close tell us whether prices are stalled ormoving. Box shape, size, volume and Candle body size all present a picture of ease or difficulty ofmovement.
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Figure C.11 Notice the increase in information as we move to the newer technique. Candlevolumecombines virtues of Equivolume and Candlestick charts.
Point & Figure technical analysis by Mike Moody
Like most technical analysts, my exposure to charts came initially from bar charts. I started as a naivestockbroker, hoping to understand markets to help my clients make money. I soon learned the “accountexecutive” position was—from the faulty point of view of the brokerage firm—primarily a sales job. I
quickly learned to use bar charts as a form of selfdefense from the firm's research department. The chartscould be used to examine the position of any security the firm's research department was recommending,in the often vain hope the recommendation and the chart were in synch.
I found the bar charts most commonly in use had a limited perspective, usually only about a year of pricedata. Soon I was taking an additional charting service that used weekly bar charts—including a relativestrength line as well.
My quest for perspective ended when I was introduced to the Point and Figure chart. I think it is anextraordinarily flexible and useful complement to bar charts because of the perspective it can supply.Analysts like Richard Wyckoff used both bar charts and Point and Figure charts in tandem because of theirdifferent features and strengths.
Point and Figure charts are now fairly rare, which is unfortunate. Novices often do not understand whatthey are looking at or how a Point and Figure chart is constructed.
I've included a simple example chart below (Figure C.12).
This chart is an example of a traditionally scaled 3-box reversal Point and Figure chart. The chart stylewas popularized by Abe Cohen of Chartcraft. The price scale is on the left. (You can see that price boxesbelow $20 are smaller than price boxes from $21 to $100. This is a clever, pre-computer attempt to adjustto a more logarithmic scale.) Columns of Xs denote rising prices and columns of Os indicate fallingprices. The small numbers embedded in the chart indicate the month a security first printed that price. (1-9for January through September, and A-C for October through December—another elegant early solution tofit a time identifier in a single-width box.) The perspective is obvious, as this chart covers well over adecade. However, for a technical analyst used to bar charts, two things stick out. First, there is no timescale; years where a lot happened are wide because many reversals occurred. Years where the stock wasquiet are represented by far fewer columns. Second, it is not immediately obvious how a 3-box reversalchart is constructed; it's simple but requires a short explanation.
A 3-box reversal chart is designed to filter out any price movements less than 3 boxes, whatever that maybe on the chart. With a 3-box reversal chart, there will never be a column that consists of less than 3 boxes.The general rule will hold—the minimum column depth will be a function of the reversal value used.
Let's pick up the chart in 2012, as it first reversed upward to $34 in September. There is a simple flowchart logic to plotting a Point and Figure chart.
1. If you are rising in a column of Xs, first look to see if a new price high was made. If yes, put a newX in the column.
2. If no new high was made, check to see if a 3-box reversal down occurred. If yes, put in a newcolumn of 3 Os.
3. If no new price high was made or no reversal down was made, do nothing.
It's the “do nothing” that is different because time can pass with no adjustment made to the chart. Thechart is a record of pure price movement.
By November 2012, General Mills had printed $35—without ever reversing down 3 boxes or more. InJanuary 2013, the price hit $36. February 2013 was a good month—the
Scaling: Traditional [Reversal: 3]
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price hit $37 and continued to $40. $41 was reached in March, and $42 and $43 in April. May 2013 sawthe first 3-box reversal, from a peak price of $44 to the minimum reversal level of $41.
Key to the value of Point and Figure charts is their flexibility. Many early practitioners of Point and Figureused single-box reversal charts calculated with intraday data. This style of chart looks more similar to abar chart, but actually captures volatility particularly well because of the use of intraday data. With a barchart, each day might be a single bar, but during a particularly volatile period for the market or for anindividual stock, a single-box reversal chart can put in many, many columns.
Like a bar chart, price targets with a Point and Figure chart are usually estimated from the width of thebase—and during a particularly volatile period like 1987 or 2008 many, many reversals can occur in asingle day! Alan Shaw, formerly the chief market technician at Smith Barney, believed that intraday,single-box reversal point & figure charts were the premier way to estimate price moves from a base. As aguide to this type of chart, Alan always recommended Alexander Wheelan's Study Helps in Point andFigure Technique. On more than one occasion, this knowledge allowed Alan to estimate large price moveswhen the base on a bar chart was narrow.
The computer age has improved Point and Figure charting immeasurably. The computer has no troublecreating true logarithmic charts. Here is the same chart of General Mills, this time using a 2% box and a 3-box reversal. Also shown is the traditional 45-degree trendline, drawn from prominent highs or lows.(Figure C.13) Percentage charts are, I think, significantly clearer. There is no reason not to use them nowsince they can be so easily generated. (All of the charts here are courtesy of StockCharts.com.) Detail canbe added by shrinking the box size; greater perspective can be achieved with a larger box size.
It seems simple but changing the box size or reversal value allows the Point and Figure chart to be adaptedto any time frame, from scalping to swing trading to infinity.
The chart below, using a 1% box size with a 3-box reversal shows a clear breakout from a downtrend thatis not visible at the same price on a chart with a larger scale. (Figure C.14)
Moving averages can also be helpful on Point and Figure charts to help determine trend. The differencewith a Point and Figure chart is that the moving average is a moving average of the center point of acertain number of columns.
The chart below simply replaces the 45-degree trendline with a 10-column moving average. (Figure C.15)Trend is critically important, but as my career developed into money management, it became importantalso to measure the power and durability of the trend. The Chartcraft service had, for years, calculated arelative strength ratio (stock price divided by index price), adjusted the decimal points to make itchartable, and then plotted it on a traditional 3-box reversal chart. At Dorsey Wright, we changed theserelative strength charts to percentage charts and gained vast additional perspective.
The chart below, of Danaher Corp., is a relative strength chart using a 6% scale with a 3-box reversalvalue. The price of Danaher is divided by the price of an S&P 500 ETF and plotted on a log scale.Suddenly, it becomes apparent—in broad terms—Danaher has been outperforming the market for morethan 15 years. (Figure C.16) The final strength of Point and Figure charts is their objectivity. A skilledpractitioner with a bar chart can be very effective, but one analyst might discern a continuation pattern
where another sees a different pattern in a larger or smaller time frame. Two analysts Scaling: Percentage(Reversal: 3, Box Size:2.0%]
(c) StockChartscom
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looking at the same Point and Figure chart, on the other hand, will always be in agreement about whether thechart is on a buy signal or a sell signal.
The criterion is incredibly simple and unambiguous. If the price exceeds the immediately previous column ofXs, it is on a buy signal. If the price declines below the immediately previous column of Os, it is on a sellsignal. On the Danaher relative strength chart, for example, there is a buy signal at 10.88 in October 2000. (Itexceeded the previous rising column, which topped out at 10.27.) There is no subsequent sell signal, as nocolumn of Os ever falls below the previous column of Os. A security, by definition, is always on either a buyor sell signal.
The objective nature of Point and Figure can be useful in other realms as well. Market indicators or diffusionindexes can be plotted on a Point and Figure chart and objectively graded as a buy or sell, for example.
Perspective, flexibility, and objectivity, then, are the cardinal virtues of the Point and Figure charting method.They give a perspective, unlike a bar chart, abstracting pure price and giving deep insight into volatility. Theyhave almost unlimited flexibility to be
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adapted to different scales, time frames, and purposes. Finally, their objectivity can become a powerful tool inthe hands of any analyst.
For further investigation, some of the best-known resources are: Alexander Wheelan, Study Helps in Point &Figure Technique A.W. Cohen, How to Use the Three-Point Reversal Method of Point & Figure Stock MarketTrading: A Technical Approach to Stock Market Trading Thomas J. Dorsey, Point and Figure Charting: TheEssential Application for Forecasting and Tracking Market Prices Jeremy du Plessis, twenty-first CenturyPoint and Figure: New and Advanced Techniques for Using Point and Figure Charts Bollinger Bands
The creation of John Bollinger, Bollinger Bands is an inventive solution to the question of measuring anddisplaying price volatility. Technicians had previously developed channels DHR:SPY DsnjhefCo<p7SWS6P'OOETF NYSE
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and envelopes which have proved productive for some. Bollinger made the concept dynamic, developing achannel whose lines (or bands) are variable depending on volatility.
Bollinger Bands are printed as three lines. The middle line (or band) is a conventional moving average. Theupper band is equivalent to the middle band but shifted two standard deviations up. The lower band is similarbut shifted two standard deviations down. As volatility varies the bands narrow and widen and technicianslook to the position of price
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relative to the lines to orient their trading. Thus, the bands are useful in lending perspective as prices oscillate.The routine is quite popular and this mention is meant only as an introduction and should inspire theinterested student to take up Bollinger's publications to explore this interesting and valuable tool. Bollinger onBollinger Bands may be found at Amazon. (Figure C.17)
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
List of Illustrations and Text
Diagrams
Regarding the illustrations in this book, except for those which are marked
as adapted from other sources, the charts listed as Figures below have been
reproduced from the authors' own “working” charts. As such, they were
made up originally for private use only and without a thought to their
eventual reproduction, much less their publication. They are not and do not
pretend to be works of art, but it is hoped that they will, despite their
“homemade” appearance, serve the purpose of illustrating the various
formations, patterns, market phenomena, and trading principles discussed in
the text. That they do not show the clean line and expert lettering of a
professional draftsman's work is regretted. The reader will, we trust, make
allowances.
As for their selection, it should be stated most emphatically that it was not
necessary to search through thousands of charts in order to find good
examples of all these various technical formations. Many dozens, even
hundreds, were available for practically every type of pattern. Anyone who
has learned to recognize them can find for himself plenty of good technical
pictures in a quick examination of even as small a portfolio as 50 or 100
charts. In other words, the illustrations in this book are in no sense unique.
In selecting them, we have tried only to show as much variety as possible
and samples from previous as well as more recent market history.
Perhaps it is not necessary, but it is at least in accord with custom, to add
that the information as to specific market prices, volume of transactions,
etc., used in preparing our illustrations (or cited in the text of this book) has
been derived from sources believed to be reliable, but is not guaranteed.
Part One
Figure Page
1945.
Shoulders Bottom in 1942. Weekly chart.
8.19 BATH IRON WORKS. Descending Triangle Top of 1946,
showing adjustment of 90 pattern lines for Ex-Dividend Gap.
with horizontal bottom line.
from apex of Triangle, and Double Top. 1946.
leverage junior utility stock. Monthly chart, 1938 to 1946.
and futures to control portfolio risk.
Part Two
Figure Page
sensitivity.
24.2 CUBAN-AMERICAN SUGAR. Weekly, 1945 to 1946. Habits of
low-priced stock 343 of fairly low sensitivity.
24.2 ELECTRIC BOAT. Weekly, 1945 to 1946. Habits of low-priced
stock of somewhat 343
higher sensitivity.
Ascending Triangle and Head-and-Shoulders Top.
Daily chart.
37.20 AVNET ELECTRONICS CORPORATION. May through
October 1961, showing 448
Bearish Trend during a time when the market Averages were strong. Daily
chart.
37.21 BURNDY CORPORATION. April to September 1961. Classic
Head-and- 449
Shoulders Top and rallies to neckline. Daily chart.
37.22 BRUNSWICK CORPORATION. Showing the end of the great
Bull Market Move 450
in this stock, and the decline which followed. 1960 to 1962. Weekly chart.
37.23POLAROID. First 6 months of 1962. Long Rectangle followed
by a precipitous drop after penetration of Support. Daily chart.451
37.24COPPER RANGE. First 6 months of 1962. Head-and-
Shoulders Top with down-sloping neckline. Daily chart.452
37.25
U.S. SMELTING, REFINING & MINING. April through
September, 1962. Head-and-Shoulders Bottom, breakout,
reaction, and advance. Daily chart.
453
37.26
The DOW-JONES INDUSTRIAL AVERAGE. Weekly, July
1961 through June 1962. The massive Head-and-Shoulders
Pattern preceding the 1962 break.
454
37.27ABC VENDING CORPORATION. Daily, April to September
1963. Head-and-Shoulders Top and Major Downtrend. 455
37.28
CERRO CORPORATION. Daily, January to June 1963.
Symmetrical Triangle and uptrend, showing reaction to “cradle
point.”
456
37.29CRUCIBLE STEEL. Daily, March to August 1963. Ascending
Triangle, showing Breakaway Gap. 457
37.30
SUPERIOR OIL. June to November 1962. Showing an
important Double Bottom, which became the base for a Major
Advance.
458
37.31GENERAL STEEL INDUSTRIES. Daily, November 1962 to
April 1963. Example of a Major Uptrend with normal reactions.459
37.32
UNITED ARTISTS. Daily, February to August 1963. A Major
Downtrend, demonstrating Resistance Levels during the
decline.
460
37.33
UTAH-IDAHO SUGAR COMPANY. January to June 1963.
Breakout and rapid advance appearing suddenly in a normally
dull stock.
461
37.34
CONTROL DATA CORPORATION. Daily, February to August
1965. Example of a Wedge with downside breakout and Major
Collapse.
462
37.35
U.S. SMELTING, REFINING & MINING. Daily, July to
December 1965. Breakout from dormancy, Major Advance,
showing Symmetrical Triangle Consolidation.
463
37.36
LIVINGSTON OIL COMPANY. Weekly, January 1965 into
January 1966. Downside Major Trend, Symmetrical Triangle
Bottom, Major Reversal to uptrend.
464
37.37
PACKARD-BELL ELECTRONICS. Daily, August 1965 to
January 1966. Flag showing “Half-Mast” situation, and a large
Ascending Triangle with powerful breakout move on the
upside.
465
37.38
PARKE, DAVIS & COMPANY. Daily, July 1969 to June 1970.
This could be regarded as a very flat Head-and-Shoulders Top,
or as a long Rounding Top.
466
37.39ASTRODATA, INC. Daily, October 1969 through February
1970. A complete collapse; then reopens 20 points lower. 467
37.40
ORACLE. Lest one think that the air pocket gap does not still
exist, here is an example from the turn of the century (third
millennium).
468
37.41PUBLIC SERVICE ELECTRIC & GAS. Monthly, 1969
through 1970. A typical electric and gas utility stock.469
37.42
MEMOREX CORPORATION. Daily, September 1969 through
May 1970. Last “Bull” fling for Memorex before gapping down
with volume in February 1970.
470
37.43FLYING TIGER CORPORATION. Monthly, October, 1969
through 1971. From the 1967 high of 48%, "FLY" started a
471
downtrend that lasted 2 years and took the stock down to 11%.
37.44
ACTION INDUSTRIES. Daily, November 1971 to April 1972.
A large Ascending Triangle formed after an advance of 90%,
and followed by a breakout and a further advance practically
duplicating the first one in percentage gain.
472
Figure Page
37.45DELL COMPUTER. From nothing (a college dorm) to
something. 473
37.46DELL. Air pockets return. 474
37.47INTEL. The heart of the Microsoft computer. Compare MSFT. 474
37.48NOKIA. The story of the communications revolution.475
37.49AMD. Intel's counterpart. 475
37.50YAHOO. Internet rocket fuel. 476
37.51YAHOO 2005. After the tulipomania. 477
37.52APPLE COMPUTER. The revenge of Steve Jobs. 478
37.53APPLE 2005. The press' whipping stock strikes back.479
37.54NDX. A ten year trade using Basing Points. 480
A.1 Important swings of the DOW-JONES INDUSTRIAL AND
RAIL AVERAGES, 1941 through 1946. 508
A.2
The DOW-JONES INDUSTRIAL AND RAIL AVERAGES.
Daily closing prices and total market volume, February 1 to
August 31, 1941.
509
A.3
The DOW-JONES INDUSTRIAL AND RAIL AVERAGES.
Daily closing prices and total market volume, March 2 to
October 31, 1942.
510
A.4
The DOW-JONES INDUSTRIAL AND RAIL AVERAGES.
Daily closing prices and total market volume, November 2,
1942, to June 30, 1943.
511
A.5
The DOW-JONES INDUSTRIAL AND RAIL AVERAGES.
Daily closing prices and total market volume, July 1, 1943, to
January 31, 1944.
512
A.6
The DOW-JONES INDUSTRIAL AND RAIL AVERAGES.
Daily closing prices and total market volume, May 1 to
November 30, 1945.
514
A.7
The DOW-JONES INDUSTRIAL AND RAIL AVERAGES.
Daily closing prices and total market volume, May 1, 1945, to
November 30, 1945.
516
A.8
The DOW-JONES INDUSTRIAL AND RAIL AVERAGES.
Daily closing prices and total market volume, December 1,
1945, to May 31, 1946.
518
A.9
The DOW-JONES INDUSTRIAL AND RAIL AVERAGES.
Daily closing prices and total market volume, May 4 to
October 19, 1946.
520
Text Diagrams
The charts listed as Figures all represent actual market history. In
contradistinction, the diagrams listed below do not depict real trading
history, but have been specially drawn as simplified, hypothetical market
situations to facilitate the explanation of certain trading principles. EN:
Certain of these rather than drawings are exhibits of other interest.
Diagram Page
Alphabetic Index of Stock Charts
FigureStock Name Summary Description of ChartPage
23.7 3COM.
Underwriters cleverly only threw 3% of
3Com-owned Palm stock onto the
market at the IPO.
331
12.9 A.O. SMITH
CORPORATION.
A technically significant (Runaway)
Gap in 1946 decline. Weekly chart.
180
37.27ABC VENDING
CORPORATION.
Daily, April to September 1963. Head-
and-Shoulders Top and Major
Downtrend.
455
37.44ACTION
INDUSTRIES.
Daily, November 1971 to April 1972. A
large Ascending Triangle formed after
an advance of 90%, and followed by a
breakout and a further advance
practically duplicating the first one in
percentage gain.
472
10.2 AIR REDUCTION.The classic Broadening Top of 1929. 123
10.8 ALLIED STORES.Flat-topped Broadening Pattern of 1945,
and Breakout Gaps. 126
33.5 ALLIED STORES.
Daily, last half of 1946. Symmetrical
Triangle Consolidation in decline; also
small Head-and-Shoulders Continuation
Pattern.
398
11.11 ALTRIA GROUP
(MO).
2005 gaps and flags galore. Chartist's
joy. 162
23.11 AMAZON.
Weekly. Internet dreams of glory.
Documenting the great Internet bubble.
Blow-off and hangover.
335
23.12AMAZON. Daily. Details of the blow-off with some
techniques to profit and not suffer. 335
23.13AMAZON. 2005. Rolls on. Biggest river in world.
Not of profits. 336
37.49AMD. Intel's counterpart. 475
7.12
AMDAHL
CORPORATION.
Complex Head-and-Shoulders Bottom,
1984. 65
11.14
AMERICAN &
FOREIGN
POWER 2D PFD.
A Head-and-Shoulders Consolidation
Pattern of 1945. 164
7.16
AMERICAN &
FOREIGN
POWER 2ND
PFD.
A Rounding Bottom formed in 1945.68
9.14 AMERICAN
AIRLINES.
Weekly Chart. Bull Market Top of 1945
to 1946, a form of Double Top. 113
Stock Name
AMERICAN BANK NOTE.
AMERICAN BOSCH CORPORATION.
AMERICAN CABLE & RADIO.
AMERICAN CAN.
AMERICAN CAR &
FOUNDRY.
AMERICAN
LOCOMOTIVE.
AMERICAN
LOCOMOTIVE.
AMERICAN
LOCOMOTIVE.
AMERICAN ROLLING MILL.
AMERICAN ROLLING MILL.
AMERICAN SAFETY RAZOR.
AMERICAN STEEL FOUNDRIES.
AMERICAN WATER WORKS & ELECTRIC.
AMERICAN WOOLEN.
AMERICAN ZINC, LEAD & SMELTING.
ANACONDA COPPER.
ANACONDA COPPER.
APPLE.
APPLE.
APPLE.
APPLIED MAGNETIC CORPORATION.
ARCHER DANIELS MIDLAND COMPANY.
ARKANSAS BEST. ARMOUR & COMPANY.
Summary Description of Chart Page
Runaway Gap and Flag. 1945.
Perfect “Half-Mast” Pattern in 1946, with gaps 161 and Ascending
Triangle.
The Consolidation Rectangle which followed a 108 Head-and-Shoulders
Top in 1946.
which distribution eventually overcame upward trend.
FigureStock Name Summary Description of ChartPage
33.3 ASSOCIATED DRY
GOODS.
Daily, first half of 1946.
Rounding Top; also Broadening
Consolidation.
396
33.10ASSOCIATED DRY
GOODS.
Daily, first half of 1945. Right-
Angled Broadening Formation
and ensuing advance.
403
10.6 ASSOCIATED
DRYGOODS.
Right-Angled Broadening
Formation with horizontal Top,
1945.
125
37.39ASTRODATA, INC.
Daily, October 1969 through
February 1970. A complete
collapse; then reopens 20 points
lower.
467
14.2 ATCHISON, TOPEKA &
SANTA FE.
Acceleration of Intermediate
Uptrend in 1936. Support Levels.209
14.1 ATLANTIC REFINING.Basic Intermediate Trendlines on
weekly chart, 1944 to 1947.208
37.20AVNET ELECTRONICS
CORPORATION.
May through October 1961,
showing Bearish Trend during a
time when the market Averages
were strong. Daily chart.
448
14.17BACYRUS ERIE. 1984Excellent Fan Pattern. 220
12.10BALTIMORE & OHIO
PFD.
Small Island in right shoulder of
Major Head-and-Shoulders Top.
1946.
180
12.6 BALTIMORE & OHIO.The measuring formula applied to
a Runaway Gap in early 1937.177
22.1 BALTIMORE & OHIO.
Weekly, first 6 months of 1945,
showing tendency of a low-priced
stock to make wide swings in a
general market move.
320
14.15BARBER ASPHALT. Application of three-fan principle
to Bull Market Reaction. 1946.219
28.1 BASING POINTS. The most important chart in the
book? 362
28.2 BASING POINTS, V2
Basing Points illustrations
showing both 366
28.3 BASING POINTS, V2
wavelow stops and new high
stops 369
28.4 BASING POINTS, V2 370
8.19 BATH IRON WORKS.
Descending Triangle Top of 1946,
showing adjustment of pattern
lines for Ex-Dividend Gap.
90
9.9 BELL AIRCRAFT.
Ex-dividend drop causing
apparent false move out of
Rectangle in 1945.
109
13.2 BENDIX AVIATION.
Support-Resistance Levels in an
Intermediate Uptrend. 1944 to
1945.
194
12.12BETHLEHEM STEEL.Unusual Island Reversal at the
1937 Bull Top. 182
14.7 BETHLEHEM STEEL.Trend Channels and Rectangle.
1945. 213
12.2 BETHLEHEM STEEL.Three types of Breakaway Gap.
1937. 173
12.5 BLAW-KNOX. Gaps following long Rectangle in
early 1946, and Major Double
176
Top.
33.2 BRANIFF AIRWAYS.
Daily, last half of 1945. Head-
and- Shoulders Bottom, reactions,
Ascending Triangle
Consolidation and advancing
trend.
395
8.14 BRIGGS
MANUFACTURING.
Weekly chart of 1941 to 1943
showing Triangular Bottom of
ascending type.
86
FigureStock Name
Summary Description of
Chart Page
11.5 BRIGGS
MANUFACTURING.
Bull and Bear Flags and
Symmetrical Triangle
Top in 1936. Support-
Resistance phenomena.
156
37.22BRUNSWICK
CORPORATION.
Showing the end of the great
Bull Market Move in this
stock, and the decline which
followed. 1960 to 1962.
Weekly chart.
450
7.18 BUDD COMPANY. Monthly chart showing Major
Rounding Bottom of 1942.70
7.7 BUDD
MANUFACTURING
(now The Budd Company).
Multiple Head-and-Shoulders
Top of 1946.
62
37.21
BURNDY
CORPORATION.
April to September 1961.
Classic Head-and-Shoulders
Top and rallies to neckline.
Daily chart.
449
17.3
CBOT DOW INDEX
FUTURES AND
DIAMONDS.
Hedging DIAMONDS with
index futures illustrated.278
17.4
CBOT DOW INDEX
FUTURES AND OPTIONS
ON FUTURES.
Using options and futures to
control portfolio risk. 282
8.13
CELANESE
CORPORATION.
Ascending Triangle of
consolidation type in 1946.85
15.11 CELOTEX.
Accelerating uptrend of a low-
priced building supply stock.
Monthly chart, 1938 to 1946.
235
37.28
CERRO
CORPORATION.
Daily, January to June 1963.
Symmetrical Triangle and
uptrend, showing reaction to
“cradle point.”
456
33.7 CERTAINTEED
PRODUCTS.
Daily, 6 months in 1946.
Broadening Top, showing rally
following the breakout, and
subsequent decline.
400
7.19 CERTAINTEED
PRODUCTS.
Monthly chart. Major
Rounding Bottom of 1942.70
37.17CHICAGO, MILWAUKEE,
ST. PAUL & PACIFIC.
The magnificent uptrend of
1954 to 1955 with numerous
Support-Resistance and Area
Pattern features.
440
6.2 CHICAGO, MILWAUKEE,
ST. PAUL & PACIFIC.
The Head- and-Shoulders Top
Formation which ended its
Bull Market in February 1946.
46
37.9 CHRYSLER.
Monthly, 1927 to 1930.
Showing Major Top in 1928
and the collapse during the
early months of 1929.
436
23.14CISCO. Exercises in adroit
speculation. 337
23.15CISCO. Zooming in on Cisco. 338
15.12CLAUDE NEON. (Curb Exchange). Strongly up-
curved Bull Trend of a low-
235
priced, highly speculative
issue. Monthly chart, 1938 to
1946.
16.12COFFEE 1994 A perfect flag and spike
reversal. 256
14.4 COMMERCIAL
Intermediate Downtrend and
Uptrend in 1946. 211
SOLVENTS.
FigureStock Name Summary Description of ChartPage
11.16
COMMONWEALTH
EDISON.
Scalloping trend of an investment
stock, 1945. 165
15.5 COMMONWEALTH
EDISON.
Straight-line Bull Trend of
investment type utility. Monthly
chart, 1938 to 1946.
232
6.7
CONSOLIDATED
EDISON.
The Head-and-Shoulders Reversal
of 1937. 50
14.11
CONSOLIDATED
VULTEE.
Part of a two-year Uptrend
Channel. 1945. 215
9.15
CONTAINER
CORPORATION.
The Major Double Bottom of 1941
to 1943. Weekly chart. 114
33.6
CONTINENTAL
MOTORS.
Daily, last half of 1945. Ascending
Triangle showing Pullback to
Support Level; also Symmetrical
Triangle with reaction to apex.
399
37.34CONTROL DATA
CORPORATION.
Daily, February to August 1965.
Example of a Wedge with
downside breakout and Major
Collapse.
462
37.24COPPER RANGE.
First 6 months of 1962. Head-and-
Shoulders Top with down-sloping
neckline. Daily chart.
452
24.1
CORN PRODUCTS
REFINING COMPANY.
Weekly, 1945 to 1946. Habits of a
stock of low sensitivity. 342
15.14CORN PRODUCTS
REFINING COMPANY.
Typical Major Uptrend of food
group. Monthly chart, 1938 to
1946.
236
16.2 COTTON FUTURES.Familiar technical action in a
futures chart (5th ed.). 247
10.1 CRANE COMPANY.
ed.).
Broadening Formation of 1945 to
1946, a warning of final top.
122
14.3 CRANE COMPANY.
Short-term trendlines in 1945, and
examples of channel “failure” and
Pullback.
210
7.24 CRAY RESEARCH.1987. Gap and Rounding Top. 74
16.9 CRB INDEX 2005.A futures triangle with breakout.254
16.10CRB INDEX 2005.The long term view, with double
bottom. 255
37.29CRUCIBLE STEEL.
Daily, March to August 1963.
Ascending Triangle, showing
Breakaway Gap.
457
8.5 CUBAN-AMERICAN
SUGAR.
A Rounding Bottom in 1945 which
merged into a Symmetrical
Triangle.
81
24.2 CUBAN-AMERICAN
SUGAR.
Weekly, 1945 to 1946. Habits of
low-priced stock of fairly low
sensitivity.
343
18.1 CUDAHY PACKING.Head-and-Shoulders Reversal at
the Major Top in 1928. 294
15.3 CURTIS PUBLISHING
$7 PFD.
Typical decurving Bull Trend of
preferred stocks. Monthly chart,
1938 to 1946.
231
15.4 CURTIS PUBLISHING
COMMON.
Accelerating Bull Trend of low-
priced, speculative common stocks.
Monthly chart, 1938 to 1946.
231
8.4
DELAWARE &
HUDSON.
Weekly chart. Wide-swinging
Symmetrical Triangle Bottom of
1941 to 1942 with Throwback to
apex Support.
80
FigureStock Name Summary Description of ChartPage
14.16DELAWARE &
HUDSON.
Application of three-fan
principle to Bull Market
Reaction. 1944.
219
37.5
DELAWARE,
LACKAWANNA &
WESTERN.
Rectangle and uptrend. 1954 to
1955. 432
37.45DELL. From nothing (a college dorm) to
something. 473
37.46DELL. A weekly look. 474
7.9 DIGITAL EQUIPMENT
CORPORATION.
1985. From a Head- and-
Shoulders Top to Complex Head-
and-Shoulders Bottom.
63
7.2 DOME MINES.
Weekly chart showing the Major
Head-and-Shoulders Bottom of
1942.
59
10.21
DOW-JONES
INDUSTRIAL
AVERAGE.
1987 Reagan Crash. 137
A.1
DOW-JONES
INDUSTRIAL AND
RAIL AVERAGES.
Important swings of the 1941
through 1946. 508
A.3
DOW-JONES
INDUSTRIAL AND
RAIL AVERAGES.
Daily closing prices and total
market volume, March 2 to
October 31, 1942.
510
FM.1
DOW-JONES
INDUSTRIAL AND
RAIL AVERAGES OW
The historic bull market of 2009-
2018. v
A.4
DOW-JONES
INDUSTRIAL AND
RAIL AVERAGES.
Daily closing prices and total
market volume, November 2,
1942, to June 30, 1943.
511
A.8
DOW-JONES
INDUSTRIAL AND
RAIL AVERAGES.
Daily closing prices and total
market volume, December 1,
1945 to May 31, 1946.
518
A.2
DOW-JONES
INDUSTRIAL AND
RAIL AVERAGES.
Daily closing prices and total
market volume, February 1 to
August 31, 1941.
509
A.5
DOW-JONES
INDUSTRIAL AND
RAIL AVERAGES.
Daily closing prices and total
market volume, July 1, 1943, to
January 31, 1944.
512
A.6
DOW-JONES
INDUSTRIAL AND
RAIL AVERAGES.
Daily closing prices and total
market volume, May 1 to
November 30, 1945.
514
A.7
DOW-JONES
INDUSTRIAL AND
RAIL AVERAGES.
Daily closing prices and total
market volume, May 1 to
November 30, 1945.
516
6.12
DOW-JONES
INDUSTRIAL
AVERAGE
2007-2008 top with large head-
and-shoulders 54
Figure Stock Name
5.2 DOW-JONES
INDUSTRIAL AVERAGE.
5.3 DOW-JONES
INDUSTRIAL AVERAGE.
5.1 DOW-JONES
INDUSTRIAL AVERAGE.
7.5 DOW-JONES
INDUSTRIAL AVERAGE.
10.12 DOW-JONES
INDUSTRIAL AVERAGE.
15.16 DOW-JONES
INDUSTRIAL AVERAGE.
Summary Description of Chart Page marked with Dow Theory signals
and Magee 39 Procedure signals from 1924-34
marked with Dow Theory signals and Magee 40 Procedure signals from
1900-2011
the unique straight downtrend developed by the 1929 to 1932 Bear Market.
15.19-20- DOW-JONES
21 INDUSTRIAL
AVERAGE.
36.1 DOW-JONES
INDUSTRIAL AVERAGE.
37.16 DOW-JONES
INDUSTRIAL AVERAGE.
37.17 DOW-JONES
INDUSTRIAL AVERAGE.
37.26 DOW-JONES
INDUSTRIAL AVERAGE.
6.6 DUPONT.
Three Bull Market tops.
150day moving average. Editor's choice.
37.9 EAGLE-PICHER LEAD.
8.9 EASTERN AIRLINES.
9.6 EASTERN AIRLINES.
8.25 EBAY.
10.25 EBAY.
Daily chart showing the Broadening Top established in May to August
1957.
Daily chart showing the Broadening Top established in 1999-2000.
Weekly, July 1961 through June 1962. The massive Head-and-Shoulders
Pattern preceding the 1962 break.
Its Major Top in 1936, with an unusual Pullback.
Monthly, 1927 to 1930. Generally Bearish Major Trend.
A Symmetrical Triangle in 1947 that did not carry through.
Long Consolidation ending in Rectangle in early 1945.
2004 Descending Triangle Surprise.
As Ebay broke its trendline and drifted sideways it became a good subject
for reversal day trading.
240
424
444
445
454
50
436
83
107
96
140
FigureStock Name Summary Description of ChartPage
10.26EBAY. 2004-5 Astonishing Ebay breaks
away on wings of great business.141
24.2 ELECTRIC BOAT.
Weekly, 1945 to 1946. Habits of
low-priced stock of somewhat
higher sensitivity.
343
23.10EMULEX. Lessons in high-speed
speculation. 334
18.3 ENRON. The most fundamental lesson.
2005. 298
37.7 FANSTEEL
METALLURGICAL.
Weekly, 1955 to 1956. Showing
Ascending Triangle, reactions to
Support, and eventual uptrend.
434
7.3
FEDERAL NATIONAL
MORTGAGE
ASSOCIATION.
1984. Head-and-Shoulders
Bottom. 60
11.18 FLINTKOTE. Consolidation Formation — a
Symmetrical Triangle —
167
providing signal of Primary
Reversal.
37.47
FLYING TIGER
CORPORATION.
Monthly, October, 1969 through
1971. From the 1967 high of
481/2, “FLY” started a
downtrend that lasted 2 years
and took the stock down to
111/4.
471
7.21 GAMEWELL
COMPANY.
The Rounding Bottom of 1932
showing a temporary rally out of
pattern.
72
7.11 GENERAL BRONZE. Multiple type Bottom formed
July-September 1945. 64
15.1 GENERAL MOTORS. Straight-line Bull Trend.
Monthly chart, 1938 to 1946.230
37.31GENERAL STEEL
INDUSTRIES.
Daily, November 1962 to April
1963. Example of a Major
Uptrend with normal reactions.
459
16.3 GOLD 2005.
A great rounding bottom?
Foretelling? 248
16.4 GOLD 2011 Showing how the great rounding
bottom was fulfilled. 249
8.24
GOODRICH (B.F)
COMPANY.
The remarkably small but perfect
Ascending Triangle which
reversed its Major Trend in 1942.
Weekly chart.
95
20.1 GOODYEAR TIRE $5
PFD.
Monthly, 1943 to 1947, showing
stability of a conservative
preferred stock of the same
company in the same period.
308
20.2 GOODYEAR TIRE
COMMON.
Monthly, 1943 to 1947, showing
rapid advance of a somewhat
speculative common stock
during a Bull Market.
308
13.9 GOODYEAR TIRE.
Four Pullbacks to neckline of
Head-and-Shoulders Top.
Weekly chart, 1945 to 1947.
203
23.16GOOGLE. 2005. More fun than a googly on
a sticky wicket.
339-
340
23.17GOOGLE. Illustrating the follow up story in
Google
37.3 GRANITE CITY STEEL.
Rectangle and Support-
Resistance phenomena in 1956
uptrend.
430
10.18GREYHOUND. A conspicuous One-Day
Reversal at the 1946 134
Bull high.
FigureStock Name Summary Description of ChartPage
33.4 GREYHOUND.
Daily, last half of 1945. Rounding
Bottom and advance with reactions
to Support Levels.
397
33.12GULF, MOBILE &
OHIO.
Daily, first 6 months of 1945.
Intermediate Bottom and Wedge. 405
15.7 HOUSTON OIL.
Accelerating trend of a speculative
oil stock.
Monthly chart, 1938 to 1946.
233
8.1
HUDSON BAY
MINING AND
SMELTING.
Major Bottom of 1941 to 1942, a
perfect Symmetrical Triangle.
Weekly chart.
78
8.22 HUDSON MOTORS. Series of Triangles in the 1929-32
Bear Market. Weekly chart. 93
10.13HUDSON MOTORS. The 1946 Major Top, a Diamond or
Complex Head-and-Shoulders.130
15.2 HUDSON MOTORS. Up-curving Bull Trend. Monthly
chart, 1938 to 1946. 230
18.2 HUDSON MOTORS.
Daily chart from January through
June 1930, showing large
Descending Triangle, also
Symmetrical Triangle
Consolidation during decline.
295
14.10HUDSON MOTORS. Measuring implications of “failure”
in Trend Channel. 1945. 215
6.1 HUMANA, INC. Daily, 1988. Head-and-Shoulders
Top. 46
18.4 IBM.
Perhaps those “best and brightest”
fundamental analysts were not as
feckless as one might think from
looking at their 20-year record.
301
6.5 IC INDUSTRIES.
1986. Head-and-Shoulders Top. 49
7.4
ILLUSTRATION OF
KILROY BOTTOM 60
9.12 INCO COMPANY,
LTD.
Subsequent to the October crash,
developed a large Head-and-
Shoulders Top.
111
37.18INDUSTRIAL RAYON
CORPORATION.
Showing Bearish action of a stock
through the entire year 1957. Daily
chart.
446
23.9 INKTOMI. Scaling the Internet. 333
7.22 INLAND STEEL. Semi-dormant Rounding Bottom of
1935. 72
37.2
INSPIRATION
CONSOLIDATED
COPPER.
Downtrend and break through
Major Support. 429
37.47INTEL. The heart of the Microsoft
computer. Compare MSFT. 474
13.11 INTERLAKE IRON.“End run” following a late breakout
from Symmetrical Triangle. 1944.204
15.6 INTERNATIONAL
HYDRO-ELECTRIC.
Up-curving Bull Trend of a high
leverage junior utility stock.
Monthly chart, 1938 to 1946.
232
10.5
INTERNATIONAL
PAPER.
Showing a form of “broadening”
which is of doubtful technical
significance. Weekly chart, 1945 to
1947.
125
Stock Name Summary Description of ChartPage
INTERNATIONAL
TELEPHONE &
TELEGRAPH.
Saucer- like Consolidation in 1944.166
INTERNATIONAL
TELEPHONE &
TELEGRAPH.
Support “field” of Symmetrical
Triangle. 1945. 204
J.I. CASE.
The Rounding Bottom of 1932
showing a temporary rally out of
pattern.
71
JEWEL TEA. Major Support-Resistance Levels on
1936 to 1946 monthly chart. 198
JOHNS-MANVILLE.Triangular Bottom development of
1941 to 1942. Weekly chart. 79
JONES & LAUGHLIN.
Normal trend action illustrating
Support and Resistance. Weekly chart,
1944 to 1947.
191
KENNECOTT COPPER. Series of Consolidation Formations in
1937 Bear Trend. 110
KRESGE (S.S.)
1936 to 1946 monthly chart showing
important 196
COMPANY. Support-Resistance Levels.
LEHIGH VALLEY
Daily, end of 1945, beginning of 1946.
Gaps of 407
RAILROAD. various types.
LIBBY, McNEILL &
Monthly, 1927 to 1930. Showing
continuance of 436
LIBBY. Bullish Trend into 1930.
LIGGETT & MYERS
Straight-line trend characteristic of
tobacco 236
TOBACCO B. stocks. Monthly chart, 1938 to 1946.
LIMA LOCOMOTIVE
Rectangular pattern of “conflict” in
1944 to 104
WORKS. 1945.
LION OIL COMPANY.
An Island “shakeout” in a thin stock.
1947. 181
LIVINGSTON OIL
Weekly, January 1965 into January
1966. 464
COMPANY.
Downside Major Trend, Symmetrical
Triangle Bottom, Major Reversal to
uptrend.
LOCKHEED AIRCRAFT. A Head-and-Shoulders Bottom
Reversal in December 1943. 58
LOEW'S, INC. Perfect Rectangle of the “pool
operation” type, 1936. 105
LOEW'S, INC. Falling Wedge of classic form in 1936;
Flag and Rectangle. 132
LORILLARD.
Showing Bullish action of a stock
through the entire year, 1957. Daily
chart.
447
LUCENT. Late 20th, early 21st century
schizophrenia. 142
LUCENT. What happened after the chart in 104.4143
MARTIN-PARRY.
Daily, 6 months in 1945. Pennant,
showing formation of Consolidation
Pattern at halfway point in advance.
406
MARTIN-PARRY. Ideal Flag in rapid advance of 1945.152
MASONITE. Downtrend showing Support-
Resistance phenomena. 1956. 431
MCA, INC. 1986. Complex Head-and-Shoulders
Top 62
FigureStock Name Summary Description of ChartPage
37.42
MEMOREX
CORPORATION.
Daily, September 1969 through
May 1970. Last “Bull” fling for
Memorex before gapping down
with volume in February 1970.
470
11.15 MIAMI COPPER. A genuine Scallop uptrend in
1945. 165
10.24MICROSOFT. A key reversal day in March.140
23.1 MICROSOFT.
A multitude of lessons in
Microsoft. 326
23.2 MICROSOFT. A Monthly perspective. 327
23.3 MICROSOFT. 2005. The long view after the fall.328
11.8
MULLINS
MANUFACTURING.
B. An overlong Flag which
worked nevertheless. 1936.159
9.1 NASH-KELVINATOR.
Rectangular distribution area of
1945 to 1946. 104
14.12NASH-KELVINATOR. Downtrend Channel in 1946.216
37.54NASDAQ 100
Basing Point Procedure applied to
weekly bars 480
11.3 NASH-KELVINATOR. Flag of “Half-Mast” type
preceding 1937 Bull Market Top. 154
10.22NATIONAL CASH
REGISTER.
An example of “One-Week
Reversal” in 1941. Weekly chart.138
13.3 NATIONAL
DISTILLERS.
1926 to 1947 monthly chart
showing Major Support-
Resistance Levels.
195
8.10 NATIONAL GYPSUM.
A typical Symmetrical Triangle
leading to continuation of the
preceding trend in 1944 to 1945.
Weekly chart.
84
11.2 NATIONAL GYPSUM.
An up Flag and another false
move from apex of Triangle.
1945.
153
8.6 NATIONAL GYPSUM.A false move out of the extreme
apex of a Symmetrical Triangle. 81
9.18 NATIONAL GYPSUM.Triple Bottom of 1941 to 1942.
Weekly chart. 117
7.14 NATIONAL SUPPLY.
The “two-headed” Top Formation
of 1946. 67
6.10 NEW YORK
CENTRAL.
Head-and-Shoulders Top in June
through July 1945, followed by a
Multiple Head-and-Shoulders
Bottom.
52
6.20
NEW YORK
CENTRAL.
A typical Panic Selling Climax in
1937. 136
37.48NOKIA.
The story of the communications
revolution. 475
8.7 NORTH AMERICAN
COMPANY.
Symmetrical Triangle topping a
recovery from a Panic Low in
1937.
82
7.25 NORTHERN INDIANA
PUBLIC SERVICE.
A magnificent Scalloping
tendency. 75
33.15NORTHERN PACIFIC.
Daily, 6 months in 1944. Support
and Resistance phenomena; also
showing Symmetrical Triangle
and reaction to apex, and small
Rectangle.
412
37.11 NORTHROP
AIRCRAFT.
1954 to 1955. Descending
Triangle at an important top.438
37.12NORTHROP
AIRCRAFT.
1956 to 1957. Ascending Triangle
and upside breakout. 439
16.1 OATS. Tracing “normal” patterns during
the 1940s (5th ed.). 246
FigureStock Name Summary Description of ChartPage
23.8 ORACLE.
Your modern misshapen rectangles in
Oracle again, marked by runaway days
and gaps.
332
37.40ORACLE.
Lest one think that the air pocket gap
does not still exist, here is an example
from the turn of the century (third
millennium).
468
37.15OTIS ELEVATOR.
Showing a full year of a typical daily
chart on TEKNIPLAT charting paper.
Shows a long Triangle Consolidation,
eventually followed by a continuation
of the Major Advance. 1954 to 1955.
443
11.7 PACIFIC TIN. Flag, following and succeeded by
Triangles, in 1944. 158
37.37
PACKARD-BELL
ELECTRONICS.
Daily, August 1965 to January 1966.
Flag showing “Half-Mast” situation,
and a large Ascending Triangle with
powerful breakout move on the upside.
465
23.5 PALM Masquerading as PLMO. A
Continuation of the shell game.329
23.6 PALM Masquerading as PSRC. Which shell is
it under? 330
23.4 PALM. Fool's gold. Fool's gold with naivete
writ large on it. 329
14.8 PAN AMERICAN
AIRWAYS.
Descending Triangle Top and long,
Double Downtrend Channel. 1945 to
1946.
214
14.6
PARAMOUNT
PICTURES.
Double trendlines in accelerated
Intermediate Advance. 1945 to 1946.213
10.7 PARAMOUNT
PICTURES.
The 1946 top, a Right-Angled
Broadening Pattern with horizontal
bottom line.
126
33.9 PARAMOUNT
PICTURES.
Weekly, 1941 to 1943. Double Bottom,
breakout, and reaction to Support
before main advance.
402
37.38PARKE, DAVIS &
COMPANY.
Daily, July 1969 to June 1970. This
could be regarded as a very flat Head-
and-Shoulders Top, or as a long
Rounding Top.
466
12.13
PENNSYLVANIA
RAILROAD.
Changes in technical lines required by
ex-dividend decline. 183
36.2 PENTAD SYSTEMIllustration of filtered moving average
system. 425
14.5 PHILLIPS
PETROLEUM.
An exception to the normal
consequences of valid trendline
penetration. Weekly chart, 1935 to
1938.
212
7.15 PHILLIPS
PETROLEUM.
The 1946 Top — a Multiple Pattern
merging into a Rounding Turn. 67
37.23POLAROID.
First 6 months of 1962. Long Rectangle
followed by a precipitous drop after
penetration of Support. Daily chart.
451
7.13
PUBLIC SERVICE
CORP.
OF NJ.
Weekly chart showing Multiple Bottom
pattern of 1941 to 1942. 66
37.41
PUBLIC SERVICE
ELECTRIC &
GAS.
Monthly, 1969 through 1970. A typical
electric and gas utility stock. 469
FigureStock Name Summary Description of ChartPage
9.17 PUBLICKER
INDUSTRIES.Triple Top of 1946. 116
10.23QUALCOMM.A church spire top in Qualcomm.139
14.13R.H. MACY.
Complex Top in 1946 and penetration of
Intermediate Up Trendline. Tentative
Fan Lines.
217
13.6 REMINGTON
RAND.
Descending Triangle Top and significant
failure of Support. Weekly chart, 1945 to
1947.
199
33.8 REMINGTON
RAND.
Daily, end of 1944, beginning of 1945.
Series of Rectangles during Bull Market
Advance, and return moves to Support
Levels.
401
6.8 REPUBLIC
AVIATION.
Its 1946 Bull Market Top. The Head-
and-Shoulders measuring formula.51
9.13 REPUBLIC
STEEL.
Major Double Top of 1946 with
subsidiary patterns. 112
15.9 REPUBLIC
STEEL.
Typical Bull Trend of steel stocks.
Monthly chart, 1938 to 1946. 234
8.20
REVERE
COPPER &
BRASS.
Large Descending Triangle Top of 1946.91
37.10S.S. KRESGE.Monthly, 1953 to 1956. Generally
Bearish Major Trend. 437
10.16SCHENLEY
DISTILLERS.
A large Wedge which signaled a Primary
Top in 1946. Weekly chart. 133
24.1 SCHENLEY
DISTILLERS.
Weekly, 1945 to 1946. Habits of a stock
of high sensitivity. 342
9.8 SEARS,
ROEBUCK.
A “hybrid” Major Bottom Formation in
1941 to 1942. 109
8.2 SEARS,
ROEBUCK.
Symmetrical Triangle Top of 1946, and
subsequent step-down pattern of same
form.
78
8.15 SEARS,
ROEBUCK.
The Symmetrical Descending Triangle
Top of 1936 and subsequent
Intermediate Recovery Bottom of
ascending form.
86
10.11 SHELL UNION
OIL.
1946 Major Diamond Top and
Descending Triangle. 128
16.4 SILVER 2005. Another great rounding bottom?249
16.5
SILVER MAY
2005 Lessons in agility, gaps and run days
16.5 SILVER 2011 How the rounding bottom was resolved250
16.13SILVER 2011 Illustrating top and stairstops. 257
8.18
SOCONY-
VACUUM
OIL.
Ascending Triangle forming head of
Head-and-Shoulders Bottom in 1942.
Weekly chart.
89
9.4
SOCONY-
VACUUM
OIL.
Rectangle Top Formation of 1946.106
12.7 SOUTHERN
PACIFIC.
A large Measuring Gap in the Panic
Decline of late 1937. 178
33.1 SOUTHERN
PACIFIC.
Daily, 6 months in 1946. Head-and-
Shoulders Top, rally, and subsequent
394
decline.
14.9 SOUTHERN
PACIFIC.
Intermediate Basic and Return Lines and
Flags 214
within Trend Channel. 1945.
FigureStock Name
Summary Description of
Chart Page
8.16 SOUTHERN RAILWAY
PREFERRED.
A perfect Ascending Triangle
in 1936. 87
13.12SOUTHERN RAILWAY.
Typical Pullbacks to Head-
and- Shoulders Neckline, and
increase of volume as Support
is violated. 1946.
205
20.3 SPDR. SPY
For illustration, here is a chart
of the Amex Index Share, the
SPYDR, or share based on the
S&P 500.
309
17.1 SPIEGEL, INC.
The Major Top of 1946 and
the first part of a Bear Trend.
1946 to 1947.
262
17.2 SPIEGEL, INC. Sequel to Figure 198.
Continuation of Bear Trend.
263
1946 to 1947.
15.17
STANDARD & POOR'S
500 INDEX. Horrors of the 1987 Crash.239
15.18
STANDARD & POOR'S
500 INDEX.
The 1987 Crash viewed from
afar. 239
20.2 STANDARD & POOR'S
500 INDEX.
Here the benefits of relaxed
long-term investing may be
seen.
308
20.4
STANDARD & POOR'S
500 INDEX.
The Broadening Top comes
home to roost. 309
15.8
STANDARD OIL OF OHIO.
Straight-line Bull Trend of an
investment oil. Monthly chart,
1938 to 1946.
233
37.30SUPERIOR OIL.
June to November 1962.
Showing an important Double
Bottom, which became the
base for a Major Advance.
458
6.4 TELEDYNE, INC.
1984. Large Head-and-
Shoulders Top. 48
37.8 TEXTRON. 1956 to 1957.
Descending Triangle, with
sharp decline after the
breakout. 1956 to 1957.
435
16.11 TLT
Bond reaction to the great
Bush bear market 255
10.17
TRANSCONTINENTAL
& WESTERN AIRLINES.
Major One-Day Reversal and
long downtrend. 1945 to 1946.134
9.16 TRINITY INDUSTRIES.1985. Triple Bottom. 115
8.11 U.S. INDUSTRIAL
CHEMICALS.
Triangular Pattern completing
an extended reaccumulation
period.
84
37.1 U.S. SMELTING,
REFINING & MINING.
Weekly, 1951 to 1953,
showing Ascending Triangle
and Head-and-Shoulders Top.
428
37.25U.S. SMELTING,
REFINING & MINING.
April through September,
1962. Head-and-Shoulders
Bottom, breakout, reaction,
and advance. Daily chart.
453
37.35U.S. SMELTING,
REFINING & MINING.
Daily,
July to December 1965.
Breakout from dormancy,
Major Advance, showing
Symmetrical Triangle
Consolidation.
463
6.11
UNION CARBIDE &
CARBON.
The Head-and-Shoulders
within a Head-and-Shoulders
Top Formation which capped
its 1929 Bull Market.
53
22.1 UNION PACIFIC.
Weekly, first 6 months of
1945, showing tendency of a
high-priced stock of the same
group to make small swings.
320
FigureStock Name Summary Description of ChartPage
9.11 UNITED AIRCRAFT.
The Double Bottom of 1942. Weekly
chart. 111
37.32UNITED ARTISTS.
Daily, February to August 1963. A
Major Downtrend, demonstrating
Resistance Levels during the
decline.
460
1.1 UNITED STATES
STEEL.
Monthly price ranges from January
1929 to December 1946. 5
10.9 UNITED STATES
STEEL.
The three-month Diamond which
formed the 1946 Bull Market Top. 127
10.14UNITED STATES
STEEL.
The Wedge as part of a Rounding
Top on the August 1937 recovery. 131
37.33
UTAH-IDAHO
SUGAR
COMPANY.
January to June 1963. Breakout and
rapid advance appearing suddenly in
a normally dull stock.
461
11.4 VANADIUM
CORPORATION.
Rapid sequence of small
Consolidation Formations in 1936 to
1937.
155
8.8
VERTIENTES —
CAMAGUEY
SUGAR
of Cuba. Triangular- like
development at 1946 Top. 83
6.9 WALT DISNEY
PRODUCTIONS.Head-and-Shoulders Top. 1986. 51
37.10WEST INDIES
SUGAR.
Monthly, 1953 to 1956. Showing
continuance of Bullish Trend
through 1956.
437
37.14
WESTINGHOUSE
ELECTRIC.
Downside trend in the early stages of
the 1955 to 1956 collapse. 437
15.15
WESTINGHOUSE
ELECTRIC.
Major Trendlines. Weekly chart,
1935 to 1938. 237
6.3
WESTINGHOUSE
ELECTRIC.
The Head-and-Shoulders Top of
January through February 1946.47
8.21 WESTINGHOUSE
ELECTRIC.
The Descending Triangle which
topped out “WX” ahead of the
general market.
92
37.10WESTINGHOUSE
ELECTRIC.
Monthly, 1953 to 1956. Showing
Major Top in 1955 and the collapse
during the early months of 1956.
437
12.8 WILLYS-
OVERLAND.
Various types of gaps in 1944, and
Head-and-Shoulders Reversal.179
11.9 WYANDOTTE
WORSTED.
Application of measuring formula to
Flag. 1946. 160
18.5 XEROX. More benefits of fundamental
analysis. 302
37.50YAHOO. After the tulipomania. 2005.476
37.51YAHOO. Internet rocket fuel. 477
13.7
YORK
CORPORATION.
Measuring Gap and long Rectangle.
1945 to 1946. 200
13.8 YORK
CORPORATION.
Sequel to Figure 141. Rectangle
Support, false move from apex of
Triangle, and Double Top. 1946.
201
9.5
YOUNGSTOWN
SHEET
& TUBE.
Major Top of Rectangle formed in
1946. 106
12.3 ZENITH RADIO.Strong Breakaway Gap on weekly
chart of 1942 Major Bottom.174
12.4 ZENITH RADIO.Monthly chart of 1936 to 1946 for
comparison with Figure 12.3.175

Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
Glossary
EN: The Glossary is the work of the distinguished editor of the seventh
edition, Richard McDermott. Minor changes are so noted.
EN9: Some entries are written by other analysts, whose names are noted.
Although it requires the use of the human brain and some discrimination
and judgment, the great virtue of Magee chart analysis is it allows the
practitioner to evaluate how well number-driven indicators function. As, for
example, use of a Moving Average to identify the trend works wonderfully
well in a trending market. If used as a signal generator in a trading market,
results will come in whipsaws. Similarly, oscillators often are useful in
trading markets but can mislead the trader when the market begins to trend.
The reasonably accomplished chart analyst can recognize the state of the
market and view the performance of number-driven indicators from a more
informed perspective. Thus, the reader should keep this in mind while
reading about the Average Directional Movement Index and suchlike.
ACCUMULATION—The first phase of a Bull Market. The period when
farsighted investors begin to buy shares from discouraged or distressed
sellers. Financial reports are usually at their worst and the public is
completely disgusted with the stock market. Volume is only moderate but
beginning to increase on the rallies.
ACTIVITY—See Volume.
ADX (Average Directional Movement Index)—The ADX is a trend-
following indicator devised by Welles Wilder (Wilder Relative Strength
Index) and is based on the concept of directional movement. It is designed
to evaluate the trending characteristics of a security. The ADX is frequently
used to avoid trendless markets, and signals when a trend reaches a
profitable trading level. In a trendless market, the ADX indicates avoidance.
Directional movement is a measure of the net total price movement during a
set period of time. First, the positive and negative directional movements
are determined by summing the daily up and down moves. The values
obtained are next normalized by dividing them by the “True Range,” the
absolute value of the total move for the period; this difference between
normalized values (expressed as a percentage) is the directional movement.
The ADX is then obtained from directional movement by the use of
exponential average and ratios. The ADX is often charted with a second
line, the ADXR Indicator. ADXR is a smoothed average of the ADX.
A rising ADX indicates significant directional movement and the beginning
of a good trading period. The declining ADX is shown during a poor period
for trend following. Normally, an ADX Indicator above 25 signals
significant directional movement and good trading.
APEX—The highest point; the pointed end, tip, of a Triangle.
ARBITRAGE—The simultaneous buying and selling of two different, but
closely related, instruments to take advantage of a disparity in their prices in
one market or different markets.
EN: Those who buy the acquirer and sell the acquired in takeover situations
—sometimes called “arbs” or arbitrageurs—are ersatz or faux
arbitrageurs; they are really spreaders. Arbitrageur is a solecism used in
that sense. It is also a false cognate to the French.
AREA GAP—See Common Gap.
AREA PATTERN—When a stock or commodity's upward or downward
momentum has been temporarily exhausted, the ensuing sideways
movement in the price usually traces out a design or arrangement of form
called an Area Pattern. The shape of some of these Area Patterns, or
Formations, has predictive value under certain conditions. (See also
Ascending Triangle, Broadening Formations, Descending Triangle,
Diamond, Flag, Head-and-Shoulders Pattern, Inverted Triangle, Pennant,
Rectangle, Right-Angle Triangles, Symmetrical Triangles, and Wedges.)
ARITHMETIC SCALE—Price or volume scale where the distance on the
vertical axis (i.e., space between horizontal lines) represents equal amounts
of dollars or number of shares.
ASCENDING (PARALLEL) TREND CHANNEL—When the tops of the
rallies composing an advance develop along a line (sometimes called a
Return Line), which is also parallel to the basic Up Trendline (i.e., the line
that slopes up across the wave bottoms in an advance); the area between the
two lines is called an Ascending or Up Channel.
ASCENDING (UP) TRENDLINE—The advancing wave in a stock or
commodity is composed of a series of ripples. When the bottoms of these
ripples form on, or very close to, an upward-slanting straight line, a basic
Ascending or Up Trendline is formed.
ASCENDING TRIANGLE—One of a class of Area Patterns called Right-
Angle Triangles. The class is distinguished by the fact that one of the two
boundary lines is practically horizontal, whereas the other slants toward it.
If the top line is horizontal and the lower slants upward to an intersection
point to the right, the resulting Area Pattern is called Ascending Triangle.
The implication is Bullish, with the expectant breakout through the
horizontal line. Measuring Formula: add the broadest part of triangle to the
breakout point.
AT-THE-MONEY—An option, the strike price of which is equal to the
market price of the underlying instrument.
AVERAGES—See Dow-Jones Industrial Averages, Moving Averages,
Dow-Jones Transportation Averages, and Dow-Jones Utility Averages.
AVERAGING COST—An investing technique in which the investor buys a
stock or commodity at successively lower prices, thereby “averaging down”
his average cost of each
stock share or commodity contract. Purchases at successively higher prices
would “average up” the price of stock shares or commodity contracts.
EN: A very foolish technique for the amateur.
AXIS—In the graphic sense, an axis is a straight line for measurement or
reference. It is also the line, real or imagined, on which a formation is
regarded as rotating.
BALANCED PROGRAM—Proportioning capital, or a certain part of
capital, equally between the long side and the short side of the market.
BAR CHART—Also called a Line Chart. A graphic representation of prices
using a vertical bar to connect the highest price in the time period to the
lowest price. Opening prices are noted with a small horizontal line to the
left. Closing prices are shown with a small horizontal line to the right. Bar
charts can be constructed for any time period in which prices are available.
The most common time periods found in bar charts are hourly, daily,
weekly, and monthly; however, with the growing number of personal
computers and the availability of “real-time” quotes, it is not unusual for
traders to use some period of minutes to construct a bar chart.
BASIC TRENDLINES—See Trendlines.
BASING POINT—The price level in the chart that determines where a
stop-loss point is placed. As technical conditions change, the Basing Point,
and stops, can be advanced (in a rising market), or lowered (in a falling
market). (See Progressive Stops.)
BASIS POINTS—The measure of yields on bonds and notes. One Basis
Point equals 0.01% of yield.
BASKET TRADES—Large transactions made up of a number of various
stocks.
BEAR MARKET—In its simplest form, a Bear Market is a period when
prices are primarily declining, usually for a long period of time. Bear
Markets generally consist of three phases. The first phase is distribution, the
second is panic, and the third is akin to a washout, during which those
investors who have held through the first two phases finally give up and
liquidate.
BENT NECKLINE—See Neckline.
BETA—A measurement of an individual stock's sensitivity to market
swings.
BETA (COEFFICIENT)—A measure of the market or non-diversifiable risk
associated with any given security in the market.
BLOCK TRADES—Large transactions of a particular stock sold as a unit.
BLOW-OFF—See Climactic Top.
BLUE CHIPS—The nickname given to high-priced companies with good
records of earnings and price stability; also called gilt-edged securities.
Examples include IBM, AT&T, General Motors, and General Electric.
BLUE PARALLEL—A line drawn parallel to the trendline (Blue Trendline)
that connects at least two highs. The Blue Parallel is started off a low and
used to estimate the next low point.
BLUE TRENDLINE—A straight line connecting two or more Tops
together. To avoid confusion, Edwards and Magee use a blue line for Top
Trendlines and a red line for Bottom Trendlines.
BOLLINGER BANDS (BB)—An envelope, in the form of two lines, that
surrounds the price bars on a chart. Bollinger Bands are plotted two
standard deviations away from a Simple Moving Average. This is the
primary difference between Bollinger Bands and other envelopes.
Envelopes are plotted a fixed percentage above and below a Moving
Average. As standard deviation is a measure of volatility, Bollinger Bands
adjust themselves to differing market conditions. The bands grow wider
during volatile market periods and narrower during less volatile periods.
Bollinger's premise is to ask the market what it is doing, rather than to tell it
what to do. He focused on volatility with the use of standard deviation to set
the bandwidth. The bands are normally plotted two deviations away from
the standard deviation, which is effectively a 20-day Moving Average Line.
The plot is valid if an average acts as a Support Line on market corrections.
If the average is penetrated on corrections, it is too short. Bollinger
recommends 10-day Moving Averages for short-term trading, 20-day for
intermediate-term trading, and 50-day for long-term trading. Deviations
also need to be adjusted: 10 days can use 1.5 deviations, 20 days use 2
deviations, and 50 days use 2.5 deviations. The nature of the time periods
does not matter; the bands can be used on monthly, weekly, daily, and even
intraday figures.
Bollinger Bands do not usually generate buy and sell signals alone. Most
often, they provide a framework within which price may be related to other
indicators. Bollinger recommends using the bands in relation to other buy
and sell signals. However, the bands can be an integral part of the signal. If
a price touches an upper band and indicator action confirms it, no sell signal
is generated (it is a continuation signal if a buy signal was in effect). If a
price touches an upper band and an indicator does not confirm (diverges), it
is a sell signal. If a Top Price Chart Formation is formed outside the bands
and is followed by a second Top inside the bands, a sell signal is generated.
The exact opposite is true on the buy side.
When combined with other indicators, such as the Relative Strength Index
(RSI), the Bollinger Bands become quite powerful. RSI is an excellent
indicator with respect to overbought and oversold conditions. Generally,
when price touches the upper Bollinger Band and RSI is below 70, it is an
indication that the trend will continue. Conversely, when price touches the
lower Bollinger Band, and RSI is above 30, it is an indication the trend
should continue. If a situation occurs in which price touches the upper
Bollinger Band and RSI is above 70 (possibly approaching 80), it is an
indication that the trend may reverse itself and move downward. On the
other hand, if price touches the lower Bollinger Band and RSI is below 30
(possibly approaching 20), the trend may reverse itself and move upward.
(See also Multicolincarity, Percent B, Wilder Relative Strength Index.)
BOOK VALUE—The conventional accounting measure of what a stock is
worth based on the value of the company's assets less the company's debt.
Eminently manipulable.
BOTTOM—See Ascending Triangle, Dormant Bottom, Double Bottom,
Head-and-Shoulders Bottom, Rounding Bottom, and Selling Climax.
BOUNDARY—The edges of a pattern. BOWL—See Rounding Bottom.
BRACKETING—A trading range market or a price area that is non-
trending.
BREAKAWAY GAP—The hole or gap in the chart created when a stock or
commodity breaks out of an Area Pattern.
BREAKOUT—When a stock or commodity exits an area pattern.
BROADENING FORMATION—Sometimes called Inverted Triangles,
these are formations that start with narrow fluctuations that widen out
between diverging, rather than converging, boundary lines. (See also
Broadening Top, Diamond Patterns, Head-and-Shoulders Pattern, and
Right-Angled Broadening Formations.)
BROADENING TOP—An Area Reversal Pattern that may evolve in any
one of three forms, comparable in shape, respectively, to inverted
Symmetrical, Ascending, or Descending Triangles. Unlike Triangles, the
Tops and Bottoms of these patterns do not necessarily stop at clearly
marked diverging boundary lines. Volume tends to be unusually high and
irregular throughout pattern construction. No Measuring Formula is
available.
BULL MARKET—A period when prices are primarily rising, normally for
an extended period. Usually, but not always, divisible into three phases. The
first phase is accumulation. The second phase is one of fairly steady
advance with increasing volume. The third phase is marked by considerable
activity as the public begins to recognize and attempt to profit from the
rising market.
CALL OPTION—An option that gives the buyer the right to buy the
underlying contract at a specific price within a certain period, and that
obligates the seller to sell the contract for the premium received before
expiration of the designated time period.
CANDLESTICKS—A Japanese graphic representation of price action
using the same data as bar charts, but that adds color to the candlestick (or
data) to indicate the direction of prices from the opening (see Nison,
Bibliography.)
CATS AND DOGS—Low-priced stocks of no investment value.
CHANNEL—If the Tops of the rallies and Bottoms of the reactions develop
lines that are approximately parallel to one another, the area between these
lines is called a Channel. (See also Ascending Trend Channel, Descending
Trend Channel, and Horizontal Trend Channel.)
CHART—A graphic representation of a stock or commodity in terms of
price and/or volume. (See also Bar Chart and Point and Figure Chart.)
CLEAN-OUT DAY—See Selling Climax.
CLIMACTIC TOP—A sharp advance, accompanied by extraordinary
volume, that is, much larger volume than the normal increase, which signals
the final “blow-off” of the trend, followed by either a Reversal, or at least
by a period of stagnation, formation of Consolidation Pattern, or a
Correction.
CLIMAX DAY—See One-Day Reversal.
CLIMAX, SELLING—See Selling Climax.
CLOSING PRICE—The last sale price of the trading session for a stock. In
a commodity, it represents an official price determined from a range of
prices deemed to have traded at or on the close; also called a settlement
price.
CLOSING THE GAP—When a stock or commodity returns to a previous
gap and retraces the range of the gap. Also called covering the gap or filling
the gap. (See also Gap.)
COIL—Another term for a Symmetrical Triangle.
COMMISSION—The amount charged by a brokerage house to execute a
trade in a stock, option, or commodity. In a stock, option, or commodity, a
commission is charged for each purchase and each sale. In a commodity, a
commission is charged only when the original entry trade has been closed
with an offsetting trade. This is called a round turn commission.
COMMON GAP—Also called Area Gap. Any hole or gap in the chart
occurring within an Area Pattern. The forecasting significance of the
Common Gap is nil. (See also Gap.)
COMPARATIVE RELATIVE STRENGTH—Compares the price
movement of a stock with that of its competitors, industry group, or the
whole market.
COMPLEX HEAD-AND-SHOULDERS—Also called Multiple Head-and-
Shoulders. It is a Head-and-Shoulders Pattern with more than one right and
left shoulder and/or head. (See also Head-and-Shoulders Pattern.)
COMPOSITE AVERAGE—A stock average composed of the 65 stocks that
make up the Dow-Jones Industrial Average and the Dow-Jones Utility
Average.
COMPOSITE LEVERAGE—In Edwards and Magee, it is a formula for
combining the principal factors affecting a given sum of capital used (i.e.,
sensitivity, price, and margin) into one index figure.
CONFIRMATION—In a pattern, it is the point at which a stock or
commodity exits an Area Pattern in the expected direction by an amount of
price and volume sufficient to meet minimum pattern requirements for a
bona fide breakout. In the Dow Theory, it means both the Industrial Average
and the Transportation Average have registered new highs or lows during
the same advance or decline. If only one of the Averages establishes a new
high (or low) and the other one does not, it would be a non-confirmation, or
Divergence. This is also true of oscillators. To confirm a new high (or low)
in a stock or commodity, an oscillator needs to reach a new high (or low) as
well. Failure of the oscillator to confirm a new high (or low) is called a
Divergence and would be considered an early indication of a potential
Reversal in direction.
CONGESTION—The sideways trading from which Area Patterns evolve.
Not all Congestion periods produce a recognizable pattern, however.
CONSOLIDATION PATTERN—Also called a Continuation Pattern, it is
an Area Pattern that breaks out in the direction of the previous trend. (See
also Ascending Triangle, Descending Triangle, Flag, Head-and-Shoulders
Continuation, Pennant, Rectangle, Scallop, and Symmetrical Triangle.)
CONTINUATION GAP—See Runaway Gap.
CONTINUATION PATTERN—See Consolidation Pattern.
CONVERGENT PATTERN (TREND)—Those patterns with upper and
lower boundary lines that meet, or converge, at some point if extended to
the right. (See also Ascending Triangle, Descending Triangle, Symmetrical
Triangle, Wedges, and Pennants.)
CORRECTION—A move in a commodity or stock that is opposite to the
prevailing trend, but not sufficient to change that trend. Called a rally in a
downtrend and a reaction in an uptrend. In the Dow Theory, a Correction is
a Secondary Trend against the Primary Trend, which usually lasts from
three weeks to three months and retraces from one-third to two-thirds of the
preceding swing in the Primary Direction.
COVERING THE GAP—See Closing the Gap.
CRADLE—The intersection of the two converging boundary lines of a
Symmetrical Triangle. (See also Apex.)
DAILY RANGE—The difference between the high and low price during
one trading day.
DEMAND—Buying interest for a stock at a given price.
DESCENDING (PARALLEL) TREND CHANNEL—When the Bottoms of
the reactions comprising a decline develop along a line (sometimes called a
Return Line), which is also parallel to the basic down trendlines (i.e., the
line which slopes down across the wave tops in a decline), the area between
the two lines is called a Descending or Down Channel.
DESCENDING TRENDLINE—The declining wave in a stock or
commodity is composed of a series of ripples. When the tops of these
ripples form on, or very close to, a downward slanting straight line, a basic
Descending or Down Trendline is formed.
DESCENDING TRIANGLE—One of a class of Area Patterns called Right-
Angle Triangles. The class is distinguished by the fact one of the two
boundary lines is practically horizontal, while the other slants toward it. If
the bottom line is horizontal and the upper slants downward to an
intersection point to the right, the resulting Area Pattern is called a
Descending Triangle. The implication is Bearish, with the expectant
breakout through the flat (horizontal) side. Minimum Measuring Formula:
add the broadest part of the Triangle to the breakout point.
DIAMOND—Usually a Reversal Pattern, but it will also be found as a
Continuation Pattern. It could be described as a Complex Head-and-
Shoulders Pattern with a V-shaped (bent) Neckline, or a Broadening Pattern
that, after two or three swings, changes into a regular Triangle. The overall
shape is a four-point Diamond. Since it requires a fairly active market, it is
more often found at Major Tops. Many Complex Head-and-Shoulders Tops
are borderline Diamond Patterns. The major difference is in the right side of
the pattern. It should clearly show two converging lines with diminishing
volume as in a Symmetrical Triangle. Minimum Measuring Formula: add
the greatest width of the pattern to the breakout point.
DISTRIBUTION—The first phase of a Bear Market, which really begins in
the last stage of a Bull Market. The period when farsighted investors sense
that the market has outrun its fundamentals and begin to unload their
holdings at an increasing pace. Trading volume is still high; however, it
tends to diminish on rallies. The public is still active but beginning to show
signs of caution as hoped-for profits fade away.
DIVERGENCE—When new highs (or lows) in one indicator are not
realized in another comparable indicator. (See also Confirmation.)
DIVERGENT PATTERN (TREND)—Those patterns with upper and lower
boundary lines that meet at some point if extended to the left. (See also
Broadening Formation.)
DIVERSIFICATION—The concept of placing your funds in different
industry groups and investment vehicles to spread risk. Not to put all your
financial eggs in one basket.
DIVIDENDS—A share of the profits, in cash or stock equivalent, paid to
stockholders.
DORMANT BOTTOM—A variation of a Rounding (Bowl) Bottom, but in
an extended, flat-bottomed form. It usually appears in “thin” stocks (i.e.,
those issues with a small number of shares outstanding) and
characteristically will show lengthy periods during which no sales will be
registered for days at a time. The chart will appear “fly-specked” due to the
missing days. The technical implication is for an upside breakout.
DOUBLE BOTTOM—Reversal Pattern. A Bottom formed on relatively
high volume that is followed by a rally (of at least 15%), and then a second
Bottom (possibly rounded) at the same level (plus or minus 3%) as the first
Bottom on lower volume. A rally back though the apex of the intervening
rally confirms the Reversal. More than a month should separate the two
Bottoms. Minimum Measuring Formula: take the distance from the lowest
bottom to the apex of the intervening rally and add it to the apex.
DOUBLE TOP—A high-volume Top is formed, followed by a reaction (of
at least 15%) on diminishing activity. Another rally back to the previous
high (plus or minus 3%) is made, but on lower volume than the first high. A
decline through the low of the reaction confirms the Reversal. The two
highs should be more than a month apart. Minimum Measuring Formula:
add to the breakout point the distance from the highest peak to the low of
the reaction. Also called an “M” Formation.
DOUBLE TRENDLINE—When two relatively close Parallel Trendlines
are needed to define the true trend pattern. (See also Trendline.)
DOW-JONES INDUSTRIAL AVERAGE—Developed by Charles Dow in
1885 to study market trends. Originally composed of 14 companies (12
railroads and 2 industrials), the Rails, by 1897, were separated into their
own Average, and 12 industrial companies of the day were selected for the
Industrial Average. The number was increased to 20 in 1916 and to 30 in
1928. The stocks included in this Average have been changed from time to
time to keep the list up to date or to accommodate a merger. The only
original issue still in the Average is General Electric.
DOW-JONES TRANSPORTATION AVERAGE—Established at the turn of
the century with the new Industrial Average, it was originally called the Rail
Average and was composed of 20 railroad companies. With the advent of
the airlines industry, the Average was updated in 1970 and the name
changed to Transportation Average.
DOW-JONES UTILITY AVERAGE—In 1929, utility companies were
dropped from the Industrial Average and a new Utility Average of 20
companies was created. In 1938, the number of issues was reduced to the
present 15.
DOWNTICK—A securities transaction at a price lower than the preceding
transaction.
DOWNTREND—See Descending Trendline and Trend.
DRAWDOWN or RETRACEMENT—The ebb, or loss, of a portfolio's
equity from a relative high to a relative low. Maximum drawdown equals
retracement from maximum high point to minimum low point.
END RUN—When a breakout of a Symmetrical Triangle Pattern reverses
its direction and trades back through axis Support (if an upside breakout) or
Resistance (if a downside breakout), it is termed an end run around the line,
or end run for short. The term is sometimes used to denote breakout failure
in general.
EQUILIBRIUM MARKET—A price area that represents a balance
between demand and supply.
EXCHANGE-TRADED FUND (ETF)—Funds tracking indexes (e.g., SPY,
DIA) or baskets of stocks that trade like stocks and do not involve the
investor in membership in a mutual fund. An ideal way to replace mutual
fund investing.
EX-DIVIDEND—The day when the dividend is subtracted from the price
of the stock.
EX-DIVIDEND GAP—The gap in price caused when the price of a stock is
adjusted downward after the dividend payment is deducted.
EXERCISE—The means by which the holder of an option purchases or
sells shares of the underlying security.
EXHAUSTION GAP—Relatively wide gap in the price of a stock or
commodity that occurs near the end of a strong directional move in the
price. These gaps are quickly closed, most often within two to five days,
which helps to distinguish them from Runaway Gaps, which are not usually
covered for a considerable length of time. An Exhaustion Gap cannot be
read as a Major Reversal, or even necessarily a Reversal. It signals a halt in
the prevailing trend, which is ordinarily followed by some sort of area
pattern development.
EXPIRATION—The last day on which an option can be exercised.
EXPONENTIAL SMOOTHING—A mathematical method of forecasting
that assumes future price action may be forecast by using a weighted
average of past periods; a mathematical series in which greater weight is
given to more recent price action. A method of trend identification.
FALLING WEDGE—An Area Pattern with two downward-slanting,
converging trendlines. Normally, it takes more than three weeks to
complete, and volume will diminish as prices move toward the apex of the
pattern. The anticipated direction of the breakout in a Falling Wedge is up.
Minimum Measuring Formula: a retracement of all the ground lost within
the Wedge. (See also Wedge.)
FALSE BREAKOUT or FALSE SIGNAL—A breakout that is confirmed
but quickly reverses and eventually leads the stock or commodity to a
breakout in the opposite direction. Indistinguishable from premature
breakout or genuine breakout when it occurs.
FAN LINES—A set of three secondary trendlines drawn from the same
starting high or low that spread out in a Fan shape. In a Primary Uptrend,
the fan would be along the tops of the Secondary (Intermediate) Reaction.
In a Primary Downtrend, the fan would be along the bottoms of the
Secondary (Intermediate) Rally. When the third Fan Line is broken, it
signals the resumption of the Primary Trend.
50-DAY MOVING AVERAGE LINE—Is determined by taking the closing
price over the past 50 trading days and dividing by 50.
EN: Simple Moving Average for n days consists of summing prices for n
days and dividing by n. On n + 1 drop the first day and add the new day to
the formula, etc.
FIVE-POINT REVERSAL—See Broadening Pattern.
FLAG—A Continuation Pattern. A flag is a period of congestion, less than
four weeks in duration, that forms after a sharp, near-vertical change in
price. The upper and lower boundary lines of the pattern are parallel, though
both may slant up, down, or sideways. In an uptrend, the pattern resembles
a Flag flying from a mast, hence the name. Flags are also called Measuring
or Half-Mast Patterns because they tend to form at the midpoint of the rally
or reaction. Volume tends to diminish during the formation and increase on
the breakout. Minimum Measuring Formula: add the distance from the
breakout point, which started the preceding “Mast” rally or reaction, to the
breakout point of the Flag.
FLOATING SUPPLY—The number of shares available for trading at any
given time. Generally, the outstanding number of shares less shares closely
held and likely to be unavailable to the public. Shares of a company held by
its employee pension fund, for example, would not generally enter the
trading stream and could be subtracted from the outstanding shares.
FORMATION—See Area Pattern.
FRONT-MONTH—The first expiration month in a series of months.
FUNDAMENTALS—Information on a stock pertaining to the business of
the company and how it relates to earnings and dividends. In a commodity,
it would be information on any factor that would affect supply or demand.
EN: Also, earnings, profits, profit margins, cash flow, sales, and other
statistics sometimes used to obfuscate the value of the issue.
GAP—A hole in the price range that occurs when either (1) the lowest price
at which a stock or commodity is traded during any time period is higher
than the highest price at which it was traded on the preceding time period,
or (2) the highest price of one time period is lower than the lowest price of
the preceding time period. When the ranges of the two time periods are
plotted, they will not overlap or touch the same horizontal level on the chart
— there will be a price gap between them. (See also Common or Area Gap,
Ex-Dividend Gap, Breakaway Gap, Runaway Gap, Exhaustion Gap, and
Island Reversal.)
GRAPH—See Chart.
HALF-MAST—See Flag. Edwards said, “The Flag flies at half-mast,”
referring to the tendency of prices to consolidate halfway through a surging
vertical run.
HEAD-AND-SHOULDERS BOTTOM—Area Pattern that reverses a
decline. (See also Head-and-Shoulders Pattern.) EN: An upside-down name
for an upside-down pattern. (See Kilroy Bottom.)
HEAD-AND-SHOULDERS CONSOLIDATION—Area Pattern that
continues the previous trend. (See also Head-and-Shoulders Pattern.)
HEAD-AND-SHOULDERS PATTERN—Although occasionally an
Inverted Head-and-Shoulders Pattern (called a Consolidation Head-and-
Shoulders) will form, which is a Continuation Pattern, in its normal form,
this pattern is one of the more common and more reliable of the Major
Reversal Patterns. It consists of the following four elements (a Head-and-
Shoulders Top will be described for illustration): (1) a rally that ends a more
or less extensive advance on heavy volume, and that is then followed by a
Minor Reaction on less volume; this is the left shoulder; (2) another high-
volume advance that exceeds the high of the left shoulder, followed by
another low-volume reaction that takes prices down to near the bottom of
the preceding reaction, and below the top of the left shoulder high; this is
the head; (3) a third rally, but on decidedly less volume than accompanied
either of the first two advances, and that fails to exceed the high established
on the head; this is the right shoulder; and (4) a decline through a line
drawn across the proceeding two reaction lows (the neckline), and a close
below that line equivalent to 3% of the stock's market price. This is the
confirmation of the breakout. A Head-and-Shoulders Bottom, or any other
combination Head-and-Shoulders Pattern, contains the same four elements.
The main difference between a Top Formation and a Bottom Formation is
in the volume patterns. The breakout in a Top can be on low volume. The
breakout in a Bottom must show a “conspicuous burst of activity.”
Minimum Measuring Formula: add the distance between the head and
neckline to the breakout point.
HEAD-AND-SHOULDERS TOP—Area Pattern that reverses an advance.
(See also Head-and-Shoulders Pattern.)
HEAVY VOLUME—The expression “heavy volume,” as used by Edwards
and Magee, means heavy only with respect to the recent volume of sales in
the stock you are watching.
HEDGING—To try to lessen risk by making a counterbalancing
investment. In a stock portfolio, an example of a hedge would be to buy 100
shares of XYZ stock, and to buy one put option of the same stock. The put
would help protect against a decline in the stock, but it would also limit
potential gains on the upside. (See also Natural Hedge.)
HISTORICAL DATA—A series of past daily, weekly, or monthly market
prices.
HOOK DAY—A trading day in which the open is above/below prior day's
high/low and the close is below/above prior day's close with narrow range.
HORIZONTAL CHANNEL—When the Tops of the rallies and Bottoms of
the reactions form along lines that are horizontal and parallel to one another,
the area in between is called a Horizontal Trend Channel. It may also be
called a Rectangle during the early stages of formation.
HORIZONTAL TRENDLINE—A horizontal line drawn across either the
Tops or Bottoms in a sideways trending market.
HYBRID HEAD-AND-SHOULDERS—A small Head-and-Shoulders
Pattern within a larger Head-and-Shoulders Pattern. (See also Head-and-
Shoulders Pattern.)
INDUSTRIAL AVERAGE—See Dow-Jones Industrial Average.
INSIDE DAY—A day in which the daily price range is totally within the
prior day's daily price range.
INSIDERS—Individuals who possess fundamental information likely to
affect the price of a stock, but which is unavailable to the public. An
example would be an individual who knows about a merger before it is
announced to the public. Trading by insiders on this type of information is
illegal.
INTERMEDIATE TREND—In Edwards and Magee, the term Intermediate
or Secondary refers to a trend (or pattern indicating a trend) against the
Primary (Major) Trend, which is likely to last from three weeks to three
months, and which may retrace one-third to two-thirds of the previous
Primary Advance or Decline.
INVERTED BOWL—See Rounding Top.
INVERTED TRIANGLE—See Right-Angled Broadening Triangle.
ISLAND REVERSAL—A compact trading range, usually formed after a
fast rally or reaction, which is separated from the previous move by an
Exhaustion Gap, and from the move in the opposite direction that follows
by a Breakaway Gap. The result is an Island of prices detached by a gap
before and after. If the trading range contains only one day, it is called a
One-Day Island Reversal. The two gaps usually occur at approximately the
same level. By itself, the pattern is not of major significance, but it does
frequently send prices back for a complete retracement of the Minor Move
which preceded it.
KILROY BOTTOM—The editor's contribution to the nomenclature. A
more descriptive term for the undescriptive “Head-and-Shoulders Bottom.”
LADDERING—A practice some Wall Street underwriters used in the
Tulipomania of the 1990s. Consists of selling initial public offering (IPO)
shares for the pre-opening price to insider customers in exchange for their
agreement to buy more in the public offering at higher prices. Caused
extreme volatility and big run ups in early days of IPOs. An unethical form
of price manipulation.
LEVERAGE—Using a smaller amount of capital to control an investment
of greater value. For example, exclusive of interest and commission costs, if
you buy a stock on 50% margin, you control $1.00 of stock for every $0.50
invested or leverage of 2-to-1.
LEVERAGE SPACE PORTFOLIO—Ralph Vince uses drawdown as the
risk metric for portfolios (as does this editor) instead of variance in returns.
A sophisticated method for determining portfolio risk and trade size and
optimizing portfolio growth.
LIMIT MOVE—A change in price that exceeds the limits set by the
exchange on which the futures contract is traded.
LIMIT ORDER—A buy or sell order limited in some way, usually in price.
For example, if you placed a limit order to buy IBM at 100, the broker
would not fill the order unless he could do so at your price or better (i.e., at
100 or lower).
LIMIT UP, LIMIT DOWN—Commodity exchange restrictions on the
maximum upward or downward movements permitted in the price for a
commodity during any trading session day.
LINE, DOW THEORY—A Line in the Dow Theory is an Intermediate
Sideways Movement in one or both of the Averages (Industrial and/or
Transportation) in the course of which prices fluctuate within a range of 5%
(of mean price) or less.
LOGARITHMIC SCALE—See Semilogarithmic Scale.
MAJOR TREND—In Edwards and Magee, the term Major (or Primary)
refers to a trend (or pattern leading to such a trend) that lasts at least one
year and shows a rise or decline of at least 20%.
MARGIN—The minimum amount of capital required to buy or sell a stock.
The rate, 50% of value in 2005, is set by the government. In a commodity,
margin is also the minimum, usually about 10%, needed to buy or sell a
contract. The rate is set by the individual exchanges. The two differ in cost
as well. In a stock, the broker lends the investor the balance of the money
due and charges interest for the loan. In a commodity, margin is treated as a
good faith payment. The broker does not lend the difference, so no interest
expense is incurred.
MARKET ON CLOSE—An order specification that requires the broker to
get the best price available on the close of trading.
MARKET ORDER—An instruction to buy or sell at the price prevailing
when the order reaches the floor of the exchange.
MARKET RECIPROCAL—Normal average range of a stock based on the
average range for a number of years, divided by the current average range.
The result is the reciprocal of the market movement for the period. Wide
market activity, for example, would show a small decimal, less than 1. Dull
trading would be a larger number.
MAST—The vertical rally or reaction preceding a Flag or Pennant
Formation.
McCLELLAN OSCILLATOR—An Index based on New York Stock
Exchange net advances over declines. It provides a measure of such
conditions as overbought/oversold and market direction on a short- to
intermediate-term basis. The McClellan Oscillator measures a Bear Market
Selling Climax when registering a very negative reading like -150. A sharp
buying pulse in the market is indicated by a very positive reading, well
above 100.
MEASURING FORMULAE—There are certain patterns that do allow the
chartist the opportunity to project at least an interim target level of the
direction of the Primary Trend. The most important of these patterns are
found to be Triangles, Rectangles, Head-and-Shoulders, and Pennants and
Flags.
• Triangles—When a stock breaks out of a Symmetrical Triangle (either up
or down), the ensuing move should carry at least as far as the height of the
Triangle as measured along its first reaction.
• Rectangles—The minimum you would expect from a breakout (up or
down) out of a Rectangle Pattern would be the distance equal to the height
of the formation.
• Head-and-Shoulders Tops/Bottoms—The Head-and-Shoulders Pattern has
one of the better measuring sticks. In either a Top or Bottom, the interim
target, once the neckline is penetrated, is the distance from the Top (or
Bottom) of the head to the level of the neckline directly below (above) the
head.
• Pennants and Flags—The one thing to remember about these Continuation
Patterns is they “fly at half-mast.” In other words, the leg in equals the leg
out.
MEASURING GAP—See Runaway Gap.
MEGAPHONES—Megaphones are Broadening Tops. The Broadening
Formation may evolve in any one of the three forms comparable,
respectively, to Inverted Symmetrical, Inverted Ascending, or Descending
Triangles. The symmetrical type, for example, consists of a series of price
fluctuations across a horizontal axis, with each Minor Top higher and each
Minor Bottom lower than its predecessor. The pattern may thus be roughly
marked off by two diverging lines, the upper sloping up from left to right,
the lower sloping down. These Broadening Patterns are characteristically
loose and irregular, whereas Symmetrical Triangles are regular and
compact. The converging boundary lines of Symmetrical Triangles are
clearly defined, as a rule. Tops and Bottoms within the formation tend to
fall within fair precision on these boundary lines. In the Broadening
Formation, the rallies and declines usually do not all stop at clearly marked
boundary lines and are subject to spikes. We could call this a Megaphone
Spike because the formation keeps on crowding at the lines to look like a
megaphone. It has a tendency to spike down more than up.
MELON—A handsome rich dividend.
MINOR TREND—In Edwards and Magee, the term Minor refers to brief
fluctuations (usually less than six days and rarely longer than three weeks)
that, in total, make up the Intermediate Trend.
MOMENTUM INDICATOR—A market indicator utilizing volume
statistics for predicting the strength or weakness of a current market and
any overbought or oversold conditions and to distinguish turning points
within the market.
MOVING AVERAGE—A mathematical technique to smooth data. It is
called moving because the number of elements are fixed, but the time
interval advances. Old data must be removed when new data are added,
which causes the average to “move along” with the progression of the stock
or commodity.
EN: Simple Moving Average for n days consists of summing prices for n
days and dividing by n. On n + 1, drop the first day and add the new day to
the formula, etc.
MOVING AVERAGE CONVERGENCE/DIVERGENCE (MACD)—An
oscillator derived by dividing one Moving Average by another. Basically, it
combines three Moving Averages into two lines. In today's computer
programs, the Moving Averages are usually exponentially weighted, thus
giving more weight to the more recent data. It is plotted in a chart with a
horizontal Equilibrium Line.
The Equilibrium Line is important. When the two Moving Averages cross
below the Equilibrium Line, it means the shorter Exponential Moving
Average (EMA) is at a value less than the longer EMA. This is a Bearish
signal. When the EMAs are above the Equilibrium Line, it means the
shorter EMA has a value greater than the longer EMA. This is a Bullish
signal.
The first line is the difference between a 12-period EMA and a 26-period
EMA. The second line (signal line) is an approximate exponential
equivalent of a nine-period Moving Average of the first line. The
exponential values being 0.15, 0.075, and 0.20.
An MACD can be displayed as a line oscillator or a histogram.
Buy signals are generated when the faster Moving Average Line crosses the
slower Moving Average Line from below. Sell signals come from the
opposite, when the faster line crosses the slower line from above. Beware of
mechanically trading every MACD crossover; it can lead to whipsaws and
drawdowns with substance. The fact is, narrow trading ranges give many
false signals that can be avoided with additional interpretation.
MOVING AVERAGE CROSSOVERS—The point at which the various
Moving Average Lines pass through or over each other.
MULTICOLINCARITY—The flawed procedure of using the identical data
to supply different types of indicators. The indicators will all confirm each
other because they are based on the same data. Combining RSI, Moving
Average Convergence/Divergence (MACD), and rate of change (where all
indicators use the same closing prices and relative time periods) should
provide the same signals, but they could easily be incorrect.
Multicolincarity can be avoided by using one indicator based on closing
prices, another from volume, and a third from price ranges. It can also be
avoided by using data-generated indicators compared to chart patterns. (See
also Bollinger Bands, MACD, Wilder Relative Strength Index.)
MULTIPLE HEAD-AND-SHOULDERS PATTERN—See Complex Head-
and-Shoulders.
NARROW RANGE DAY—A trading day with a narrower price range
relative to the previous day's price range.
NATURAL and UNNATURAL METHODS or SYSTEMS—Bassetti's half-
humorous identification of “natural methods” of analysis, such as chart
analysis, which looks directly at market data, as opposed to “unnatural
methods,” which place an algorithm between the data and the analysis, such
as Moving Averages, oscillators, and so on.
NATURAL HEDGE—Bassetti's formulation of a technique recommended
by Magee whereby a portfolio is always somewhat long and somewhat
short. It is an imperfect hedge intended to cushion downside (or upside)
risks—for example, long the DIA and short its members (or their proxies)
which are in downtrends.
NECKLINE—In a Head-and-Shoulders Pattern, it is the line drawn across
the two reaction lows (in a Top), or two rally highs (in a Bottom), which
occur before and after the head. This line must be broken by 3% to confirm
the Reversal. In a Diamond Pattern, which is similar to a Head-and-
Shoulders Pattern, the neckline is bent in the shape of a V or inverted V.
(See also Diamond and Head-and-Shoulders Pattern.)
NEGATIVE DIVERGENCE—When two or more Averages, indexes, or
indicators fail to show confirming trends.
NORMAL RANGE FOR PRICE—EN: An analytical tool invented by
Magee for measuring the volatility of stocks. Cumbersome in the modern
context, but interesting. Described in Appendix A, ninth edition.
NUMBER-DRIVEN TECHNICAL ANALYSIS—The use of statistics and
algorithms to analyze the market instead of pure chart analysis. Moving
Averages and oscillators are examples as are stochastic. There are
innumerable indicators of this type. Although having many virtues, it places
an algorithm between the price and the analyst.
ODD LOT—A block of stock consisting of fewer than 100 shares.
ON BALANCE VOLUME (OBV)—OBV is a popular Volume Indicator,
developed by Joseph Granville. Constructing an OBV line is very simple:
the total volume for each day is assigned a positive or negative value
depending on whether prices closed higher or lower that day. A higher close
results in the volume for that day getting a positive value, whereas a lower
close results in a negative value. A running total is kept by adding or
subtracting each day's volume based on the direction of the close. The
direction of the OBV line is watched, not the actual volume numbers.
Formula:
• If Today's Close > Yesterday's Close, then OBV = Yesterday's OBV +
Today's Volume
• If Today's Close < Yesterday's Close, then OBV = Yesterday's OBV -
Today's Volume
• If Today's Close = Yesterday's Close, then OBV = Yesterday's OBV
ONE-DAY REVERSAL—See Island Reversal.
OPTION—The right granted to one investor by another to buy (called a call
option) or sell (called a put option) 100 shares of stock, or one contract of a
commodity, at a fixed price for a fixed period of time. The investor granting
the right (the seller of the option) is paid a nonrefundable premium by the
buyer of the option.
OPTIONS RESEARCH, INC.—Founded by Blair Hull, later of Hull
Trading Co. The first company to computerize the Black-Scholes Model.
ORDER—See Limit Order, Market Order, and Stop Order.
OSCILLATOR—A form of momentum or rate-of-change indicator usually
valued from +1 to -1 or from 0% to 100%.
OVERBOUGHT—Market prices that have risen too steeply and too
quickly.
OVERBOUGHT/OVERSOLD INDICATOR—An indicator that attempts
to define when prices have moved too far and too quickly in either
direction, and thus are liable to a reaction.
OVERSOLD—Market prices that have declined too steeply and too
quickly.
PANIC—The second stage of a Bear Market when buyers thin out and
sellers sell at any price. The downward trend of prices suddenly accelerates
into an almost vertical drop, whereas volume rises to climactic proportions.
(See also Bear Market.)
PANIC BOTTOM—See Selling Climax.
PASSIVE INDEXER—Investor who invests in a major index and holds it
through up and down waves.
PATTERN—See Area Pattern.
PEAK—See Top.
PENETRATION—The breaking of a pattern boundary line, trendline, or
Support and Resistance Level.
PENNANT—A Pennant is a Flag with converging, rather than parallel,
boundary lines. (See also Flag.)
POINT AND FIGURE CHART—A method of charting believed to have
been created by Charles Dow. Each day the price moves by a specific
amount (the arbitrary box size), an X (if up) or O (if down) is placed on a
vertical column of squared paper. As long as prices do not change direction
by a specified amount (the Reversal), the trend is considered to be in force
and no new column is made. If a Reversal takes place, another vertical
column is started immediately to the right of the first, but in the opposite
direction. There is no provision for time on a Point and Figure Chart.
PREMATURE BREAKOUT—A breakout of an Area Pattern, and then a
retreat back into the pattern. Eventually, the trend will break out again and
proceed in the same direction. At the time they occur, false breakouts and
premature breakouts are indistinguishable from each other or from a
genuine breakout.
PRICE/EARNINGS RATIO—Price of stock divided by earnings (which
may or may not be real) to give the P/E ratio. Sometimes an unnatural, or
imaginary, number.
PRIMARY TREND—See Major Trend.
PROGRAM TRADING—Trades based on signals from various computer
programs, usually entered directly from the trader's computer to the
market's computer system.
EN: Usually indicates large volume transactions on large baskets of stocks
by professional traders.
PROGRESSIVE STOP—A stop order that follows the market up or down.
(See also Stop.)
PROTECTIVE STOP—A stop order used to protect gains or limit losses in
an existing position. (See also Stop.)
PULLBACK—Return of prices to the boundary line of the pattern after a
breakout to the downside. Return after an upside breakout is called a
Throwback.
PUT—An option to sell a specified amount of a stock or commodity at an
agreed time at the stated exercise price.
RAIL AVERAGE—See Dow-Jones Transportation Average.
RALLY—An increase in price that retraces part of the previous price
decline.
RALLY TOPS—A price level that finishes a short-term rally in an ongoing
trend.
RANGE—The difference between the high and low during a specific time
period.
REACTION—A decline in price that retraces part of the previous price
advance.
RECIPROCAL, MARKET—See Market Reciprocal.
RECOVERY—See Rally.
RECTANGLE—A trading area bounded on the Top and the Bottom with
horizontal, or near horizontal, lines. A Rectangle can be either a Reversal or
Continuation Pattern depending on the direction of the breakout. Minimum
Measuring Formula: add the width (difference between Top and Bottom) of
the Rectangle to the breakout point.
RED PARALLEL—A line drawn parallel to the trendline (Red Trendline)
that connects at least two Bottoms. The Red Parallel (basically a Return
Line) is started off a high and used to estimate the next high point.
RED TRENDLINE—A straight line connecting two or more Bottoms
together. To avoid confusion, Edwards and Magee use a red line for Bottom
Trendlines and a blue line for Top Trendlines.
RELATIVE STRENGTH (RS or RS INDEX)—A stock's price movement
over the past year as compared with a market index (most often the
Standard & Poor's 500 Index). Value below 1 means the stock shows
relative weakness in price movement (underperformed the market); a value
above 1 means the stock shows relative strength over the one-year period.
Equation for Relative Strength:
Current Stock Price/Year-Ago Stock Price
Current S&P 500/Year-Ago S&P 500
(See also Wilder Relative Strength Index.)
RESISTANCE LEVEL—A price level at which a sufficient supply of stock
is forthcoming to stop, and possibly turn back for a time, an uptrend.
RETRACEMENT—A price movement in the opposite direction of the
previous trend.
RETURN LINE—See Ascending or Descending Trend Channels.
REVERSAL GAP—A chart formation where the low of the last day is
above the previous day's range with the close above midrange and above
the open.
REVERSAL PATTERN—An Area Pattern that breaks out in a direction
opposite to the previous trend. (See also Ascending Triangle, Broadening
Formation, Broadening Top, Descending Triangle, Diamond, Dormant
Bottom, Double Bottom or Top, Head-and-Shoulders Pattern, Rectangle,
Rising or Falling Wedge, Rounding Bottom or Top, Saucer, Symmetrical
Triangle, and Triple Bottom or Top.)
RIGHT-ANGLED BROADENING TRIANGLE—Area Pattern with one
boundary line horizontal and the other at an angle that, when extended, will
converge with the horizontal line at some point to the left of the pattern.
Similar in shape to Ascending and Descending Triangles, except they are
inverted and look like Flat-Topped or Bottomed Megaphones. Right-Angled
Broadening Formations generally carry Bearish implications regardless of
which side is flat. But any decisive breakout (3% or more) through the
horizontal boundary line has the same forceful significance as does a
breakout in an Ascending or Descending Triangle.
RIGHT-ANGLE TRIANGLES—See Ascending and Descending Triangles.
RISING WEDGE—An Area Pattern with two upward-slanting, converging
trendlines. Normally, it takes more than three weeks to complete and
volume will diminish as prices move toward the apex of the pattern. The
anticipated direction of the breakout in a Rising Wedge is down. Minimum
Measuring Formula: a retracement of all the ground gained within the
wedge.
ROUND LOT—A block of stock consisting of 100 shares of stock.
ROUND TRIP—The cost of one complete stock or commodity transaction,
that is, the entry cost and the offset cost combined.
ROUNDING BOTTOM—An Area Pattern that pictures a gradual,
progressive, and fairly symmetrical change in the trend from down to up.
Both the Price Pattern (along its lows) and the Volume Pattern show a
concave shape often called a Bowl or Saucer. There is no minimum
measuring formula associated with this Reversal Pattern.
ROUNDING TOP—An Area Pattern that pictures a gradual, progressive,
and fairly symmetrical change in the trend from up to down. The Price
Pattern, along its highs, shows a convex shape sometimes called an Inverted
Bowl. The Volume Pattern is concave shaped (a bowl) as trading activity
declines into the peak of the Price Pattern and increases when prices begin
to fall. There is no measuring formula associated with this Reversal Pattern.
RUNAWAY GAP—A relatively wide gap in prices that occurs in an
advance or decline gathering momentum. Also called a “Measuring Gap”
because it frequently occurs at just about the halfway point between the
breakout that started the move and the Reversal Day that calls an end to it.
Minimum Measuring Formula: take the distance from the original breakout
point to the start of the gap and add it to the other side of the gap.
RUNNING MARKET—A market wherein prices are moving rapidly in one
direction with very few or no price changes in the opposite direction.
SAUCER—See Rounding Bottom and Scallop.
SCALLOPS—A series of Rounding Bottom (Saucer) Patterns where the
rising end always carries prices a little higher than the preceding Top at the
beginning of the pattern. Net gains will vary from stock to stock, but there
is a strong tendency for it to amount to 10%-15% of the price. The total
reaction, from the left-hand Top of each Saucer to its Bottom, is usually in
the 20%-30% area. Individual Saucers in a Scallop series are normally five
to seven weeks long, and rarely less than three weeks. The volume will
show a convex or Bowl Pattern.
SECONDARY TREND—See Intermediate Trend.
SECULAR TREND—A major long-lived trend based in solid economic
conditions, as opposed to cyclic or technical.
SELLING CLIMAX—A period of extraordinary volume that comes at the
end of a rapid and comprehensive decline that exhausts the margin reserves
of many speculators or patience of investors. Total volume turnover may
exceed any single day's volume during the previous upswing as Panic
Selling sweeps through the stock or commodity. Also called a Clean-Out
Day, a Selling Climax reverses the technical conditions of the market.
Although it is a form of a One-Day Reversal, it can take more than one day
to complete.
SEMILOGARITHMIC SCALE—Price or volume scale in which the
distance on the vertical axis (i.e., space between horizontal lines) represents
equal percentage changes.
SENSITIVITY—An index used by Edwards and Magee to measure the
probable percentage movement (sensitivity) of a stock during a specified
percentage move in the stock market as a whole.
EN: More or less equivalent, or with the same intent as beta.
SHAKEOUT—A corrective move large enough to “shake out” nervous
investors before the Primary Trend resumes.
SHORT INTEREST—The number of shares that have been sold short and
not yet repurchased. This information is published monthly by the New
York Stock Exchange.
SHORT SALE—A transaction in which the entry position is to sell a stock
or commodity first and to repurchase it (hopefully at a lower price) at a later
date. In the stock market, shares you do not own can be sold by borrowing
shares from the broker and replacing them when the offsetting repurchase
takes place. In the commodity market, contracts are created when a buyer
and seller get together through a floor broker. As a result, the procedure to
sell in the commodity market is the same as it is to buy.
SHOULDER—See Head-and-Shoulders Pattern.
SMOOTHING—A mathematical approach that removes excess data
variability while maintaining a correct appraisal of the underlying trend.
SPIKE—A sharp rise in price in a single day or two.
STOCHASTIC—Random.
STOCHASTICS—The Stochastic Oscillator, developed by George Lane,
compares a security's price closing level to its price range over a specific
period of time. This indicator shows, Lane theorized, in an upward-trending
market, prices tend to close near their high; and during a downward-
trending market, prices tend to close near their low. As an upward trend
matures, prices tend to close further away from their high; as a downward
trend matures, prices tend to close away from their low. The Stochastic
Indicator attempts to determine when prices start to cluster around their low
of the day in an uptrending market, and cluster around their high in a
downtrend. Lane theorizes these conditions indicate a Trend Reversal is
beginning to occur. The Stochastic Indicator is plotted as two lines, the %D
Line and %K Line. The %D Line is more important than the %K Line. The
Stochastic is plotted on a chart with values ranging from 0 to 100. The
value can never fall below 0 or above 100. Readings above 80 are
considered strong and indicate a price is closing near its high. Readings
below 20 are strong and indicate a price is closing near its low. Ordinarily,
the %K Line will change direction before the %D Line. However, when the
%D Line changes direction prior to the %K Line, a slow and steady
Reversal is often indicated. When both %K and %D Lines change direction,
and the faster %K Line changes direction to retest a crossing of the %D
Line, though does not cross it, the incident confirms stability of the prior
Reversal. A powerful move is under way when the Indicator reaches its
extremes around 0 and 100. Following a Pullback in price, if the Indicator
retests extremes, a good entry point is indicated. Many times, when the %K
or %D Lines begin to flatten out, the action becomes an indication the trend
will reverse during the next trading range.
STOCK SPLIT—A procedure used by management to establish a different
market price for its shares by changing the common stock structure of the
company. Usually a lower price is desired and established by canceling the
outstanding shares and reissuing a larger number of new certificates to
current shareholders. The most common ratios are 2-to-1, 3-to-1, and 3-to-
2. Occasionally, a higher price is desired and a reverse split takes place
where one new share is issued for some multiple number of old shares.
STOP—A contingency order placed above the current market price if it is to
buy, or below the current market price if it is to sell. A stop order becomes a
market order only when the stock or commodity moves up to the price of
the buy stop, or down to the price of a sell stop. A stop can be used to enter
a new position or exit an old position. (See also Protective or Progressive
Stop.)
STOP LOSS—See Protective Stop.
SUPPLY—Amount of stock available at a given price.
SUPPLY LINE—See Resistance.
SUPPORT LEVEL—The price level at which a sufficient amount of
demand is forthcoming to stop, and possibly turn higher for a time, a
downtrend.
SYMMETRICAL TRIANGLE—Also called a Coil. Can be a Reversal or
Continuation Pattern. A sideways congestion in which each Minor Top fails
to attain the height of the previous rally and each Minor Bottom stops above
the level of the previous low. The result is upper and lower boundary lines
that converge, if extended, to a point on the right. The upper boundary line
must slant down and the lower boundary line must slant up, or it would be a
variety of a Wedge. Volume tends to diminish during formation. Minimum
Formula: add the widest distance within the Triangle to its breakout point.
TANGENT—See Trendline.
TAPE READER—One who makes trading decisions by watching the flow
of New York Stock Exchange and American Stock Exchange price and
volume data coming across the electronic ticker tape.
TEKNIPLAT™ PAPER—A specially formatted, two-cycle,
semilogarithmic graph paper, with sixth-line vertical accents, used to chart
stock or commodity prices. Check http:// www.edwards-magee.com.
TEST—A term used to describe the activity of a stock or commodity when
it returns to, or “tests,” the validity of a previous trendline, or Support or
Resistance Level.
THIN ISSUE—A stock with a low number of floating shares and is lightly
traded.
THREE-DAYS-AWAY RULE—An arbitrary time period used by Edwards
and Magee in marking suspected Minor Tops or Bottoms.
THROWBACK—Return of prices to the boundary line of the pattern after a
breakout to the upside. Return after a downside breakout is called a
Pullback.
TOP—See Broadening Top, Descending Triangle, Double Top, Head-and-
Shoulders Top, Rounding Top, and Triple Top.
TREND—The movement of prices in the same general direction, or the
tendency or proclivity to move in a straight line. (See also Ascending,
Descending, and Horizontal Parallel Trend Channels, Convergent Trend,
Divergent Trend, Intermediate Trend, Major Trend, and Minor Trend.)
TREND CHANNEL—A parallel probable price range centered about the
most likely price line.
TRENDING MARKET—Price continues to move in a single direction,
usually closing strongly for the day.
TRENDLINE—If we actually apply a ruler to a number of charted price
trends, we quickly discover the line most often really straight in an uptrend
trend is a line connecting the lower extremes of the Minor Recessions
within these lines. In other words, an advancing wave in the stock market is
composed of a series of ripples, and the bottoms of each of these ripples
tend to form on, or very close to, an upward-slanting straight line. The tops
of the ripples are usually less even; sometimes they also can be defined by a
straight line, but more often, they vary slightly in amplitude, and so any line
connecting their upper tips would be more or less crooked. On a descending
price trend, the line most likely to be straight is the one that connects the
tops of the Minor Rallies within it, while the Minor Bottoms may or may
not fall along a straight edge. These two lines—the one that slants up along
the successive wave bottoms within a broad up-move and the one that slants
down across successive wave tops within a broad down-move—are the
Basic Trendlines. You draw an Up Trendline by drawing the line on the
inner side. You draw a Down Trendline by drawing it on the outside. You
draw a Sideways Trendline on the bottom.
TRIANGLE—See Ascending Triangle, Descending Triangle, Right-Angled
Broadening Triangle, and Symmetrical Triangle.
TRIPLE BOTTOM—Similar to a flat Head-and-Shoulders Bottom, or
Rectangle, the three Bottoms in a Triple Bottom.
TRIPLE TOP—An Area Pattern with three Tops widely spaced and with
quite deep, and usually rounding, reactions between them. Less volume
occurs on the second peak than the first peak, and still less on the third
peak. Sometimes called a “W” Pattern, particularly if the second peak is
below the first and third. The Triple Top is confirmed when the decline
from the third Top penetrates the Bottom of the lowest valley between the
three peaks.
200-DAY MOVING AVERAGE LINE—Determined by taking the closing
price over the past 200 trading days and dividing by 200, then repeating the
process each succeeding day, always dropping off the earliest day.
UPTICK—A securities transaction made at a price higher than the
preceding transaction.
UPTREND—See Ascending Trendline and Trend.
UTILITY AVERAGE—See Dow-Jones Utility Average.
V/D VOLUME—Is the ratio between the daily up-volume to the daily
down-volume. It is a 50-day ratio determined by dividing the total volume
on those days when the stock closed up from the prior day by the total
volume on days when the stock closed down.
VALIDITY OF TRENDLINE PENETRATION—The application of the
following three tests when a trendline is broken to determine whether the
break is valid or whether the trendline is still basically intact: (1) the extent
of the penetration, (2) the volume of trading on the penetration, and (3) the
trading action after the penetration.
VALLEY—The V-shaped price action that occurs between two peaks. (See
also Double Top and Triple Top.)
VINCE, RALPH—Author of Handbook of Portfolio Mathematics where
optimal f is described as a quantitative way to achieve optimal allocation
and leverage of a portfolio. The Leverage Space Model achieves optimal
bet sizing for maximizing gains while minimizing risk.
VOLATILITY—A measure of a stock's tendency to move up and down in
price, based on its daily price history over the latest 12-month period. (See
Appendix B, Resources, for the formula.)
VOLUME—The number of shares in stocks or contracts in commodities
traded over a specified period of time.
“W” FORMATION—See Triple Top.
WEDGE—A chart formation in which the price fluctuations are confined
within converging straight (or practically straight) lines.
WILDER RELATIVE STRENGTH INDICATOR (RSI)—Although relative
strength, comparing a security price to a benchmark index price, has been
around for some time, this indicator was developed by J. Welles Wilder, as
explained in his 1978 book, New Concepts in Technical Trading.
Relative Strength is often used to identify price Tops and Bottoms by
keying on specific levels (usually “30” and “70”) on the RSI chart, which is
scaled from 0 to 100. The RSI can also be useful to show the following:
1. Movement that might not be as readily apparent on the bar chart.
2. Failure Swings above 70 or below 30, warning of coming Reversals.
3. Support and Resistance Levels appear with greater clarity.
4. Divergence between the RSI and price can often be a useful
Reversal indicator.
The RSI requires a certain amount of lead-up time to operate successfully.
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
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Index
A
ABC Vending Corp., 455, 576, 579
Absolute certainty, 275
Accelerating Downward Trend, 68
Accumulation, 14, 17, 43, 44, 107, 157, 159, 168, 184, 241, 245, 265, 32,
538, 542, 595
Pattern, 73, 401
Action Industries, 472, 576, 579
Activity, see Volume
Acts of God, 12, 248
Acute Triangle, 79-80
Advisors, 252, 268, 310
ADXR Indicator, 595
Agricultural commodity, 247-248
AIQ Trading Expert Pro, 531-532
Amazon, 2 , 335-336, 358, 47 , 563, 573, 579
AMD, 475, 57 , 579
American Locomotive, 63, 163, 433, 566, 570, 575, 580
American Stock Exchange (AMEX), 271, 309, 311, 312, 316, 349, 494,
524, 616
Apex, 80, 83, 84, 8 , 88, 94, 9 , 99-100, 122, 128, 142,
145, 153, 201, 203-205, 209, 398-400, 404, 408, 412, 423, 440, 443, 596
Apex of Symmetrical Triangle, 414
Appel, Gerald, 542
Apple Computer Inc (APPL), 135, 366, 478-479, 577 Appreciated portfolio,
protecting profits in, 285-286 Arbitrage, 344, 596
Area Gap, see Common Gap
Area Pattern, 8, 90, 145, 176, 184, 186, 198, 202, 221, 261, 264, 319, 423,
439, 596, 601, 604, 605, 611-614, 617-618
Area Reversal Pattern, 599
Arithmetic paper, 8, 229
Arithmetic scale, 8, 58, 69, 143, 211-216, 596
Arms CandleVolume charting, 551-553
Arms Index, 545, 548-549
Aroon, 538, 542
Aroon Down, 538, 542
Aroon Oscillator, 538
Aroon Up, 538, 542
Ascending Channel, 596
Ascending Formation, 99
Ascending Pattern, 98-99
Ascending Trend Channels, 596, 599, 613
Ascending Trendline, 596, 618
Ascending Triangle, 84-89, 94-95, 97-98, 114-115,
122, 135-136, 141, 147, 161, 166, 177-178, 189, 204, 294, 373-375, 395,
399, 408, 428, 434, 439-441, 465, 472, 596, 613-614
Asset allocation, 275, 278, 280-282, 491
Astrodata Inc. (ADA), 46, 576, 581
At-the-money, 283, 596
Automated trendline, 421-425, 540
Average(s), 4, 17, 19, 26, 41, 50, 99, 106, 112, 135, 145, 151, 181, 313, 34 ,
393-394, 428, 436, 445, 459, 481, 482, 596, 600
discount, 12
Dow, see Dow averages
gaps in, 187
investor, 192 moving, see Moving averages support and resistance in, 206
trendlines in, 243
Average Directional Index (ADX), 538, 542, 595 Average True Range
(ATR), 358-359, 538
Averaging Cost, 442, 485, 596-597
Avnet Electronics Corp., 448, 459, 575, 581
Axis, 196, 205, 597
B
Balanced program, 481-486, 597
Bandwidth, 538, 598
Bar Chart, 31, 266, 304, 531, 532, 545, 550, 552, 554, 558, 597
Baruch, Bernard, 265
Basic Trendlines, see Trendlines
Basing Points (BP), 31-40, 198, 239, 256, 258, 260, 299-300, 308, 314,
326, 328, 340, 357-359, 362-366, 368-370, 404, 414, 480, 504, 506, 574,
581, 597
Basket Trades, 389-390, 597
Bearish Move, 391, 451
Bearish Trend, 310, 482
in Industrial Rayon, 446
in Lorillard, 447
Bear Market, 13, 15, 225, 242, 264, 293, 299, 386, 413,
481, 509, 511-512, 597,602, 611
signal, 519-521
Bear Market Bottom in Socony-Vacuum, 89, 109
Bear Market Rallies, 61, 63
rising wedges in, 144
Bear Market Selling Climax, 608
Bear Raiding, 168
Bent Neckline, see Neckline (NL)
Bent neckline, 138, 444, 597
Beta, 310, 321, 322, 342-343, 346, 597
coefficient, 597
Bitcoin, 326-328
Black Scholes model, 266, 273, 531
Block Trades, 97-99, 105, 597
Blow-Off, see Climactic Top
Blue Chips, 41, 280, 301, 320, 353, 43 , 598
Blue Parallel, 373-374, 378-380, 410, 598
Blue Trend, 373, 375-379
Blue Trendline, 373-378, 578, 598
Bollinger Bands (BB), 266, 267, 53 , 561-563, 598
Bollinger, John, 533, 561
Bona fide breakout, 600
Bond
futures for asset allocation, 280-282
traders and investors, 496
Book value, 4, 5, 175, 599
Bottom, 599
Kilroy, see Head-and-Shoulders Bottom
Patterns, 5 , 58, 117, 161, 458
Trendlines, 224, 273, 414
Boundary, 54, 78, 599
Bowl Pattern, see Rounding Bottoms
Bracketing, 599
Breakaway gaps, 4 , 63, 91, 142, 162, 173-174, 177-182, 186, 202, 254,
258, 410, 412, 417, 423, 470, 599, 607
Breaking neckline, 47-49
Breakout failure, 603
Breakout Gap, 126, 175, 184
signals, 185
“Breakout of dormancy,” 73
Breakouts, 88, 108, 161, 418, 551, 599 decisive, 221, 37 , 378 downside,
95, 99, 398, 408 premature, 85, 108 pullbacks, 224 from Right-Angle
Triangles, 100 upside, 89, 99, 402, 408
Broadening Bottoms, 135
Broadening Formations, 121-122, 599, 608-609 volume during, 122-128
Broadening Pattern, 604
Broadening Price Formation, 130-131
Broadening Price Patterns, 121, 122, 126, 131, 136
Broadening Tops, 122, 124, 125, 129, 133, 309, 400, 404, 408, 617
in Dow-Jones Industrial Average, 444-445
Orthodox, see Orthodox Broadening Top
Broad market, 243
Broad market background, 264
Broad Market Trend, 243
Brokerage firms, 270
Brokerage houses, 526-527
Brokers, 145, 146, 268, 269, 313, 347
Brooker, Brian, 27
Brunswick Corporation, 450, 575, 581
Bullish Market, 321, 460, 481, 483
Bullish Move, 391, 406
Bull Market, 13-19, 23, 70, 226, 241, 264, 293, 299, 396-39 , 481, 492, 493,
514, 518, 595, 599, 602 in commodities, 260 dynamic phase of, 157
Primary, see Primary Bull Market
Publicker, 116
Bull Market Advance, 159, 225, 294
Bull Market Concomitants, 159
Bull Market High, 52
Bull Market Peaks, 114
Bull Market Reaction, 219
Bull Market Top, 53, 86, 240
of Head-and-Shoulders Form, 50
Symmetrical Triangle Bottom, 80
Symmetrical Triangle Reversal, 78
in U.S. Steel, 127
in Westinghouse, 96
of Westinghouse Electric, 47
Bull Market Trend, 237
of General Motors, 230
Bull Market Trendlines, 229
Bull signal, 513-514
Bull trap, 139, 148, 326, 32 , 420, 473
Bull Trend reaffirmation, 515-516
Burndy Corporation, 449, 575, 582
Buy-and-Hold investor, 26, 27
Buying at the top, 487
C
Call option, 599, 611
Candlestick charts, , 8, 182, 266, 267, 553 Candlesticks, 551, 599
Canny investor, 278
CANSLIM system, 316
Capital, 489 application in practice, 491-494 to use in trading, 489-490
Cash, differences with future transactions, 277 Catastrophic Risk, 503
“Cats and dogs,” 15, 320, 493, 517, 599
Caveats, 330-331
of Moving Averages, 422
CBOT® DJIASM Index futures, 276, 282
Cerro Corporation, 456, 576, 582
Chaff, 270
Chaikin Money Flow (CMF), 538
Chaikin Oscillator, 538
Chandelier Exit, 359, 537
Chande Trend Meter (CTM), 538 Channel, 599
Chart(s), 15, 19, 261, 267, 269, 304, 505, 599, 605 Ascending Triangle, 399
associated dry goods winds up, 396 Broadening Tops, 400, 408 candlestick,
, 8, 182, 266, 26, 553 Complex or multiple Head-and-Shoulders, 403 daily
chart in Northern Pacific, 412 daily chart of Lehigh Valley R. R, 407
decorating graphic charts, 304 Diamond, 409
Diamond Pattern in American Can, 404 Double Tops and Bottoms, 409
Dow Theory, 393-399
Flags and Pennants, 410-411
Gaps, 411-413
Gulf, Mobile, and Ohio builds beautiful Wedge, 405
Head-and-Shoulders Bottom, 401-403 Head-and-Shoulders Top, 400-401 of
New York Central, 175
One-Day Reversals, 410
Pennant in Martin-Parry, 406 Rectangles, 408-409
Rectangles in Remington Rand, 401 Right-Angled Broadening Formations,
409 Right-Angle Triangles, 408 rounding Bottom in 1945, 397
Rounding Tops and Bottoms, 403-406 Spiegel's Bear Market, 262 of stocks,
163
Support and Resistance, 414 Symmetrical Triangle in allied stores, 398
Symmetrical Triangles, 406-408 Trendlines, 414
trendlines in American steel foundries, 413 types of scales, 8-9
Wedges, 409-410
wide Descending Triangle of, 262
Chart analysis, 304, 539-540 computer for, 304-305
Chart analysts, 259, 266 Commodity Research Bureau Index, 254 trading
futures, 259-260
Chicago Board of Trade (CBOT®), 271
Chicago Board Options Exchange (CBOE), 273, 494
Chicago Mercantile Exchange, 276-27 , 312
Chicago, Milwaukee, St. Paul and Pacific, 440 Chrysler, 436
Classical technical analysis, 4 Clean-cut Triangle, 82
Clean-Out Day, see Selling Climax
Climactic Top, 59 , 600
Climax Day, see One-Day Reversal
Climax, Selling, see Selling Climax Close-only charts, 267
Closing gap, 171-173
Closing prices, 18, 600
Closing the gap, 600, 601
Cloud, 269
Coil, see Symmetrical Triangle
Colby, Robert, 21
Commission, 600 Commitments, 417-418
Commodity, 276
agricultural, 247-248
market, 615
traders, 298
Commodity Channel Index (CCI), 538
Commodity charts, technical analysis of application of Edwards and
Magee's methods, 252-259
chart analyst trading futures, 259-260 rocket scientists, 249-250
Turtles, 250-252
21st-century perspective, 249
variety of methods, 259
Common Gap, 175-17, 184, 596, 600
Comparative relative strength, 600
Complete Basing Points Procedure, 368-370 Complex Formations, 59
Complex Head-and-Shoulders Pattern, 59, 403, 600, 602, 610
EN, 60
ragged Kilroy Bottom, 61 strong movement toward lower interest rates
evident, 60
Composite Average, 600
Composite Leverage, 498, 600
Composite Leverage Index, 492, 493
Compound Annual Growth Rates (CAGR), 32
Computer, 265
for charting analysis, 304-305 technology, 267-268
Computer software packages, 267
Conant, James Bryant, 289
Confirmation, 16-19, 600-601
Congestion, 151, 601
Congestion Formations, 115, 175-176
Conservative investing, 310-311
Consolidating, 151
Consolidation Formation, 110, 151
a, 156
Bull Flag in February and Bear Flag in April 1936 compact type of price
“Congestion,” 158 Consolidation Pattern, 167 down-sloping, converging
price formation, 157 flag pictures on weekly and monthly charts, 158-159
Flags and Pennants, 151-153
Flag seemed for several weeks, 163
“Half-Mast” Pattern, 161
Head-and-Shoulders Consolidations, 160-162, 164 measuring formula, 154-
156 modern vs. old-style markets, 168-169 rectangular Consolidations, 159
reliability of Flags and Pennants, 156-157
Consolidation Formation (Continued)
scallops, 162-167
series of Flag-type Consolidations, 159 stock make long series of small
Consolidation Patterns, 155
Consolidation Head-and-Shoulders, see Head-And-Shoulders Pattern
Consolidation Pattern, 79, 94-9 , 156, 161, 167, 190, 392, 600, 601, 604
Consolidations of Rectangle, 159
Construction of index shares and similar instruments, 311-312
Continuation Formation, see Consolidation Formation
Continuation Gap, see Runaway Gap Continuation-of-Trend Pattern, 137
Continuation Pattern, see Consolidation Pattern Control Data Corp (CDA),
462, 576, 583
Controlling risk, 351, 499, 503
Convergent Pattern (Trend), 601
Copper Range Co., 452, 576, 583
Coppock Curve, 538
Correction, 601
Corrective trends, 226-227
Correlation Coefficient, 500, 538
“Cost of carry,” 276-279
Costs, 390
Covering the gap, see Closing the gap
“Cradle,” 205, 601
“Cradle point,” 440, 456
Crossovers, 422-424
Crucible Steel Co. of America, 45 , 576, 583
Cyber trader, 316
Cyclical approach, 3
D
Daily Range, 148, 173, 508, 601
Dampened risks, 313
Danaher Corp., 558
Day-to-day chart analysis, 196
“Day traders,” 31, 166, 168, 298, 302
Day trading, 168, 298
DecisionPoint Price Momentum Oscillator (PMO),
538
Definite warning, 428
Degree of fluctuation, 283, 345
Delaware, Lackawanna And Western, 432 “Delivery,” 276
Dell, 473-474
Delphic Options Research, 523, 529
Demand, 70, 86, 98, 112, 117, 601
Demand Line, 98, 104, 176, 202
Descending Channel, 601
Descending Trend, 603
Descending Trend Channel, 374-375, 599, 601, 613, 619 Descending
Trendline, 601, 603
Descending Triangle, 92, 97-99, 122, 136, 175, 294, 408,
601-602, 613-614, 617
Detrended Price Oscillator (DPO), 538 Diagonal Movements, 423
Diamond, 74, 12 , 129, 130, 137-139, 602
Pattern, 610
Reversal Formation, 128, 137-138, 409 DIAMONDS™ (DIA), 271, 274,
299, 312, 317, 323, 350, 351, 390 Directional tendency, 110 Discipline,
260, 28 , 501, 542 Dissecting Dow Theory, 499 “Distance away” criteria,
194, 203 Distribution, 43, 44, 117, 136, 168, 602 frequency, 500 Line, 538,
542 Pattern, 90 planned, 98
Distribution period, 15, 17 Divergence, 4, 99, 212, 510, 511, 513, 600-602
definite, 166
negative, 610 Divergent Pattern, 206, 602 Divergent Trend, 617 Divergent
Trend Channel, 376, 377, 379 Diverging boundary lines, 100
Diversification, 41, 298, 313, 319, 389, 390, 481-486, 602 Dividends, 23,
194, 27 , 294, 297-298, 30 , 310-311, 315, 341, 345, 348, 361, 419, 469,
602 Donchian system, 251 Dormant Bottom, 72-74, 602
Double Bottoms, 113-115, 118, 409, 602 Double Top, 103-105, 113-115,
118, 409, 602, 617
at Primary Trend Reversals, 118 Double trendlines, 222-223, 603 Dow
averages, 12
basic tenets, 12-14 major trend phases, 14-16 principle of confirmation, 16-
19 tide, wave, and ripple, 14 Dow Index futures, 27 , 287 Dow Industrial
Average (DIA), 481 Dow interpretation, 507-508 Dow-Jones Industrial
Average (DJIA), 6, 41, 146, 311,
444-445, 454, 486, 600, 603, 606 Dow-Jones Industrial Index differences
between cash and futures, 277 Dow Index futures, 277 exercising option,
284 exploiting market reversals, 285 fungibility, 276-277 futures and
options, 275, 284 investment and hedging strategies, 276 investment uses of
Dow Index futures, 279-282 marking-to-market trading, 276 option
premiums, 283 options on Dow Index futures, 282-283 option spreads in
high-or low-volatility markets, 286-287
perspective, 287
portfolio yields improvement, 286 profits in rising markets, 284-285
protecting profits in appreciated portfolio, 285-286
settlement of futures contracts, 276 stock index futures to control exposure
to market, 277-278
volatility, 283-284 Dow-Jones Stock Composite, 12 Dow-Jones
Transportation Average, 603, 612 Dow-Jones Utility Average, 600, 603, 618
Down Channel, see Descending Channel Down-slanting boundary line, 79-
80 Downtick, 603 Downtrends, 143, 202, 242, 423, 429
Intermediate, see Intermediate downtrends Major, see Major downtrends
Primary, see Primary downtrends
Dow principles, 16, 17, 23-24
Dow Theory, 3, 11, 18, 21-23, 28-29, 31, 41, 7, 207, 259,
264, 313, 365, 381, 393-399, 50 , 533, 600, 601 in 20th and 21st centuries,
26-27 Bear Market signal, 519-521 bull signal, 513-514
Bull Trend reaffirmation, 515-516 closing price levels of Dow-Jones
Industrial and Rail averages, 509, 510, 511, 512, 514 failure to confirm,
510-511 final up-thrust, 519 first correction, 514-515 first severe test, 508-
510 five years of Dow interpretation, 507-508 intermediate trend investor,
23-26 leaving investor in doubt, 23 Rails falter, 516-517 signs of major
turn, 511-513 spring of 1946, 517-518 utilization, 507 Dow Theory Line,
151 Dow Theory replacement with John Magee's Basing Points Procedure
Dow-Jones Industrials (1924-1934), 39-40 fractal nature of market, 31
interesting charts ever made of Dow-Jones Industrials, 40 trades made by
Magee Basing Points Procedure,
33-37
2008 top in industrials, 38 Drawdown, 498-499, 603 Dreman, David, 280,
496 Dunn and Hargitt, 251
E
Eagle-Picher Lead, 436 “Earnest money,” see Futures “margins” Ease of
Movement (EMV), 538 Economic tide, 264
Edwards and Magee's methods, 252-258 stops, 258-259
Electronic marketplaces, 269
Electronic portfolio, 270
Elliott Wave Theory, 6, 528-531
Emotion-driven markets, 266
End Run, 83, 204, 205, 603
Equilibrium Line, 609
Equilibrium Market, 603
Equivolume charting, 550
result, 551-553
technique, 551
Evaluative Index, 39 , 448, 482-483
Ex-Dividend, 90, 173, 175, 361, 443, 603
Ex-dividend gaps, 174, 603
breakaway gaps, 177-182 common or area gap, 175-177 continuation or
runaway gaps and measuring rule, 182-184
exhaustion gaps, 185-186 two or more runaway gaps, 184-185
Exaggerated leverage, 272
Exception, 381
Exchange-traded fund (ETF), 271, 317, 322, 603
Exchange Traded Notes (ECNs), 268, 321
Execution of buys, 376-377
Exercise, 283, 325, 603 exercising option, 284 price, 272, 282, 494
Exhaustion Gap, 184, 185-186, 258, 410, 603-604, 607 Experimental lines,
224
Expiration, 271, 284, 604
Exponential Moving Average (EMAs), 422, 53 , 542, 609
Exponential Smoothing, 604 “Extent of decline” criterion, 193 Extent of
penetration, 221
Extraordinary Risk, 503
F
Facebook, 332
Fact chart analysis, 266
Failure to confirm, 510-511, 513-514, 515
Faith, Curtis, 251
Falling Wedge, 132, 139, 142-143, 410, 604
False Breakout, 604, 612
False moves, 48, 66, 81, 89, 108, 179, 487
False Signal, 66, 88, 129, 149, 266, 479, 604
Fan lines, 217, 218, 220, 22, 309, 604
Fan principle, 226-227
Fansteel Metallurgical, 434, 448, 585
Filling the gap, see Closing the gap
Final up-thrust, 519
Finance theory and practice developments in, 271 futures on indexes, 273-
274
MPT, 275
options, 271-272 options on futures and indexes, 274 options pricing
models and importance, 273
Finance theory and practice (Continued) quantitative analysis, 272-273
wonders and joys of investment technology, 275
Fin de siecle, 139
First correction, 514-515 First severe test, 508-510
Five-Point Reversal, see Broadening Pattern Flag-type Consolidation, 411
Flag, 151-159, 258, 410-411, 604 Flag Consolidation, 15 , 179, 392, 465
Flag of mid-April, 175 Flat-Topped Broadening Formation, 136-137, 163
Flat-Topped Broadening Pattern, 151 Flat-Topped Price Formation, 177
Floating Supply, 73, 107, 117, 145, 315, 341, 604 Flying Tiger Corp, 471,
586
Force Index, 538 Forecasting methods, 11, 176, 421, 604 Formation, see
Area Pattern
Formula measurement, 154-156, 160, 164, 596, 608 Fractal nature of
market, 31
Dow-Jones Industrials (1924-1934), 39 interesting charts ever made of
Dow-Jones Industrials, 40
trades made by Magee Basing Points Procedure, 33-37
2008 top in industrials, 38
Front-Month, 605
Fundamental analysis, 3, 6, 91, 266, 328, 605
essence of, 528-531 Funds tracking indexes, 603 Fungibility, 276-277
Futures “margins,” 277 Futures contract, 274, 276-27 , 282, 283, 349, 494
Futures options, 283, 28 , 313
to participate in market movements, 284 price of, 283
Future transactions, differences between cash and, 277
G
Gains and losses, percentage, 496 Galbraith, John Kenneth, 326 Gamblers
Anonymous, 302 Gaps, 171, 411-413, 423, 605
April-June Rectangle on 1945 chart of “AW,” 172 in averages, 187 closing
gap, 171-173 daily chart of Blaw-Knox, 176 ex-dividend gaps, 174-186
Island “shakeouts, 181 Island in “PA,” 183 Island Reversal, 186-187
monthly chart of Zenith Radio, 175
Panic Declines produce large Runaway Gaps, 178 small Island in right
shoulder of Head-and-
Shoulders Top, 180
SMC, 180
TLT, 183
Gates, Bill, 244
General Motors, 41, 99, 229, 230, 586, 598 straight-line Bull Market Trend,
230
General Semantics of Wall Street, The, 269
General Steel Industries, Inc. (GSI), 459, 586 Gilt-edged securities, 598
Gimlet-eyed investor, 270
Google, 321, 331, 339, 340, 343, 389, 586
Granite City Steel, 430-431, 586
Graph, see Chart
“Graphic Stocks,” 437
Great Crash, The (1929), 326
Greenspan, Alan, 248, 281
H
“Hair splitting” theory, 521
“Half-Mast” patterns, 154, 161, 604, 608
Handbook of Portfolio Mathematics (Vince), 618 Head-and-Shoulders
Bottom, 55, 57-59, 61-63, 161, 336, 395, 401-403, 58 , 605, 60 , 608
Head-and-Shoulders Consolidation, 160-162, 164, 605 Head-and-Shoulders
Formation, 48, 88, 373
Head-and-Shoulders formula, 100, 162 Head-and-Shoulders Pattern, 4 , 13 ,
241, 392, 414,
454, 605-606, 608, 610, 615
Head-and-Shoulders Reversal Pattern, 211 Head-and-shoulders to Dow
Theory, 55 Head-and-Shoulders Top, 44, 45, 46, 48, 54, 57-59, 63, 75, 7 ,
103, 108, 118, 160, 161, 180, 198, 202, 241, 24 , 294, 35 , 394, 400-401,
449, 454, 455, 466, 602, 605, 606, 608, 617
Daily chart of Chicago, 46 hypothetical daily stock chart, 45 starting in
March, “HUM,” 46 variations in, 49-52
Heavy Volume, 355, 356, 363, 398, 402, 435, 605, 606 Hedging, 137, 240,
246, 276, 279, 28 , 312, 606 Hedging strategies using CBOT® DJIASM
futures contract, 276
High-risk stocks
hope springs eternal, 332-340
managing tulipomanias and internet frenzies and Bitcoin, 326-328
multitudinous lessons in Microsoft, 326 techniques for management of
runaway issues, 328-332
High-volatility markets, option spreads in, 286-287 Higher priced stocks,
353
Historical Data, 606
Hook Day, 606
Horizontal Channel, 213, 606
Horizontal Congestion Pattern, 178, 189
Horizontal Line Formations, 103, 207
Horizontal Movements, 423
Horizontal pattern boundary, 177
Horizontal Trendline, 256, 333, 606
Hull, Blair, 26 , 531, 611
Hybrid Head-And-Shoulders, 606
I
Ichimoku Cloud, 537
I C Industries (ICX), 49
“Ideal” trend, 197
“Implied volatility,” 284
In-the-money, 283
Indexes, , 19, 243, 261, 271, 310, 312, 314, 341, 343 funds tracking, 603
futures on, 273-274
options on futures and, 274
Index funds, 299, 390
Index futures for asset allocation, 280-282
“Indexing,” 310-311
Index Shares, 302, 310-312, 313, 390, 447
Individual stocks, 26, 41, 55, 112, 145, 146, 206, 243, 342, 44 , 454, 484,
493, 495
Industrial Average, 11, 12, 13, 16, 18, 20, 23, 393, 444, 446, 454, 514, 515,
518, 600, 603
Industrial Rayon Corporation, 446, 587
Inflationary and deflationary movements, 481, 587
Information revolution, 265-266, 268, 270-271
Initial public offering share (IPO share), 327-328, 607
Inside Day, 606
Insiders, 41-42, 168, 322, 32 , 606
Inspiration Copper, 429
Intel, 319, 474, 475, 587
Intermediate Bottom, 64, 8 , 193, 202, 294, 384, 386, 414
Intermediate downtrends, 225-226
Intermediate Reversals, 59, 200, 206
Intermediate Support, 197, 198, 226, 384, 385
Intermediate Support Range, 198
Intermediate Swing, 13, 50 , 508
Intermediate Tops, 200, 211, 294, 361, 386, 414, 513
Intermediate Trend, 14, 41, 216, 224, 296, 380, 515, 519, 590, 606, 614
investor, 23-26
Intermediate Trendlines, 208, 226, 229
Intermediate Uptrend, 194, 212, 213, 219, 222, 225
Intermediate Up Trendline (IUT), 52, 176, 211, 212, 21 , 220-221, 224
Internet-age markets, 351
Internet, 265, 268-269, 532
Internet Age, 269, 351, 393, 494
Internet frenzies and Bitcoin, 326-328
Internet technical analysis sites, 305, 531-533
Intraday gaps, 173
Inverted Bowl, see Rounding Top
Inverted Triangles, 100, 121, 135-136
Investment advancements in investment technology, 271 bond and index
futures for asset allocation, 280-282
developments in finance theory and practice, 271-275
finance theory and practice, 271-275 futures and options on Dow-Jones
Industrial Index, 275-287
increasing exposure with futures, 280 investment-oriented sites, 524-527
investment/information revolution tools, 265 portfolio protection, 279-280
strategies using CBOT® DJIASM futures contract, 276
uses of Dow index futures, 279
Investor, 297-298, 332, 351 cyber, 270 experienced, 268 gimlet-eyed, 270
long-term, 310-311 modern, 244 private, 312 sophisticated, 302 iPod, 479
Island Congestion, 186 Island Pattern, 147, 186, 187
Island Reversal, 182, 186-187, 60 , 611
J
Johns-Manville's Primary Trend Reversal, 79 Jorion, Philippe, 500, 502,
524
July-August Flag, 158-159
K
Kaufman's Adaptive Moving Average (KAMA), 537 Kelly Criterion, 534,
535
Keltner Channels, 537
Key Reversal Days, 147-149
Kilroy bottom, 57-59, 63, 309, 336, 401, 58 , 607 Kovner, Bruce, 35 , 365
Kresge (S.S.) Co., 196, 43 , 588, 591
L
Laddering, 607
Lane, George, 615 Lane theorizes, 615 Leisurely pattern, 65-66 Leverage,
258, 315, 607 Leverage factor, 534-535
Leverage Space Model, 351, 504, 618
Leverage Space Portfolios (LSP), 533-536, 607 Libby, McNeill And Libby,
436
Limit Move, 258, 607
Limit Order, 391, 60 , 611 Limit Up, Limit Down, 607
Linear Moving Averages, 422 Line Chart, see Bar Chart Line in Dow
Theory, 17-18, 607
Liquidating, 378-379
Livingston Oil Company (LVO), 464, 588 Logarithmic scale, 211-216, 229,
607
Long-term charts, 9
Long-term investment problem, 293
Long-term investor, 293, 29 , 299, 313, 314, 389 strategy and tactics for,
297-298
Long-term investor (Continued)
strategy of, 299-300
viewpoint, 310-311
“Long side” of market, 41
Lorillard, 44 , 588
Low-volatility markets, option spreads in, 286-287 Lower-priced stocks,
353
“Lunatic fringe,” 3
M
MacKay, Charles, 325
“M” Formation, 119, 602
Magee-type technical analysts, 266
Magee analyst, 267, 268, 270
Magee chart analysis, 266, 270, 595
Magee Evaluative Index (MEI), 19, 300, 485-486, 491,
495, 503-504
Magee methodology, 260
Magee's admonitions, 316
Magee's Composite Leverage, 499
Magee's concept of “sensitivity,” 342
Magee's method, 252-259, 343, 497
Magee's Sensitivity Index, 342, 354, 497
Magee's simple-as-pie method, 32
Major Bear Market signal, 393
Major Bear Moves, 159
Major Bear Trend, 15 , 226
Major Bull Market, 225
Major Bull trendlines, 241
Major charts, 9
Major Double Tops, 114
Major Downtrend, 242, 428-429, 439, 511-512, 519, 576,
579, 592
Major Market Turn, 60
Major Reversal, 106, 114, 123, 132-133, 139, 158, 180,
491, 510, 513-514, 604-605
Major Reversal Formation, 66, 114, 123, 186
Major Reversal Patterns, 44, 605
Major Signals, 394
Major Trend, 17-18, 22, 9 , 198-199, 212, 225, 229, 242,
296, 314, 356, 380-381, 384, 386, 393, 398,
430, 446, 449, 456, 482, 491, 493, 510, 512, 515, 60 , 612
general outline of policy for trading in, 380-381 of market, 410-411
Major Trend Channels, 242-243
Major trendlines, 227
accelerating uptrend of common stock, 231
Bull Market tops, 240 conservative investment-type utility stock, 232
decurving Major Bull Trend of high-grade preferred stock, 231
high-grade food issues, 236
low-priced building stock, 235
Major Bull Trend, 234
Major Downtrends, 242
Major Trend Channels, 242-243
primary Bear Market, 238
S&P long-term perspective, 239
S&P Reagan Crash, 239 speculative oil stock, 233 steel stocks, 234 straight-
line uptrends in investment oil, 233 tobacco stocks, 236 trading Averages in
21st century, 244 trendlines in averages, 243 up-curving trend of
speculative motors stock, 230 Major Turn, 121, 167, 226, 242, 290, 483,
487 signs, 511-513
Margin, 88, 108, 145, 147, 221, 223, 274, 276, 342, 345,
367, 445, 492, 495, 535, 607-608 decisive, 48, 57-58, 118, 128 transaction,
346, 349 use, 345-346
Market, 3, 6, 11, 19, 2, 31, 42, 7, 82, 104-105, 121, 139,
143, 147, 192, 20 , 256, 259, 264, 270, 274, 280, 285, 289, 29, 299, 312,
315, 32, 383, 42, 48, 493, 505, 507
Dow-Jones Industrials (1924-1934), 39 exploiting market reversals, 285
fractal nature, 31 indicator, 609
interesting charts ever made of Dow-Jones
Industrials, 40 marking-to-market, 269-270 marking-to-market trading, 276
technical trading effect on market action, 419-420
trades made by Magee Basing Points Procedure,
33-37
2008 top in industrials, 38
Market on Close, 608
Market Order, 29 , 328, 608, 611, 616
Market Reciprocal, 49 , 608, 612
Market Technicians Association, 499
Market Technicians Association of New York
(MTANY), 6
Masonite, 431, 575, 588
Mass Index, 538
Mast, 152, 217, 392, 411, 604, 608
move, 410
Maximum drawdown, 2 , 32, 502, 52 , 603
Maximum retracement, 502
McClellan Oscillator, 608
McDermott, The Redoubtable Richard, 325, 528 Measuring Formulae, 608
Measuring Gap, see Runaway Gap
Measuring or Half-Mast Patterns, see Flag
Measuring rule, 55, 65, 100, 154-155, 182-184, 392 Mechanical Dow
Theory, 299
Mechanical systems, 250, 252, 260, 296, 423 Megaphones, 608, 613
Melon, 194, 609
Memorex Corp. (MRX), 470
Metastock 9.0, 531-532
Mike Moody, 545, 556-561
Mining engineers, 326
Minor Bottom, 88, 91-92, 122-123, 193, 198, 208, 210, 222, 354, 362-363,
373, 378-379, 386, 403, 413, 414, 41 , 517, 608-609, 616-617
Minor Bottoms, 123, 208, 222, 361, 363, 373, 386, 413-414, 617
Basing Points, 362-365
Basing Points paradigm, 365-366 complete Basing Points Procedure, 368-
370 narrative of events in chart, 367-368, 371-372 representative case fully
analyzed using wave lows and new highs, 370-371
Variant 2 procedure, 370
Minor Correction, 209, 363, 386
Minor Fluctuations, 13, 74, 7 , 99, 129-130, 138, 151, 186, 190
process, 153
Minor phenomena, 202
Minor Reaction, 95-96, 115, 172, 181, 186, 362, 39 , 40 , 440, 605
Minor Reversal, 122-123, 155-156
Minor Reversal Areas, 157
Minor Setback, 17, 216, 432, 517
Minor Swings, 186
Minor Top, 79-80, 122, 198, 206, 354-355, 361, 363, 373-374, 378, 385,
414, 439, 444, 513, 616
Basing Points, 362-365
Basing Points paradigm, 365-366 complete Basing Points Procedure, 368-
370 narrative of events in chart, 367-368, 371-372 representative case fully
analyzed using wave lows and new highs, 370-371
Variant 2 procedure, 370
Minor Trend, 13-14, 82, 144, 229, 290, 386, 410, 50 , 609 Minor Wave
Pattern, 197
Minor Waves, 13, 223, 509
Misconceptions, 198-200 Model-driven market, 266, 272 “Models,” 266-26
, 273
Modern-style markets, 168-169
Modern era development, 271
Modern Portfolio Theory (MPT), 275, 499 Momentum, 43, 49, 184, 326,
539, 611, 614 Momentum Indicator, 538, 542, 609
Money, 41, 249, 253, 265-266, 270, 272, 283, 299, 332, 348, 489-490, 608
management procedures, 503-504 management rules, 258
Money Flow Index (MFI), 538
sophisticated risk and, 504
Monthly chart gaps, 171
Moving Average, 421, 424, 53 , 539, 609, 610
150-Day Moving Average, 424
200-Day Moving Average Line, 31, 267, 299, 300,
31 , 422, 423, 484, 618
50-Day Moving Average Line, 316, 422, 484, 604 crossovers and
penetrations, 422-424
PENTAD Moving Average system from formula research, 424-425
Sensitizing Moving Averages, 422
Moving Average Convergence/Divergence (MACD),
538, 542-544, 609, 610 Histogram, 538
Moving Average Crossovers, 609 Moving Average Envelopes, 537
Moving Average Line, 422-423, 541, 598, 604,
609, 618 Multicolincarity, 598, 610 Multiple Bottoms, 414, 434 Multiple
Formations, 66, 68
Multiple Head-And-Shoulders Pattern, see Complex Head-and-Shoulders
Pattern
Multiple Tops, 364, 403, 409, 414 Mutual funds, 43, 268, 390, 495
N
Narrow Range Day, 610
NASA, 249
National Association of Securities Dealers
Automated Quotations (NASDAQ), 19, 316 NASDAQ 100, 312, 480
Natural Hedge, 485, 610
Natural mechanical systems, 260
Natural method, 359, 610 NDX, 480, 577
Near progressive stops, 139
Neckline (NL), 47-49, 57, 59, 610
on multiple head-and-shoulders formations, 61 Ned Davis Research, Inc.
(NDR), 424 Negative divergence, 610 Negative Volume Index (NVI), 538
Nelson Freeburg of Formula Research, 424 New commitments, 418
New Concepts in Technical Trading (Wilder), 618 “New Haven Investor,”
298
New York Stock Exchange (NYSE), 4, 269, 300, 311,
313, 316, 341, 349, 615, 616
NOKIA (NOK), 475
Normal Range for Price, 344, 346, 354, 49 , 610 Normal Uptrend Channel,
141-142 Northrop Aircraft, 438-439
Number-driven systems, 259-260 Number-driven technical analysis, 4, 26 ,
610
Number-driven technical analysts, 266
O
Odd lots, 351, 610 Old-style markets, 168-169
Old-time “plunger,” 168
On Balance Volume (OBV), 538, 610-611 One-Day Island Reversal, 607
One-Day Reversal, 42, 144-145, 410, 600, 615 One-Week Reversal, 147,
450, 589 Operational Risk, 501-504 Opportunity vs. Security, 308 Optimal
formula, 534, 535 Optimization, 275
Options, 271-272, 611
on Dow index futures, 282-283 exercising, 284
on futures and indexes, 274 pricing models and importance, 273 spreads in
high-or low-volatility markets, 286-287 as strategic investment, 273 traders,
272
trading, 272
Options Research, Inc, 611 Oracle Corporation, 332, 468, 573, 576, 579
Order, see Limit Order; Market Order; Stop Order Orthodox Broadening
Top, 123, 130-135 “Orthodox” investors, 419
Oscillator, 4, , 304, 419, 600, 611 Aroon, see Aroon Oscillator
Chaikin, see Chaikin Oscillator
Out-and-out boardroom gamblers, 168 Out-of-the-money, 283 strike price,
285
Overbought, 611 Oversold market, 486, 611 “Oversold-overbought”
indicator, 485, 611 Overtrading, 351, 493, 496-498
P
Pacific Coast Options Exchange, 531 Packard-Bell Electronics Corp (PKB),
465
Palm Computing, 327 Panic, 611
decline, 145, 157, 159, 171, 178, 192, 201 phase, 15, 147, 380
Panic Bottom, see Selling Climax Parabolic SAR, 359, 537
Paradigm-setting model, 271 Paradox, 496-498
Parallel Trend Channel, see Descending Trend Channel
Parke, Davis and Company (PDC), 466 Passive Indexer, 611
Patience, 265 Pattern
analysis, 357 boundary, 203 gaps, 176, 184 resistance, 202-205
Peak, see Top
Penetration(s), 422-424, 611 validity, 220-222
Pennant(s), 151-154, 410-411, 611 consolidations, 157 and flags, 608
reliability, 156-157
Pennant Consolidation, 392 PENTAD Moving Average system from
formula research, 424-425
%B Indicator, 538
Percentage Price Oscillator (PPO), 538
Percentage Volume Oscillator (PVO), 538 Performance measurement, 275
Personal body digital assistants (PBDAs), 268 Philosopher's Stone, 249,
265, 275, 539
Pivot Points, 53 , 543
Plain scale, 8
Planned distribution, 98
Point and figure (P&F), 392, 532, 545
analysis, 543
charting, 26 , 532, 545, 612
technical analysis by Mike Moody, 556-561 Polaroid Corporation, 451
Polymath, 31
Pool operations, 105-112
Portfolio ordinary or operational risk, 502-503 Portfolio protection, 279-
280
Portfolio Risk Analysis screen, 529, 530
Portfolio Risk Factor (PRF), 502
Portfolio risk management
controlling risk, 503
measuring maximum drawdown, 502 overtrading, 496-498
risk and money management procedures, 503-504
risk and trend, 499
risk of portfolio, 499
risk of single stock, 498-499
sophisticated risk and money management procedures, 504
VAR, 499-500
Portfolio Risk Strategy, 496, 497
Portfolio valuation, 275
Portfolio yields improvement, 286
Pragmatic analysts, 275
Pragmatic portfolio analysis, 502
portfolio extraordinary or catastrophic risk, 503 portfolio ordinary or
operational risk, 502-503 portfolio risk over time, 503
Pragmatic portfolio risk measurement, 500
determining risk for portfolio, 501-502
risk of one stock, 500-501
Pragmatic portfolio theory, 500 Premature breakouts, 108, 612 Preparatory
buying signals, 375-376 Preparatory selling signals, 379 Price Congestion
Formation, 177 “Price-earnings ratio” index, 469, 612 Price
Relative/Relative Strength, 538 Price(s), 196
channels, 537
fluctuation, 261
of futures option, 283
line, 423
pattern, 52, 5 , 70, 12 , 135, 138, 614
Primary Bear Market, 238, 242, 243, 507-508 Primary Bull Market, 21, 22,
41, 86, 122, 242
Primary Direction, 13, 355, 363, 380, 381, 383, 385, 386, 391
Primary Downswing, 202, 242
Primary Downtrends, 15
Primary Market Trend, 26
Primary Reversal phenomenon, 118
Primary trends, 12-14, 16
Pring's Know Sure Thing (KST), 538-539
Pring's Special K, 539
Probable moves of stocks, 341-344
Profit-taking patterns, 168
Profit analysis, 530
Profits in rising markets, 284-285
Program Trading, 311, 612
Progressive stop, 328, 355-357, 359, 370, 379, 612
Protective stop(s), 295, 353, 355, 356, 358, 361, 612, 616
Proxy markets, 278
Psychological grounds, 117
Psychological handicap, 293
Public Service Electric and Gas (PEG), 469
Pullback(s), 110, 202, 205, 224, 612, 617
Pullback Rallies, 58
“Pure investor,” 294-295
Put option, 272, 284, 285, 312, 611, 612
Q
QID, 350
QQQ, 244, 271, 312, 313, 490
Quantitative analysis, 272-273
Quantitative analysts, 266
R
Rail Average, 513, 603
Rails falter, 516-517
Rally, 612
Rally Tops, 612
Range, 612
Rate of Change (ROC), 539
Reaction, 612
Reciprocal, Market, see Market Reciprocal
Recovery, see Rally
Recovery Trends, 202
Rectangle(s), 18, 151, 159, 173, 189, 373, 408-409, 606, 608, 613
to Dow Line, 112-113
patterns, 378
from Right-Angle Triangles, 113
in Socony-Vacuum, 106
tops, 103-105
Rectangular Consolidations, 159
Red Parallel, 373, 378, 379, 613
Red Trend, 373, 375, 376, 379, 380
Red Trendline, 373, 376, 37 , 613
Relative Strength, 619
Relative Strength Index (RSI), 539, 598, 613, 618-619
Relative Strength Indicator, see Relative Strength Index (RSI)
Reliability of flags and pennants, 156-157
Repeated saucers, 162-167
Resistance, 189, 603, 616
Level, 155, 184, 189, 194, 198, 202, 206, 226, 246, 613
Lines, 99, 196
Range, 189, 193, 196, 197
Zones, 192, 194, 19 , 200, 206
Resources, 523
essence of fundamental analysis, 528-531 important and indispensable sites,
523 investment-oriented sites, 524-527 leverage space portfolio model,
533-536 references for further study, 524 Sharpe Ratio, 527
software packages and internet technical analysis sites, 531-533
volatility calculation, 527-528 Retracement, 118, 172, 603, 613 Return
Line, 223, 225, 596, 601 Reversal
Broadening Bottoms, 135
Broadening Formations, 121-122
The Diamond, 137-139 Falling Wedge, 142-143
Key Reversal Days, 148-149 One-Day Reversal, 144-145 Orthodox
Broadening Top, 130-135 Right-Angled Broadening Formations, 135-137
Rising Wedges common in Bear Market
Rallies, 144
Runaway Days, 148 Selling Climax, 145-147 short-term phenomena of
potential importance, 147-148
Spikes, 147-148
typical example, 128-130
volume during broadening formations, 122-128 wedge formations, 139-142
wedges on weekly and monthly charts, 143-144 Reversal Area, 42, 55, 158
Reversal Days, see Key Reversal Days Reversal Formation, 42, 50, 155,
168, 198
Reversal Gap, 613
Reversal Levels, 190
Reversal Pattern(s), 41, 42, 7 , 132-133, 493, 602, 613 ADM turned sharply
lower, 64 breaking neckline, 47-49 Descending Triangles, 98-99
distinguishing characteristics, 115-118 Dormant Bottom variation, 73-74
Double and Triple Tops and Bottoms, 113-115 Double Bottoms, 118 Dow
Theory, 41
fine Symmetrical Triangle Reversal Formation, 78 Head-and-Shoulders
Bottoms, 57-59 Head-and-Shoulders to Dow Theory, 55 Head-and-
Shoulders Top, 44, 45, 46, 63 “ideal” multiple top made by Budd in (1946),
62 intermediate bottom of complex class, 64 Johns-Manville's Primary
Trend Reversal (1942), 79
leisurely pattern, 65-66
long multiple head-and-shoulders top, 63
Reversal Pattern(s) (Continued)
MCA enjoyed 62excellent advance from (1980-1986), 62
measuring implications of Triangles, 100 multiple head-and-shoulders
patterns, 59-61 planned distribution, 98 pool operations, 105-112 price
action confirmation, 52-55 prices break out of Symmetrical Triangle,
88-90
Rectangles, double and triple tops, 103-105 Rectangles from Right-Angle
Triangles, 113 relation of Rectangle to Dow Line, 112-113 reversal or
consolidation, 94-97 Right-Angle Triangles, 97-98 Rounding Tops and
Bottoms, 66-70 Rounding Turns affect trading activity, 70-73 Sears
Roebuck made Symmetrical Triangle Reversal, 78
slide in Amdahl occupied Bears, 65 Symmetrical Triangles, 79-88 tendency
to symmetry, 61 time to reverse trend, 42-44 Triangles on weekly and
monthly charts, 100 Triangular formations, 100-101 Triple Tops and
Bottoms, 118-120 typical Triangle development, 90-94 variations in head-
and-shoulders tops, 49-52 volume, 44-45, 4 , 74-75, 99-100
Rhythmic investing, 300-302
Rhythmic Trading, 485
Richard Arms work, 545
Arms CandleVolume charting, 551-553
Arms Index, 545-548 calculation, 548
Equivolume charting, 550-551 using index, 548-549 reasoning, 548
Right-Angled Broadening Formations, 135-137, 409
Right-Angled Broadening Triangle, 606, 613
Right-Angle Triangle(s), 97-98, 103, 139, 173, 408, 596, 601
chart, 99
rectangles from, 113
Ripple, 14
Rising Channel, 413
Rising Wedge(s), 139, 141, 143, 614
common in Bear Market Rallies, 144
Risk
analysis, 529 management, 495-504 measurement, 502-503 and money
management procedures, 503-504 sophisticated, 504
“Risk-free” interest rate, 273
Rocket scientists, 249-250
Round-trip costs, 389
Rounding Bottom(s), 66-70, 403-406, 599, 614
Rounding Top(s), 66-70, 403-406, 606, 614, 617
Rounding Turn(s), 66, 68
affecting trading activity, 70-73 picture, 70
Round lots, 351, 614
RRG Relative Strength, 539
Runaway Days, 147, 148
Runaway Gap, 17 , 182-186, 202, 258, 601, 608, 614
Runaway issues, 327 techniques for management of, 328-332
Runaway or Continuation Gap, 392 Running Market, 614
S
Saucer-Like Reaction Pattern, 99 Saucer Pattern, see Rounding Bottoms
Scales, types of, 8-9
Scallops, 162-167, 614
Schadenfreude, 326 Schannep, Jack, 21, 26 Scholes, Myron, 271 Schwager,
Jack
Secondary Reaction, 13, 18, 35 , 493, 515, 516, 517, 519 Secondary
Recovery swing, 508
Secondary Trend, see Intermediate Trend Secondary trends, 12, 13, 17
Secular Trend, 614 “Self-correction,” 197
Selling Climax (SC), 138, 145-147, 190, 201, 600, 611, 615
Selling Climax Day, 615
Selling stock short, 379 Semilogarithmic paper, 8
Semilogarithmic Scale, 8, 144, 220, 242, 60 , 615 Sensitivity, 341, 342,
346, 354, 422, 495, 600, 615 Sensitivity Index, 322, 342, 345, 346, 353,
492, 497 Sensitizing Moving Averages, 422
Settlement
of futures contracts, 276
price, 276, 600
“Settlement date,” 276
Shakeout, 89, 145, 181, 221, 264, 505, 615
Sharpe Ratio, 499, 527
Short-term phenomena of potential importance,
147-148
Short-term profits, 297
Short-term trader, 190, 29 , 389, 419 Shorting stocks, 284
Short Interest, , 348, 615
Short sale(s), 379-380, 400, 409, 615
Short selling, 145, 346-350, 485 “Short side” of market, 41
Shoulder, see Head-and-Shoulders Pattern “Sideways” chart pattern, 151
Sideways Movements, 423
Simple Moving Averages (SMAs), 422, 537, 549 Single stock risk, 498-499
Sites, important and indispensable, 523 “Skullduggery,” 168, 169
Skyrocket, 184, 185, 196, 321, 401, 493 effect, 71
run-up of Willys-Overland, 179
Slauson, John, 387
Slope, 539
“Smart money,” 265
Smoothing, 615
Software packages, 305, 531-533 “Special Opening Quotation,” 276
Speculative aims, 245
Speculative blow-offs, 326
Speculative stock, 345, 492
Speculator(s), 3, 145, 149, 274, 286, 293, 297-298, 300 agile, 148
commodity, 246
psychology, 245
Spiegel's Bear Market, 262 Spike(s), 147-148, 615 Spring of 1946, 517-518
SPY, see Standard & Poor's Depositary Receipts (SPDRs) Standard & Poor
(S&P), 274, 310-311, 482
Standard & Poor's Depositary Receipts (SPDRs), 271, 274, 299, 317, 323,
351, 390
Standard Deviation, 539
Statistical approach, 3
Statistical driven technical analysts, 266
Statistics fundamentalists, 4 “Stepping off” point, 417
Stick to guns, 505-506 Stochastic(s), 542, 615-616
Stochastic Indicator, 615
Stochastic Oscillator, 539, 615
StochRSI, 539
Stock(s), 12, 30 , 353, 356, 414, 41 , 482 alphabetic index of stock charts,
579-593 averages, 483 chart, 7
construction of index shares and similar instruments, 311-312
at different times, 427-479 index futures to control exposure, 277-278
instruments, 313s
kinds of stocks long-term investors want, 311 long-term investor's
viewpoint, 310-311 Major Downtrends, 428-429, 439
NDX, 480 opportunity vs. security, 308 options, 494 prices, 42, 266, 505
probable moves, 341-344
S&P, 308
S&P 500 in glory and tragedy, 309 selection of stocks to chart, 315-323
SPY. for illustration, 309 trends, 218
StockCharts Technical Rank (SCTR), 539
Stock Exchange vigilance, 168
Stock market(s), 3, 189, 266 fundamentalist, 3 to newcomer, 427 Support-
Resistance Level, 430
Stock Split, 616
Stop, 616
Stop Loss, see Protective Stop
Stop orders, 353, 611
ATR, 358-359 natural method using by Turtles, 359 progressive stop, 355-
357
SAR, 359
stop distances, 354 stop systems and methods, 357-358 survey of stop
methods, 358 target stops, 359
Street, 3
Street firms, 325 “Strike” price, 282
Superior Oil Co (SOC), 458 Supply, 616
Supply and demand, 77 balance, 245 equation, 42 relation, 175
Supply Line, see Resistance
Support, 189, 603 significance of support failure, 197-198
Support and Resistance, 383-38 , 410, 414 in averages, 206 estimating
support-resistance potential, 194-196 explanation, 191-193 levels, 198, 200,
264 locating precise levels, 196-197 normal trend development, 190 pattern
resistance, 202-205 popular misconceptions, 198-200 predictions, 189-190
principle, 189 repeating historical levels, 200-202 round figures, 200
significance of support failure, 197-198 theory, 202 volume on breaks
through support, 205-206
Support Level, 151, 189, 192, 198, 206, 210, 364, 383, 386, 391, 414, 41 ,
616
Support Line, 598
Support Range, 189, 192 Support-Resistance Level, 266, 430 Support-
Resistance Theory, 224 “Swing” power, 30 , 345
Symmetrical Triangle, 80, 600 Symmetrical Triangles, 79-88, 103, 121,
151, 168,
203-205, 406-408, 609, 616 pattern, 603 prices break out, 88-90
T
Tactical methods making new commitments, 418
Tactical methods (Continued)
present commitments, 417-418 quick summation, 417
Tactical problem
Hudson Motors, 295
long-term investor, 299 rhythmic investing, 300-302
strategy and tactics for long-term investor, 297-298
strategy of long-term investor, 299-300 “Tangents,” 208
Tape Reader, 9, 166, 616 “Tape watchers,” 163, 166 Target stops, 359
Tax, 313
consequences, 277
selling, 517
Technical analysis, 4-6, 419, 478, 537
Bollinger Bands, 561-563
number driven tools, 537-545
Point & Figure technical analysis by Mike Moody, 556-561
Richard Arms work, 545-553 and technology, 265-266
Technical chart patterns, measuring implications in, 391-392
Technical data, 6, 22 , 528
Technical indicators, 538-539
Technical Magee analyst and investors, 268
chaff, 270
information revolution, 270-271 internet, 268-269
marking-to-market, 269-270 separating wheat from chaff, 270
Technical overlays, 537-538 Technical regularity, 313
Technical trading effect on market action, 419-420 “Teenie,” 272
TEKNIPLAT
chart paper, 305, 443, 616 semilogarithmic chart sheet, 219-220
Tenets, 12-14, 20 , 50 , 517 Test(s), 617
of authority, 216-220
Text diagrams, 565-578 Textron, 435, 575, 592 “Theoretical value” of
future, 277 Thin Issue, 174, 356, 617 3COM, 319, 32 , 331, 579
“Three-days-away” rule, 300, 328, 361, 369, 414, 617 Throwback(s), 99,
110, 181, 202, 203, 221, 224-225, 612, 617
Tide, 14 Time
requiring to reverse trend, 42-44
scale, 8, 31
TLT chart, 258
Top, 611, 617
Broadening, see Broadening Top
Double, see Double Top
Head-and-Shoulders, see Head-and-Shoulders Top Rounding, see Rounding
Top
Triple, see Triple Top
Top of Ascending Triangle, 177 Top Price Chart Formation, 598 Top
Trendlines, 414, 598, 613 Total Capital (TC), 30 , 492, 498, 502, 503, 504
Total Composite Leverage, 297 Trader(s), 251, 284, 293, 296, 300, 315, 505
Traders, 358 Trades, 33-3 , 409 Tradestation 2000i, 532 Tradestation 8, 532
Trading, 4
activity, 17, 44-45, 80, 91, 122, 163, 185, 221, 316, 441, 511, 614
area, 103, 121, 151, 175, 423, 613 averages in 21st century, 244 costs, 390
opportunities, 42, 163, 266, 475 range, 73, 79, 149, 186, 286, 599, 60 , 609,
616 Transportation Average, 596, 600, 603 Treasury bonds, 253, 281
Trend(s), 12, 13, 14, 223, 229, 617
consolidation, 151
ranges, 222-223
and trendline studies, 264
Trend Channels, 214, 215, 223, 242-243, 356, 392, 617
in Bethlehem Steel, 213
Parallel Trend Channel, 373-375, 378
Rising Trend Channel, 225
Trending Market, 252, 253, 286, 423, 595, 617 Trendline(s), 207-209, 209-
211, 414, 429, 59 , 616, 617 in action, 375 additional suggestions, 380
amendment of trendlines, 222 analysis, 357 arithmetic vs. logarithmic scale,
211-216 buying stock, 375-377 consequences of Trendline penetration, 224-
225 corrective trends, 226-227 covering short sales, 379-380 double
trendlines and trend ranges, 222-223 experimental lines, 224 intermediate
downtrends, 225-226 liquidating, or selling long position, 378-379 policy
for trading in Major Trend, 380-381 selling stock short, 379 tests of
authority, 216-220 validity of penetration, 220-222 Triangular Price
Formations, 103 Triangular/Triangle(s), 79-80, 423, 608, 617 development,
90-94, 98 formations, 100-101 measuring implications, 100 patterns, 378 on
weekly and monthly charts, 100 Triple Bottom(s), 113-115, 118-120, 617
Triple Top, 103-105, 113-115, 118-120, 504, 568, 617-618 TRIX, 539
True Range, 358, 595
True Strength Index, 539
Tulipomania, 61, 308, 325, 331, 332, 339, 57 , 593, 607 managing, 326-328
PALM, 329
Tulips, 241, 325, 329, 331, 339
“Turbulent period,” 485, 486
Twain, Mark, 26-2 , 304, 365, 532
Turtle(s), 250-252, 259
natural method using by, 359
system, 258-260
U
Ulcer Index, 539
Ultimate Oscillator, 539
United Artist Corporation (UNA), 460
Unnatural method, 610
Up-slanting
bottom boundary, 92-93
line, 79-80, 91
Up Channel, 596
Uptick, 349, 350, 618
Up trendline, 208, 209, 210, 211, 216-217, 221, 596, 617 Uptrends, 14, 104,
153, 158, 208, 212, 219, 225, 233, 422-423, 429, 432
U.S. Securities and Exchange Commission (SEC), 105, 145, 168, 390
U.S. Smelting, Refining and Mining Co, 453, 463
a, 428
Head-and-Shoulders Top in (1952)
U.S. Steel, 4, 5, 79, 105, 12, 131, 147, 200, 201, 569
Utah-Idaho Sugar Co. (UIS), 461, 576, 593
Utility Average, see Dow-Jones Utility Average
V
Validity of Trendline Penetration, 618
Valley, 116, 118, 119, 176, 618
Value-at-risk procedure (VAR procedure), 499-500
Variance, 212, 311, 344, 501, 527, 536
Variant 2 procedure, 368, 370
Variations in head-and-shoulders tops, 49-52
V/D volume, 618
“Vertical” Panic Declines, 157
“Vested interest,” 186, 199, 200, 201, 202
Vigor, 95, 144, 197, 516
Vince, Ralph, 504, 533, 60 , 618
Volatility, 283-284, 343, 354, 498, 500, 501, 528, 539, 618 calculation, 527-
528
Volume-Weighted Average Price (VWAP), 538
Volume, 44-45, 4 , 108, 193, 194, 264, 595, 616, 618 on breaks through
support, 205-206 during broadening formations, 122-128 characteristics
same as symmetrical type, 99-100 confirmation, 398, 401, 40 , 408, 432,
449 pattern, 46, 4 , 5 , 59, 63, 64, 6 , 74-75, 13 , 161, 196, 20 , 216, 605,
614 by Price, 537-538, 543 of trading, 67, 193, 197, 221, 618
Vortex Indicator, 539
“Voyeur” feature, 532
W
Wall Street investment banks, 325 Wall Street Journal, 11, 12, 243, 312
“Wash sales,” 107
Wave, 14
Wave analysis methods, 260
Wedge(s), 139, 409-410, 618 formations, 139-142 on weekly and monthly
charts, 143-144
Weighted Moving Averages, 422
West Indies Sugar, 43 , 575, 593
Westinghouse Electric, 4 , 237, 437, 442, 566, 568, 572, 575, 593
“W” Formation, see Triple Top
Wide-Ranging Days, see Runaway Days Widening Channel effect, 243
Wilder Relative Strength Index (Wilder RSI), 595, 610, 618-619
Wieckowicz, R.T., 307 Williams, Larry, 420, 531
Williams %R, 539
World Equity Benchmarks (WEBs), 312
World War II, end of, 515, 516 “W” Pattern, see Triple Top Wright, Charlie,
494
Wyckoff, Richard, 259, 392, 550
Wyckoff's charts, 531
Y
Yahoo! (YHOO), 330, 476, 47, 526, 577, 593
Z
Zen, 269
ZigZag, 197, 383, 538 Zone, Resistance, 189, 192-194, 196, 197, 199-200,
202, 206, 387
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