s follows. The editor offers this exposition only for perspective. His
own preferred method, Pragmatic Portfolio Theory, follows thereafter.
EN9: Risk and trend
Risk of a portfolio and risk of a stock are affected by being the right way in the trend. It
seems intuitive and it is observable that losses (thus risk) expand in an Enron case in which
the trader remains long while the stock dies. The converse is also true; Risk is diminished
to a portfolio and a stock when it is with the trend. In a paper submitted to the Market
Technicians Association ( http:/ /www.mta.org), “Dissecting Dow Theory,” Bassetti and
Brooker argue (with some success in the opinion of this editor) that risk can be proved to
diminish in the Industrials when the portfolio (of Industrials) is with the trend as identified
by Dow Theory. This paper is available at the Magee website, http:/ /www.edwardsmagee.
com. The paper was subsequently expanded into the book, Sacred Chickens, the Holy Grail
and Dow Theory.
Value-at-Risk procedure
(EN: VAR is a method of assessing and controlling risk. Particularly, VAR measures the worst
expected loss over a given time interval under normal market conditions at a given confidence
level. This rather complex statistical process is in use in numerous banks, American and
European regulators in Basel and at the Federal Reserve have largely accepted it as an acceptable
risk control procedure. The hole in the procedure is in the words “normal market conditions.”
The procedure is based in MPT. As Mandelbrot has remarked, MPT ignores 5% of market data,
treating market collapse as if it did not exist. VAR and MPT both ignore trend risk, as though
it does not exist.
500 Technical Analysis of Stock Trends
As a brief description of the VAR procedure, I offer the following: returns of the individual securities
are determined and, from these, returns of the portfolio are calculated. This is done based on some time
period for which the portfolio is held. Thus, from day to day the returns, or changes in value, of the
portfolio will vary—some positive and some negative. Taking a totality of returns, an average return
will be determined. A frequency distribution of returns may be constructed. The width of this frequency
distribution measures the riskiness of the portfolio. Thus, a portfolio with a minimum return of 1% and
a maximum return of 8% is inherently less risky (according to investment theory) than one with returns
varying from −1% to 20%. Although a frequency distribution is illustrative, it does not give us a
common measure for two different portfolios. That is done by determining the volatility of the portfolio.)
Volatility measures the deviation of returns from the mean, known as the standard deviation and
is indicated by the Greek letter sigma (σ). (EN: The higher the volatility of a portfolio the greater its
risk, according to the academic theory. This would seem to be intuitive, in that a commodity portfolio
might range from −30% to 100% returns because of leverage, whereas a bond portfolio would vary
only by the market price of the bonds and would return face value at maturity. In calculating bond
risks, managers ignore the deterioration of money—but that is a little secret among us pragmatic
analysts and we need not bother academicians and bond traders with that information, as they would
not want to know it anyway.
As pointed out, portfolio volatility can be easily obtained if we have sufficient experience with
the portfolio. If we have to calculate the volatility, the procedure gets quite complicated and the entire
procedure for determining our VAR requires some statistical sophistication as well as a gamut of data.
We must weigh the components of our portfolio, determine their correlations, compute correlation
coefficients, and on and on. As Mandelbrot notes in Scientific American, at the end of all this, we
would still be wondering what to do in the Perfect Storm. A crystal-clear procedure for computing
VAR is presented in Philippe Jorion’s excellent book Value at Risk.
Pragmatic Portfolio Theory (and practice)
Perhaps, rather than giving ourselves headaches trying to remember college statistics, we should look for
something simpler and more pragmatic—something just as serviceable for the general investor: Pragmatic
Portfolio Theory. The academic world, and the world of rarefied Wall Street, strives madly to quantify
everything in the world except the risks and liabilities that they themselves create for their customers.
Let us seek simpler methods to quantify the risks of individual stocks and the portfolios they
reside in, knowing all the time that absolute precision is impossible (namely, professional portfolio
managers’ performance in the Great Panics—1929, 1957, 1987, 1989, 2008–2009; Long-Term Capital
Management, which almost brought down the world financial system in 1998; and Leland O’Brien
Rubinstein Portfolio Insurance, which contributed significantly to the Reagan Crash in 1987).
Pragmatic portfolio risk measurement
Determining the risk of one stock
The theoretical risk of a stock is commonly agreed to be its volatility, which is determined as detailed
in Chapter 24. Subsequently, we might say the theoretical risk of our stock, Microsoft, for example,
equals on 100 shares, our position, at the market price of 120 and annualized volatility of 0.44:
 Theoreti cal Risk = Volatility × Position × Price
 V × Po × Pr = T$Risk
 .44 × 100 × 120 = $5,200
501Chapter forty-two: Portfolio risk management
where
T$Risk = Theoretical Risk (dollar)
 V = Volatility
 Po = Position (number of shares)
 Pr = Price
Theoretically speaking, the annual risk for Microsoft should be Volatility × Price or (in
2000) 0.44 × 120 or $52.00. In fact, those non-chart analysts who bought Microsoft at 120
(there were some), and who did not have the technician’s ability to set a stop and discipline to
stick to it, saw a risk of 50% from its top of 120 in Febr


V = Volatility
 Po = Position (number of shares)
 Pr = Price
Theoretically speaking, the annual risk for Microsoft should be Volatility × Price or (in
2000) 0.44 × 120 or $52.00. In fact, those non-chart analysts who bought Microsoft at 120
(there were some), and who did not have the technician’s ability to set a stop and discipline to
stick to it, saw a risk of 50% from its top of 120 in February 2000 to its (presumed) bottom of
60 in June 2000.
There is another measurement that might be more meaningful to us, Operational Risk.
Operational Risk refers to the specific instance of the particular trade. For example, we have
taken an initial position in Microsoft of 100 shares. Our analysis has identified a stop point at
which we put our stop, which is 5% away from the market price. Our Operational Risk is as
follows:
 Operational Risk = Market Price − Stop Price × Position
 (MP − S) × Po = O$Risk
 (120 − 114) × 100 = 600
where
O$Risk
 = Operational Risk (dollar)
 MP = Market Price
 Po = Position
 S = Stop Price
Determining the risk for a portfolio
Computing the theoretical risk for a portfolio is quite a complex process. It involves, in
essence, finding the volatility for the portfolio as a whole, and multiplying the portfolio
market value by the portfolio volatility. This does not sound so complex, but volatility
is not determined by simply adding together volatilities of individual securities. Rather,
correlations between instrument returns must be computed, and variance and covariance
of securities must be determined as steps along the way. This by no means presumes to be
a complete description of the process, further study of which may be guided by entries in
Appendix B, Resources.
The theoretical risk for a portfolio is, for a simple case, as follows:
 Volatility × Market Value
 TP$Risk = MV × V
where
TP$Risk = Portfolio Theoretical Risk (dollar)
 MV = Market Value
 V = Volatility
502 Technical Analysis of Stock Trends
Under normal market conditions, the Operational Risk of a simple Portfolio, PO$Risk, may be
calculated by first taking the sum of the Operational Risk figures, O$Risk, for each stock held long.
Then the sum of O$Risk for short positions is subtracted from the first figure.
 PO$Risk = (sum of O$Risk longs) − (sum of O$Risk shorts)
In the situation of perfect negative correlation, the two factors would be summed.
Measuring maximum drawdown (maximum retracement)
In the designing and testing of a system, or in actual trading experience, we care little about standard
deviations and cold statistics. What bothers us is the flow of blood—the worst run of “luck” or
experience we have. What is the greatest sustained loss we suffer before our system or trading method
rights itself, stanches the flow of blood, and begins to accumulate profits again? Constructing a wave
chart is one way to look at this experience.
Measuring from the top of the wave to the bottom gives us our maximum drawdown, and
an idea of what amount of capital we need and how much reserves to maintain. It also gives us
a vivid depiction of our results. A chart with many tsunamis (in the wrong direction) probably
means we need to modify our methods—unless we genuinely enjoy riding roller coasters (with the
full understanding that dreadful accidents do sometimes happen on thrill rides). If constructing a
system without actual market experience, one should multiply maximum drawdown by 3 or 4 to get
a reasonable amount of capital with which to back the system.
Pragmatic portfolio analysis: measuring the risk
In analyzing a portfolio, we must first know what is important to measure. To be able to control risk, we
must be able to measure it. Theoreticians identify risk with volatility. There are some real-life problems
with this concept, but we will use it for the moment anyway. In a portfolio, we want to be able to separate
our various types and weights of risk. In terms of volatility, bonds are obviously less volatile than stocks,
and unleveraged commitments are less volatile than, say, futures. Similarly, if the portfolio is not risk
balanced, that is, if one issue represents a large proportion of the whole, then it represents a larger portion
of the risk. But, if a portfolio consisted of only the Standard & Poor’s 500, that would obviously be a
different case, because a commitment like this would be by definition diversified. Thus, we must know
what is important to measure (see Philippe Jorion’s Value at Risk. In addition, there is a piece of tutorial
software called Risk Management 101, Zoologic Corp., which is excellent in presenting these concepts).
In operational or pragmatic terms, a trader wants to know what his operational risk is, rather than his
theoretical risk, and does not consider upside equity volatility a negative. A trader may choose to measure
risk by the pragmatic method outlined here. In doing so, he will want to know for his Portfolio Ordinary
or Normal Risk, POR, his Risk Over Time, PRT, and his Extraordinary or Catastrophic Risk, PCR.
Portfolio Ordinary or Operational Risk
“Ordinary” and “Operational” may be used interchangeably when discussing daily risk. First
consider we want to measure our risk today. Our Ordinary Risk today is easily computed by taking
the stop price from the market price on each position and summing the differences, as above. Dividing
this figure by the allocated capital (Total Capital, TC) will give us a Portfolio Risk Factor (PRF),
which is the risk factor the trader is willing to assume for one day.
 POR = sum of differences
 PRF = PO$Risk/TC
503Chapter forty-two: Portfolio r isk management
Portfolio risk over time
The Daily Operational Risk number can be annualized to give us a number for risk over time—or it
can be computed for a week or a month, and so on. Or, this factor may be collected from operations.
It may be collected by taking each day’s Ordinary Risk, summing and dividing for the desired time
period (and plott

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


PO$Risk/TC
503Chapter forty-two: Portfolio r isk management
Portfolio risk over time
The Daily Operational Risk number can be annualized to give us a number for risk over time—or it
can be computed for a week or a month, and so on. Or, this factor may be collected from operations.
It may be collected by taking each day’s Ordinary Risk, summing and dividing for the desired time
period (and plotted). It also may be computed by taking the average return and the variances therefrom
and calculating the standard deviation. This is Risk Over Time. Annualized risk, for example:
 DR × (square root 365) where DR = Daily Risk
Portfolio extraordinary or catastrophic risk
Extraordinary Risk is the risk of market collapse or panic on any given day. The way to look at this
risk is, first of all, to assume normal behavior of the markets, or your everyday panic. In this case, if
all of one’s positions cratered, one would take his worst-case, one-day loss and be out of the market.
To extend this analysis, assume the market makes a two, then four, then six standard deviation move.
What will be the effect on your position in this event, when stops will not be honored by specialists
and market makers and the market will be stampeding like spooked cattle for the exits? That is,
meltdown. This is Extraordinary or Catastrophic Risk. If you have no capital reserve you are out
of business.
Controlling the Risk
The most danger in these meltdown events is in the greatest leverage—so the greatest risk is in short
options—and usually short puts. You will remember my story of my customer at Options Research
Inc. who lost $57 million during the Reagan Crash of 1987; he was short puts. Some market makers
have been destroyed by shorting calls, but the case is rare and specifically results in the case of
takeovers and unwise concentration of commitments in one issue only.
The least risk lies in being hedged. To oversimplify, long the stock, long the put. The profit of one
makes up for the loss on the other. Also, if one were long some stocks and short others, that also is a
kind of hedge. Or long the Dow and short futures on the Dow, or some of its components.
Now, let us be pragmatic; if during the management of our portfolios we consistently measured
the market with the MEI and balanced our portfolio accordingly, we will be at less risk, both from
the Ordinary and the Extraordinary viewpoint. In fact, we may profit from an event that disemploys
many professional money managers.
If you have been religiously raising your stops, following the market with progressive stops,
and in fact raising them on the basis of new highs as described in Chapter 28 (the three-days-away
rule), it is quite possible that while the market is storming, you will be sailing to Byzantium in your
customer yacht.
Summary of Risk and Money Management Procedures
The procedures described above are easily reducible to simple formulas, even for the math phobic.
Trade size is the basic unit for controlling risk. Regardless of volatility, 500 shares of anything is
riskier than 100 shares.
To determine trade size, take the difference between the entry price and the stop price, giving
Dollar Risk 1 ($R1). Take the Risk Control Factor, the percentage of total capital to be ventured on
the trade, and multiply times Total Capital—for example, 3% times TC of $100,000, giving Risk-
per-Trade. Divide Risk-per-Trade by Dollar Risk 1 to determine Trade Size.
504 Technical Analysis of Stock Trends
 EP − SP = $R1
 RCF × TC = RpT
 RpT/$R1 = TS
where
 TS = Trade Size
 EP = Entry Price
 SP = Stop Price
 $R1 = Dollar Risk 1
RCF = Risk Control Factor
 TC = Total Capital
 RpT = Risk-per Trade
Measure daily Operational Risk as described above. Divide Operational Risk by Total Capital
to determine Portfolio Operational Risk Factor. If this factor is too high, look for hedges or positions
to eliminate, starting with those that are underwater.
Recompute stops frequently (daily for a trader), raising them according to the Basing Points
Procedure, Support and Resistance, or Trendlines. Additionally, a money management stop may be
employed, where the trader says, for instance, no more than 8% from the market price will be risked
and this 8% must represent no more than x% of total capital. Money management stops, it should
be noted, are inherently less dynamic than technically placed stops.
As the markets proceed inevitably through their phases, track their internal composition with the
MEI, and as positions are naturally terminated, put on new positions in accord with the general long
and short strength readings of the MEI. Remember that exceptionally high MEI readings coincide
with broad market tops, and exceptionally low MEI readings coincide with broad market bottoms.
Professional risk managers compute daily the Extraordinary Risk potential in the markets using
the procedure described in this chapter to constrain traders under their authority from overexposure.
In fact, panics and crashes rarely occur out of the blue. There is almost always a pre-panic phase the
truly alert trader can identify, especially with the aid of a computer; these are marked by insider and
professional selling that creates increasing volume with Reversal Days occurring in many stocks
and Gaps and Runaway down days. Almost always, these conditions will be preceded by many top
formations among key stocks—Double and Triple Tops and Heads-and-Shoulders and V-Tops.
Eternal vigilance is the cost of freedom. It is also the cost of investing success.
Infinitely more sophisticated risk and money management
procedures—Ralph Vince and optimal f
Undoubtedly, one of the most sophisticated analysts now practicing is Ralph Vince, author of The
Handbook of Portfolio Mathematics and progenitor of the Leverage Space Model. He defines
risk as we do, as drawdown, not as the variance of returns. His procedure for determining trade size
is extremely sophisticated—more so than th


ted risk and money management
procedures—Ralph Vince and optimal f
Undoubtedly, one of the most sophisticated analysts now practicing is Ralph Vince, author of The
Handbook of Portfolio Mathematics and progenitor of the Leverage Space Model. He defines
risk as we do, as drawdown, not as the variance of returns. His procedure for determining trade size
is extremely sophisticated—more so than the procedures I have outlined here. Although I feel these
procedures meet the needs of the general investor, Vince’s procedure is must reading for the more
sophisticated investor and trader. He has described the Leverage Space Model in a short article found
in Section 8 of Appendix B, Resources.
505
chapter forty-three
Stick to your guns
It has often been pointed out that any of several different plans of operation, if followed
consistently over a period of years, would have produced consistently a net gain on market
operations. The methods we have discussed in this book (representing the technical
approach) are a case in point.
The fact is, however, that many traders, not having set up a basic strategy and having
no sound philosophy of what the market is doing and why, are at the mercy of every Panic,
boom, rumor, tip, in fact, of every wind that blows. Since the market, by its very nature,
is a meeting place of conflicting and competing forces, they are constantly torn by worry,
uncertainty, and doubt. As a result, they often drop their good holdings for a loss on a
sudden dip or shakeout; they can be scared out of their short commitments by a wave of
optimistic news; they spend their days picking up gossip, passing on rumors, trying to
confirm their beliefs or alleviate their fears; and they spend their nights weighing and
balancing, checking, and questioning, in a welter of bright hopes and dark fears.
Furthermore, a trader of this type is in continual danger of getting caught in a situation
that might be truly ruinous. Since he has no fixed guides or danger points to tell him when
a commitment has gone bad and it is time to get out with a small loss, he is prone to let
stocks run entirely past the red light, hoping the adverse move will soon be over, and there
will be a “chance to get out even,” a chance that often never comes. What is more, even
should stocks be moving in the right direction and showing him a profit, he is not in a much
happier position because he has no guide as to the point at which to take these profits. The
result is he is likely to get out too soon and lose most of his possible gain or overstay the
market and lose part or all of the expected profits.
If you have followed the preceding chapters carefully, you will have realized none of
the technical formations and signals is certain and unfailing. The chart action of a stock
discounts and records all presently known information about that stock (which includes all
matters of dividends declared or expected, split-ups, and mergers that are known to be
planned, political angles as they affect the market, world affairs, management, earning
records, and so on). The chart does not and cannot forecast unforeseeable events, matters
that are completely unknown to anybody. In a majority of cases, the charts are dependable. If
you are not satisfied this is true, you should study further, or else plan not to use charts at all.
On the other hand, if you are satisfied the charts are, for you, the most dependable
indication of the probable future course of stock prices, then you should follow explicitly
the signals given on your charts, either according to the rules we suggest here or according
to such other rules and modifications as your experience dictates. Nevertheless, while you
are following any set of rules and policies, follow them to the letter. It is the only way they
can help you.
If you do this, you will have certain large advantages, right at the start: (1) you will
never be caught in a situation in which a single stock commitment can wipe out your entire
capital and ruin you; (2) you will not find yourself frozen in a market that has turned
against you badly, with a large accumulated loss and your capital tied up, so that you
cannot use it in the reversed trend to make new and potentially profitable commitments;
506 Technical Analysis of Stock Trends
and (3) you can make your decisions calmly, knowing exactly what you will be looking
for as a signal to take profits, and knowing also that your losses, at the very worst, will be
limited to a certain definite amount.
All of this means you will have peace of mind. You will take losses and you will make
gains. In neither case will you have to take your notebooks home and lie awake worrying.
You will have made certain decisions. If developments prove you were right, you will, at
the proper point, take your profit. And if it turns out that you were wrong, then you can
take your comparatively small loss, and start looking for a better situation, with your capital
still largely intact, liquid, and available.
Your job, as a speculator, is to provide liquidity in the market and to counteract the
irrational excesses of market-in-motion. Part of that job is to keep yourself free to become
liquid whenever it is necessary to reverse your position. It is part of your job to keep
yourself free from irrational and excessive emotional actions. If you do this intelligently
and consistently, you will be performing a useful and necessary service to the general
economic welfare, and you will find the market offers as good or better returns for your
efforts as any other line of endeavor.
(EN9: With the ninth edition, I expect the reader will have some powerful new guns to stick to:
new lessons in Basing Points that show what a powerful procedure it can be; new analyses of Dow
Theory that refresh and reinforce the validity and persuasiveness not just of the Theory, but also of
long-term investing as such. EN10: And a host of new stop systems


fforts as any other line of endeavor.
(EN9: With the ninth edition, I expect the reader will have some powerful new guns to stick to:
new lessons in Basing Points that show what a powerful procedure it can be; new analyses of Dow
Theory that refresh and reinforce the validity and persuasiveness not just of the Theory, but also of
long-term investing as such. EN10: And a host of new stop systems to work with. Good trading and
stick to all your guns!)
507
Appendix A: The Dow Theory in practice
EN10: This appendix appears as Chapter 4 in the ninth edition.
EN9: The casual and careless reader will shake his head at this chapter and ask why on earth the
editor has not excised it from the book. The editor has not deleted the chapter because, like old-
fashioned cod liver oil, it is good medicine. It will appeal mainly to the serious student of not just Dow
Theory but also of long-term investing. If the reader has absolutely no interest in Dow Theory or
long-term investing, he may skip over this chapter and return to it in his old age, when he is wiser.
At this point, the reader, if he has little previous knowledge of the stock market, may be
suffering a mild attack of mental indigestion. The Dow Theory is a pretty big dose to
swallow at one sitting. We departed deliberately in the foregoing chapter from the order
in which its principles are usually stated in an effort to make it a little easier to follow and
understand. Actually, not all of the 12 tenets we named are of equal import. The essential
rules are contained in 2, 3, 4, 5, 8, 10, and 11. Number 1 is, of course, the basic assumption,
the philosophical justification for these rules. The other points (6, 7 , 9, and 12) furnish
“background material,” as the news reporters might put it, which aid in interpretation.
Theoretically, one should, by strict adherence to the essential rules alone, accomplish just
as much as he could with the added collateral evidence. (For illustrations in this appendix,
see Figures A.1 through A.9.)
However, the utilization of Dow Theory is, after all, a matter of interpretation. You may
memorize its principles verbatim and yet be confounded when you attempt to apply them to
an actual market situation. We can better organize our knowledge of the theory and acquire
some understanding of its interpretation by following through a few years of market action
and seeing how it looked at the time through the eyes of a Dow theorist. For this purpose,
we may well take the period from late 1941 to the beginning of 1947 because this covers the
end of one Bear Market, an entire long Bull Market, and part of another Bear Market, and
includes examples of most of the market phenomena with which the Dow Theory has to deal.
Five years of Dow interpretation
Figure A.2 is a condensed chart of the course of the two Dow–Jones Averages from January
1, 1941, to December 31, 1946, on which most of the Minor Trends have been disregarded
but all the recognized Intermediate Swings (Primary and Secondary) have been indicated.
Certain portions of this history will be supplemented by complete daily charts in connection
with our detailed discussion that follows.
The year 1941 opened with the stock market in a Minor Rally. A Primary Bear Market
had been signaled when prices collapsed in the spring of 1940 and that Bear Market was
508 Appendix A
still in effect. After the May Panic had ended, a Secondary Recovery swing, which lasted
for more than five months, had regained more than half of the ground previously lost by
the Averages, carrying the Industrials from their closing price of 111.84 on June 10 to 138.12
on November 9 and the Rails from 22.14 on May 21 to 30.29 on November 14. (During
this long Bear Market Secondary, incidentally, volume tended to increase on rallies, which
encouraged many who did not hold strictly to first principles to believe that this rise was
the beginning of a new Bull Trend, illustrating the point we cited under “Volume” in
Chapter 3.) From the November highs, however, the trend turned down again. Then a
Minor Rally developed, as stated, at the end of the year, reaching its peak on January 10 at
133.59 in the Industrials and 29.73 in the Rails. From there, prices fell again to 117 .66 and
26.54, respectively, on February 14.
The first severe test
The next few months will be particularly interesting for us to trace because they put the
Dow Theory to a real test. Figure A.3 shows the daily ranges and closing prices of the
two Averages and total daily market volume for the seven months from February 1 to
DOW-JONES INDUSTRIALS
RAILS
RAILS
INDUSTRIALS
’41 ’42 ’43 ’44’ 45 ’46
220
200
180
160
140
120
100
80
70
60
50
40
30
20
Figure A.1 “Swing” (EN: or Wave) chart showing all the Intermediate and some of the more extensive
Minor Trends of the Dow–Jones Industrial and Rail Averages, January 1941 to December 1946.
Industrial price scale left, Rails right.
509Appendix A
August 31, 1941. Before we examine it in detail, however, let us first review the situation
on February 14. The Bear Market lows to date had been registered in May–June, 1940.
Thereafter, an extended Intermediate Recovery had advanced the Industrial Average
26.28 points and the Rail Average 8.15 points. This had been followed by a three-month
decline of 20.46 and 3.75 points, respectively, and this decline, incidentally, had consisted
of three well-defined Minor Waves. In duration, and in extent of price change with
respect to the previous swing—46% in the Rails and nearly 78% in the Industrials—this
downswing qualified as an Intermediate Trend, and now prices were turning up again.
Dow theorists were on the alert. If both Averages could continue their rise to levels
above their high closes of the previous November (138.12 and 30.29), that action would
constitute a signal of a new Primary Bull Market, and reinvestment of funds withdrawn
from stocks in May 1940 would be at once in order. Also, it would t


ified as an Intermediate Trend, and now prices were turning up again.
Dow theorists were on the alert. If both Averages could continue their rise to levels
above their high closes of the previous November (138.12 and 30.29), that action would
constitute a signal of a new Primary Bull Market, and reinvestment of funds withdrawn
from stocks in May 1940 would be at once in order. Also, it would then be necessary to
go back and label the May–June lows of 1940 as the end of a Bear Market, the advance to
November as the first Primary Swing in the new Bull Market, and the decline to February
as its first Secondary Reaction. Note Rule 12 of our preceding chapter ( EN11: Chapter 3 )
applied here; the presumption was it was still a Bear Market until a definite signal to the
contrary appeared.
Let us now turn again to Figure A.3 and see what actually did happen. The Industrials
rallied for six weeks, reaching 124.65 on April 3. The Rails got up to 29.75 on the same date,
registering double the percentage gain of the Industrials, but both Averages were still below
their November highs. Then the Industrials slipped off within two weeks and had broken
down below their February low and drifted down to close at 115.30 on May 1. This Average was,
therefore, still in an Intermediate Downtrend. The Rails, meanwhile, were staging a different
sort of performance; they dropped back from their April 3 high for two weeks, but held at 27 .72,
rallied smartly and then sold off again to 27 .43 on May 31. The picture became at once even more
130
128
126
124
122
120
116
118
INDUSTRIALS
RAILS
1941
31
30
29
28
27
26
FEBRUARY MARCHA PRIL MAYJ UNE JULY AUGUST
81 52 21 81 52 22 95 12 19 26 31 01 72 43 17 14 21 28 51 21 92 62 91 62 33 0
Sales in
Millions
2.0
1.5
1.0
.5Total Vol.
Figure A.2 Closing price levels of the Dow–Jones Industrial and Rail Averages, February 1 to August
31, 1941, and total daily market volume. Vertical lines show net daily change from one closing level
to next.
510 Appendix A
interesting. Here was a Divergence between the two Averages, a failure to confirm; the Rails,
after two opportunities, were refusing to confirm the Industrials in the latter’s downtrend.
Failure to confirm
When prices began to work upward in June, many commentators seized on this “failure to
confirm” as a Bullish omen and the wishful thinkers again talked Bull Market. There is an
unfortunate tendency in the Street to overstress any such divergence, particularly when
it can be twisted into a favorable sign. The fact is Dow Theory’s refusal of one Average
to confirm the other can never produce a positive signal of any sort. It has only negative
connotations. Divergences sometimes occur at Reversals in the Major Trend—there have
been several instances in market history, in which, perhaps, the most remarkable occurred
way back in 1901 and 1902, and we shall soon inspect another—but they also occur with
equal frequency at times when no Major Reversal is developing, and the instance we are
discussing here was one of the latter.
The situation at the end of May in 1941 was precisely the same to the Dow theorist,
insofar as the Major Trend was concerned, as it had been on February 14. The June–July
rally topped out in the Rails at 30.88 on August 1, and in the Industrials at 130.06 on July
28 (compare these figures with their 1940 November highs) and prices then declined at
an accelerating pace, temporarily culminating in the Pearl Harbor Panic. This took the
Industrial Average below its previous Bear Market low (111.84 on June 10, 1940), although the
Rails, again, did not follow. They had, however, by this time, broken below their previous
(February 14) Intermediate Bottom by a liberal margin.
The next period of importance began in April 1942. We can skip any detailed chart of
the months between December and April because they posed no Dow Theory problems.
INDUSTRIALS
RAILS
1942
30
29
28
27
26
25
24
23
116
114
112
110
108
106
104
102
100
98
96
94
92 Sales in
Millions
Total Vol.
1.0
2.01.5
.5
MARCHA PRIL MAYJ UNE JULY AUGUST SEPTEMBERO CTOBER
71 42 1284 11 18 25 29 16 23 3061 32 02 74 11 18 25 18 15 22 2951 21 92 6310 17 24 31
Figure A.3 Daily closing price levels of the Dow–Jones Industrial and Rail Averages from March 2
to October 31, 1942, and total daily market volume. This period saw the beginning of a 4-year major
bull market.
511Appendix A
After a Minor Rally in the Rails in January, prices simply drifted lower and lower, but it
was increasingly evident that trading volume did not expand on the dips (Minor Declines).
Liquidation was drying up; the boardrooms were void of customers; the atmosphere was
typical of the last stages of a Bear Market.
The daily action of the Averages from March 2 to October 31, 1942 is shown in Figure
A.4. New lows (since 1940) were registered both in late April, at 23.72 on April 24 in the
Rails and at 92.92 on April 28 in the Industrials. Shortly thereafter, a notable Divergence
developed, when, after rallying for only seven days, the Railroad Index began to slip off
while the other Average kept right on going up. Trading activity remained at a low ebb
(there was no sustained volume increase, in fact, until late September). On June 1, the Rails
dropped to another new low and on the 2nd closed at 23.31. On June 22, it looked as though
the Industrials were going to be pulled down again, but only a few days later, the best rally
in months got started, taking the Industrials to new highs and more than recovering all of
the April–May loss in the Rails. Activity also speeded up briefly, with one day registering
a greater turnover than the market had enjoyed in any session since early January. ( EN9:
Note this warning sign. The ringing of an alarm clock.)
Signs of Major Turn
Again, the Dow theorists were very much on the alert. An advance of Intermediate
proportions was obviously under way. Until proved otherwise, it had to be labeled a
Secondary withi


also speeded up briefly, with one day registering
a greater turnover than the market had enjoyed in any session since early January. ( EN9:
Note this warning sign. The ringing of an alarm clock.)
Signs of Major Turn
Again, the Dow theorists were very much on the alert. An advance of Intermediate
proportions was obviously under way. Until proved otherwise, it had to be labeled a
Secondary within the Bear Market, which was still presumably in effect, but that Major
INDUSTRIALS
RAILS 1942–1943
142
140
138
136
134
132
130
128
126
124
122
120
118
116
114
38
37
36
35
34
33
32
31
30
29
28
27
26
NOVEMBER DECEMBER JANU ARYM ARCHFEBRUARY APRILM AY JUNE
71 42 1 2851 21 9 26 29 16 23 30 61 32 02 76 13 20 27 31 01 72 41 81 5 22 29 51 21 92 63
Sales in
Millions
Total Vol.2.0
1.5
1.0
.5
Figure A.4 Daily closing price levels of the Dow–Jones Industrial and Rail Averages from November 2,
1942, to June 30, 1943, and total daily market volume.
512 Appendix A
Downtrend had by now run for nearly three years—nearly as long as any on record—and
its last decline had shown no selling pressure whatever, simply a dull drift. This presumed
Secondary might turn out to be a new Primary; hopes for such a denouement had been
blighted 12 months earlier under somewhat-similar circumstances, but this time prices
were lower and there was a different “feel” to the market. The general news offered little
encouragement, but the Dow Theory does not concern itself with any news other than the
market itself (which discounts all other kinds of news). In any event, there was nothing to
do but wait and see—let the market, in its own time and way, state its own case.
In early July, the Industrials started to “mark time”; for 11 weeks, they fluctuated within
a 5-point range, building a typical Dow Line from which they emerged on the upside in
late September. The Rails pushed up to a new high for the move at the same time, and by
November 2, both Averages had surpassed their Rally Tops of the preceding January. At
this stage, some Dow theorists were willing to announce a Bull Market had been signaled.
Their arguments, aside from points of a nontechnical nature or having nothing to do with
Dow Theory, were as follows:
 1. The conspicuously low level of volume at the April–June Bottom, typical of the end
of a Bear Swing. (True and cogent.)
 2. The Rail Average had refused to follow the Industrials into new Major low ground at
that time. It had held above its closing level of May 1940. (Also true, but of questionable
significance. More about this later.)
 3. The Industrials had constructed a Line and gone up out of it. (Again true, but the Line
was somewhat short to have, beyond a doubt, major import.)
INDUSTRIALS
RAILS
1943–1944
146
144
142
140
138
136
134
132
130
37
36
35
34
33
32
30
JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER JANUARY
31 01 72 43 17 14 21 28 41 11 82 52 91 62 33 06 13 20 27 41 1 18 25 18 15 22 29 5
Sales in
Millions
2.0
1.5
1.0
.5
Total Vol.
Figure A.5 Daily closing price levels of the Dow–Jones Industrial and Rail Averages from November
2, 1942, to June 30, 1943, and total daily market volume. This chart follows and should be compared
with Figure A.4. The decline in the Rail Average during November and early December produced the
first test of the Major Trend since the preceding June. When this Index recovered and, on February
1, 1943, closed above its November 2 high, a Primary Bull Market was thereby signaled according
to Dow Theory.
513Appendix A
 4. The Rail Average had produced successively higher Minor Tops and Bottoms for four
months. (This also was true but did not permit positive differentiation from a Bear
Market Secondary.)
The more conservative Dow theorists were not yet convinced. They maintained this
uptrend had yet to undergo the test, bound to occur sooner or later, of an Intermediate
Reaction. They admitted that the picture was most encouraging, but they called attention
to the fact that, except for Point 1, it was no better than that of November 1940. Let’s
follow along through the next five months. Figure A.5 shows the daily market action from
November 1, 1942, to June 30, 1943.
The Bull signal
After reaching 29.28 at their close on November 2, the Rails declined in almost a straight
line for six weeks to 26.03 on December 14. This move indubitably rated as an Intermediate
in duration and it had “given up” more than half of that Average’s entire advance from
the June 2 low point. The Industrial Index, however, held stoutly in another narrow Line
throughout November, December, and January. From December 14, the Rails turned up,
and finally, on February 1, 1943, closed at 29.55, out above their previous Intermediate Top
of 29.28 recorded the previous November. By then, the Industrials had also moved up into
new high ground. This development at last satisfied every strictest requirement of Dow
Theory; a new Primary Bull Market was in force. Trading volume had also been expanding
on each Minor Advance during the fall and winter months, but its evidence was not needed;
the price action alone was conclusive. The Rails had produced the necessary sequence of
higher Intermediate Tops and Bottoms. In the Industrials, Lines had served the purposes
of the theory as substitutes for Intermediate Reactions.
It was necessary now to relabel the up-move from April–June to November of 1942
as the first Primary Swing in a Bull Market. The decline of the Rails from November 2 to
December 14 was now recognized as the first Secondary within that Major Trend.
We may turn back for a moment at this point to comment on the performance of
the Rail Index in June 1942. Since it held above its low of May 1940, some commentators
have maintained the Bull Market should really have been dated from that former year as
representing the last “confirmed” lows. This strikes us as rather impractical hair-splitting.
Regardless of the 1.17 higher level in the Rail Average in June 1942,


r a moment at this point to comment on the performance of
the Rail Index in June 1942. Since it held above its low of May 1940, some commentators
have maintained the Bull Market should really have been dated from that former year as
representing the last “confirmed” lows. This strikes us as rather impractical hair-splitting.
Regardless of the 1.17 higher level in the Rail Average in June 1942, a genuine Bull Move
did not start until that time. We suspect, before many years have passed, Dow theorists
will have occasion greatly to regret the importance that has since been assigned to the
Rails’ “failure to confirm” in the spring of 1942. Remember, such a Divergence does not
and cannot produce a positive signal; at the time of its occurrence, it can serve merely to
negate or cast in doubt the implications of the other Average; only subsequent action in the
opposite direction can establish the existence of a change in trend. If the Rails’ decline in
May 1942 had carried them below 22.14, but their subsequent action had followed the course
it actually did, point for point at a lower level, a Bull Market Signal would nevertheless have
been given at the very same time, not one day later and not one day sooner.
Moreover, a Divergence does not necessarily imply a move of consequence in the
opposite direction will ensue. We have already examined one comparable instance (in the
spring of 1941) that resulted otherwise. Logically, if a failure to confirm such as occurred
in 1942 is to be taken as an indication of a turn in trend, then its opposite, (confirmation or
reaffirmation by both Averages) should argue with equal force against a turn in trend. Yet
the simple truth is that many more Major Reversals have come when the Averages were in
514 Appendix A
agreement than when they were divergent. We have no wish to belabor the point or waste
the reader’s time, but we do feel he should be warned against the wishful thinking that
every “failure to confirm” seems to inspire when the market is in a Bear Trend.
To return to our history, the Averages closed at 125.88 and 29.51, respectively, on the day
following our conclusive Bull Market Signal in February 1943. Theoretically, that is where an
investor who strictly followed the Dow Theory would have bought his stocks. (Those who
were satisfied the Primary Trend was up in November 1942 bought with Averages around
114.60 and 29.20.) It was reasonable to assume this Bull Market, which as yet showed few of
the usual characteristics of the second phase and none whatever of the third phase, would
continue for some time to come. The next four months produced no market developments
that required interpretative attention, and we can move on to the events of July. Figure A.6
charts the action from July 1, 1943, to January 31, 1944.
The first correction
After closing at 145.82 on July 14, 1943, the Industrial Average drifted off. The Rails pushed
up to a new high (38.30) 10 days later, but the Industrials refused to join in the rally and
then both indexes cracked down sharply for seven sessions. Turnover increased and the
decline was the greatest occurring in the Bull Market up to that date. However, everyone
realized the market, after several months of quite persistent advance, was “entitled to a
correction.” In neither duration nor extent could this down move be qualified as more than
a Minor Trend. Next ensued three months of desultory fluctuation with little net progress
in either Average. The Industrials pulled up to 141.75 on September 20 and then drifted
off again, whereas the Rails struggled back to 35.53 on October 27 . Another quick break
developed in early November, culminating in a high-volume shakeout that cut the value
INDUSTRIALS
RAILS
1945
192
188
184
180
176
172
168
164
160
66
64
62
60
58
56
54
52
50
MAY JUNEJ ULYA UGUSTS EPTEMBER OCTOBERN OVEMBER
51 21 92 62 91 62 33 07 14 21 28 41 11 82 51 81 52 22 96 13 20 27 31 01 72 43 1
Sales in
Millions
Total Vol.2.01.5
1.0.5
Figure A.6 Daily closing prices of Dow–Jones Industrial and Rail Averages, and total market volume,
July 1, 1943, to January 31, 1944.
515Appendix A
of the Industrials by 3.56 points and the Rails by 1.75 on November 8. Prices rallied a little
and sold off again, reaching new lows (since early spring) on November 30—Industrials
129.57 and Rails 31.50.
There was no question now that a full-fledged Secondary Reaction had developed. The
problem for Dow interpreters was whether there was more involved. If the first drop in July
could be construed as an Intermediate Trend in itself, and the August– October action as
another Intermediate Swing, then the November break would signal a Bear Market. As a
matter of fact, no Dow theorist, so far as we know, gave very serious consideration to any
such interpretation. The July break, as aforesaid, did not rate as an Intermediate in either
duration or points retraced; the whole move from July to November 1943 had to be regarded
as all-of-a-piece, all one Secondary Reaction. The real Major Trend test would come on the
next advance, whenever that should develop; if that failed to top the July peaks, and prices
thereafter declined to new lows, a Bear Market would indeed be in effect.
The decision was long deferred. Prices began again to move up, but the advance in
the Industrials was slow and grudging. The Rails forged ahead more rapidly and pushed
through their July Top on February 17 , 1944, going on to a Minor Peak at 40.48 on March 21.
The Industrial Average attained 141 on March 13, but still nearly 5 points below its “signal”
level, faltered and fell back. Here was another striking case of “failure to confirm.” For
those who chose to assign grave significance to such developments, it could have only a
very Bearish meaning. All it did mean, in fact, was continuation of the Primary Bull Move
had not as yet been confirmed. Only if both Averages now declined and closed below
their respective Novem


s below its “signal”
level, faltered and fell back. Here was another striking case of “failure to confirm.” For
those who chose to assign grave significance to such developments, it could have only a
very Bearish meaning. All it did mean, in fact, was continuation of the Primary Bull Move
had not as yet been confirmed. Only if both Averages now declined and closed below
their respective November 30 Bottoms would the new high registered by the Rails alone
in February have to be disregarded and a Primary Bear Market announced. In brief, the
situation at the end of March was no different, so far as its Major Trend implications were
concerned, from what it had been in early January before the Rails pushed through.
Bull Trend reaffirmed
The situation remained in doubt (but subject always to that basic presumption of the Dow
Theory that we named as Rule 12 in the preceding chapter [EN10: Chapter 3]) until June 15,
1944, when the Industrials finally came through to close at 145.86. It had taken them four
months to confirm the Rails, almost a full year to reaffirm the Primary Uptrend. The effect
of this “signal” on traders was electric; trading volume increased by 650,000 shares on the
following day as prices jumped another full point.
The following 12 months need no detailed discussion as they produced nothing in
the way of market action to give a Dow theorist any concern. Prices drifted off irregularly
for nine weeks after mid-July, but their net loss was of minor proportions, and they then
climbed with only brief interruptions to 169.08 in the Industrial Index on May 29, 1945, and
63.06 in the Rail Index on June 26, 1945. We should take a brief look at the period following,
not because it illustrates anything new in our study, but because it takes in the surrender
of Japan and the end of fighting in World War II.
The seven months from May 1 to November 30, 1945 are covered in Figure A.7. The
Industrials held steady for four weeks while the Rails were making the spurt to their June
26 Top. On June 28, with nothing in the newspaper headlines to account for such a radical
trend change, prices broke sharply and turnover climbed to nearly 3 million shares, the
highest day’s total for the Bull Market up to that time. Nevertheless, the Industrial Average
gave ground reluctantly thereafter, and by June 26, at 160.91 had given up less than 5% of its
top price. The Rails shook down rapidly, however. The Hiroshima bomb was dropped on
August 5, and Japan surrendered on the 14th. The Industrials were now rallying up from
516 Appendix A
their July 26 low, but the Rails could not hold and plunged again, hitting bottom finally
(for this move) on August 20 at 51.48, for a loss of more than 18% of their June peak value.
The Rails falter
Before we go on with our examination of the market action here, it is interesting to note up
to this point the Rail Average had been the “hero” of our story. Starting with its refusal to
go down to a new Bear Market low in June of 1942, it was the spearhead of each important
advance, had staged the most spectacular rallies, had gained 170% in value as compared
with the Industrials’ 82%. In retrospect, the explanation is obvious: the railroads were the
chief business beneficiaries of the war. They were rolling up profits, paying off indebtedness,
and reducing their fixed charges at a rate unheard of in this generation (and probably never
to be seen again). Although the “public’s” eye was on the traditional and better publicized
“war industries,” the market began, as far back as Pearl Harbor, to shrewdly appraise and
discount this unprecedented harvest for the Rails. But from here on, the picture changes
and the Rails become the laggards. As we look back now, it is just as obvious that, with
equal shrewdness, the market began in July of 1945 to discount a change in their fortunes.
An illuminating demonstration of the basic assumption (Tenet Number 1) in Dow Theory!
Turning back to our chart, prices began to push up again with renewed vigor after
August 20. Both Averages had experienced a Secondary Reaction and now Dow theorists
had to watch closely to see whether the Primary Uptrend would again be reaffirmed by
their going to new highs. The Industrials “made the grade” when they closed at 169.89 on
INDUSTRIALS
RAILS
1945–1946
216
212
208
204
200
196
192
188
184
70
68
66
64
62
60
DECEMBER JANUA RY FEBRUARY MARCH APRIL MAY
81 52 22 95 12 19 26 29 16 23 29 16 23 30 61 32 02 74 11 18 25 1
Sales in
Millions
Total Vol.2.0
1.5
1.0
.5
Figure A.7 Daily closing price levels of the Dow–Jones Industrial and Rail Averages from May 1 to
November 30, 1945, and total daily market volume. This period, which saw the end of World War
II, produced only a moderate Secondary Correction in the Primary Bull Market, which had already
run for three years from its beginnings in April/June, 1942.
517Appendix A
August 24, but the Rails had much more ground to recover and were running into offerings
as they came up in succession to each of the Minor Bottom levels of their June–August
downtrend (a phenomenon to which we shall devote some attention later on in the chapter
on Support and Resistance). Not until early November 1945 were they able to confirm the
signal of the Industrials by closing above 63.06. At this point, the Averages had, once again,
announced that the Primary Bull Market was still in force. It had now lasted for three
and a half years—longer than most Bull Markets, and “third phase” signs were rapidly
appearing. The public was buying, the boardrooms were crowded, stock market news was
making the front pages of even small city newspapers, the “cats and dogs” were being
whooped up, business was booming.
With both Averages in new high ground and the Bull Market reaffirmed, all
previous low points could now be disregarded. For example, the 160.91 Bottom of July
26 in the Industrials and the 51.48 of August 20 in the Rails had no further si


ms were crowded, stock market news was
making the front pages of even small city newspapers, the “cats and dogs” were being
whooped up, business was booming.
With both Averages in new high ground and the Bull Market reaffirmed, all
previous low points could now be disregarded. For example, the 160.91 Bottom of July
26 in the Industrials and the 51.48 of August 20 in the Rails had no further significance
in Dow Theory. This is a point we have not stressed heretofore, but it is important. It
might, indeed, be added to our set of rules in the preceding chapter (EN11: Chapter 3)
were it not implicit in the basic tenets. Once a Primary Trend has been confirmed or
reconfirmed, the past is forgotten and everything hinges on future action. At the end
of 1945, with “third phase” symptoms rife, the action of the market had to be followed
with redoubled vigilance. The third phase could last for two more years (as it did in
1927 to 1929) or be concluded at any moment. Our next chart (Figure A.8 ) carries us
through May 1946.
The spring of 1946
The market went through a Minor Setback in late December, a development has come to be
expected as the normal pattern for that month and is usually attributed to “tax selling”—
and stormed ahead again in January 1946. Daily volume on January 18 exceeded 3 million
shares for the first time in more than five years. During the first week of February, prices
“churned” with little net change. Extreme high closes were registered during this period
by the Rail Average at 68.23 on February 5, and by the Industrial Average at 206.97 on
February 2. On February 9, both started to slide off, pulled back sharply from the 13th to
the 16th, and then broke in a selling wave that ran to a climax on February 26 with closings
at 60.53 and 186.02, respectively. The loss in the Industrials was the greatest in points (20.95)
they had suffered during the entire Bull Market; in the Rails, it was exceeded only by their
July–August decline of the previous year. It amounted to a little more than 10% in the
former and 11% in the latter and gave up a little less than half of their advances from the
1945 summer lows. The decline was three weeks old on February 26. It was an unqualified
Intermediate—in Dow Theory a Secondary Reaction presumptively within the still existing
Major Uptrend.
Labor troubles were dogging the steel and motor industries in 1946 from early
January on, with a coal strike looming. The February break was attributed to those news
developments, but the ruling cause was more likely the discontinuance of margin trading.
In January, the Federal Reserve Board announced after February 1 stocks could be bought
only for full 100% cash. The late January up-fling was featured by the “little fellow” seizing
his last chance to buy on margin. (Those who participated in this scramble will doubtless
regret it for a long time yet to come.) Professionals seized the opportunity to unload
their trading commitments, but the “little fellow” was now temporarily out of funds; his
brokerage account was quickly “frozen.” Under the circumstances, as we look back, it is
amazing that a more extensive Panic did not then eventuate.
518 Appendix A
Yet the Dow theorist was not concerned with causes. The Bull Market had been
reaffirmed by both Averages in early February, canceling all previous “signal” levels.
Bullish Forces were still evidently in effect because the February 26 lows held and prices
began to recover. The Industrials came back quickly and by April 9 had closed in new high
ground at 208.03. The Rails dragged; when the market showed signs of weakening at the
end of April, the Rail Average was still nearly 5 points below its early February high. Was
this another “failure to confirm” to worry about?
INDUSTRIALS
RAILS
1946
216
212
208
204
200
196
192
188
184
180
176
172
168
164
160
70
68
66
64
62
60
58
56
54
52
50
48
46
44
MAY JUNE JULY AUGUST SEPTEMBERO CTOBER
11 18 25 18 15 22 29 61 3 20 27 31 01 72 43 1 7 14 21 28 5 12 19
Sales in
Millions
2.0
1.5
1.0
.5
Total Vol.
Figure A.8 Daily closing price levels of the Dow–Jones Industrial and Rail Averages from December
1, 1945, to May 31, 1946, and total daily market volume. Noteworthy features of this period included
the extremely high volume that prevailed during January and February as compared with lower
turnover in April and May, and the laggard performance of the Rails when the Industrial Average
pushed up to a new high in April and again at the end of May. At the latter date, the February lows
were still the critical downside “signal” levels according to the Dow Theory.
519Appendix A
Final Up-Thrust
The late February Bottoms were now the critical points on the downside; if both Averages
should decline below the Intermediate Low closes then recorded, before the Rails could
make a new high above 68.23 (in which event the Bullish Signal of the Industrials would
be canceled), a Bear Market would thereby be signaled. Despite a miner’s strike and an
imminent rail workers’ strike, the market turned firm again in mid-May and put forth a
surprising rally that swept the Industrial Index up to 212.50 on May 29, 1946—a new Bull
high by nearly 6 points. The Rails failed in May by only 0.17 to equal their February high
close, slid back a trifle, and then pushed through at last on June 13 to close at 68.31, thereby
confirming the Industrials in their announcement that (as of that date) the Primary Trend
was still up. The February lows (186.02 and 60.53) now ceased to signify in Dow Theory,
but keep those figures in mind because they are involved in an argument that raged among
Dow students for months thereafter.
The preceding picture is overlapped by Figure A.9, taking up the market’s action on
May 4 and carrying it forward to October 19, 1946. Trading volume, it may be noted, in late
May and early June did not come up to the levels of either the late January to early February
Top or the late Fe


gures in mind because they are involved in an argument that raged among
Dow students for months thereafter.
The preceding picture is overlapped by Figure A.9, taking up the market’s action on
May 4 and carrying it forward to October 19, 1946. Trading volume, it may be noted, in late
May and early June did not come up to the levels of either the late January to early February
Top or the late February Bottom; the market appeared to be losing vitality, an ominous,
although by no means, decisive manifestation. Prices began to fall off rapidly immediately
after the Rail Confirmation on June 13. The Industrials rallied for two weeks in early July,
but the Rails continued to decline; the Industrials broke again on July 15 and the two
Averages continued their slide until they stood at 195.22 and 60.41 at the close on July 23.
There, as it subsequently developed, was the end of that particular Intermediate
Swing—one in accord with our Rule 12 had to be labeled a Secondary Reaction in a Bull
Market until proved otherwise. The market swung up again. It climbed slowly and steadily,
but with turnover running well under a million shares, until exactly three weeks later, the
Industrials at 204.52 (August 13) had regained a little more than half of their June–July loss
and the Rails at 63.12 (August 14) a little more than a third of theirs. This advance, therefore,
had met the minimum requirements of an Intermediate Trend. If prices could continue to
rise and eventually push through their May–June Tops, the Major Bull Trend once again
would be reaffirmed. Although, if they should turn down and fall below the July 23 closing
levels, it would signal a Reversal of the Primary Trend.
The Bear Market signal
The situation was critical, as evident in the volume chart. Ever since the end of May,
turnover had tended not only to increase on the declines, but also, and more importantly,
dried up on the rallies. Compare Figure A.9 with Figures A.7 and A.8 , and you can see
how conspicuous this phenomenon had become by mid-August. Prices did turn down,
with activity increasing on the breaks, and on August 27 , the closing prices, 191.04 for the
Industrials and 58.04 for the Rails, told a sad story. The Averages had spoken: a four-year
Bull Market had ended, and a Bear Market was under way. A Dow investor should have
sold all his stocks on the following day (at approximately 190 and 58 in terms of the two
Averages).
To clear the record, it was necessary for the Dow theorist now to go back and mark
the May 29 and June 13 highs in the Industrials and Rails, respectively, as the end of the
Bull Market. The June–July decline then became the first Primary Swing in the new Bear
Trend, and the July 23 to August 14 advance became the first Secondary Recovery within
the Major Downtrend. A second Primary Swing was now in the process of development.
520 Appendix A
You will have noted in the foregoing, a Bear Market was signaled as soon as both
Averages penetrated their July 23 lows. Let us return now and take up that argument we
mentioned on the preceding page. Some students of Dow Theory refused to recognize the
new high of June 13 in the Rail Average as a decisive reaffirmation of the Bull Trend. The
previous close should be bettered by at least a full point (1.00), many argued, to confirm
the signal previously given by the Industrials; the margin of only 0.08 was inconclusive.
Nevertheless, this opinion, if accepted, had logical consequences that later proved
INDUSTRIALS
RAILS
1946
216
212
208
204
200
196
192
188
184
180
176
172
168
164
160
70
68
66
64
62
60
58
56
54
52
50
48
46
44
MAY JUNE JULY AUGUST SEPTEMBERO CTOBER
11 18 25 18 15 22 29 61 3 20 27 31 01 72 43 1 7 14 21 28 5 12 19
Sales in
Millions
2.0
1.5
1.0
.5
Total Vol.
Figure A.9 Daily closing price levels of the Dow–Jones Industrial and Rail Averages from May 4 to
October 19, 1946, and total daily market volume. This chart overlaps Figure A.8. Compare the closing
price of the Rail Average on June 13 with its February 5 high close. This June action nullified the
previous Dow Theory importance of the February lows. Note significant change in volume pattern
after May, especially during the August rally.
521Appendix A
embarrassing. For, if the Bull Market had not been reaffirmed in June, then the critical levels
on the downside remained at 186.02 in the Industrials and 60.53 in the Rails, the February
26 Bottoms. Therefore, a Bear Market could not be “called” until those prices had been
penetrated downside by both Averages. This view acquired a large following, especially
among those who were not interested in “hair splitting” theory but wanted “to give the
market every chance in view of the still improving fundamentals.”
The market did, of course, proceed to break its February lows, and by that time, the
Panic (second phase) was on. Obviously, in this case, the orthodox “any-penetration-
whatever” school had all the best of it; they had sold out at least 13 points higher up in
terms of the Industrial Index (at least 6 in the Rails). Six weeks later, on October 9, 1946, this
second Primary Intermediate Swing ended at Industrials 163.12, Rails 44.69, and another
Intermediate Recovery Move started.
Before closing this history of six years of Dow Theory interpretation, we might note the
June 13 high in the Rail Average furnished a perfect illustration of the rule stating a trend
can change any time after it has been confirmed or reaffirmed, also of the diminishing odds
in favor of continuance with each successive reaffirmation of the Primary Trend.

523
Appendix B: Resources
• Section 1: Important and indispensable sites
• Section 2: References for further study
• Section 3: Investment-oriented sites
• Section 4: The Sharpe Ratio
• Section 5: Calculating volatility and examples of professional risk analysis
• Section 6: The essence of fundamental analysis
• Section 7: Software packages and Internet technical analysis sit


f the Primary Trend.

523
Appendix B: Resources
• Section 1: Important and indispensable sites
• Section 2: References for further study
• Section 3: Investment-oriented sites
• Section 4: The Sharpe Ratio
• Section 5: Calculating volatility and examples of professional risk analysis
• Section 6: The essence of fundamental analysis
• Section 7: Software packages and Internet technical analysis sites
• Section 8: The Leverage Space Portfolio Model of Ralph Vince
Section 1: Important and indispensable sites
Contact information for John Magee:
John Magee technical analysis::Delphic options research ltd (jmta::dor)
E-mail bassetti@edwards-magee.com
bassetti@att.net
Edwards-Magee website http://www.www.edwards-magee.com
SEC Enforcement http://www.enforcement@sec.gov
(Whenever I receive touts or investment spam, I immediately forward it to this important
branch of the SEC. All responsible investors should do the same.)
Volatilities and options: http://www.optionstrategist.com
Portfolio hedge computation http://www.cboe.com/portfoliohedge
http://www.cboe.com
http://www.abg-analytics.com
Software reviews and information http://www.traders.com
Software demonstrations and packages http://www.omegaresearch.com
http://www.comstar.com http://www.aiqsystems.com
http://www.tradestation.com http://www.equis.com
Web chart analysis site http://www.stockcharts.com
Morningstar http://www.morningstar.net
Industry evaluations http://www.gomez.com
Mutual fund cost calculator http://www.sec.gov/mfcc-int.htm
Internet analysis http://www.stockcharts.com
524 Appendix B
Section 2: References for further study
On Volatilities and Options: http://www.optionstrategist.com
(and futures) http://www.cboe.com
DOW futures and options http://www.cbot.com
AMEX iShares (DIA, QQQ, etc.) http://www.amex.com
On betas http://www.finance.yahoo.com
On risk
Value at Risk, Phillipe Jorion, New York: John Wiley & Sons, 1996
Against the Gods, Peter Bernstein, New York: John Wiley & Sons, 1996
Risk Management 101 (software), Zoologic, Inc., 1997 .
See also Chapter 42
On candlesticks
Japanese Candlestick Charting Techniques, Steve Nison, New York: NYIF, 1991
Beyond Candlesticks, Steve Nison, New York: John Wiley & Sons, 1994
On futures
Schwager on Futures, Technical Analysis, Jack Schwager, New York: John Wiley & Sons, 1996
(and other titles by Schwager in References).
On portfolio management
The Journal of Portfolio Management
Risk Management 101 (software), Zoologic, Inc., 1997
Chapter 42
Section 5, this appendix
Section 8, this appendix
Section 3: Investment-oriented sites
AARP Investment Program http://www.aarp.scudder.com
Accutrade http://www.accutrade.com
ADR.com http://www.adr.com
American Association of Individual Investors http://www.aaii.com
American Century http://www.americancentury.com
American Express Financial Services http://www.americanexpress.com/directa
American Stock Exchange http://www.amex.com
Ameritrade (has little-advertised free trade site) http://www.tdameritrade.com
Annual Report Gallery http://www.reportgallery.com
Barron’s http://www.barrons.com
BigCharts http://www.bigcharts.com
Bloomberg Financial http://www.bloomberg.com
Bonds Online http://www.bondsonline.com
525Appendix B
Briefing.com http://www.briefing.com
Brill’s Mutual Funds Interactive http://www.fundsinteractive.com
Business Week http://www.businessweek.com
CBS MarketWatch http://www.marketwatch.com
Chicago Board of Options Exchange http://www.cboe.com
CNNFN http://www.cnnfn.com
DailyStocks http://www.dailystocks.com
Excite http://www.excite.com
Federal Deposit Insurance Corporation http://www.fdic.gov
Federal Trade Commission http://www.ftc.gov
Fidelity Investments http://www.fidelity.com
Financial Times http://www.ft.com
Forrester Research http://www.forrester.com
FundFocus http://www.fundfocus.com
Fund Spot http://www.fundspot.com
Gomez Advisers http://www.gomez.com
H&R Block http://www.hrblock.com
Hoover’s StockScreener http://www.stockscreener.com
IPO Central http://www.ipocentral.com
Lombard http://www.lombard.com
Marketplayer http://www.marketplayer.com
Market Technician’s Association http://www.mta.org
Microsoft MoneyCentral http://www.moneycentral.com
Morningstar http://www.morningstar.net
National Association of Securities Dealers http://www.nasd.com
National Discount Brokers http://www.ndb.com
Net Investor http://www.netinvestor.com
New York Stock Exchange http://www.nyse.com
Online Investor http://www.onlineinvestor.com
Philadelphia Stock Exchange http://www.phlx.com
Quick & Reilly http://www.quickwaynet.com
Quicken http://www.quicken.com
Quicken Financial Network http://www.qfn.com
Realty Stocks http://www.realtystocks.com
Reuters http://www.reuters.com
Schwab, Charles http://www.schwab.com
Securities and Exchange Commission http://www.sec.gov
Securities and Exchange Commission Enforcement http://enforcement@sec.gov
Securities Industry Association http://www.sia.com
Securities Investor Protection Corporation http://www.sipc.org
SmartMoney http://www.smartmoney.com
Social Security Online http://www.ssa.gov
Standard & Poor’s Fund Analyst http://www.micropal.com
Standard & Poor’s Ratings Services http://www.ratingsdirect.com
Stock Guide http://www.stockguide.com
Stockpoint http://www.stockpoint.com
Suretrade http://www.suretrade.com
526 Appendix B
1040.com http://www.1040.com
The Motley Fool http://www.fool.com
TheStreet.com http://www.thestreet.com
Technical Securities Analysis Association of San
Francisco
http://www.tsaasf.org
T. Rowe Price http://www.troweprice.com
Treasury Direct http://www.publicdebt.treas.gov
Vanguard Brokerage Services http://www.vanguard.com
Wall Street Access http://www.wsaccess.com
Wall Street Journal Interactive Ed http://www.wsj.com
Yahoo! Finance http://www.finance.yahoo.com
Zacks Investment Research http://www.zacks.com
ZD Interactive Investor http://www.zdii.com
a American Express now advertises free trades for some accounts.
Brokerage houses
Waterhouse Securities http://www.tdameritrade.com
800-934-4134


http://www.vanguard.com
Wall Street Access http://www.wsaccess.com
Wall Street Journal Interactive Ed http://www.wsj.com
Yahoo! Finance http://www.finance.yahoo.com
Zacks Investment Research http://www.zacks.com
ZD Interactive Investor http://www.zdii.com
a American Express now advertises free trades for some accounts.
Brokerage houses
Waterhouse Securities http://www.tdameritrade.com
800-934-4134
A. B. Watley http://www.abwatley.com
888-229-2853
Web Street Securities http://www.webstreetsecurities.com
800-932-0438
Jack White http://www.jackwhiteco.com
800-753-1700
WitCapital http://www.witcapital.com
888-494-8227
Net Investor http://www.netinvestor.com
800-638-4250
Quick & Reilly http://www.quickwaynet.com
800-672-7220
Charles Schwab http://www.schwab.com
800-435-4000
Suretrade http://www.suretrade.com
401-642-6900
Vanguard Brokerage Services http://www.vanguard.com
800-992-8327
Wall Street Access http://www.wsaccess.com
888-925-5782
Empire Financial Group, Inc. http://www.lowfees.com
800-900-8101
E*TRADE http://www.etrade.com
800-786-2575
Lombard http://www.lombard.com
National Discount Brokers http://www.ndb.com
800-888-3999
527Appendix B
Accutrade http://www.accutrade.com
800-494-8939
Ameritrade http://www.tdameritrade.com
800-326-7507
See also http://www.freetrade.com
Discover Brokerage http://www.discoverbrokerage.com
800-688-3462
DLJ Direct http://www.dljdirect.com
800-825-5723
Datek Online http://www.datek.com
DLJ Direct http://www.dljdirect.com
Dow Jones Markets http://www.djmarkets.com
DRIP Central http://www.dripcentral.com
Empire Financial Group http://www.lowfees.com
Section 4: The Sharpe Ratio
Although this formula is flawed, it will not hinder the reader to know about it and
understand it. Believing in it would be quite a different matter, however. The Sharpe Ratio
itself is as follows:
 SR = (E − I)/sd
where
E is the expected return,
I is the risk-free interest rate,
Sd is the standard deviation of returns.
The effect of this inflexible formula is to stick the trader with a measuring tool
of little use to the practical trader. It assumes volatility of returns as measured by sd
equals risk (the common academic problem). In the inflexibility of the sd calculation,
it fails to measure the most important fact in trading, the maximum drawdown, or,
the inevitable fluctuations in gains and losses. Specifically, the greatest expected or
experienced loss, the retracement from greatest high to greatest low, and the sequences
of these experiences.
Section 5: Calculating volatility
To calculate the volatility of a portfolio or of an individual instrument, first find the
difference between each return and the average. Then square each difference and add
them together. Divide the sum by the number of returns minus one. This result is known
as the variance. Finally, take the square root of the variance to get the volatility. Combining
these steps into a formula (see Diagram B.1):
Step 1: Calculate the average return.
Step 2: Calculate the deviation of each return.
Step 3: Square each period’s deviation.
Step 4: Add them together.
Step 5: Divide the sum by the number of periods minus 1.
Step 6: Take the square root.
528 Appendix B
Note this is the formula to use when you have experience with the portfolio. There is quite
a more complex procedure in Modern Portfolio Theory.
Section 6: The essence of fundamental analysis
From the John Magee Market Letters, December 15, 1984
by Richard McDermott
The Elliott Wave Theory: perspective and comments
We had the pleasure of attending the December meeting of the Market Technicians
Association of New York.
Long-term subscribers will remember the MTANY as the organization that honored
John Magee with its “Man of the Year” award in 1978. The speaker was Robert Prechter,
publisher of “The Elliott Wave Theorist,” an investment advisory which bases its forecasts
on interpretations of R. N. Elliott’s work on the stock market.
Of primary interest to SAS subscribers are Prechter’s comments on technical analysis
itself. The Elliott Wave Theory, it must be remembered, is really no more than a “catalog”
of stock market price movements, laid one on top of the other, so to speak, until a grand,
underlying, and enduring pattern is observed; in short, pure technical analysis. Among
Prechter’s definitions and observations regarding fundamental analysis are the following:
 1. “First let’s define ‘technical’ versus ‘fundamental’ data … technic al data is that which
is generated by the action of the market under study.”
 2. “The main problem with fundamental analysis is that its indicators are removed from
the market itself. The analyst assumes causality between external events and market
movements, a concept which is almost certainly false. But, just as important, and
less recognized, is that fundamental analysis almost always requires a forecast of the
fundamental data itself before conclusions about the market are drawn. The analyst is
then forced to take a second step in coming to a conclusion about how those forecasted
events will affect the markets! Technicians only have one step to take, which gives
them an edge right off the bat. Their main advantage is that they don’t have to forecast
their indicators.”
 3. “What’s worse, even the fundamentalists’ second step is probably a process built on
quicksand…. The most common application of fundamental analysis is estimating
companies’ earnings for both the current year and next year and recommending stocks
on that basis…. And the record on that basis alone is very poor, as Barron’s pointed
out in a June 4 article, which showed that earnings estimates averaged 18% error in the
thirty DJIA stocks for any year already completed and 54% error for the year ahead.
The weakest link, however, is the assumption that correct earnings estimates are a
σ=
µ(R
n1
1
2
1
−
−
=
∑ )
i
n
Diagram B.1 Volatility formula. Illustrated is the formula for computing volatility. (1) Calculate the
average


out in a June 4 article, which showed that earnings estimates averaged 18% error in the
thirty DJIA stocks for any year already completed and 54% error for the year ahead.
The weakest link, however, is the assumption that correct earnings estimates are a
σ=
µ(R
n1
1
2
1
−
−
=
∑ )
i
n
Diagram B.1 Volatility formula. Illustrated is the formula for computing volatility. (1) Calculate the
average return; (2) calculate the deviation of each return; (3) square each period’s deviation; (4) add
them together; (5) divide the sum by the number of periods minus 1 to get the variance; and (6) take
the square root.
529Appendix B
basis for choosing stock market winners. According to a table in the same Barron’s
article, a purchase of the ten DJIA stocks with the best earnings estimates would have
produced a ten-year cumulative gain of 40.5%, while choosing the ten DJIA with the
worst earnings estimates would have produced a whopping 142.5% gain.”
We enjoyed Prechter’s polished exposition of a technical approach, which differed from
our own. As for his observations about fundamental analysis, we simply could not agree more.
Key: portfolio risk report. The Portfolio Risk Analysis screen summarizes delta, profit,
and several measures of risk for a portfolio of user-specified stocks and options.
The screen displays:
STOCK SYM = The stock symbol;
STOCK POS = The stock position, or number of shares owned;
DELTAS TOTAL = The sum of the stock deltas and option deltas;
BETA = The stock beta for each stock (implementation pending);
$BETA = $The dollar risk due to movement of the general market: $Beta = (Delta × Stock
Price) × Beta;
$DELT = An annualized risk figure based on Position imbalance: $Delta = (Total
Delta × Stock Price) × Volatility;
Portfolio Analysis Screens
Diagrams B.2 and B.3 deal with portfolio risk and profi t
analysis. Illustrated are the sophisticated quantita-
tive portfolio Profi t and Risk reports of Delphic Options
 Research as implemented for Standard & Poor’s trading
systems and Prudential Securities to give the reader an
appreciation of the depth and complexity of professional
thinking about risk and portfolio analysis. The originals
of these reports were designed by Blair Hull and Lester
Loops for their own use in market making.
PORTFOLIO RISK ANALYSIS (.30 Filename )
OMS+ .30 PORTFOLIO RISK ANALYSIS 3/24/87 10:55:28
--STOCK-- ----DELTAS----
SYM POS OPTION TOTAL PROFIT BETA $BETA $DELTA $GAMMA $THETA $RISK %RISK
FDX 2800 –3063 –263 16,734 1.60 –32,081 –7017 158,136 –121 18,075 7.3
GE 3200 –3089 110 12,632 .95 11,374 2993 120,104 –16 13,000 5.3
HWP –6200 5682 –517 8270 1.20 –45,959 –13,404 –522,208 734 56,617 22.9
LIT –6700 0 –6700 0 1.40 –56,9834 –122,107 0 0 122,107 49.3
NSM 3600 –4080 –480 10,411 1.45 –21,076 –7267 150,464 –169 17,436 7.0
XRX –3600 3991 391 –882 1.05 18,132 4835 186,506 –260 20,232 8.2
⋅ ⋅ ⋅
⋅ ⋅ ⋅
⋅ ⋅ ⋅
*TOT –6900 –559 –7459 47,165 –63,9444 –141,969 93,000 166 24,7470 100.0
AV ER AGE VOLATILIT Y: .338
EQUIVALENT MARKET EQUITY: –419613.40
PORTFOLIO PROFIT RATIO: .191
PORTFOLIO PROFIT GAMMA RATIO: 4.815
Diagram B.2 Risk analysis.
530 Appendix B
$GAM = An annualized risk figure based on curvature of the position. A positive
$Gamma indicates a backspread, and a negative $Gamma indicates a vertical position:
$Gamma = Total
Gamma × (Stock Price × Volatility);
$THETA = Theoretical dollar amount a position will gain or lose in one day if the stock
price remains unchanged;
$RISK = The annualized standard deviation of the position based upon a composite of
$Delta and $Gamma;
%RISK = Percent of portfolio risk in each position;
TOT = Totals for each of the above categories;
A VERAGE VOLATILITY = Average volatility for the stocks;
EQUIV ALENT MARKET EQUITY = Sum of each of the stock prices multiplied by their
total deltas; PORTFOLIO PROFIT RATIO = Total portfolio profit divided by the total
portfolio risk; PORTFOLIO PROFIT GAMMA RATIO = Total portfolio profit divided
by the portfolio $Gamma squared.
Key: portfolio profit report. The Portfolio Profit Analysis screen summarizes delta, profit,
and several measures of profit for a portfolio of user-specified stocks and options.
The screen displays:
STOCK SYM = The stock symbol;
STOCK POS = Stock position, or number of shares owned;
DELTAS OPTION = Total delta of the option position;
DELTAS TOTAL = Sum of the stock deltas and option deltas;
M TO M = Mark to market: Total value of stock and options positions based upon
market prices;
PROFIT TOTAL = Total theoretical profit for each position;
PROFIT/DAY = Theoretical profit divided by the number of days to expiration;
PROFIT/RISK = Ratio of theoretical profit to risk;
PROFIT/DY/RISK = Ratio of theoretical profit per day to risk;
PORTFOLIO PROFIT ANALYSIS (.31 Filename )
OMS+.31 PORTFOLIO PROFIT ANALYSIS 3/24/87 10:55:28
--STOCK— ----DELTAS---- ---------PROFIT--------- $ $ %
SYM POS OPTION TOTAL M TO M TOTAL /DAY /RISK /DY/RISK THETA RISK RISK
FDX 2800 –3063 –263 42,3162 16,734 213 .93 4.31 –121 18,075 7.3
GE 3200 –3089 110 704,006 12,632 107 .97 3.01 .16 13,000 5.3
HWP –6200 5682 –517 53,787 8270 150 .15 .97 734 56,617 22.9
LIT –6700 0 –6700 –407,025 0 0 .00 .00 0 122,107 49.3
NSM 3600 –4080 –480 157,293 10,411 105 .60 2.21 –169 17436 7.0
XRX –3600 3991 391 –4431 –882 –18 –.04 –.34 –260 20,232 8.2
⋅ ⋅ ⋅
⋅ ⋅ ⋅
⋅ ⋅ ⋅
*TOT –6900 –559 –7459 926,792 47,165 557 .19 .00 166 247,470 100.0
AV ER AGE VOLATILIT Y: .338
EQUIVALENT MARKET EQUITY: –419613.40
PORTFOLIO PROFIT RATIO: .191
PORTFOLIO PROFIT GAMMA RATIO: 4.815
Diagram B.3 Profit analysis.
531Appendix B
$THETA = Theoretical dollar amount a position will gain or lose in one day if the stock
price remains unchanged;
$RISK = The annualized standard deviation of the position based upon a composite of
$Delta and $Gamma;
%RISK = Percent of portfolio risk in each position;
TOT = Totals for each of the above categories;
A VERAGE VOLATILITY = Average volatility for the stocks;
EQUIV ALENT MARKET EQUITY = Sum of eac


oretical dollar amount a position will gain or lose in one day if the stock
price remains unchanged;
$RISK = The annualized standard deviation of the position based upon a composite of
$Delta and $Gamma;
%RISK = Percent of portfolio risk in each position;
TOT = Totals for each of the above categories;
A VERAGE VOLATILITY = Average volatility for the stocks;
EQUIV ALENT MARKET EQUITY = Sum of each of the stock prices multiplied by their
total deltas;
PORTFOLIO PROFIT RATIO = Total portfolio profit divided by the total portfolio risk;
PORTFOLIO PROFIT GAMMA RATIO = Total portfolio profit divided by the portfolio
$Gamma squared.
Section 7: Software packages and internet technical analysis sites
The first cavemen, fighting over resources, used teeth and claws. The nature of warfare
was changed forever when one of the smarter ones picked up a tree branch. Then another
smart one discovered the principle of artillery and picked up a rock. Naïve and arrogant
traders laughed at Wyckoff’s charts. Market makers on the Pacific Coast Options Exchange
sniggered at Blair Hull when he started appearing on the floor with printouts. In the days
of the wooden racquet, squash players hated the arrivistes who appeared with metal and
then composite racquets.
No longer—the last to adopt the new weapons is a dead man. Charts showed their
power and so did Hull’s wonky printouts made with the Black Scholes Model. The losers
figured out pretty quickly they needed new weapons. With that dissertation on the
epistemology of warfare, I present some of my favorite weapons in the following software
and internet sites. No attempt whatsoever is made to be comprehensive or encyclopedic.
On the contrary, idiosyncrasy is my operating method and no disfavor is implied to those
not included here.
For myself, three desktop software packages are powerful and sufficient for all the
needs of a technical analyst: AIQ Trading Expert Pro ( http:/ /www.aiqsystems.com),
Metastock 9.0 (http:/ /www.equis.com), and TradeStation 2000i and later versions (h t t p : //
www.tradestation.com). The reader will find examples of charts sprinkled throughout this
book, supplementing the beautiful hand-drawn charts of Magee. All these packages have
the basic requirements necessary for technical chart analysis, basic charting on readily
available data and portfolio. I have said before that all the chart analyst really needs is the
ability to draw lines on a chart … and then pe rhaps to see the chart as a line chart, or a
candlestick chart or … and so on and s o on. The analyst is soon seduced by the dazzling
features, and the analysis is enriched and made more powerful. Even if one says (as I do),
when he looks at an oversold tool, “What do I need that for? I saw it on the bar chart.” The
analyst finds himself wanting to know more about % R. If it worked for Larry Williams,
there must be something in it.
AIQ: TRADING EXPERT PRO
AIQ’s package includes an on-screen control panel and scrolling indicator boxes that
are color-coded, and this information is synthesized in an indicator barometer. Data
management is smooth and easy, and the user may use a system module to create and test
his own trading ideas. A panoply of reports is available to aid the investor. For the trader,
532 Appendix B
real-time alerts are a feature. A portfolio manager module aids the investor in managing
not just the portfolio, but also his positions by making stop management facile. An Expert
Guru lurks behind the curtain to aid the user in analyzing situations.
METASTOCK 9.0
Metastock 9.0 boasts an impressive array of tools and indicators. “System Experts” pop
up on demand and can also guide the user through systems tests and explorations. The
Experts can also suggest buys and sells. A point and figure toolbox is a valuable feature.
The ability to create and test trading systems, with exhaustive and critical data analysis, is
a powerful tool. Metastock adapts easily to add-ons, of which Slauson’s Powerstrike (the
quantitative tool for finding critical Support–Resistance zones) is a good example.
Tradestation 2000i and Tradestation 8
Tradestation 2000i is the standalone version of Tradestation 8. Tradestation 8 is a real-time
online package that allows for trading through the Tradestation brokerage affiliate. The
package is so powerful that online professional and semiprofessional users probably benefit
by combining their software arrangement with a brokerage arrangement. 2000i requires
the user to maintain his local database, whereas Tradestation 8 always has the data on
demand. For the creatively lazy (among them the editor) this is an attractive feature. Systems
building and testing has always been and remains a powerful feature of Tradestation. With
“EasyLanguage,” the user may specify virtually any system and then chat about it with the
Tradestation community of traders. This community has contributed to a large database of
trading systems and ideas.
The Internet: prophet (http://www.thinkorswim.com)
For the even lazier and more casual investor, there is http:/ /www.prophet.net (now at
thinkorswim.com), an internet technical analysis site whose free features will fulfill the
needs of the general charting investor. With powerful interactive charts and portfolio
reporting, the penurious investor will save many pennies at http:/ /www.prophet.net. As
Mark Twain said, a penny saved is a penny earned. Actually, what did Ben Franklin mean
by a penny saved is capital when put to work? A user community and sharing are other
attractions. And no local data maintenance is necessary. Among its most valuable features,
http:/ /www.prophet.net occasionally distributes market commentary and analysis by this
editor. All in all, http:/ /www.prophet.net appears to deserve the continuing awards it has
received from Barron’s and Forbes, as well as Technical Analysis magazine. Prophet charting
is now available to customers of http:/ /www.tda


d no local data maintenance is necessary. Among its most valuable features,
http:/ /www.prophet.net occasionally distributes market commentary and analysis by this
editor. All in all, http:/ /www.prophet.net appears to deserve the continuing awards it has
received from Barron’s and Forbes, as well as Technical Analysis magazine. Prophet charting
is now available to customers of http:/ /www.tdameritrade.com.
The Internet: http://www.stockcharts.com
Of similar quality, and similarly honored by Forbes and Technical Analysis magazine, h t t p : //
www.stockcharts.com has an additional valuable feature: point and figure (P&F) charting.
I have not remarked on P&F charting here, but it is an important technical method, especially
for the patient investor. All the other features are available at http:/ /www.stockcharts.com,
including candlesticks, bar charts, and others. Also, the distinguished analyst John Murphy
makes his electronic home there. There is also a “Voyeur” feature that allows the user to
see what other traders are doing.
533Appendix B
A brief summary
Knowledge is power. Knowing where to find knowledge is even more powerful. The inquiring
investor can keep himself up to date on these sites through the yearly evaluations in Barron’s
and Forbes, and the financial press regularly updates its evaluations of Internet resources.
Section 8: The Leverage Space Portfolio Model
No less than John Bollinger called Ralph Vince’s Handbook of Portfolio Mathematics, the most
important work on the subject. Mr. Vince has done the readers of this book, and me, the
very great favor of describing his work in a short article I present here verbatim.
In 1884, Charles H. Dow began his compilation of what would
become known as the Dow Jones Indexes. Theories pertaining to
non-confirmation of these indices, known as “Dow Theory,” would
become the cornerstone of modern Technical Analysis.
It is fitting then, with Dow Jones Indexes having embraced the
concepts expressed herein with the commercial offerings of The
Dow Jones LSP indexes in 2011, this explanation of Optimal f and
the resultant Leverage Space Portfolio Model be included in this the
foundational text on modern Technical Analysis.
Let us consider a case of a simple trade with two possible outcomes.
In one of the outcomes, we win 2 units, and in the alternative outcome,
we lose 1 unit. We can construct a spectrum ranging between a value
0, where we risk nothing, and 1, where we risk our entire equity. We
will consider this value between 0 and 1 as the fraction (f) of our stake
at risk, and we will refer to this interchangeably as our leverage. Thus,
on any given trade or over any given period, we are risking some
fraction of our stake, and thus for any given trade or over any given
period, we have a value, f, assigned to us whether we are aware of
it or not.
If we consider over this hypothetical, simplistic 2-outcome, 2–1
trading situation (similar to if it were the two outcomes of a coin toss)
we could plot what we would expect to make on our trading equity
(expressed as a multiple of our initial equity) over one play at various
values for f as depicted in Diagram B.4.
1.5
1.25
1
0.75
0.5
0.25
0 .05 1.0
Fraction of Stake (f )
Multiple
Diagram B.4 Expected Multiple of Starting Stake in a Single 2:1 Coin Toss.
534 Appendix B
When there is more than 1 trade or period and what we have left
to invest in the immediate play or period is a function of what we
have made or lost up to this period, the straight line becomes curved,
and the peak of the curve settles into a fixed point, migrating in from
1.0 off to the right where a positive expectation trade or period is
growth-maximized over 1 trade or period. Thus, after many trades
or periods, it settles in to a given location, and for the simplistic case
of a coin toss that pays 2–1, that peak will settle in at .25 as depicted
in Diagram B.5.
The height of the curve for any given value for f is given by the
formula for Optimal f, determined as:
multiple f t
W f t
W
p
n=+







 +







11
1*|| ** *||
() (
…
p p number_of_expected_plays_or_tradesn )











Thus, for n trades or periods, for a given value of f, we can
determine the multiple made on our stake with simply the outcome
of each trade or period ( t), probability of that outcome ( p), and the
worst-case outcome (w), the lowest of all the values for t. We raise the
resultant product to the power of however many plays we want to
determine our expected growth, obtaining the multiple on our initial
tradable equity at that many trades or periods.
This represents what you would expect to make as a multiple on
your starting stake for risking a given fraction, f, of your stake.
Notice this is not the same as what is known as The Kelly Criterion,
which gives a peak as a “leverage factor,” a value between 0 and
infinity representing how much to lever up one’s account, rather than
12
11
10
9
8
7
6
5
4
3
2
1
95 90 85 80 75 70 65 60 55 50 45 40 35 30 25 20 15 1005
Diagram B.5 Expected Multiple of Starting Stake after Forty Tosses in a 2:1 Coin Toss.
535Appendix B
a fraction (a value between 0 and 1) of an account to risk as expressed
by the Optimal f formula. Under certain conditions the two will give
an equivalent value for the peak, for example, the leverage factor will
equal the optimal fraction to risk, as in the 2:1 coin toss example
herein, but often not, and it can be a perilous mistake to assume
that the answer given by The Kelly Criterion is an optimal fraction
of account equity to risk to be expected growth optimal. The Kelly
Criterion never yields a peak whose value is the expected growth
optimal fraction of an account to risk, but rather always yields the
expected growth optimal leverage factor. The two can be translated
between one another, but the real benefit of the Optimal f formula is
it gives us the height to this curve, expressed as an