e whole story of how these operations are carried out. For
all practical purposes, however, all you need to do is tell your broker what you wish to sell
and leave the rest to him.
He will advise you if, by any chance, the stock you have selected for short sale is not
available for loan. Another practical point, although of minor consequence, is that a slight
additional tax is assessed against short sales. (EN: In that gains on short sales are not eligible
for long-term capital gains tax.)
It is important also, if you are a trader, to accept opportunities to sell short as readily
as you go long stock. Unfortunately, there are psychological barriers to short selling. There
are, for example, the unintelligent and entirely irrelevant slogans about “selling America
short.” There is the feeling on the part of many who are poorly informed that short selling
is the somewhat unethical trick of the manipulator. Others have the impression that, in
selling short, one is hoping to profit by the misfortunes of others at times of disaster and
Panic. It is not the purpose of this book to persuade anyone to sell stocks short, any more
348 Technical Analysis of Stock Trends
than it is our purpose to advise anyone who should not to speculate on the long side of the
market. Nevertheless, so many questions are constantly raised, even by fairly sophisticated
investors, about the ethics, as well as the practical procedure of short selling, that we may
perhaps be pardoned for saying a few more words in its defense.
All of the popular ideas about short selling mentioned in the preceding paragraph
may be branded as so much nonsense. There is nothing more reprehensible about selling
short than buying long. Each is a speculation in relative values. The truth is money is
a commodity, just as much as a share of stock. There is no moral or practical difference
between borrowing money to buy stock because you believe the latter will go up in value
in terms of the former and borrowing stock to “buy” money because you believe the latter
is going to go up in value in terms of the former. In each case, you are obligated eventually
to repay the loan whether it be money or stock. In each case, you are taking a risk on the
basis of your considered forecast as to the future trend of relative values.
There are, in fact, many common business practices that are more or less analogous to
selling stocks short. For example, every time the publisher of a magazine accepts cash in
advance for a subscription, he is making something like a short sale. His ultimate profit
or loss will depend on what the magazines he will eventually supply have cost him by the
time the subscription runs out.
When you sell stocks short, you (or rather your broker) receive the proceeds of the sale
at once but you are obligated to turn back an equal number of the same shares at some
future date to the man from whom the stock certificates were borrowed. (EN: One of the
advantages or edges that professionals enjoy over private investors is the credit of short sales to
their accounts and the payment of interest thereon. Although the proceeds are credited to the private
investor, no interest is generally paid on it, unless the investor has influence with the broker. A
favorable situation is created, however, if a short sale of $100,000 were made on, say, 50% margin, a
credit of $150,000 would be made to his account, and no interest would be charged. Any dividends
the trader paid on the transaction would be expensable.) Consequently, sooner or later, you have
to go into the market again and buy those shares. When you buy them, you (or rather your
broker) return the shares to the original lender, thus discharging your obligation. If the cost
of your purchase was less than the proceeds of the earlier sale, the difference is your profit.
If it costs you more to buy in the shares—or as it is termed, cover your short—the difference
represents a loss. You do not enter into a short-side transaction unless you expect the price
of the stock to go down; hence, showing you a profit.
One of the little-appreciated results of a large volume of short selling is actually to
strengthen the market. Every short seller is a potential buyer. Most short sellers are glad
to cover and take their profits on a relatively Minor Decline. Consequently, if there is a
big short interest at any given time in a particular issue, it means there are many people
waiting to buy that stock when it goes down. This situation tends to “cushion” bad breaks.
Some astute operators will actually buy a stock when they learn there is a very large short
interest in it, meaning a great many shares of it have been sold short and not yet covered,
because they realize competition among the short sellers to buy the stock whenever it has
a small decline may result in a very fast and profitable Short-Covering Rally. Any stock is
stronger, technically, if there is a good-size short interest in it.
There is one further objection raised against short selling. It will be pointed out when
you buy stock that your loss, if worse comes to worst, can be no more than the total amount
you paid for it. In the case of a short sale, the price of your stock could, theoretically, rise
against you to $50.00, $100, $1,000, $10,000 a share; in other words, it could rise without
limit. This argument sounds much more alarming than it really is. Certainly there is no
occasion to lose sleep over it. Stocks do not go up without limit all of a sudden. It is just
349Chapter twenty-five: Two touchy q uestions
as easy to set a stop on the loss you are willing to take on a short-side transaction as it is
on a long purchase. Such situations as the famous 1901 corner in Northern Pacific are not
likely ever to occur again under present regulations. (EN: The famous “short squeeze.” Short
squeezes still occur but are extremely rare in big liquid issues. A famous short squeeze occurred
in the


y q uestions
as easy to set a stop on the loss you are willing to take on a short-side transaction as it is
on a long purchase. Such situations as the famous 1901 corner in Northern Pacific are not
likely ever to occur again under present regulations. (EN: The famous “short squeeze.” Short
squeezes still occur but are extremely rare in big liquid issues. A famous short squeeze occurred
in the silver markets of the 1980s when the Hunt brothers trapped Exchange members and almost
bankrupted them. The members, being in control, retaliated by quintupling margin requirements
and bankrupted the Hunts.) The authors realize nothing said, and probably no amount of
cold-blooded analysis on the part of the reader himself, will remove entirely the trepidation
that most nonprofessional traders experience when they sell short. The mental hazards will
always be slightly greater than in buying long. Nevertheless, from every practical angle,
a short sale is exactly the same thing (although in a reverse direction) as a long purchase,
with no greater risk, with actually somewhat greater chance of quick profit, and differing
only in details of execution.
A commitment in commodity futures contracts, whether long or short, although quite
different in theory, has some similarities to a short sale of stock. In making a contract,
no actual sale takes place, and no loan of either cash or the commodity is involved. Such
a contract is simply a binding legal agreement to accept delivery or to deliver a certain
commodity at a certain price at a certain time. In this respect, it is different from a short
sale of stock. It is also different in that it must be closed out on or before a definite date.
Although, the purchase or sale of a commodity contract is similar to a stock short sale in
that (1) it is necessarily a margin transaction, and (2) it creates an “open” or incomplete
transaction that eventually must be liquidated.
A short sale of stock must always and necessarily be a margin transaction. Thus, if
you buy 100 shares of stock outright at 20, it can sink to 15 and you cannot be called for
more margin. You have lost $500, but the stock is still yours. If you sell, you get back $1,500,
disregarding commissions. On the other hand, if you sell a stock short at 20, putting up a
margin of 100%, and the stock rises to 25, you will also have lost $500. The broker, under
certain conditions, such as the 100% margin requirements in effect at one time, might call
on you for $500 additional margin. Or, if the transaction were to be closed out at that point,
you would receive back $1,500 less commissions, the same as in the long transaction. In
the case of this short sale, had the price dropped to 15, your profit would have been $500.
On short-term moves, the effect of short selling is exactly the same as the buying of long
stock, but in the opposite direction. You simply apply the same methods here in reverse,
during a Bear Market, that you would use in a Bull Market. As we have already seen, the
various technical indications that point to upward moves in a Bullish Phase have their
counterparts in downside signals during a Bearish Phase.
Execution of short sales cannot be made at any time and at any price you wish. A
short sale must be made in a rising market. You are not permitted to sell a stock short on
the New York Stock Exchange during a market break when each regular sale is at a lower
price than the one before it (EN9: the uptick rule). However, this need not bother you much
because, ordinarily, you would make such a sale on the rally as it reached your price, and
this would naturally fill the requirement of a rising market. Your broker can give you,
in detail, the special rules and regulations that apply to short sales. It will pay for you to
study these so you can place your orders correctly when the proper time comes to make
such sales. (EN9: At the AMEX, short sales on ETFs and some HOLDRS are exempt from the
uptick rule as are futures contracts on the futures exchanges. EN10: In 2007, the uptick rule was
removed in an ill-considered bow by the Securities and Exchange Commission to large speculative
interests. The reader may judge for himself whether subsequent markets have been more volatile
on the downside. It is our observation that the loss of this rule results in accelerating slides in fast
350 Technical Analysis of Stock Trends
downside markets. Since 2009, there has been wide debate about reinstatement of the uptick rule,
so far to no avail.
In the current context, short selling has been institutionalized. The public may buy ETFs, which
take the short side of almost any instrument, as, for instance, QID for the Qs is a short bet, as is
DOG for the DIAMONDS™ (DIA). There are even leveraged [two times, three times] ETFs [long
and short].)
351
chapter twenty-six
Round lots or odd lots?
(EN: Or, put another way, size?)
One of the minor tactical questions bound to plague you is whether to trade in round lots
of 100 shares or odd lots (less than 100 shares in active stocks).
 (EN: In Internet-age markets, this question has virtually lost its relevancy. In Magee’s time, there
was a distinct disadvantage to trading odd lots, and one traded odd lots only if hampered by limited
capital. Now that an investor can achieve full diversification in an odd lot position by buying odd
lots of Standard & Poor’s Depositary Receipts (SPYs) and DIAMONDs™ (DIA), there seems little
point in discussing it. There is, of course, always the question of broker commission—if the broker
has a fixed commission rate, regardless of the size of the trade, then the small investor gets nicked. It
would seem this follows the old adage that the rich get richer. Nevertheless, now the small investor
can strike back by finding a broker who does not charge commissions. At first I thought commission-
free brokers were making up their profit on volume; in fact, there are other ways to make a pr

eBooks\Technical Analysis of Stock Trends 11thed\original\Technical Analysis of Stock Trends.pdf


a fixed commission rate, regardless of the size of the trade, then the small investor gets nicked. It
would seem this follows the old adage that the rich get richer. Nevertheless, now the small investor
can strike back by finding a broker who does not charge commissions. At first I thought commission-
free brokers were making up their profit on volume; in fact, there are other ways to make a profit on
trades than charging a commission—for example, directing the execution of the orders to a trader
who needs “order flow.”
In the Internet age, the question of what size a trade or investment should be is different from
the question that confronted traders of, as it were, ancient times. Now, it is not so much a matter
of cost disadvantage in trading odd lots as it is a much deeper question—that of risk and portfolio
management. So how does the aware investor determine the size of any individual trade?
I am indebted to a longtime friend, colleague, broker, and fellow trader, William Scott, for
articulating the common-sense procedure here for calculating trade size and controlling risk.
First, we determine the percentage of our capital we want to risk on any given trade. Among many
professional traders of our acquaintance, this figure is often 2% or 3%. For the sake of illustration,
using round numbers, if we have $100,000 capital this means we will be risking $3,000 on a trade.
Let us say we are going to buy a $20.00 stock and defend our position with a stop-loss order $5.00
away. Our formula for computing position size is as follows:
 3,000/5 = n number of shares (600 shares)
If we were going to accept a $10.00 risk, our trade size would be 3,000/10 = 300 shares. Thus,
we adjust our trade size to fit our risk parameters.
This is a simple, practical, and elegant way to implement risk control at the individual trade
level.
Trade size is, without doubt, one of the most crucial factors in success for the general investor.
Ignorance, or denial, of its importance is a major reason for the failure of many traders. In short,
overtrading. Other perspectives on risk and trade size are found in Chapter 42 and in Appendix B,
where the Leverage Space Model is explained.)

353
chapter twenty-seven
Stop orders
We are going to take up two kinds of stop orders, or, rather, two entirely different uses of
the mechanism of stop orders.
First, let us look at the protective stop order. At best, it is not a happy subject. Stop orders
of this type are like fire extinguishers; the occasions when they are put into operation are
not times of rejoicing. Stop orders are used for emergency rescue when things get so bad
there seems no reasonable hope for a situation.
Wherever you set your protective stop, it is likely to be touched off at what seems to
be the worst possible moment. You will set it at a safe distance under a certain bottom; the
stock will break through, catch your stop, and then proceed to build a new bottom at this
level for the next rise, or to rally at once and make new highs. No matter, you had your
reasons for setting the stop. The stock did not act the way it should have. The situation is
not working out according to Hoyle and certainly not the way you hoped it would. Better
to be out of it, even at a loss, rather than face a period of uncertainty and worry. If the stock
has started to act badly, you cannot tell how much worse it is going to behave. If you fail
to set a stop, you may go on day after day hoping for a rally that never comes while your
stock sinks lower and lower until, eventually, you find (as millions have found) that what
started to be a small reaction, and an annoying but trivial loss, has turned out to be a
ruinous catastrophe. Stop orders cannot always be placed; in certain cases in active stocks,
the exchanges may even restrict the use of stop orders.
The question is where and when to set the stop, realizing there is no perfect and
absolutely satisfactory rule. If the stop is too close, you will take unnecessary losses; you
will lose your holdings of stocks that eventually forge ahead and complete the profitable
rise you hoped for. If stops are too wide (too far away), you will take larger losses than
necessary in those cases in which your stock definitely has broken out of pattern.
Now, it will be obvious, as the setting of stop orders depends on the price of the stock
and its habits. You would not place your stop level at the same percentage distance under a
Bottom in a conservative, high-priced stock when it is selling at 80 that you would to protect
a speculative issue at a time when it is selling at 8.
The higher priced stocks, as we have already seen, make smaller percentage moves.
Conversely, the lower-priced stocks make wider percentage moves. Therefore, the lower-
priced stocks should have more leeway for their gyrations. We will need a wider stop for
them than we will for the less volatile “blue chips.”
Similarly, we can take our Sensitivity Indexes (EN: betas in considering a stock relative to
the market, and volatilities for absolute measure of one stock against another) to give us a picture of
the individual habits of the stock. Although two stocks may be selling at the same price at
a given moment, you would expect a high-beta, high-volatility stock to make wider swings
than a low-beta, low-volatility stock; therefore, you will set your stops wider on the higher
volatility stock.
We must take these factors into account and work out some sort of simple rule of thumb
to follow. Let us arbitrarily assume an imaginary stock of “average” habits and a price of
354 Technical Analysis of Stock Trends
25 and further assume we will be satisfied, in this particular case, with stop protection 5%
below the last established Minor Bottom.
For a stock of the same sensitivity selling at 5, we would need about half again as much
stop leeway (on a percentage basis). That is, the stop would be placed 7 .5% below the last
Bottom (EN9:


erage” habits and a price of
354 Technical Analysis of Stock Trends
25 and further assume we will be satisfied, in this particular case, with stop protection 5%
below the last established Minor Bottom.
For a stock of the same sensitivity selling at 5, we would need about half again as much
stop leeway (on a percentage basis). That is, the stop would be placed 7 .5% below the last
Bottom (EN9: significant low).
(EN10: Here Magee gave an account of how, using his Sensitivity Index and his normal range
for price, he computed stop positions. The process is too convoluted for modern investors—and
unnecessary because Magee boiled the procedure down to a table I have modernized below. The
Procedure is intact in the eighth and ninth editions for the scholarly (or obsessed) investor or academic.)
For most ordinary purposes, a simplified table of stop distances will be sufficient.
Ta ble   27.1 gives you the approximate stop distance you would get by the method outlined
above, for stocks in various price classifications and of various degrees of sensitivity
(volatility).
(EN10: Magee originally constructed this table based on his Sensitivity Index. The informed
reader may consider an alternative to Magee’s Sensitivity Index, which I have conjectured here for
the modern context—that is, basing the stop distance on volatility, which would present a dynamic
method of adjustment.)
The stop level should be marked on your chart as a horizontal line as soon as an actual
or theoretical transaction has been entered into, and it should be maintained until the
transaction is closed, or until progressive stops (which we will explain in a moment) have
been started to close it out. In the case of purchases, the stop level ordinarily will be at
the indicated distance below the last previous Minor Bottom. In the case of short sales, it
ordinarily would be at the indicated distance above the last Minor Top.
To determine the position of this stop level, simply figure what the percentage distance
would amount to at the price of the stock. If you are dealing with a stock selling at 30 and
the stop distance comes out 10%, then allow 3 points under your last Minor Bottom.
In no case would we ever set a protective stop level at less than a 5% interval, even for
the most conservative, high-priced stocks.
These questions remain: What constitutes a Minor Bottom? What makes an established
Minor Top? How do we know how to choose the Basing Point (EN9: see Chapter 28 ) from
which to measure off our stop level interval? The constitution of a Bottom or a Top (EN10:
wave high, wave low) will be taken up in the next chapter. For the present, let us accept the
proposition we will determine the correct Basing Point and will always, always set our stop
level at the moment we make the commitment.
Table 27.1 Table of stop distances (expressed in percent of the price of
the stock)
Conservative
sensitivity
Median
sensitivity
Speculative
sensitivity
Price
Volatility
under 0.40
Volatility
0.41–0.79
Volatility
over 0.79
Over 100 5% 5% 5%
40–100 5% 5% 6%
20–40 5% 5% 8%
10–20 5% 6% 10%
5–10 5%a 7% 12%
Under 5 5%a 10% 15%
a Ordinarily, stocks in these price ranges would not be in the conservative group.
355Chapter twenty-seven: Stop orde rs
It is understood protective stops under long stock are never moved down, nor are
protective stops over shorts ever moved up. As soon as the stock has moved in the right
direction far enough to establish a new Basing Point, the stop level is moved up (on longs)
or down (on shorts), using the same rules for determining the new stop level as were used
in fixing the original level.
The progressive stop
There is another use of a stop that is properly considered here. This is the progressive stop,
which is used to close out a stock that has made a profitable move, or in some cases, where
a stock has given a danger signal before either completing a profitable move or violating a
previous Minor Bottom.
You will find on many moves, the stock will progress in the primary direction for
several days and then may develop exceptional volume. Often, this occurs just as the stock
reaches an important trendline or pattern border or Resistance Area. This heavy volume
means one of two things: usually, that the Minor Move has come to an end, being this is the
top of the rise for the moment; occasionally, the volume may signal the start of a breakaway
move that may run up several (and perhaps many) points, almost vertically. (The reverse
situation may develop on downside moves.)
If, noticing the heavy volume following a good rise, and assuming this day marks the
end of the move, you sell the stock at the market or at a limit, you are going to be dreadfully
disappointed if this should be one of those rare cases in which the stock opens the next day
on an upside gap and continues 3, 5, or 20 points up in the following days. On the other
hand, experience will have shown you it will not pay to expect that sort of move very often.
You will know that, 9 times out of 10, you will be better off out of the stock.
After such a day when volume is exceptionally high (provided this is not the first day of
breakout into new high ground beyond the last previous Minor Top), cancel your protective
stop and set a stop order, for the day only, just 1/8 (0.125) point under the closing price. For
example, you have bought a stock at 21; it goes up on moderate volume, smashes through
the old Minor Top one day at 23 on very heavy volume, the next day continues to 23 3/ 4 on
moderate volume, the third day advances on moderate volume to 24 1/ 4, and, finally, the
fourth day makes a rise to 25 on much heavier volume than it has shown on any day of the
rise except the day it broke through 23. The morning after this close at 25, you will notice
the volume signal. You will cancel your protective stop, which may be at 18, and you will
place a stop order, for the day only, to sell on stop at 24 7 /8


y advances on moderate volume to 24 1/ 4, and, finally, the
fourth day makes a rise to 25 on much heavier volume than it has shown on any day of the
rise except the day it broke through 23. The morning after this close at 25, you will notice
the volume signal. You will cancel your protective stop, which may be at 18, and you will
place a stop order, for the day only, to sell on stop at 24 7 /8. In most cases, this will mean
your stock will be stopped out on the first sale of the day. Plus, you may get a slightly lower
price than you would get with a straight market order. On the other hand, after a day of
high volume activity, you are not likely to be left in a thin market; there should be bids
enough, near the top, to get you out at or near your stop price.
Meanwhile, you are protected against losing the stock if there should be a continued
move in the right direction. Suppose the opening the morning after you set your stop at
24 7 /8 should be a gap at 25 1/ 4, and that prices then move up further, closing at 26. (On
“runaway” moves of this sort, the closing for the day during the move is likely to be at
the top.) You will then set your stop, again for a single day only, at 25 7 /8. If the stock then
opens at 26 3/8 and moves up to 28, you will set another day stop at 27 7 /8, which, let us
assume, is caught at the opening the following day at 27 5/8. In this example, you risked
only 1/8 point on the first day, and eventually netted an extra gain of 2 5/8 points. This,
it should be pointed out, is all net gain because your commissions are approximately the
same in either case.
356 Technical Analysis of Stock Trends
A progressive stop of this sort can be indicated on the chart by any mark you choose to
use—for example, a band of short diagonal lines. When a stock moves for several days in a
runaway move, you may repeat this mark each day, indicating a tight stop 1/8 point under
the close for each successive day, until finally, one of these stops is caught. In the case of
short sales, a buy stop is used in precisely the same way as the selling stop, by following
the stock down on a sharp runaway dive.
This use of tight progressive stop orders is indicated wherever a stock has reached its
reasonable objective on high volume, or where it has exceeded its objective and is moving
out of the Trend Channel in free air, so to speak, and in some cases, where the stock has
failed to reach its objective.
If your stock, for instance, is rising in a Trend Channel, and, about halfway between the
lower and upper trendlines, suddenly develops great volume, then a progressive tight stop
will protect you against the threatened failure of the move. Extreme volume in such a case,
before there has been a breakout to a new high above the last Minor High, is definitely a
warning and a threat. This would be especially true if there were also a gap or a One-Day
Reversal at this point.
The one day on which a tight stop would not be applied after heavy volume had
appeared would be the day the stock made a new high, running entirely through the
previous Minor Top and closing above it. This action generally means the move is not yet
completed. Should the move continue higher and again show heavy volume, even if it is
the very next day, we would then protect with a progressive stop.
In this chapter, as throughout the book, the expression “heavy volume” means heavy
only with respect to the recent volume of sale in the stock you are watching. A thousand
shares may be significantly heavy volume in some thin issues, whereas 10,000 shares would
be no more than a normal turnover in more actively traded stocks. The volume chart itself
will show, by a market peak, when a day of abnormally heavy volume occurs.
It should be understood the progressive stops we have been discussing are intended to
take short-term gains, or to close out an exceptionally profitable runaway move terminating
in an Intermediate Climax. Although the extreme conditions that call for this type of
operation are by no means rare, they are not the usual, everyday action of the market. In
the case of ordinary Minor Tops, even when they are fairly apparent on the basis of Trend
Channels, volume peak, and other indications, many traders and investors will prefer to
wait out the expected reaction rather than pay additional commissions and lose a position
that is still presumably in a favorable Major Trend.
In short, the progressive stop is a device that may be very useful on occasion, but it is
intended to cope with a special and somewhat unusual move.
The protective stops, on the other hand, offer the average trader, the man who is not
able to spend his entire time studying the market, or who has not had long experience, a
device by which he can limit his possible loss. He will be protected from his own reluctance
to close out the bad holding, and he will avoid the ruinous condition of becoming frozen
into a hopeless situation. Since he will be taken out automatically, regardless of whether
he has an ultimate gain or loss, he will have the capital to use in better-looking issues and
will not have to worry about the prospects of recovery in his stock after it has gone many
points against him.
If one has sufficient knowledge and sufficient determination to get out as soon as the
trend has shown convincing evidence on a turn, there is less need for the stop orders. (EN:
This editor believes that only the proven trader-investor should trade without a stop in the market.
The reader may determine whether he meets this criterion by examining his portfolio to see whether
he has ever let a loss run or allowed a significant profit to slip away. If so he, or she, or they, or it, is
357Chapter twenty-seven: Stop orders
not proven.) It is possible for such a person to operate successfully without them; and there
are some advantages in doing this because a stop order will occasionally be caught by a
false move or


s criterion by examining his portfolio to see whether
he has ever let a loss run or allowed a significant profit to slip away. If so he, or she, or they, or it, is
357Chapter twenty-seven: Stop orders
not proven.) It is possible for such a person to operate successfully without them; and there
are some advantages in doing this because a stop order will occasionally be caught by a
false move or an extended dull reaction. There are also advantages in not using stop orders
for the experienced technician who is looking toward a possible long-term gain and who
is willing to wait out a Secondary Reaction. Yet it is a thousand times better for the person
who is not sure of his methods to be stopped out early, than to be left holding a stock bought
at, say 60, when it has declined to 29—or to 5!
Stop systems and methods
The two most important concepts in investing and trading are trends and stops. Being right,
the trend immeasurably diminishes risk and increases our probability of profit. However,
without skillful setting of stops, all our work and study can easily result in nothing as
the markets dodge and weave, deceive, and throw off false signals. If our analysis has not
resulted in skillful stop setting, we will be no better off than that unfortunate fellow who
is acting on a tip from his brother-in-law—or his bootblack.
Consequently, let us first attack this question from the viewpoint of the trend-following
investor and deal with trading stops thereafter. In Magee’s systems for the trend follower,
there are two basic stop methods. One is based on trendlines (sloped and horizontal), and
the other is rooted in Basing Points. Chart patterns interact with these two methods. This
entire book treats the former at length in too many chapters to mention here. The second,
Basing Points, is discussed exhaustively in Chapter 28.
The breaking of trendlines is always significant. Magee tested the validity of the
break by requiring that prices penetrate the line by 2%–3%. This may not be perfect, but
it serves for the majority of situations. The longer the trendline the more important the
break, as illustrated in the market breaks of 2008 and 2011 (a trendline of more than 700
days). The downwaves (crashes?) resulting from these trendline breaks were recognized
and commented on at the time at http:/ /www/edwards-magee.com. Figure 5.1 illustrates
the serendipitous convergence of all three methods combining to exit longs and short the
market in 2008. Trendline analysis, pattern analysis, and Basing Points analysis by their
very nature are complementary and lead to similar conclusions, as, for example, in August
2011 when the long-term trendline from March 2009 was broken, a Head-and-Shoulders
Top was identified, and the Basing Point stops were taken out.
Therefore, we have three ways of setting stops in extended trends—trendlines, patterns,
and Basing Points. Are there other stop methods for trend following? Indeed. A multitude.
A plethora. A cornucopia. An excess. First, let us remark on the crucial question of stop
setting in trends.
Stops set too close to the market result in the trader losing his position. The stop must be
set to give the market room to move against his position, thus (crocodile tears) apparently
surrendering precious profits. As the market advances in waves (truism)—wave up, wave
down—stops must be, as in the Basing Points Procedure, set sufficiently below wave-low
points to avoid being exercised. In an interview in Market Wizards, Jack Schwager asked a
major trader, Bruce Kovner, where he set his stops. “Where they’re hard to get to,” replied
Kovner.
This is the principle at work in Basing Point stops. Knowing that locals and market
mischief-makers probe for stops at wave lows and support zones, the stop is set with a
filter, thus some distance below the wave low (or wave high). This stop is hard to access.
The same thing is true if using a moving average. Magee used a 2% or 3% stop for
trendlines and a stop of this type is probably good for a moving average, too. At the same
358 Technical Analysis of Stock Trends
time, if volatility and excitement are running high, the trader must adjust the size of his
filter. In a rising market tracked with a moving average, the trailing stop would be moving
every day the dotted line moved up. Naturally, with a filter that might be enlarged if market
volatility became excessive.
A brief survey of stop methods
Here we are going to deal primarily in exit stops. (EN: My book Signals [available on Amazon’s
Kindle platform] analyzes at length methods for entering trades and trends.) Many traders use
stops to enter positions, but that is not our interest at this moment. We want to know how
to protect our initial entry and how to advance our stops so as to lock in our profits when
the trade has gone our direction. The initial stop may be set as with Basing Points (as
described in Chapter 28), or it may be set above or below a Support–Resistance zone, or as
a percentage (William O’Neil says a stop should be set 8% below the entry), or even as a
percentage of capital—for example, 2% risk per trade—a $2,000 stop ($100,000 capital) is a
common money management system.
If the market moves against our trade, the protective stop limits the loss. If the market
moves with us and begins to accumulate profits for us, we have a different, and happy,
problem. It is only a matter of time until the market throws us a downwave to test our
mettle—or to dislodge us altogether. We are trend followers, so we buy strength and
sell weakness, but our antagonists are contrarians—they do the opposite. Thus, after a
reasonable upwave, contrarians will be taking profits and driving prices down. Swing
traders will be doing the same thing. We want to stick to the trend until it changes, even
taking these “corrective” waves against our position. Basing Point stops will do this,
and the inevitable result is fluctuation in e


sell weakness, but our antagonists are contrarians—they do the opposite. Thus, after a
reasonable upwave, contrarians will be taking profits and driving prices down. Swing
traders will be doing the same thing. We want to stick to the trend until it changes, even
taking these “corrective” waves against our position. Basing Point stops will do this,
and the inevitable result is fluctuation in equity. Long experience has shown that fleeing
from downwaves and exiting invariably results in smaller long-range profits. Accepting
downwaves and fluctuations in profit leads to greater long-range profits. Look at the tables
of Dow and Basing Points performance. It is not unusual to see downwaves of 10%–30%
without a change of trend occurring. We have seen how we can stop these trends with trend
analysis and Basing Points analysis—and there are other philosophies and other methods.
Some other stop methods
Average True Range
Average True Range (ATR) is an interesting concept and tool. It is a measure of volatility,
in actuality, and tracking it gives us some interesting information. True Range is defined
as the largest of the following:
Today’s high minus today’s low.
Today’s high minus yesterday’s close.
Today’s low minus yesterday’s close.
ATR is the average of True Range over some defined period. Twenty days is a not
uncommon parameter, as is 14. Five days is very sensitive, which has advantages and
disadvantages.
ATR may be used to set stops. For example, we might set our initial protective stop 2
(or x) ATRs below our entry. We might set our trailing profit protection stop in the same
way: x ATRs below the recent high—or the low of the recent high.
359Chapter twenty-seven: Stop orde rs
Stops set this close are typical of trading situations. There is at least one practitioner of
my knowledge (Eric Crittenden, http:/ /www.blackstarfunds.com) who judges if prices take
out the stop 10 ATRs below the most recent high, the trend has changed. This is sometimes
called a Chandelier Exit. This kind of concept can be examined using trendlines and reversal
formations. ATR is a natural way of measuring market volatility and it rhythmically adjusts
to market behavior. This makes a system more flexible than fixed percentages or fixed
dollar amounts. An interesting paper on Crittenden’s method is found at http:/ /www.
trendfollowing.com/whitepaper/Does_trendfollowing_work_on_stocks.pdf. Feature this,
relevant to my point, that the market must be given room to work: Crittenden found that
a 10-ATR filter averaged a space of 27%. So what we have here is an inherent stop system
that posits a 27% reversal to indicate a change of trend.
Parabolic stop and reverse
Welles Wilder’s (1978) parabolic stop and reverse (SAR) technique uses an “acceleration
factor.” Consequently, the stop rises parabolically, which has its strengths and weaknesses
as the reader can imagine. Chuck LeBeau has conjectured a Modified Parabolic Exit, which
tweaks the acceleration factor at http:/ /lcchong.files.wordpress.com/2011/05/precise-
exits-entries-manual.pdf. This presentation includes other interesting comments on stop
methods.
Target stops
I am not a great proponent of target stops, but many traders analyze a formation or market
situation and compute a possible target and exit the market when their target is reached.
Other target criteria may be used—a dollar or point amount, or as in Bill Scott’s method,
five days down causes liquidation of half the position, six days the other half.
Similar to the target method, the trailing stop is raised when x% of profits are achieved
and raised again as prices advance. An old Japanese saying has it as follows: “Sell half at 8
new prices, half again at 10 new prices, and the rest at 12 new prices.”
Of a similar nature, some traders will close the trade when an extreme move occurs
in their direction.
A natural method used by the Turtles
The Turtles used the breakdown from a 10-day channel to exit their long trades. This can
be modified to as little as three days, in which case the trader would set a very tight stop
based on the three-day low if a market were running away. Such a situation might also be
managed with Magee’s tight progressive stops—raising the stop each day to just under the
low of the day to be in effect for the next day.
In the end, as the reader can see, there are as many stop methods as there are traders.
For our purposes, the more natural and less algorithmic the method, the better—so it
comes back down to trendlines, formations, and Basing Points, which can be tweaked to
the individual taste.
If there is a truism about the markets it is this: a trader without stops will soon be a
trader without capital.

361
chapter twenty-eight
What is a Bottom and what is a Top?
(EN9: In this extremely important chapter, I have left intact Magee’s usage of “Tops and Bottoms.”
It will be less potentially confusing for the reader to think of “highs and lows” as that terminology
is commonly used in the business in the modern era. Also, thinking in terms of highs and lows is an
important concept in itself. Thus, for a Bull trend, higher highs, higher lows. When this pattern is
broken in an important way, the trader should be alert for a trend change. Also, as the use of eighths is
of the essence in Figure 28.1, I have left the discussion in eighths, although the reader knows decimals
are now used in the markets.)
In this chapter, we are not talking about what makes a Major Top or Bottom or what
makes an Intermediate Top or Bottom. We are speaking of the Minor Tops and Bottoms
that give us important hooks on which to hang our technical operations. Stop-order levels,
trendlines, objectives, and Supports and Resistances are determined by these Minor Tops
and Bottoms. They are of prime importance to us as traders. (For illustrations in this
chapter, see Figures 28.1 through 28.4.)
Usually, these Minor Tops and Bottoms are well marked and perfectly


nor Tops and Bottoms
that give us important hooks on which to hang our technical operations. Stop-order levels,
trendlines, objectives, and Supports and Resistances are determined by these Minor Tops
and Bottoms. They are of prime importance to us as traders. (For illustrations in this
chapter, see Figures 28.1 through 28.4.)
Usually, these Minor Tops and Bottoms are well marked and perfectly clear, though
often they are not. Sometimes, it is not possible to say definitely that this or that place is or
is not a Top or Bottom, but it is possible to set certain standards and practical working rules
that will help us in making these points, and these rules will not fail us too often.
A good rule for setting stop levels is to consider a Bottom has been made when the
stock has moved “three days away” from the day marking the suspected low of the Bottom.
If a stock reacts for some days and finally makes a low at 24, with a high for that day at 25,
then we will not have an established Bottom until we have had three days in which the stock
sells at no lower than 25 1/8. The entire price range for three full days must be entirely
above the top price for the day making the low. This is the three-days-away rule, and it
would apply in reverse in declining markets, in which the range for three days must be
entirely below the entire range of the day making the high.
This gives a rule for setting an original stop order. It also gives a rule for changing the
stop order. As soon as the stock has moved three days away from a new Bottom, we move
the stop order to a position below that Bottom. (We have already explained in Chapter 27
how we determine the distance this stop level should be below the Bottom.)
Protective stops for long stocks can move only up. A stop level, once established, is
never to be moved down except when the stock goes ex-dividend or ex-rights; then, the
stop may be dropped the amount of the dividend or rights. Similarly, protective stops for
short sales are to be moved only down and may not be raised. (In the case of ex-dividends
and ex-rights, the short-sale stop would be dropped the amount of the dividend or rights.)
There are certain situations in which it is difficult to determine Bottoms and Tops;
where, indeed, it seems as though a Consolidation or Correction had been made without
any significant move in the Secondary Direction. In such cases (as contrasted to the obvious
situation in which the stock moves up or down in series of well-marked steps and reactions,
like a staircase), you will need all your judgment and experience to determine the point at
which the Minor Basing Points actually occur.
362 Technical Analysis of Stock Trends
The first protective stop would immediately be placed 6% below the previous Minor
Bottom of August 21, using Table 27 .1 in Chapter 27 . This would put the stop level at 9 7 /8.
On September 19 and 20, we would have two days of market action entirely “away” from
the September 17 Minor Bottom, and, on September 28, a third day. We would then move
the stop up to 6% under the September 17 Bottom, or to 10 5/8. The next move would come
after the new high closing of October 11, which is more than 3% higher than the October 1
Minor Peak. The stop would now be placed at 11 7 /8. On November 2, a new high close was
registered more than 3% over the October 15 Minor Peak; the stop would be raised to 12
3/ 4. On November 15, another high closing topped by more than 3% the Minor Peak made
on November 7 . The stop would be moved up again, this time to 13 1/2. November 29 made
the third day the entire range was “three days away” from the November 26 Bottom, and
the stop was upped to 13 3/ 4. The closing on December 5 gave us a 3% advance over the
November 17 high, and again we moved the stop, raising it to 14 7 /8. Finally, on January 3,
1946, this stop was caught as shown on the chart. In a Bear Market, protective stops would
be moved down in exactly the same manner to protect a short sale. (EN9: A number of
inconsistencies exist in this figure and caption that are clarified later in the text.)
Basing Points
Let us call the levels that determine where stops should be placed Basing Points. In a Bull
Market Move, we will consider the Bottom of each Minor Reaction as a Basing Point, from
AMERICAN CABLE and RADIOA CR
1945–1946
JULY AUGUSTS EPTEMBERO CTOBERN OVEMBERD ECEMBER
17
16
15
14
13
12
11
10
Sales
100’s
250
200
150
100
50
7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1 8 15 22 29 5
Figure 28.1 Advance of a protective stop order in a long commitment. The daily chart of American
Cable and Radio in the summer of 1945 made a Rounded Bottom, part of a long period of Consolidation
following the advance that ended in July 1944. A breakout on heavy volume occurred September 12,
and purchases were then possible on any Minor Reactions.
363Chapter twenty-eight: What is a Bot tom and what is a Top?
which we will figure our stop-order level as soon as the stock has moved up to “three days
away.” We will also use each Minor Top as a Basing Point in a Bull Move. In a Bear Market,
we will consider the Tops of each rally and also each Minor Bottom as Basing Points for the
protective stops in the same way.
Where a stock makes a substantial move in the Primary Direction, say a move of 15%
or more, and then moves back at least 40% of the distance covered from the previous Basing
Point to the end of the Primary Move, that surely gives us a Basing Point as soon as the stock
again starts off in the Primary Direction. If the stock reacts less than 40%, however, perhaps
even marks time at the same level for a week or more, that should also be considered a
Basing Point as soon as the move in the Primary Direction is continued (provided the
volume indications are right).
The daily volume, as we have seen, is like the trained nurse’s clinical thermometer; it
tells a great deal about what is happening in a stock, more th


ock reacts less than 40%, however, perhaps
even marks time at the same level for a week or more, that should also be considered a
Basing Point as soon as the move in the Primary Direction is continued (provided the
volume indications are right).
The daily volume, as we have seen, is like the trained nurse’s clinical thermometer; it
tells a great deal about what is happening in a stock, more than the superficial symptoms
of price alone. There are three times at which you may look for exceptionally heavy volume:
(1) on the day of breakout from a pattern or a period of inaction, especially if the breakout
is on the upside; (2) on the day on which the stock goes into new ground in the Primary
or Intermediate Direction, that is, goes above the last Minor Top in a Bull Market or below
the last Minor Bottom in a Bear Market; and (3) on the day on which the Minor Move is
completed or nearly completed, that is, the new Minor Top in a Bull Market and the Minor
Bottom in a Bear Market. To this we might add that extra heavy volume on any other day
during a move in the Primary Direction is likely to indicate the move is at an end and will
not complete the hoped-for advance or decline.
Now, after a Minor Top has occurred, the stock now being in new high ground, and
the Top having been made on very heavy volume, we may look for the corrective move.
Ordinarily, that would be a decline of several days, a week, sometimes longer. Occasionally,
the correction, as we said a few paragraphs back, will take the form of a horizontal hesitation
lasting a week or more without any particular corrective move in the downward direction.
Where there is a downward correction, it is likely to come down to or near the Top of the last
previous Minor High (support). Also, and often at the same time, the corrective move will
carry down to the Basic Trendline drawn through two or more previous Minor Bottoms; or
to the “parallel”; or to a trendline drawn through the last two or more previous Minor Tops.
If the corrective move is horizontal, it is likely to run out until it meets one of these lines.
In any case, the thing to watch for is the decline of volume. If the trading shrinks,
perhaps irregularly, but on the whole, steadily, for some days after a new Top has been
made, during which time the stock either reacts or, at any rate, makes no progress in the
Primary Direction, then you are justified in considering this as a Minor Correction. If the
stock now continues the Primary Move and gets to a point that is “three days away,” you
can consider the Bottom (i.e., the point you draw your trendline through, not necessarily
the extreme low point in the case of horizontal moves) as a new Basing Point.
Where a stock is starting what appears to be a new move or a breakout from a period
of vacillating moves, it is sometimes hard to say precisely what point should be considered
the Bottom. There may be several small and indecisive moves on low volume preceding
the real breakout. In such a case, we would consider the appearance of high volume as the
breakout signal and set our Basing Point at the low point immediately preceding this signal.
There usually will be such a point on one of the low-volume days in the three or four days
just before the breakout.
All that has been said about Basing Points in a Bull Market would also be true, in
reverse, in a Bear Market, except that heavy volume does not always accompany a downside
breakout.
364 Technical Analysis of Stock Trends
Now comes the difficult and distressing situation in which the stock, having made
a long runaway move (let us assume it is an upward move), starts out to make a Flag; is
bought after a sufficient correction of 40% with a decline of volume; and then continues to
go down steadily, without any rallies and without any clear volume indications. This is an
unusual situation, but it does happen on both the upside and the downside, from time to
time. In the case we have just mentioned, we would look for Support Levels (Consolidation
Patterns, Multiple Tops, and so on) formed on the way down in the previous trend and lying
below the level at which we purchased the stock. We would use these supports as Basing
Points rather than hold a stop under the extreme Bottom of the vertical move.
In many cases of this type, you will not be able to find adequate Basing Points. Therefore, it
seems unwise to try to get in on corrections after long runaway moves except in the following
cases: (1) the stock has risen well above good Support that can serve as a Basing Point, or (2)
the stock is completely above all prices for several years and is moving “in the clear.” (And
the reverse: in Bear Markets, the stock should have fallen below a strong Resistance Area or
must be in new low ground for the past several months before you consider a short sale.) In
any case of this sort in which you are thinking of a trade in a stock that appears to be making
a Consolidation after a fast, long, vertical move, you must have pronounced and conspicuous
drying up of volume throughout the formation of the Flag or Pennant Correction.
There is one more word of caution needed here regarding trading in an Intermediate
Trend. A series of moves in a trend will often take place in very regular form. There may
be a good trendline, and the reactions may be about 40%–50% and may come back to the
previous Minor Tops. The volume on the Corrections may shrink with increasing volume
on the new Tops. It is easy to start trading on such a “staircase” in the expectation the moves
will continue to be regular and consistent, but trends do not go on forever. Any Minor Top
may be the last. The importance of finding your Basing Points is to enable you to get out, at
best, on any closing violation of one of these points, and at worst, on your protective stop
order. The volume may again come to your aid in this question of when to stop trading on
a trend. Although you loo


es
will continue to be regular and consistent, but trends do not go on forever. Any Minor Top
may be the last. The importance of finding your Basing Points is to enable you to get out, at
best, on any closing violation of one of these points, and at worst, on your protective stop
order. The volume may again come to your aid in this question of when to stop trading on
a trend. Although you look for high volume on the Tops, you will be exceedingly suspicious
of volume that is much higher than on any of the preceding Minor Tops (or Bottoms in
a Bear Market). The final, or the next-to-final, “blow-off” of a trend usually will show
more volume than any of the Minor blow-offs along the way. When you see such climactic
volume, you should prepare to retire into your shell and wait for a full Correction of the
entire series of moves making up your Intermediate Trend. Later, weeks later, or perhaps
months later, you may find the stock has corrected 40% or more of the whole Intermediate
Move and is resting quietly with very little activity. Then is the time to watch it for new
opportunities and a new trend in the Primary Direction.
(EN9: In a book composed of nothing but important chapters, this Chapter 28 might not get the
emphasis it deserves from the unwary reader. In fact, the procedure outlined here is of absolutely basic
importance in analyzing and trading trends. I have added to this chapter material that has been of
great importance to my trading and to the trading of my students.)
Basing Points: a case analyzed
The longer one thinks about the chart so casually tossed off in Figure 28.1, the more he
realizes it embodies a profound and natural understanding of trends and the market.
Consider—wave up, wave recedes, wave up, wave recedes, and so on. As long as the trader
or investor is not chased from his position by the corrective wave, he will, under normal
circumstances, ride the trend to its natural end. Nevertheless, locals and hedge funds and
those who profit from volatility know the previous low is where investors and traders set
365Chapter twenty-eight: What is a Bott om and what is a Top?
their stops. So in the ordinary flow of trading, if they see an opportunity to take out an
important low, they will do it—if possible. Indeed, it is sometimes possible and the low
sometimes falls from the natural flow of trading.
Bruce Kovner, on being interviewed by Jack Schwager ( Market Wizards), was asked
where he set his stops. “Where they’re hard to get to,” he said. A twice told tale for its
importance a stop set on a Basing Point with a prudently calculated filter is hard to get to
unless the market has truly reversed direction. In fact, what is a long-term moving average
but a lagging stop with a filter built in?
Basing Points are merely the marking of highs and lows in full realization that a pattern
of higher highs and higher lows is a Bull trend, and when that pattern changes to one of
lower highs and lower lows the trend is changing or has changed. This is the principle
behind Dow Theory, and it is the principle behind trading trends of lesser duration than
Dow trends. Moreover, as is quickly realized, a pattern of lower highs and lower lows
means inevitably the trendline has been broken.
As for Figure 28.1, Mark Twain had some cogent comments on it. He said anyone trying to
make sense of it would go crazy, and anyone trying to justify the prices with the chart would
be shot. Figure 28.1 preserves unexplainable conundrums and conflicts carefully preserved
since the earliest editions. The reader is urged to take it as a concept rather than using it as a
lesson (See Figure 28.2). Let me codify the rules implicitly presented in the figure:
• A high is made, being recognized by no higher prices occurring for the moment.
• Prices recede and a low is made. This low is found by watching each day after the
previous high until no lower prices are made. As prices begin to rise again, we note
each day on which prices are completely outside the range of our low day candidate.
• When three such days are observed (three days away) before a new low is made, we
mark the candidate day as a Basing Point and raise our stop to 6% (or x%) under the
low of the Basing Point day (see Chapter 27).
• If a new high is 3% greater than the previous high, a new Basing Point is found at the
low of the new high day.
The Basing Points paradigm
By no means will every issue be amenable to this kind of analysis. However, the method
is so paradigmatic, it is worth examining at greater length. Similar to virtually every other
method of classical chart analysis, it must be used with caution and good, thoughtful
judgment. Sometimes some stocks will seem to work as smooth as silicon lubricant, while
other issues will appear to be useless. Even on recalcitrant issues, however, the principles
underlying the method will be of use, if not the actual method itself. With this in mind,
Figure 28.2 is presented; the careful reader will see the chart in this example uses only
bottoms or lows in stop setting and does not advance stops on the making of new highs
as in Figure 28.1. This is done for instructional purposes and to keep the example simple
for the general investor. More advanced traders will want to study and perhaps utilize the
new high techniques in Figure 28.1.
Figure 28.2 actually serves more than one instructional purpose. It illustrates a picture-
perfect case of the use of Basing Points, as well as a complete analysis of a Bull Market from
entry to exit with keys marking events in the life of the market. Thus, the observation of
Basing Points, the setting of the stops, the tracking of potentially false turns are all noted.
The chart is accompanied by the keys. Originally the marked and keyed chart was used in
graduate seminars at Golden Gate University for instructional purposes. Shortly, it became
366 Technical Analysis of Stock Trends
obvious that marking the cha


s in the life of the market. Thus, the observation of
Basing Points, the setting of the stops, the tracking of potentially false turns are all noted.
The chart is accompanied by the keys. Originally the marked and keyed chart was used in
graduate seminars at Golden Gate University for instructional purposes. Shortly, it became
366 Technical Analysis of Stock Trends
obvious that marking the chart in this manner was extremely useful in trading. Thus, it is
suggested to the reader as a way of making his charts more communicative and more useful.
Key to Figure 28.2 analysis
 1. A rounding bottom, or perhaps a scallop.
 2. Resistance or breakout line.
 3. Wake-up call on volume.
 4. Run day, big volume. Breakout through line 2. Sure entry signal.
 5. First Basing Point (BP). Notice prior volume fall-off in consolidation and surge on run
day. A stop was entered before this BP using the low of the formation before the entry.
 6. BP.
 7. A weak BP (because of shallowness of retracement).
 8. BP.
 9. Test of BP at 8.
 10. A trendline drawn after point 9.
 11. BP.
 12. BP candidate that fails the three-day-away rule.
 13. BP.
 14. A potential BP , but not a very good one because a new high has not been made from 13.
 15. A Support–Resistance line.
 16. A test of 16 BP .
 17. BP.
 18. A Resistance–Support line.
30.000
26
18
15
1
Volume 7635200.00
Created with TradeStation 2000i by Omega Research © 1999
AS ON D8 7F MA MJ JA SO
16000000
12000000
8000000
4000000
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14 17
22
24
25
27
21
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2320
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AAPL LAST-Daily 10/16/1987 C=24.125 O=.000 H=.000 L=.000 V=0
28.000
26.000
24.000
22.000
20.000
18.000
16.000
14.000
12.000
10.000
Figure 28.2 Apple Computer, Bull Market of 1987 . A near-perfect example of the use of Basing
Points for trading of a reasonably regular and smooth Bull Market. Only wave-low Basing Points
are illustrated.
367Chapter twenty-eight: What is a Bot tom and what is a Top?
 19. Flag that becomes BP .
 20. Trendline, but too steep to last.
 21. Trendline.
 22. BP.
 23. Trendline.
 24. BP.
 25. BP.
 26. Horizontal trendline.
 27. BP at 26.75 (stop 25.41). Stopped out at 25.41.
A narrative of the events in the chart
 1–3. Had we been asleep, the event at number 3 should have awakened us; a volume day
like this should catch our attention. We begin paying attention to the stock and note
the pattern that has been developing—the rounding bottom, or scallop.
 4. At number 4 we see a run day on heavy volume. A good signal for entry with the
breaking of the horizontal line at number 2. When we enter, we set our stop 5%
under the recent low. After entering on strength, there is every possibility that some
profit-taking will occur as well as probing by locals to chase out arrivistes.
 5. We watch with interest for the first reaction. Each day we observe as a candidate for a
possible Basing Point. This occurs at 5, and we now begin to count “days away” from
the Basing Point—days whose range is entirely outside the range of the candidate
day and occur before a lower low is made. When the Basing Point at 5 is confirmed,
we raise our stop to 5% under the low of 5.
 6. A higher high is made after 5 with a subsequent reaction to 6, which proves to be
another Basing Point. Therefore, we raise our stop to 5% under 6.
 7. Prices continue to climb and another Basing Point is made at 7. The procedure is
becoming clear: find a Basing Point and establish a stop a prudent distance under
it. If a new Basing Point is made, raise the stop. Watch with interest the reactions
against the trend. Either they allow you to establish a new higher Basing Point, or
they end your trade.
 8–10. We find a new Basing Point at 9, raise our stop and draw the trendline at 10. At 9 we
have a lower low than 8, but our “filter,” our 5% padding, keeps our position intact.
We do not lower our stops using 9 as a new Basing Point. One of the inviolable rules
is stops are never lowered. The filter is important because traders try to take out
nearby lows and exacerbate volatility. It is called the running of the sheep.
 11. At 11 we find a new, if tenuous, Basing Point. An advance with a thin higher high.
 12. At 12 we have a candidate for a Basing Point that fails the three-day-away rule.
 13. At 13 we find the Basing Point that is good and raise our stop.
 14. At 14 we are confronted with a marginal situation. It is a potential Basing Point, but
a marginal one because a higher high was not made after 13.
 15. At 15 we are able to draw a line defining resistance—a line that will become a support
line.
 16. At 16 we have a new Basing Point that would have tested a point at 14.
 17–21. At 17 we find a new Basing Point, and at 18, we can identify a resistance line. The
spurt across this line is both gratifying and a warning because it becomes a flagpole
from which the flag at 19 flies. Flags and flagpoles are messages the market has
heated up and now wants close watching. A flag can serve as a Basing Point, so we
move our stop again, fully aware the end may be approaching. The trendline at 20
368 Technical Analysis of Stock Trends
is further confirmation of this environment because of its steepness, but we see two
good anchor points in 16 and 17 and draw trendline 21—a better line to defend.
 22, 23. A good reaction finally occurs at 22, giving a strong Basing Point and good rationale
for raising the stop. Notice the interesting fact that points 22 and 24 have come back
to rest on the trendline we drew at 10.
 24. As the tempo has increased and the volatility 24 furnishes us another valid Basing
Point.
 25, 26. Even 25 is a valid point, and we can now see the clear support line at 26.
 27. When this line is pierced at 27 upon extraordinary volume, and in the process takes
out our Basing Point stop from 25, it is clearly time to exit the train. The Basing Points
concept is even more thoroughly explored in the book entitled, StairStops, which is
available on the John Magee Technica


sing
Point.
 25, 26. Even 25 is a valid point, and we can now see the clear support line at 26.
 27. When this line is pierced at 27 upon extraordinary volume, and in the process takes
out our Basing Point stop from 25, it is clearly time to exit the train. The Basing Points
concept is even more thoroughly explored in the book entitled, StairStops, which is
available on the John Magee Technical Analysis website at http:/ /www.edwards-
magee.com and on http:/ /www.amazon.com, including Kindle edition.
The complete Basing Points Procedure: taking into consideration
the setting of Basing Points on both wave lows and new highs
As previously discussed by Magee, the Basing Points Procedure may set Basing Points on
both wave lows and on new highs. We find the wave-low Basing Point by the three-days-
away rule; we find the new high Basing Point, by marking wave highs and subsequent
new highs so when price exceeds by 3% the old wave high, or recent high, whether or not
an intervening wave low has occurred, we may set the new Basing Point at the low of the
new high day. If a new high were made subsequent to this new high, we would reset the
Basing Point again if we were using this variant of the procedure, which I call Variant 2.
Once again, the one-armed economist rules. On the one hand, raising the stops like
this on new highs may easily result in being ejected from the position by a price dip;
then you watch the train leaving the station on the way to incredible new highs amid
much teeth gnashing and irritation. (Incidentally, if emotional distress occurs in this or
other like situations it is a message to you are too emotionally attached to the market.
Complete market maturity is not achieved until such situations can be viewed with relative
equanimity so the event is viewed with detached interest and a plan to set things right.)
On the other hand, after having accumulated large paper profits, the issue collapses
and snatches back from you a third (or more) of your hard-earned profits. (If you had only
advanced stops based on new highs!) Remember, the problem with Dow Theory (and trend
following) is you give up the first third of the move and the last third of the move and
sometimes there is not a middle third, as conventional market wisdom has it.
What essentially occurs when using Variant 2 of the procedure is as follows: when
blow-off or runaway conditions occur, the procedure changes from selling weakness to
selling strength. I believe very strongly in the variation of tactics, generally. Also, I am
intimately familiar with the pitfalls of varying tactics, but I like the procedure in general
and also think knowing when to use it and when not to use it can require a great deal
of experience and emotional coolness in potentially high-stress conditions. If the entire
(Variant 2) procedure is executed and also combined with a scale-in/scale-out plan, the
user may succeed in shooting the moon.
The phlegmatic Marc Antony (who sleeps well of night and is sleek and well fed)
follows the conservative wave-low method (Variant 1) and probably wins in the long
run. The Variant 1 procedure is simpler and naturally expands to accommodate the high-
volatility market that ejects the trader attempting to escape the inevitable collapse before
going on to new completely unexpected heights.
369Chapter twenty-eight: What is a Bot tom and what is a Top?
As it goes, damned if you do, damned if you don’t, unless you are charmed or kissed
by the market fairy—or lucky.
The complete Basing Points procedure
 1. A wave high is made, recognized by no higher prices coming for the moment. If this
high is 3% (Magee’s number, but could be a parameter) higher than the previous wave
high (or the recent high in a run or blow off), the Basing Point is raised to the low of
the new high day. Obviously, this comes into effect for the next trading day.
 2. Prices recede and a low is made. This low is found by watching each day after the
previous high until no lower prices are made (a potential wave low or Basing Points
candidate). As prices begin to rise again, we note each day on which prices are
completely out of the range of (away from) our low-day candidate, or a “day away.”
 3. When three such days are observed (the three-days-away rule) before a new low is
made, we mark the candidate day as a Basing Point and raise our stop to 6% (or x% as
this is a parameter) under the low of the Basing Point day. Obviously, the new stop is
established the day after the three days away have occurred.
 4. If a new high is made without an intervening wave low Basing Point, the process
starts over from the new high.
 5. If the new high is 3% (or x%) higher than the previous high (whether made from a wave
low or wave high), or from surging prices continually making new highs, a new Basing
Point is found at the low of the new high day. Thus, a price move that went from 10 to
10.3 to 10.61 to 10.93 would create new Basing Points at the low of each new high day.
Apple Inc.- (Nasdaq NM) 85.70 -1.09 -11.26%
19A
New High 12.55
New High 13.82
24B 25A
14BP 13.36
13.41
24A
Stop
Stop 11.19
2219
17A
BP Low of New high 9.89
17
YY Y
BP
Stop based on low of New High
New Stop
NN
16
BP
BPC
Y
NN N
13
BP
Y
NN
BP
Y
Y
NBPC
Y
N
YY
N
NN NNNN N
New High 10.81
17B
16A
H 10.35
BP Flag
17C
High 11.62
Stop from new high
24
BP
Low 11.91
Stop12.56
12.93
25
Stop 11.68
12.24
New
New
BP
BP 12.43High
13.67High
13.5
13
12.5
12
11.5
11
10.5
10
9.5
9
8.5
8
7.5
7OctSepAugJul
©1998-2006 Prophet Financial Systems, Inc. Terms of use apply.
JunMayApr
Figure 28.3 Basing Points candlestick version. This chart is a candlestick version of Figure 28.2. It
illustrates the complete procedure, showing establishment of Basing Points made by wave lows and
by higher highs. This is a blow up of the period in the chart during which higher high conditions
exist. As might be obvious, the higher high rules begin to come into play late in the life of a tr


r
Figure 28.3 Basing Points candlestick version. This chart is a candlestick version of Figure 28.2. It
illustrates the complete procedure, showing establishment of Basing Points made by wave lows and
by higher highs. This is a blow up of the period in the chart during which higher high conditions
exist. As might be obvious, the higher high rules begin to come into play late in the life of a trend,
in the runaway and blow-off stages.
370 Technical Analysis of Stock Trends
Two charts giving a long-view perspective on
the complete (Variant 2) procedure
There is another method Magee advocated for surging and blow-off markets. He called this
alternative method “progressive stops,” which is explained in the ninth edition. Strictly
speaking, although there is a variation in tactics involved in using new highs for stop
calculation, this method is a twist on selling on strength. Variant 2 is still lagging stops
behind prices. A pure strength selling method would attempt to time exit on a blow-off day,
or a key reversal day or a one-day reversal, or even on a strong long running day up. This
is perhaps a little easier to visualize on the downside. A panic selling day (which tends to
finish at the lows) would provoke an exit on the close.
The representative case fully analyzed
using wave lows and new highs
The case will not be unfamiliar to readers, and its use will fully highlight the differences
found in the procedure. The same materials will be used, and the differences will be boldfaced in
the text.
 1. A rounding bottom, or perhaps a scallop.
 2. Resistance or breakout line.
AAPL(D) - Daily NASDAQ L=62.69 -0.03 -0.05% B=62.60 A=62.72 O=63.67 Hi=64.12 Lo=62.61 C=62.65 V=29150123
12.59
14.00
10
20
24
19
11.33
21
17
13
18
26
15 12
11
98
7
6
1
MA MJ JA SO ND 87 FM AM JJ AS ON D
3 2
4
5
14
16
22 27
25 13.72
23
13.00
12.00
11.00
10.00
9.00
8.00
7.63
7.00
6.00
5.00
4.00
Created with TradeStation
10.92
9.05
4.76
Figure 28.4 Apple Variant 2 of the Basing Points Procedure. This chart shows the trend from
beginning to end as in Figure 28.2, with the addition of dotted lines to show where stops fell when
computed from higher highs. The previous candlestick chart is used for the close-up analysis. This
chart puts into broad perspective the relative level of stops using the Variant 2 method. As can be
seen, setting stops from new higher highs results in stops closer to the market prices. This can be
good or bad, depending on what the market does to you.
371Chapter twenty-eight: What is a Bot tom and what is a Top?
 3. Wake-up call on volume.
 4. Run day, big volume; breakout through line 2; sure entry signal.
 5. First Basing Point (BP). Notice prior volume fall-off in consolidation, and surge on run
day.
 6 . BP.
 7 . A weak BP (because of shallow retracement).
 8. BP.
 9. Test of BP at 8.
 10. A trendline drawn after point 9.
 11. BP.
 12. BP candidate that fails the three-day-away rule.
 13. BP.
 14. A potential BP but not a very good one because new high has not been made from 13.
 15. A Support-Resistance line.
 16 . BP.
 16A. New High: 10.35.
 17. BP.
 17A. New Higher High 10.81; Low BP 9.89 (+3% 11.13); Stop 9.30.
 17B. New Higher High 11.16; Low BP 10.58 (+3% 11.49); Stop 10.49.
 17C. New Higher High 11.62; Low BP 11.22 (+3% 11.96); Stop 10.55.
 18. A Resistance–Support line.
 19. Flag that becomes BP . High 11.62.
 19A. New Higher High 12.55; Low BP 11.91 (+3% 12.93); Stop 11.19.
 20. Trendline, but too steep to last.
 21. Trendline.
 22. BP .
 23. Trendline.
 24 . BP.
 24A. New Higher High 12.93; Low BP 12.43 ( +3% 13.34); Stop 11.68.
 24B. New Higher High 13.41; Low BP 13.07 (+3% 13.81); Stop 12.29.
 2 5. BP.
 25A. New Higher High 13.82; Low BP 13.36 ( +3% 14.23); Stop 12.56.
 25B. Stopped out at 12.56.
 26. Horizontal trendline.
 27 . BP at 25 (stop 11.80); Stopped out at 11.80.
A narrative of the events in the chart
 1–3. Had we been asleep, the event at number 3 should have awakened us; a volume day
like this (Cf. chart 28.2) should catch the attention. We begin paying attention to
the stock and note the pattern that has been developing—the rounding bottom, or
scallop.
 4. At number 4 we see a run day on heavy volume. A good signal for entry with the
breaking of the horizontal line at 2. When we enter, we set our stop 6% under the
recent low. After entering on strength, there is every possibility that some profit-
taking will occur as well as probing by locals to chase out arrivistes.
 5. We watch with interest for the first reaction. Each day we observe as a candidate for
a possible Basing Point. This occurs at 5 and we now begin to count “days away”
from the Basing Point, that is, days whose range is entirely outside the range of the
372 Technical Analysis of Stock Trends
candidate day, and that occur before a lower low is made. When the Basing Point at
5 is confirmed, we raise our stop to 6% under 5.
 6. A higher high is made after 5 with a subsequent reaction to 6, which proves to be
another Basing Point, so we raise our stop to 6% under 6.
 7 . Prices continue to climb and another Basing Point is made at 7 . The procedure is
becoming clear: find a Basing Point and establish a stop a prudent distance under
it. If a new Basing Point is made, raise the stop. Watch with interest the reactions
against the trend. Either they allow you to establish a new higher Basing Point, or
they end your trade.
 8–10. We find a new Basing Point at 8, raise our stop, and draw the trendline at 10. At 9 we
have a lower low than 8, but our “filter,” our 6% padding, keeps our position intact.
We do not lower our stops using 9 as a new Basing Point. One of the inviolable rules
is that stops are never lowered. The filter is important, because traders try to take
out nearby lows and exacerbate volatility. It is called the running of the lambs.
 11. At 11 we find a new, if tenuous, Basing Point. An advance with a thin higher high.
 12. At 12 we have a candidate for a Basing Poi


intact.
We do not lower our stops using 9 as a new Basing Point. One of the inviolable rules
is that stops are never lowered. The filter is important, because traders try to take
out nearby lows and exacerbate volatility. It is called the running of the lambs.
 11. At 11 we find a new, if tenuous, Basing Point. An advance with a thin higher high.
 12. At 12 we have a candidate for a Basing Point that fails the three-day-away rule.
 13. At 13 we find the Basing Point that is good and raise our stop.
 14. At 14 we are confronted with a marginal situation. It is potential Basing Point, but a
marginal one because a higher high was not made after 13.
 15. At 15 we are able to draw a line defining resistance—a line that will become a
support line.
 16. At 16 we get a Basing Point.
 16A. New High: 10.35 (a benchmark).
 17 . At 17 we find a new Basing Point and at 18 we can identify a resistance line. The
spurt across this line is both gratifying and a warning because it becomes a flagpole
from which the flag at 19 flies. Flags and flagpoles are messages that the market has
heated up and now wants close watching. A flag can serve as a Basing Point, so we
move our stop again, fully aware the end may be approaching. The trendline at 20
is further confirmation of this environment due to its steepness. However, we see
two good trendline anchor points in 16 and 17 and draw trendline 21—a better line
to defend.
 17A. New Higher High 10.81; Low BP 9.89 (+3% 11.13).
 17B. New Higher High 11.16; Low BP 10.58 (+3% 11.49).
 17C. New Higher High 11.62; Low BP 11.22 (+3% 11.96).
 18. Support-resistance line.
 19. Flag that becomes BP . High 11.62.
 19A. New Higher High 12.55; Low BP 11.91 (+3% 12.93); Stop 11.19.
 22–24. A good reaction finally occurs at 22 giving a strong Basing Point and good rationale
for raising the stop. Notice the interesting fact that points 22 and 24 have come back
to rest on the trendline we drew at 10. As the tempo has increased, and the volatility,
24 furnishes us another valid Basing Point.
 24A. New Higher High 12.93; Low BP 12.43 ( +3% 13.34); Stop 11.68.
 24B. New Higher High 13.41; Low BP 13.07 (+3% 13.81); Stop 12.29.
 25. Even 25 is a valid point and we can now see the clear support line at 26.
 25A. New Higher High 13.82; Low BP 13.36 ( +3% 14.23); Stop 12.56.
 25B. Stopped out at 12.56.
 26. Support-resistance line.
 27 . When this line is pierced at 27 upon extraordinary volume, and in the process takes
out our Basing Point stop from 25, it is clearly time to exit the train.
373
chapter twenty-nine
Trendlines in action
From what has already been said in Section I of this book, you will be familiar with the
characteristic single-line trends of stocks and the numerous exceptions and deviations that
come into the picture from time to time. We know stocks often move in parallel trends,
sometimes for months, occasionally even for years. We also know they may, and do, break
out of trend or change the direction of their trends without notice.
Most of the pattern formations we have studied can be considered as manifestations of
trend action, or Continuations or Reversals of a trend.
Thus, a Symmetrical Triangle is simply the meeting of two trends. During the formation
of the Triangle, the stock is following both trends in a narrowing pattern until, finally, the
dominant trend asserts itself. An Ascending Triangle is following an upward trend but has
encountered a Resistance Level at the Top. A Head-and-Shoulders Formation shows the
end of an upward trend and the beginning of a downward trend. A Rectangle is a Parallel
Trend Channel running in a horizontal direction, and so on.
We can project a Parallel Trend and, in the case of stocks continuing to move in that
trend, we can buy and sell at almost the precise points of contact with the trendline.
Unfortunately, long and perfect straight-line trends of this sort are the exception rather than
the rule. For actual trading purposes, we will project our trends more or less continuously
on the basis of the most recently established data.
From the standpoint of tactics, let us consider the trends as they are indicated by the
successive Minor Tops and Minor Bottoms. For illustration of this, and as a guide to what
we are leading up to, we will consider simplified, ideal situations (see the examples in
Diagrams 29.1 through 29.6).
To avoid confusion, mark the top trendline in blue pencil and the bottom trendline in
red pencil. We will refer to the upper trendline as the Blue Trend, and the lower trendline as
the Red Trend. From time to time, we will also want to draw a line parallel to a Blue Trend
across the Bottom of the trend so as to include a segment of the Trend Channel between
two Tops within parallel lines. This we will call the Blue Parallel, and we will mark it with
a dotted or broken blue line. Conversely, we may wish to draw a parallel to the Red Trend
so as to include the segment of the Trend Channel between two Bottoms, and this dotted
red line we will call the Red Parallel.
Ordinarily, a Top (wave high) will be formed after a Bottom (wave low) and a Bottom after
a Top; thus, we will expect to draw, alternately, a Blue Trendline and a Red Trendline with
these lines being drawn as soon as the new Top or Bottom is established. (In some cases, a
light pencil line may be drawn to indicate suspected Tops or Bottoms, until developments
confirm their validity.)
We have already taken up the important and rather difficult question of determining
the Minor Tops and Bottoms. Very often, these points will be clear and obvious. Sometimes
they will be obscure, and you will be able to draw trendlines with confidence, in such cases,
only after considerable experience covering many types of actions. The most difficult times
to determine Minor Trends are during Reversals, especially in cases in which these are of
374 Technical Analysis of Stock Trends
the rounded and irregular types. In thes


nts will be clear and obvious. Sometimes
they will be obscure, and you will be able to draw trendlines with confidence, in such cases,
only after considerable experience covering many types of actions. The most difficult times
to determine Minor Trends are during Reversals, especially in cases in which these are of
374 Technical Analysis of Stock Trends
the rounded and irregular types. In these cases (of Reversal), however, we will not depend
much on the trendlines to determine buying and selling points.
As long as a stock persists in a Parallel Trend Channel, it is perfectly clear to buy
near the Bottom of the channel and sell near the Top. From the geometry of the situation
(see examples), you will see at a glance it is not likely to be profitable to sell short in an
Diagram 29.1 Here is a rising trend showing the Basic Trendline across two Bottoms, which we call
the Red Trendline, and its parallel (indicated by a broken line) through the Top of the intervening
peak. The parallel suggests the approximate objective of the next move if the stock continues in trend.
Diagram 29.2 The same rising trend with the Return Line, which we call the Blue Trendline, drawn
through two Tops. The broken line represents its parallel through the intervening Bottom. This Blue
Parallel is useful in determining a buying point, especially in trends of rapidly changing form when
the stock may not react to its Basic Trendline.
Diagram 29.3 This is a declining trend showing the Basic Trendline across two Tops, which we call
the Blue Trendline, and its parallel (indicated by a broken line) through the Bottom of the intervening
decline. The parallel suggests the approximate objective of the next move if the stock continues in
trend.
375Chapter twenty-nine: Trendli nes in action
upward-moving trend (because the reactions are necessarily smaller than the advances),
or to buy stock in a downward-moving trend.
Therefore, a trend must show it is presumably an uptrend before you are justified in
buying stock. Plus, you must have what is presumably a downtrend to justify a short sale.
You will notice from the simplified examples shown here that pattern formations
indicate trends. The breaking of a Rectangle on the upside results in an upward slope of
the Blue Trend. The move up out of an Ascending Triangle confirms the rising Red Trend
and creates a rising Blue Trend. The downside breaking of a Head-and-Shoulders neckline
confirms a descending Blue Trend and sets up a descending Red Trend, and so on.
From studies of these patterns and various trend actions, we arrive at a compact set of
trading rules based on these Red and Blue trendlines. These rules are summarized below.
Buying stock, “going long”
• Preparatory buying signals (indicating a buying opportunity may be in the making).
Penetration of Blue Trend to a new high closing (in most cases). The simple breaking
of a descending Blue Trendline, in cases in which no other pattern or indication is
present, is not sufficiently conclusive evidence of Reversal to justify commitments.
A
B D
C E F
G
H I
K
J
W Y
Diagram 29.5 Simplified diagram of a stock chart showing trend action. Basic Trendlines are
marked with heavy lines; Return Lines are marked lightly.
Diagram 29.4 The same declining trend with the Return Line, which we call the Red Trendline,
drawn through two Bottoms. The broken line represents its parallel through the intervening Top.
This Red Parallel is useful in determining a point at which to make short sales, especially in trends
of rapidly changing form when the stock may not rally to its Basic Trendline.
376 Technical Analysis of Stock Trends
• Contact with the ascending Blue Trend if the Red Trend is also ascending, provided
the trends do not converge (Parallel or Divergent Trend Channel).
• Contact with the horizontal Blue Trend if the Red Trend is also horizontal or
ascending (Rectangle, Ascending Triangle).
• Penetration of the descending Blue Trend on volume if the Red Trend is ascending
(Symmetrical Triangle).
• Execution of buys (after preparatory buying signal).
• In case the previous Blue Trend has been ascending, draw the Blue Parallel and
buy at or near this line.
a b c
d e f
g h i
Diagram 29.6 Preparatory buying signals shown by trend action.
 a. Penetration of an ascending Blue Trendline.
 b. Penetration of a horizontal Blue Trendline.
 c. The penetration of a descending Blue Trendline without other technical indications is not
conclusive evidence of a change in trend and does not justify long commitments.
 d. Contact with the Blue Trendline of an Ascending Parallel Trend Pattern.
 e. Contact with the Blue Trendline of an Ascending Divergent Trend Pattern.
 f. In this case, contact with the Blue Trendline does not suggest a buy on the next reaction,
because the trend appears to be converging; a possible Wedge in the making, with Bearish
implications.
 g. Contact with the Blue Trendline of a Rectangle at its fifth point of Reversal.
 h. Contact with the Blue Trendline of an Ascending Triangle.
 i. Penetration on volume of descending Blue Trendline when Red Trendline is ascending
(Symmetrical Triangle).
377Chapter twenty-nine: Trendli nes in action
• In case the previous Blue Trend has been horizontal or descending (that is to say,
emerging from Rectangles, Triangles, and various Reversal Patterns), buy on a
reaction of 40%–45% of the distance from the last previous Minor Bottom to the
extreme Top of the most recent move.
j k l
m n o
p q r
Diagram 29.6 (Continued ) Preparatory signals for short sales shown by trend action.
 j. Penetration of a descending Red Trendline.
 k. Penetration of a horizontal Red Trendline.
 l. The penetration of an ascending Red Trendline without other technical indications is not
conclusive evidence of a change in trend and does not justify short commitments.
 m. Line of a Descending Parallel Trend Channel.
 n. Contact with the Red Trendline of a Descending Divergent Trend Patte


d action.
 j. Penetration of a descending Red Trendline.
 k. Penetration of a horizontal Red Trendline.
 l. The penetration of an ascending Red Trendline without other technical indications is not
conclusive evidence of a change in trend and does not justify short commitments.
 m. Line of a Descending Parallel Trend Channel.
 n. Contact with the Red Trendline of a Descending Divergent Trend Pattern.
 o. In this case, contact with the Red Trendline does not suggest a short sale on the next rally,
because the trend appears to be converging; a possible Wedge in the making, with Bullish
implications.
 p. Contact with the Red Trendline of a Rectangle at its fifth point of Reversal.
 q. Contact with the Red Trendline of a Descending Triangle.
 r. Penetration of ascending Red Trendline (with or without volume) when Blue Trendline is
descending (Symmetrical Triangle).
 In descending trends, the Red Trendline is a return Line, and short sales will be made on
rallies to a line parallel to the new Red Trendline established at the Bottom of the signal move
and drawn through the intervening peak. Note in the case of decisive breakouts from patterns
such as Rectangles and Triangles, a short sale might also be made on the basis of a computed
40%–50% correction of the breakout move, or on a return to Resistance.
378 Technical Analysis of Stock Trends
Liquidating, or selling a long position
Immediately on execution of the buy order, determine the stop level (see Chapter 27, Stop
Orders) and place your protective stop. Penetration of this stop level will automatically
close out your transaction. The stop level may be moved up according to the “three-days-
away” rule but may never be moved down (except to adjust for ex-dividend or ex-rights). If
the stock closes below a previous Minor Bottom (thus setting up a descending Red Trend),
sell on tight (EN: or hair-trigger) progressive stops.
At the start, the stock declines in a Parallel Trend Channel. The Blue Trendline is basic
here. A short sale on a rally to the Red Parallel at point A will find its objective on the Blue
Parallel at B. Another short sale on the Red Parallel at C would be followed by failure to
reach the objective. Chances are good, however, that increased volume would develop at the
Double Bottom and give warning to get out of short commitments. The upside penetration
of the basic Blue Trendline at E, alone, is not sufficient reason to reverse position and go long.
Trendlines set up during formation of the Rectangle would be marked in the regular way, but
they are indicated here by broken lines to emphasize the pattern. Another short sale, if tried
on the sixth point of contact with the Rectangle at F, would be stopped out on the breakout.
The trend is now rising, although we cannot yet draw a Basic (Red) Trendline. The first
buy would be made on a 40%–50% correction of the breakout move from the Rectangle, or
on a return to the Top (Support) level at H.
A trendline would be drawn to the first Bottom established in the Triangle. This is
not shown, as it would ultimately be replaced by the line shown through the outermost
point in the Triangle. We have indicated by broken lines the trendlines set up during the
formation of the pattern.
The objective of the breakout move from the Triangle would be the Red Parallel to our
now rising Basic Trendline; this objective is reached at J. A Return Line (Blue) would be
drawn from the first Reversal Top of the Triangle at G through the Top of the breakout move
at J, and the parallel to this through point I would indicate about where to make the next
purchase. As a matter of fact, the stock does not actually get back to that point; in practice,
the purchase would probably be made at K on the basis of a 40%–50% correction, or on a
reaction to the Support Level G.
The subsequent upward move would not carry through to the Red Parallel marked W;
however, the alarm would probably be sounded clearly by a day of heavy volume, a One-
Day Reversal, or a gap. Since the trend is now obviously convergent, no further purchases
would be considered. The next move fails to make such headway and falls far short of the
objective set by the Red Parallel marked Y. Soon after, the Wedge breaks out downside.
If the stock advances on moderate volume and then develops unusually high volume
on any day during the advance before either the Blue Trend is broken (with a close above
that trendline) or before the stock has made a new high closing over the last Minor Top,
close out the transaction on tight progressive stops.
If the stock develops high volume on the day on which it either tops and closes above
the Blue Trend or makes a new high closing over the previous Minor Top, hold it. If heavy
volume again occurs on the following day or any subsequent day, however, sell on tight
progressive stops.
In rising trends, the Blue Trendline is a Return Line, and purchases will be made on
reactions to a line parallel to the new Blue Trendline established at the Top of the signal
move and drawn through the intervening Bottom. Note in the case of decisive breakouts
from patterns such as Rectangles and Triangles, a purchase may also be made on the basis
of a computed 40%–50% correction of the breakout move, or on a return to Support.
379Chapter twenty-nine: Trendlin es in action
You will find in many cases the heavy volume signal will develop (sometimes with also
a One-Day Reversal or an Exhaustion Gap) on or near the Red Parallel; watch especially for
this volume indication as a sign of a good profit-taking point. If the volume signal does not
show up, your selling objective is this Red Parallel, at a limit or on tight progressive stops.
In case there is no such volume signal at the top of the move and the move does not reach
the Blue Trend or make a new high, you are very likely running into a Triangle situation.
In that case, you will have to wait for a breakout one way or another. Meanwhil