e 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 fo


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 ten

eBooks\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf


ler. 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 su


rds' 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 c


, 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 12/29/2017


/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


n 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


hort 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
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
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


e 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
10/22/1929Sell337.92241.412


9
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 matt


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 if


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 h


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.
44
40
38
34
36
32
30
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


hly 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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OCTOBER NOVEMBER DECEMBER
3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 6 13 20 27 6 13 20 27
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;
136
128
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104
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100
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UNION CARBIDE & CARBON
UK
1929
AUGUST SEPTEMBER OCTOBER
NOVEMBER DECEMBER
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 ofSept


2
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UNION CARBIDE & CARBON
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AUGUST SEPTEMBER OCTOBER
NOVEMBER DECEMBER
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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. TheBot