vestor considers stocks a complex or difficult area [although
it is hoped this book will make it less so for him] options are exponentially
more difficult. Professionals beat amateurs at that game so thoroughly and
so often as to consider it easy money. So, the general investor should be
sternly warned that much training and study should be undertaken before
becoming fodder for the pros.
EN9: Tradestation, the superlatively fine trading system and brokerage
operation, distributed at one time an intelligent little book by Charlie
Wright, Trading for a Living, which among its other fine points offered a
plan for the ongoing allocation of capital to trading.)
chapter forty-two
Portfolio risk management
As we suggested in the preceding chapter, there is some relation between
the state or stage of a Major Market and its potentialities for profit. There
are many mechanical plans and systems for coping with the problem, but
we do not believe it can be fully solved by mechanical means alone. We
mentioned one plan by which the commitments were governed according to
the consensus of trends in an entire portfolio of charts. (EN: The Magee
Evaluative Index, or MEI.) There are other plans dependent on pyramiding
the commitment as the trend proceeds, and still others based on averaging
costs by increasing the commitment working against the trend, namely, by
buying on a scale-down at progressively lower levels in a Bear Market and
selling on a scale-up in Bull Markets. (EN9: Invitations to disaster, the first,
and demanding adroit skill, the second. Avoid such methods unless you are
an expert position trader.)
None of the plans, taken by themselves, are adequate to answer the
questions of when to buy and when to sell. The primary purpose of this
book is to study the technical phenomena of individual stocks. If we can
learn from the charts at what points to buy and under what conditions to
sell, we have acquired the basic machinery for successful trading. On the
other hand, if buying and selling at points that more often than not result in
net losses, then it makes no difference how you divide up your capital or
apply it in the market, for it will be bound to shrink until, eventually, it has
all disappeared. (EN: An investor who finds himself in this situation should
set a benchmark. He should decide if he loses 50% of his capital he will
quit trading and put his money in index or mutual funds or in the hands of
an advisor. Generally speaking, an advisor is preferable to a mutual fund,
yet both are preferable to an investor with two left feet. They can certainly
do no worse than a consistently losing performer. EN10: On second
thought, from the vantage point of 2011, maybe they can.)
The first problem, then, is to learn to use the technical tools, patterns,
trends, Supports, Resistances, and so on. Then we can consider how much
money we will risk and in what way.
We have already grasped it makes a difference, sometimes a great
difference, how we apply our capital. The various factors of price level,
sensitivity, and margin enter into the concept we are going to call the
Portfolio Risk. Meanwhile, we have said enough so you will understand
what we are driving at if we use the term in connection with your market
commitments.
You realize, of course, you do not want to be so conservative to rule out
practically all opportunities for making gains. If you decide never to oppose
the Primary Trend, you will have to be inactive during long Secondary
Trends and may be left waiting, sometimes for weeks on end, for a
continuation of the Primary Move. Naturally, you will pass up all weak
signals and convergent trends and shun new commitments after very active
blow-offs or Panic Climaxes. You could, no doubt, carry your refinement of
caution so far that your percentage of success, instead of being a mere 60%,
70%, or 80%, might approach 90%; you might actually be right 95% of the
time in your decisions, but this extreme conservatism would also mean you
would trade only in the very finest possible situations, when every factor
was clean-cut and favorable. You would not have such opportunities very
often. The result might be a profit, but too small a profit to justify all the
work and study you would be
putting into your charts, for you can obtain nominally respectable returns on
your capital without very much study and without much risk, and you must
expect a much higher rate of return if your efforts are to be worthwhile.
(EN: These “nominally respectable returns” are obtained by investing in T
Bonds and similar instruments. Bond traders and investors traditionally
consider these investments “risk free,” which is another form of the denial
of reality. In reality, as David Dreman has demonstrated (Contrarian
Investment Strategy, Simon & Schuster), bonds are a kind of deteriorating
asset because of the unarrestable depreciation in the commodity-
denominated value of currency.)
To put your charts to work, you have to avail yourself of the higher
leveraged stocks that carry more opportunity for gain, hence, more risk of
loss. You have to accept, deliberately, a greater risk than the man who is
content to buy a “safe” security, put it in the box, and forget it.
By maintaining your Portfolio Risk at or near some constant level that your
experience and judgment tells you is safe for the particular state of the
market, you will be protected against overcaution and irrational exuberance.
More important, if you maintain this risk posture in your operations, you
will be protected against unconsciously overtrading. This is a fault more
common than extreme caution and can be a dangerous enemy even when
your percentage of theoretical trading gains is high. When you select a
definite Portfolio Risk Strategy and adhere to it in your trading
commitments, changing it as necessary to meet changed conditions, you
will be forced to restrain your enthusiasm within safe limits, and you will
be continually aware of the risks you are taking.


common than extreme caution and can be a dangerous enemy even when
your percentage of theoretical trading gains is high. When you select a
definite Portfolio Risk Strategy and adhere to it in your trading
commitments, changing it as necessary to meet changed conditions, you
will be forced to restrain your enthusiasm within safe limits, and you will
be continually aware of the risks you are taking.
Overtrading: a paradox
A series of identical percentage gains and losses on your capital does not
give you a series of equal gains and losses in dollars and cents. This is a
serious problem, worth understanding, for a trader who is greatly
overextended is intensifying this problem (which exists in any case, but
which does not need to cause him too much worry if he has planned his
program).
You can understand the paradoxical statement that percentage gains and
losses are not equal if you take the extreme case, first, of a man, who, in
every business venture he enters, risks his entire capital with the
expectation of either a 100% gain or a 100% loss. If this first venture is a
loss, he loses 100%. He is finished, because he cannot gain by making
100% on nothing. However, if the first venture is successful and he then
uses his entire capital, including the new profits, again on the same terms,
and the second venture is a failure, he will be wiped out completely. No
matter how many successes he may have, he stands to lose everything on
his first failure.
In a lesser degree, this is the situation in which we speak; you would not
risk all of your capital on the basis of doubling your money or losing all.
Though, suppose you were extended, continually, to a point at which you
were taking the risk of a 40% net loss on each transaction, with the hope of
a 40% net gain. Should you start with $1,000 and have a succession of 10
losses, you would wind up with about $6.00. Now suppose the very next 10
transactions were all successful. You would finally come out, after 10 losses
and 10 gains, each of 40%, with capital of less than $100. It would not be
necessary either that these 10 losses and 10 gains come in the order given.
You might have the 10 gains first, or three gains, four losses, seven gains,
and then six losses. The result would be the same. After 10 gains and losses,
in any order, you would have lost more than 90% of your capital.
On the other hand, if you risked your entire capital each time on 20
ventures, in 10 of which you took an 8% net gain and in 10 an 8% net loss,
your $1,000 after the 10 gains and losses would be reduced only to $937.
You would still have about 94% of your original capital. Therefore, in this
case (and 8% is a fair average figure for short-term transactions resulting in
a loss, in fact, a rather liberal figure according to extensive tabulations of
actual transactions), you would have a handicap due to this paradox of only
about one-third of 1% on each trade.
Now it is conceivable that 10 successive trades might go wrong, although
that would be an unusual condition. There was one period of 10 months
between the actual turn of the market and the Dow Signal for a Reversal of
the Primary Trend. True, the resulting new trend, once established, ran far
and long, and it would have made up all losses and produced fine profits;
however, during the 10 hard months, allowing the fair average time of 30
days per transaction, it is possible that 10 successive wrong-way trades
might have been stopped out for losses, reducing the original $1,000 to
$434.
The important thing is that the next 10 successful trades would have
brought this $434 back to $937; in other words, you could have righted the
boat and sailed right on if you were working on the 8% basis, whereas if
you had been following the 40% basis we gave previously as an example,
you would have been sunk without a trace, a victim of overtrading.
Therefore, by maintaining a sane Portfolio Risk Strategy and letting the law
of averages work for you and with you, you will be on solid mathematical
ground. Your technical studies will have every opportunity to make you a
profit. Otherwise, you can, simply by unwise overextension of your trading,
prevent even the best technical analysis from producing a net profit.
EN: John Magee could easily be called the father of modern investment
theory but modern investment theory is so unenlightened as to technical
analysis that academics largely have not recognized his contributions—and
many probably have not read his work. If they had, he would be recognized
as having identified what theorists now call systematic risk, and what is
now called the beta (Greek letter 3) with his concept of the Sensitivity Index.
Similarly, his work on Composite Leverage precedes (and may be more
practical than) modern Portfolio Risk analysis, if cumbersome in the
modern context.
Systematic risk, simply put, is market risk in aggregate; beta relates the
individual instrument risk to the market. Thus, Magee's Sensitivity Index did
what beta calculations do—relate instrument behavior to market behavior.
A stock with a beta of 1 will move up or down 1 point for each 1 point of
market move. A 1.5 will move 1.5 for each 1 point of market move, and a
0.5 will move 0.5 for each 1 point of market move. This number tells us
immediately which stocks are more volatile and sensitive to aggregate
market behavior.
Composite Leverage was Magee's method of determining how much risk the
investor was assuming in a stock or portfolio.
The formula was (is) as follows:
CL = SNT
15.5 x C
where S = the Sensitivity Index, N = Normal Range-for-Price (an attempt to
quantify volatility), T = Total Paid, C = Capital dedicated to this
commitment, 15.5 a constant Magee called a Market Reciprocal, a sort of
proxy for market volatility. The same formula, using sums, was used for
Portfolio Composite Leverage. The number that falls out of this formula
quantifies risk for Magee and uses concepts that are extremely modern.
In his original exposition of

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


(an attempt to
quantify volatility), T = Total Paid, C = Capital dedicated to this
commitment, 15.5 a constant Magee called a Market Reciprocal, a sort of
proxy for market volatility. The same formula, using sums, was used for
Portfolio Composite Leverage. The number that falls out of this formula
quantifies risk for Magee and uses concepts that are extremely modern.
In his original exposition of Composite Leverage in this chapter, Magee
made use of some cumbersome manual chart procedures and tables that I
have relegated to Appendix A in the eighth and ninth editions, and deleted
in this edition. There is nothing invalid about them, even now, I feel, but
there might be simpler and more convenient ways for the present-day trader
to assess his leverage, risk, and profit exposure. One of these is certainly
utilizing Value at Risk (VAR) technology. However, there might be simpler
more pragmatic (and even more effective) ways of extracting this
information from our trading portfolios. In short, Pragmatic Portfolio
Theory and practice, which we will explore shortly.
Volatility, for example, tells us something about the risk of a stock insofar as
the dispersion of returns. Portfolio volatility gives us a way of measuring
the riskiness of a group of stocks. In researching our systems and methods,
we should be able to get some handle on “drawdown,” or the average and
largest negative swings against our equity in an account. Simple
conclusions follow: if we are willing to accept larger risks, we pick a
portfolio of volatile stocks—a portfolio of Internet (or whatever the current
frenzy is) stocks rather than a portfolio of utility stocks.
It is indispensable to maintain a regular periodic review of portfolio
statistics to assure oneself that excessive risks are not being undertaken
heedlessly. These important numbers include the following:
• Original risk per trade
• Actual realized loss
• Average (and ranges) loss and profit per trade and their relationship
(average profit divided by average loss)
• Number of winning and losing trades and their ratio
• Time in winning and losing trades (long-time trades combined with
oversize losses is an ominous sign)
• Equity swings: average drawdown, maximum drawdown
• Costs and expenses, summation, and per trade
• Daily risk, yearly risk, and catastrophic risk, as computed by Pragmatic
Portfolio Theory (as discussed below)
Risk of a single stock
The beginning of conventional, or academic, analysis of risk is the
examination of volatility.
The formula for calculating the volatility of a stock (or downloading it) was
discussed in Chapter 24. As a theoretical exercise, the formula and the
theory make certain assumptions that are not necessarily of interest to the
pragmatic practitioner. One of the assumptions is the holder chooses to
accept the inherent volatility of the stock at hand. Except the point of
technical analysis is to limit the risk accepted while attempting to realize
profit opportunities. Thus, the volatility of a stock, its (academic) risk, is
0.30% or 30%, but when we trade it, we put a stop loss on it and only risk a
move of (say arbitrarily) 5%-8% against our position (where the 5%-8%
sums to 2%-3%, or x% of total capital.) Thus, our method of risk control is
basically more dynamic than the theory. Nonetheless, volatility will give us
a measure of the stocks that make interesting trading vehicles.
It is perfectly possible to take our own experience with a stock or our
system's experience with a stock and calculate its volatility to ourselves,
using the method described in Chapter 24. If the dispersion of its returns (in
our trading) was greater than our appetite, we could then eliminate it from
our watch list. To my knowledge, the literature does not mention this
method for customizing our analysis of risk. Use of a customizing procedure
like this would give us an idea of the reliability of our methods in a
particular case. Stocks that did not behave would be banished to the
portfolios of mutual fund managers.
We subscribe to a much more pragmatic and practical concept of risk. Risk
is, to us, drawdown, or the probability of loss. Volatility qua risk is static
and non-descriptive of the “risks” we take in trading and investing. We will
choose a volatile stock or instrument because that is where the profit
opportunity is—in movement. Less risk-oriented investors will choose utility
stocks. As some carnival goers choose the Ferris wheel and others the
roller coaster. The probability of an exciting ride will be in the volatile
instruments. Our skills as traders give us the confidence to manage the
probabilities of the more “dangerous” instrument.
By measuring the drawdowns, we empirically measure the risks of trading.
Risk of a portfolio
If you have sufficient experience with a portfolio, you can calculate its
volatility the same way you calculate the volatility of a stock using the
method in Chapter 24. Note Modern Portfolio Theory (MPT) has a complex
procedure for computing portfolio volatility. (The value of MPT may be
computed by examining MPT portfolios after a market collapse.) You may
also dramatize the volatility of your portfolio by preparing a frequency
distribution. The dispersion of the returns would certainly highlight
characteristics of your trading system or style.
Academicians and investment managers use a measure called the Sharpe
Ratio to compare the performance of two systems or competing money
managers. It is discussed in Appendix B, Resources, and has deficiencies in
analyzing Portfolio Risk. I will address this question later in this chapter
after looking at some of the ways professionals treat risk.
The reader may judge for himself in the use of Composite Leverage as
presented in Appendix A of the ninth Edition by Magee, or he may consider
the following brief presentation of modern portfolio management and risk
analysis. The purpose of Magee's Composite Leverage is to measure and
control risk and profit exposure in a more o


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


ined as detailed in Chapter 24. Subsequently, we might say the
theoretical risk of our stock, Microsoft, for example, equals on 100 shares,
our position, at the market price of 120 and annualized volatility of 0.44:
Theoretical Risk = Volatility x Position x Price
V x Po x Pr = T$Risk
.44 x 100 x 120 = $5,200
where
T$Risk = Theoretical Risk (dollar)
V = Volatility
Po = Position (number of shares)
Pr = Price
Theoretically speaking, the annual risk for Microsoft should be Volatility x
Price or (in 2000) 0.44 x 120 or $52.00. In fact, those non-chart analysts
who bought Microsoft at 120 (there were some), and who did not have the
technician's ability to set a stop and discipline to stick to it, saw a risk of
50% from its top of 120 in February 2000 to its (presumed) bottom of 60 in
June 2000.
There is another measurement that might be more meaningful to us,
Operational Risk. Operational Risk refers to the specific instance of the
particular trade. For example, we have taken an initial position in
Microsoft of 100 shares. Our analysis has identified a stop point at which
we put our stop, which is 5% away from the market price. Our Operational
Risk is as follows:
Operational Risk = Market Price — Stop Price x Position
(MP — S) x Po = O$Risk
(120 — 114) x 100 = 600
where
O$Risk = Operational Risk (dollar)
MP = Market Price
Po = Position
S = Stop Price
Determining the risk for a portfolio
Computing the theoretical risk for a portfolio is quite a complex process. It
involves, in essence, finding the volatility for the portfolio as a whole, and
multiplying the portfolio market value by the portfolio volatility. This does
not sound so complex, but volatility is not determined by simply adding
together volatilities of individual securities. Rather, correlations between
instrument returns must be computed, and variance and covariance of
securities must be determined as steps along the way. This by no means
presumes to be a complete description of the process, further study of which
may be guided by entries in Appendix B, Resources.
The theoretical risk for a portfolio is, for a simple case, as follows:
Volatility x Market Value
TP$Risk = MV x V
where
TP$Risk = Portfolio Theoretical Risk (dollar)
MV = Market Value
V = Volatility
Under normal market conditions, the Operational Risk of a simple
Portfolio, PO$Risk, may be calculated by first taking the sum of the
Operational Risk figures, O$Risk, for each stock held long. Then the sum of
O$Risk for short positions is subtracted from the first figure.
PO$Risk = (sum of O$Risk longs) - (sum of O$Risk shorts)
In the situation of perfect negative correlation, the two factors would be
summed.
Measuring maximum drawdown (maximum retracement)
In the designing and testing of a system, or in actual trading experience, we
care little about standard deviations and cold statistics. What bothers us is
the flow of blood—the worst run of “luck” or experience we have. What is
the greatest sustained loss we suffer before our system or trading method
rights itself, stanches the flow of blood, and begins to accumulate profits
again? Constructing a wave chart is one way to look at this experience.
Measuring from the top of the wave to the bottom gives us our maximum
drawdown, and an idea of what amount of capital we need and how much
reserves to maintain. It also gives us a vivid depiction of our results. A chart
with many tsunamis (in the wrong direction) probably means we need to
modify our methods—unless we genuinely enjoy riding roller coasters (with
the full understanding that dreadful accidents do sometimes happen on
thrill rides). If constructing a system without actual market experience, one
should multiply maximum drawdown by 3 or 4 to get a reasonable amount
of capital with which to back the system.
Pragmatic portfolio analysis: measuring the risk
In analyzing a portfolio, we must first know what is important to measure.
To be able to control risk, we must be able to measure it. Theoreticians
identify risk with volatility. There are some real-life problems with this
concept, but we will use it for the moment anyway. In a portfolio, we want
to be able to separate our various types and weights of risk. In terms of
volatility, bonds are obviously less volatile than stocks, and unleveraged
commitments are less volatile than, say, futures. Similarly, if the portfolio is
not risk balanced, that is, if one issue represents a large proportion of the
whole, then it represents a larger portion of the risk. But, if a portfolio
consisted of only the Standard & Poor's 500, that would obviously be a
different case, because a commitment like this would be by definition
diversified. Thus, we must know what is important to measure (see Philippe
Jorion's Value at Risk. In addition, there is a piece of tutorial software
called Risk Management 101, Zoologic Corp., which is excellent in
presenting these concepts).
In operational or pragmatic terms, a trader wants to know what his
operational risk is, rather than his theoretical risk, and does not consider
upside equity volatility a negative. A trader may choose to measure risk by
the pragmatic method outlined here. In doing so, he will want to know for
his Portfolio Ordinary or Normal Risk, POR, his Risk Over Time, PRT, and
his Extraordinary or Catastrophic Risk, PCR.
Portfolio Ordinary or Operational Risk
“Ordinary” and “Operational” may be used interchangeably when
discussing daily risk. First consider we want to measure our risk today. Our
Ordinary Risk today is easily computed by taking the stop price from the
market price on each position and summing the differences, as above.
Dividing this figure by the allocated capital (Total Capital, TC) will give us
a Portfolio Risk Factor (PRF), which is the risk factor the trader is willing
to assume for one day.
POR = sum of differences
PRF = PO$Risk/TC
Portfolio risk over time
The Daily Operational Risk number can be annualized to give us a number
for risk over time—or it can be compute


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


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


rns for your efforts as any other line of endeavor.
(EN9: With the ninth edition, I expect the reader will have some powerful
new guns to stick to: new lessons in Basing Points that show what a
powerful procedure it can be; new analyses of Dow Theory that refresh and
reinforce the validity and persuasiveness not just of the Theory, but also of
long-term investing as such. EN10: And a host of new stop systems to work
with. Good trading and stick to all your guns!)
Appendix A: The Dow Theory in practice
EN10: This appendix appears as Chapter 4 in the ninth edition.
EN9: The casual and careless reader will shake his head at this chapter and ask why on earth theeditor has not excised it from the book. The editor has not deleted the chapter because, like old-fashioned cod liver oil, it is good medicine. It will appeal mainly to the serious student of not justDow Theory but also of long-term investing. If the reader has absolutely no interest in DowTheory or long-term investing, he may skip over this chapter and return to it in his old age, whenhe is wiser.
At this point, the reader, if he has little previous knowledge of the stock market, may be sufferinga mild attack of mental indigestion. The Dow Theory is a pretty big dose to swallow at onesitting. We departed deliberately in the foregoing chapter from the order in which its principlesare usually stated in an effort to make it a little easier to follow and understand. Actually, not allof the 12 tenets we named are of equal import. The essential rules are contained in 2, 3, 4, 5, 8,10, and 11. Number 1 is, of course, the basic assumption, the philosophical justification for theserules. The other points (6, 7, 9, and 12) furnish “background material,” as the news reportersmight put it, which aid in interpretation. Theoretically, one should, by strict adherence to theessential rules alone, accomplish just as much as he could with the added collateral evidence. (Forillustrations in this appendix, see Figures A.1 through A.9.)
However, the utilization of Dow Theory is, after all, a matter of interpretation. You may memorizeits principles verbatim and yet be confounded when you attempt to apply them to an actual marketsituation. We can better organize our knowledge of the theory and acquire some understanding ofits interpretation by following through a few years of market action and seeing how it looked atthe time through the eyes of a Dow theorist. For this purpose, we may well take the period fromlate 1941 to the beginning of 1947 because this covers the end of one Bear Market, an entire longBull Market, and part of another Bear Market, and includes examples of most of the marketphenomena with which the Dow Theory has to deal.
Five years of Dow interpretation
Figure A.2 is a condensed chart of the course of the two Dow-Jones Averages from January 1,1941, to December 31, 1946, on which most of the Minor Trends have been disregarded but allthe recognized Intermediate Swings (Primary and Secondary) have been indicated. Certainportions of this history will be supplemented by complete daily charts in connection with ourdetailed discussion that follows.
The year 1941 opened with the stock market in a Minor Rally. A Primary Bear Market had beensignaled when prices collapsed in the spring of 1940 and that Bear Market was
Figure A.1 “Swing” (EN: or Wave) chart showing all the Intermediate and some of the moreextensive
Minor Trends of the Dow-Jones Industrial and Rail Averages, January 1941 to December 1946.Industrial price scale left, Rails right.
still in effect. After the May Panic had ended, a Secondary Recovery swing, which lasted for morethan five months, had regained more than half of the ground previously lost by the Averages,carrying the Industrials from their closing price of 111.84 on June 10 to 138.12 on November 9and the Rails from 22.14 on May 21 to 30.29 on November 14. (During this long Bear MarketSecondary, incidentally, volume tended to increase on rallies, which encouraged many who didnot hold strictly to first principles to believe that this rise was the beginning of a new Bull Trend,illustrating the point we cited under “Volume” in Chapter 3.) From the November highs, however,the trend turned down again. Then a Minor Rally developed, as stated, at the end of the year,reaching its peak on January 10 at 133.59 in the Industrials and 29.73 in the Rails. From there,prices fell again to 117.66 and 26.54, respectively, on February 14.
The first severe test
The next few months will be particularly interesting for us to trace because they put the DowTheory to a real test. Figure A.3 shows the daily ranges and closing prices of the two Averagesand total daily market volume for the seven months from February 1 to
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845 22'1 8 151122 29 5 121926'3'1017'2431 7 14"21'28 5'12'19 ' 26 2 9 16 23 "30'
FigureA.2 Closing price levels of the Dow-Jones Industrial and Rail Averages, February 1 toAugust 31, 1941, and total daily market volume. Vertical lines show net daily change from oneclosing level to next.
August 31, 1941. Before we examine it in detail, however, let us first review the situation onFebruary 14. The Bear Market lows to date had been registered in May-June, 1940. Thereafter, anextended Intermediate Recovery had advanced the Industrial Average 26.28 points and the RailAverage 8.15 points. This had been followed by a three-month decline of 20.46 and 3.75 points,respectively, and this decline, incidentally, had consisted of three well-defined Minor Waves.


t review the situation onFebruary 14. The Bear Market lows to date had been registered in May-June, 1940. Thereafter, anextended Intermediate Recovery had advanced the Industrial Average 26.28 points and the RailAverage 8.15 points. This had been followed by a three-month decline of 20.46 and 3.75 points,respectively, and this decline, incidentally, had consisted of three well-defined Minor Waves. Induration, and in extent of price change with respect to the previous swing—46% in the Rails andnearly 78% in the Industrials—this downswing qualified as an Intermediate Trend, and nowprices were turning up again. Dow theorists were on the alert. If both Averages could continuetheir rise to levels above their high closes of the previous November (138.12 and 30.29), thataction would constitute a signal of a new Primary Bull Market, and reinvestment of fundswithdrawn from stocks in May 1940 would be at once in order. Also, it would then be necessaryto go back and label the May-June lows of 1940 as the end of a Bear Market, the advance toNovember as the first Primary Swing in the new Bull Market, and the decline to February as itsfirst Secondary Reaction. Note Rule 12 of our preceding chapter (EN11: Chapter 3) applied here;the presumption was it was still a Bear Market until a definite signal to the contrary appeared.
Let us now turn again to Figure A.3 and see what actually did happen. The Industrials rallied forsix weeks, reaching 124.65 on April 3. The Rails got up to 29.75 on the same date, registeringdouble the percentage gain of the Industrials, but both Averages were still below their November
highs. Then the Industrials slipped off within two weeks and had broken down below theirFebruary low and drifted down to close at 115.30 on May 1. This Average was, therefore, still inan Intermediate Downtrend. The Rails, meanwhile, were staging a different sort of performance;they dropped back from their April 3 high for two weeks, but held at 27.72, rallied smartly andthen sold off again to 27.43 on May 31. The picture became at once even more
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INDUSTRIALS
1942
RAILS
OCTOBER
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Figure A.3 Daily closing price levels of the Dow-Jones Industrial and Rail Averages from March2 to October 31, 1942, and total daily market volume. This period saw the beginning of a 4-yearmajor bull market.
interesting. Here was a Divergence between the two Averages, a failure to confirm; the Rails,after two opportunities, were refusing to confirm the Industrials in the latter's downtrend.
Failure to confirm
When prices began to work upward in June, many commentators seized on this “failure toconfirm” as a Bullish omen and the wishful thinkers again talked Bull Market. There is anunfortunate tendency in the Street to overstress any such divergence, particularly when it can betwisted into a favorable sign. The fact is Dow Theory's refusal of one Average to confirm theother can never produce a positive signal of any sort. It has only negative connotations.Divergences sometimes occur at Reversals in the Major Trend—there have been several instancesin market history, in which, perhaps, the most remarkable occurred way back in 1901 and 1902,and we shall soon inspect another—but they also occur with equal frequency at times when noMajor Reversal is developing, and the instance we are discussing here was one of the latter.
The situation at the end of May in 1941 was precisely the same to the Dow theorist, insofar as theMajor Trend was concerned, as it had been on February 14. The June-July rally topped out in theRails at 30.88 on August 1, and in the Industrials at 130.06 on July 28 (compare these figures withtheir 1940 November highs) and prices then declined at an accelerating pace, temporarilyculminating in the Pearl Harbor Panic. This took the Industrial Average below its previous BearMarket low (111.84 on June 10, 1940), although the Rails, again, did not follow. They had,however, by this time, broken below their previous (February 14) Intermediate Bottom by aliberal margin.
The next period of importance began in April 1942. We can skip any detailed chart of the monthsbetween December and April because they posed no Dow Theory problems.
Figure A.4 Daily closing price levels of the Dow-Jones Industrial and Rail Averages fromNovember 2, 1942, to June 30, 1943, and total daily market volume.
After a Minor Rally in the Rails in January, prices simply drifted lower and lower, but it wasincreasingly evident that trading volume did not expand on the dips (Minor Declines). Liquidationwas drying up; the boardrooms were void of customers; the atmosphere was typical of the laststages of a Bear Market.
The daily action of the Averages from March 2 to October 31, 1942 is shown in Figure A.4. Newlows (since 1940) were registered both in late April, at 23.72 on April 24 in the Rails and at 92.92on April 28 in the Industrials. Shortly thereafter, a notable Divergence developed, when, afterrallying for only seven days, the Railroad Index began to slip off while the other Average keptright on going up. Trading activity remained at a low ebb (there was no sustained volumeincrease, in fact, until late September). On June 1, the Rails dropped to another new low and onthe 2nd closed at 23.31. On June 22, it looked as though the Industrials were going to be pulleddown again, but only a few days later, the best rally in months got started, taking the Industrials tonew highs and more than recovering all of the April-May loss in the Rails. Activity also speededup briefly, with one day registering a greater turnover than the market had enjoyed in any sessionsince early January. (EN9: Note this warning sign. The ringing of an alarm clock.)
Signs of Major Turn
Again, the Dow theorists were very much on the alert. An advance of Intermediate proportionswas obviously under way. Until proved otherwise, it had to be l


May loss in the Rails. Activity also speededup briefly, with one day registering a greater turnover than the market had enjoyed in any sessionsince early January. (EN9: Note this warning sign. The ringing of an alarm clock.)
Signs of Major Turn
Again, the Dow theorists were very much on the alert. An advance of Intermediate proportionswas obviously under way. Until proved otherwise, it had to be labeled a Secondary within theBear Market, which was still presumably in effect, but that Major Downtrend had by now run fornearly three years—nearly as long as any on record—and its last decline had shown no sellingpressure whatever, simply a dull drift. This presumed Secondary might turn out to be a newPrimary; hopes for such a denouement had been blighted 12 months earlier under somewhat-similar circumstances, but this time prices were lower and there was a different “feel” to themarket. The general news offered little encouragement, but the Dow Theory does not concernitself with any news other than the market itself (which discounts all other kinds of news). In anyevent, there was nothing to do but wait and see—let the market, in its own time and way, state itsown case.
In early July, the Industrials started to “mark time”; for 11 weeks, they fluctuated within a 5-pointrange, building a typical Dow Line from which they emerged on the upside in late September.The Rails pushed up to a new high for the move at the same time, and by November 2, bothAverages had surpassed their Rally Tops of the preceding January. At this stage, some Dowtheorists were willing to announce a Bull Market had been signaled. Their arguments, aside frompoints of a nontechnical nature or having nothing to do with Dow Theory, were as follows:
1. The conspicuously low level of volume at the April-June Bottom, typical of the end of aBear Swing. (True and cogent.)
2. The Rail Average had refused to follow the Industrials into new Major low ground at thattime. It had held above its closing level of May 1940. (Also true, but of questionablesignificance. More about this later.)
3. The Industrials had constructed a Line and gone up out of it. (Again true, but the Line wassomewhat short to have, beyond a doubt, major import.)

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32
30
Figure A.5 Daily closing price levels of the Dow-Jones Industrial and Rail Averages fromNovember 2, 1942, to June 30, 1943, and total daily market volume. This chart follows andshould be compared with Figure A.4. The decline in the Rail Average during November andearly December produced the first test of the Major Trend since the preceding June. Whenthis Index recovered and, on February 1, 1943, closed above its November 2 high, a PrimaryBull Market was thereby signaled according to Dow Theory.
4. The Rail Average had produced successively higher Minor Tops and Bottoms for fourmonths. (This also was true but did not permit positive differentiation from a Bear MarketSecondary.)
The more conservative Dow theorists were not yet convinced. They maintained this uptrend hadyet to undergo the test, bound to occur sooner or later, of an Intermediate Reaction. They admittedthat the picture was most encouraging, but they called attention to the fact that, except for Point 1,it was no better than that of November 1940. Let's follow along through the next five months.Figure A.5 shows the daily market action from November 1, 1942, to June 30, 1943.
The Bull signal
After reaching 29.28 at their close on November 2, the Rails declined in almost a straight line forsix weeks to 26.03 on December 14. This move indubitably rated as an Intermediate in durationand it had “given up” more than half of that Average's entire advance from the June 2 low point.The Industrial Index, however, held stoutly in another narrow Line throughout November,December, and January. From December 14, the Rails turned up, and finally, on February 1, 1943,closed at 29.55, out above their previous Intermediate Top of 29.28 recorded the previousNovember. By then, the Industrials had also moved up into new high ground. This development atlast satisfied every strictest requirement of Dow Theory; a new Primary Bull Market was in force.Trading volume had also been expanding on each Minor Advance during the fall and wintermonths, but its evidence was not needed; the price action alone was conclusive. The Rails hadproduced the necessary sequence of higher Intermediate Tops and Bottoms. In the Industrials,Lines had served the purposes of the theory as substitutes for Intermediate Reactions.
It was necessary now to relabel the up-move from April-June to November of 1942 as the firstPrimary Swing in a Bull Market. The decline of the Rails from November 2 to December 14 wasnow recognized as the first Secondary within that Major Trend.
We may turn back for a moment at this point to comment on the performance of the Rail Index inJune 1942. Since it held above its low of May 1940, some commentators have maintained theBull Market should really have been dated from that former year as representing the last“confirmed” lows. This strikes us as rather impractical hair-splitting. Regardless of the 1.17higher level in the Rail Average in June 1942, a genuine Bull Move did not start until that time.We suspect, before many years have passed, Dow theorists will have occasion greatly to regret theimportance that has since been assigned to the Rails' “failure to confirm” in the spring of 1942.Remember, such a Divergence does not and cannot produce a positive signal; at the time of itsoccurrence, it can serve merely to negate or cast in doubt the implications of the other Average;only subsequent action in the opposite direction can establish the existence of a change in trend. Ifthe Rails' decline in May 1942 had carried them below 22.14, but their subsequent action hadfollowed the course it actually did, point for point at a lower level, a Bull Market Signal wouldnevertheless have been given at the very same time, not one day later and not one day sooner.


e other Average;only subsequent action in the opposite direction can establish the existence of a change in trend. Ifthe Rails' decline in May 1942 had carried them below 22.14, but their subsequent action hadfollowed the course it actually did, point for point at a lower level, a Bull Market Signal wouldnevertheless have been given at the very same time, not one day later and not one day sooner.
Moreover, a Divergence does not necessarily imply a move of consequence in the oppositedirection will ensue. We have already examined one comparable instance (in the spring of 1941)that resulted otherwise. Logically, if a failure to confirm such as occurred in 1942 is to be taken asan indication of a turn in trend, then its opposite, (confirmation or reaffirmation by both Averages)should argue with equal force against a turn in trend. Yet the simple truth is that many more MajorReversals have come when the Averages were in
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FigureA.6 Daily closing prices of Dow-Jones Industrial and Rail Averages, and total marketvolume, July 1, 1943, to January 31, 1944.
agreement than when they were divergent. We have no wish to belabor the point or waste thereader's time, but we do feel he should be warned against the wishful thinking that every “failureto confirm” seems to inspire when the market is in a Bear Trend.
To return to our history, the Averages closed at 125.88 and 29.51, respectively, on the dayfollowing our conclusive Bull Market Signal in February 1943. Theoretically, that is where aninvestor who strictly followed the Dow Theory would have bought his stocks. (Those who weresatisfied the Primary Trend was up in November 1942 bought with Averages around 114.60 and29.20.) It was reasonable to assume this Bull Market, which as yet showed few of the usualcharacteristics of the second phase and none whatever of the third phase, would continue for sometime to come. The next four months produced no market developments that required interpretativeattention, and we can move on to the events of July. Figure A.6 charts the action from July 1,1943, to January 31, 1944.
The first correction
After closing at 145.82 on July 14, 1943, the Industrial Average drifted off. The Rails pushed upto a new high (38.30) 10 days later, but the Industrials refused to join in the rally and then bothindexes cracked down sharply for seven sessions. Turnover increased and the decline was thegreatest occurring in the Bull Market up to that date. However, everyone realized the market, afterseveral months of quite persistent advance, was “entitled to a correction.” In neither duration norextent could this down move be qualified as more than a Minor Trend. Next ensued three monthsof desultory fluctuation with little net progress in either Average. The Industrials pulled up to141.75 on September 20 and then drifted off again, whereas the Rails struggled back to 35.53 onOctober 27. Another quick break developed in early November, culminating in a high-volumeshakeout that cut the value of the Industrials by 3.56 points and the Rails by 1.75 on November 8.Prices rallied a little and sold off again, reaching new lows (since early spring) on November 30—Industrials 129.57 and Rails 31.50.
There was no question now that a full-fledged Secondary Reaction had developed. The problemfor Dow interpreters was whether there was more involved. If the first drop in July could beconstrued as an Intermediate Trend in itself, and the August- October action as anotherIntermediate Swing, then the November break would signal a Bear Market. As a matter of fact, noDow theorist, so far as we know, gave very serious consideration to any such interpretation. The
July break, as aforesaid, did not rate as an Intermediate in either duration or points retraced; thewhole move from July to November 1943 had to be regarded as all-of-a-piece, all one SecondaryReaction. The real Major Trend test would come on the next advance, whenever that shoulddevelop; if that failed to top the July peaks, and prices thereafter declined to new lows, a BearMarket would indeed be in effect.
The decision was long deferred. Prices began again to move up, but the advance in the Industrialswas slow and grudging. The Rails forged ahead more rapidly and pushed through their July Topon February 17, 1944, going on to a Minor Peak at 40.48 on March 21. The Industrial Averageattained 141 on March 13, but still nearly 5 points below its “signal” level, faltered and fell back.Here was another striking case of “failure to confirm.” For those who chose to assign gravesignificance to such developments, it could have only a very Bearish meaning. All it did mean, infact, was continuation of the Primary Bull Move had not as yet been confirmed. Only if bothAverages now declined and closed below their respective November 30 Bottoms would the newhigh registered by the Rails alone in February have to be disregarded and a Primary Bear Marketannounced. In brief, the situation at the end of March was no different, so far as its Major Trendimplications were concerned, from what it had been in early January before the Rails pushedthrough.
Bull Trend reaffirmed
The situation remained in doubt (but subject always to that basic presumption of the Dow Theorythat we named as Rule 12 in the preceding chapter [EN10: Chapter 3]) until June 15, 1944, whenthe Industrials finally came through to close at 145.86. It had taken them four months to confirmthe Rails, almost a full year to reaffirm the Primary Uptrend. The effect of this “signal” on traderswas electric; trading volume increased by 650,000 shares on the following day as prices jumpedanother full point.
The following 12 months need no detailed discussion as they produced nothing in the way ofmarket action to give a Dow theorist any concern. Prices drifted off irregularly for nine weeksafter mid-July, but their net loss was of minor proportions, and they then climbed with only briefinterruptions to 169.08 in the Industrial Index on May 2


res on the following day as prices jumpedanother full point.
The following 12 months need no detailed discussion as they produced nothing in the way ofmarket action to give a Dow theorist any concern. Prices drifted off irregularly for nine weeksafter mid-July, but their net loss was of minor proportions, and they then climbed with only briefinterruptions to 169.08 in the Industrial Index on May 29, 1945, and 63.06 in the Rail Index onJune 26, 1945. We should take a brief look at the period following, not because it illustratesanything new in our study, but because it takes in the surrender of Japan and the end of fighting inWorld War II.
The seven months from May 1 to November 30, 1945 are covered in Figure A.7. The Industrialsheld steady for four weeks while the Rails were making the spurt to their June 26 Top. On June28, with nothing in the newspaper headlines to account for such a radical trend change, pricesbroke sharply and turnover climbed to nearly 3 million shares, the highest day's total for the BullMarket up to that time. Nevertheless, the Industrial Average gave ground reluctantly thereafter,and by June 26, at 160.91 had given up less than 5% of its top price. The Rails shook downrapidly, however. The Hiroshima bomb was dropped on August 5, and Japan surrendered on the14th. The Industrials were now rallying up from
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Figure A.7 Daily closing price levels of the Dow-Jones Industrial and Rail Averages from May 1to November 30, 1945, and total daily market volume. This period, which saw the end of WorldWar II, produced only a moderate Secondary Correction in the Primary Bull Market, which hadalready run for three years from its beginnings in April/June, 1942.
INDUSTRIALS
RAILS
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FEBRUARY
iigii -
JANUARY
In I 1 n T 6
APRIL
1 £ I i Q I on
MAY
l"l I 1 O I QK 111
DECEMBER
I o I i K Inn I on I
their July 26 low, but the Rails could not hold and plunged again, hitting bottom finally (for thismove) on August 20 at 51.48, for a loss of more than 18% of their June peak value.
The Rails falter
Before we go on with our examination of the market action here, it is interesting to note up to thispoint the Rail Average had been the “hero” of our story. Starting with its refusal to go down to anew Bear Market low in June of 1942, it was the spearhead of each important advance, had stagedthe most spectacular rallies, had gained 170% in value as compared with the Industrials' 82%. Inretrospect, the explanation is obvious: the railroads were the chief business beneficiaries of thewar. They were rolling up profits, paying off indebtedness, and reducing their fixed charges at arate unheard of in this generation (and probably never to be seen again). Although the “public's”eye was on the traditional and better publicized “war industries,” the market began, as far back asPearl Harbor, to shrewdly appraise and discount this unprecedented harvest for the Rails. Butfrom here on, the picture changes and the Rails become the laggards. As we look back now, it isjust as obvious that, with equal shrewdness, the market began in July of 1945 to discount achange in their fortunes. An illuminating demonstration of the basic assumption (Tenet Number 1)in Dow Theory!
Turning back to our chart, prices began to push up again with renewed vigor after August 20.Both Averages had experienced a Secondary Reaction and now Dow theorists had to watchclosely to see whether the Primary Uptrend would again be reaffirmed by their going to newhighs. The Industrials “made the grade” when they closed at 169.89 on August 24, but the Railshad much more ground to recover and were running into offerings as they came up in successionto each of the Minor Bottom levels of their June-August downtrend (a phenomenon to which weshall devote some attention later on in the chapter on Support and Resistance). Not until earlyNovember 1945 were they able to confirm the signal of the Industrials by closing above 63.06. Atthis point, the Averages had, once again, announced that the Primary Bull Market was still inforce. It had now lasted for three and a half years—longer than most Bull Markets, and “thirdphase” signs were rapidly appearing. The public was buying, the boardrooms were crowded,stock market news was making the front pages of even small city newspapers, the “cats and dogs”were being whooped up, business was booming.
With both Averages in new high ground and the Bull Market reaffirmed, all previous low pointscould now be disregarded. For example, the 160.91 Bottom of July 26 in the Industrials and the51.48 of August 20 in the Rails had no further significance in Dow Theory. This is a point wehave not stressed heretofore, but it is important. It might, indeed, be added to our set of rules in
the preceding chapter (EN11: Chapter 3) were it not implicit in the basic tenets. Once a PrimaryTrend has been confirmed or reconfirmed, the past is forgotten and everything hinges on futureaction. At the end of 1945, with “third phase” symptoms rife, the action of the market had to befollowed with redoubled vigilance. The third phase could last for two more years (as it did in1927 to 1929) or be concluded at any moment. Our next chart (Figure A.8) carries us throughMay 1946.
The spring of 1946
The market went through a Minor Setback in late December, a development has come to beexpected as the normal pattern for that month and is usually attributed to “tax selling”— andstormed ahead again in January 1946. Daily volume on January 18 exceeded 3 million shares forthe first time in more than five years. During the first week of February, prices “churned” withlittle net change. Extreme high closes were registered during this period by the Rail Average at68.23 on February 5, and by the Industrial Average at 206.97 on February 2. On February 9, bothstarted to slide off, pulled back sharply from the 13th to the 16th, and then broke in a selling wavethat ran to a climax on February 26 with


five years. During the first week of February, prices “churned” withlittle net change. Extreme high closes were registered during this period by the Rail Average at68.23 on February 5, and by the Industrial Average at 206.97 on February 2. On February 9, bothstarted to slide off, pulled back sharply from the 13th to the 16th, and then broke in a selling wavethat ran to a climax on February 26 with closings at 60.53 and 186.02, respectively. The loss inthe Industrials was the greatest in points (20.95) they had suffered during the entire Bull Market;in the Rails, it was exceeded only by their July-August decline of the previous year. It amountedto a little more than 10% in the former and 11% in the latter and gave up a little less than half oftheir advances from the 1945 summer lows. The decline was three weeks old on February 26. Itwas an unqualified Intermediate—in Dow Theory a Secondary Reaction presumptively within thestill existing Major Uptrend.
Labor troubles were dogging the steel and motor industries in 1946 from early January on, with acoal strike looming. The February break was attributed to those news developments, but theruling cause was more likely the discontinuance of margin trading. In January, the FederalReserve Board announced after February 1 stocks could be bought only for full 100% cash. Thelate January up-fling was featured by the “little fellow” seizing his last chance to buy on margin.(Those who participated in this scramble will doubtless regret it for a long time yet to come.)Professionals seized the opportunity to unload their trading commitments, but the “little fellow”was now temporarily out of funds; his brokerage account was quickly “frozen.” Under thecircumstances, as we look back, it is amazing that a more extensive Panic did not then eventuate.
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' AUGUST SEPTEMBER OCTOBER’-
1 1 3 1 2 90 2 97 2 3 2 10 2 1 7 2 9A 2 31 L 7 2 1A ^Tl2 9 32 3 219 IQ
Final Up-Thrust
The late February Bottoms were now the critical points on the downside; if both Averages shoulddecline below the Intermediate Low closes then recorded, before the Rails could make a new highabove 68.23 (in which event the Bullish Signal of the Industrials would be canceled), a BearMarket would thereby be signaled. Despite a miner's strike and an imminent rail workers' strike,the market turned firm again in mid-May and put forth a surprising rally that swept the IndustrialIndex up to 212.50 on May 29, 1946—a new Bull high by nearly 6 points. The Rails failed inMay by only 0.17 to equal their February high close, slid back a trifle, and then pushed through atlast on June 13 to close at 68.31, thereby confirming the Industrials in their announcement that (asof that date) the Primary Trend was still up. The February lows (186.02 and 60.53) now ceased tosignify in Dow Theory, but keep those figures in mind because they are involved in an argumentthat raged among Dow students for months thereafter.
The preceding picture is overlapped by Figure A.9, taking up the market's action on May 4 andcarrying it forward to October 19, 1946. Trading volume, it may be noted, in late May and earlyJune did not come up to the levels of either the late January to early February Top or the lateFebruary Bottom; the market appeared to be losing vitality, an ominous, although by no means,decisive manifestation. Prices began to fall off rapidly immediately after the Rail Confirmation onJune 13. The Industrials rallied for two weeks in early July, but the Rails continued to decline; theIndustrials broke again on July 15 and the two Averages continued their slide until they stood at195.22 and 60.41 at the close on July 23.
There, as it subsequently developed, was the end of that particular Intermediate Swing—one inaccord with our Rule 12 had to be labeled a Secondary Reaction in a Bull Market until provedotherwise. The market swung up again. It climbed slowly and steadily, but with turnover runningwell under a million shares, until exactly three weeks later, the Industrials at 204.52 (August 13)had regained a little more than half of their June-July loss and the Rails at 63.12 (August 14) alittle more than a third of theirs. This advance, therefore, had met the minimum requirements ofan Intermediate Trend. If prices could continue to rise and eventually push through their May-June Tops, the Major Bull Trend once again would be reaffirmed. Although, if they should turndown and fall below the July 23 closing levels, it would signal a Reversal of the Primary Trend.
The Bear Market signal
The situation was critical, as evident in the volume chart. Ever since the end of May, turnover hadtended not only to increase on the declines, but also, and more importantly, dried up on the rallies.Compare Figure A.9 with Figures A.7 and A.8, and you can see how conspicuous thisphenomenon had become by mid-August. Prices did turn down, with activity increasing on thebreaks, and on August 27, the closing prices, 191.04 for the Industrials and 58.04 for the Rails,told a sad story. The Averages had spoken: a four-year Bull Market had ended, and a Bear Marketwas under way. A Dow investor should have sold all his stocks on the following day (atapproximately 190 and 58 in terms of the two Averages).
To clear the record, it was necessary for the Dow theorist now to go back and mark the May 29and June 13 highs in the Industrials and Rails, respectively, as the end of the Bull Market. TheJune-July decline then became the first Primary Swing in the new Bear Trend, and the July 23 toAugust 14 advance became the first Secondary Recovery within the Major Downtrend. A secondPrimary Swing was now in the process of development.
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Figure A.9 Daily closing price levels of the Dow-Jones Industrial and


14 advance became the first Secondary Recovery within the Major Downtrend. A secondPrimary Swing was now in the process of development.
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Figure A.9 Daily closing price levels of the Dow-Jones Industrial and Rail Averages from May 4to October 19, 1946, and total daily market volume. This chart overlaps Figure A.8. Compare theclosing price of the Rail Average on June 13 with its February 5 high close. This June actionnullified the previous Dow Theory importance of the February lows. Note significant change involume pattern after May, especially during the August rally.
You will have noted in the foregoing, a Bear Market was signaled as soon as both Averagespenetrated their July 23 lows. Let us return now and take up that argument we mentioned on thepreceding page. Some students of Dow Theory refused to recognize the new high of June 13 inthe Rail Average as a decisive reaffirmation of the Bull Trend. The previous close should bebettered by at least a full point (1.00), many argued, to confirm the signal previously given by theIndustrials; the margin of only 0.08 was inconclusive. Nevertheless, this opinion, if accepted, hadlogical consequences that later proved embarrassing. For, if the Bull Market had not beenreaffirmed in June, then the critical levels on the downside remained at 186.02 in the Industrialsand 60.53 in the Rails, the February 26 Bottoms. Therefore, a Bear Market could not be “called”until those prices had been penetrated downside by both Averages. This view acquired a largefollowing, especially among those who were not interested in “hair splitting” theory but wanted“to give the market every chance in view of the still improving fundamentals.”
The market did, of course, proceed to break its February lows, and by that time, the Panic (secondphase) was on. Obviously, in this case, the orthodox “any-penetration-whatever” school had allthe best of it; they had sold out at least 13 points higher up in terms of the Industrial Index (atleast 6 in the Rails). Six weeks later, on October 9, 1946, this second Primary Intermediate Swingended at Industrials 163.12, Rails 44.69, and another Intermediate Recovery Move started.
Before closing this history of six years of Dow Theory interpretation, we might note the June 13high in the Rail Average furnished a perfect illustration of the rule stating a trend can change anytime after it has been confirmed or reaffirmed, also of the diminishing odds in favor ofcontinuance with each successive reaffirmation of the Primary Trend.
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
1
2.0
21..05
1.0
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FigureA.8 Daily closing price levels of the Dow-Jones Industrial and Rail Averages fromDecember
2
1945, to May 31, 1946, and total daily market volume. Noteworthy features of this periodincluded the extremely high volume that prevailed during January and February as compared withlower turnover in April and May, and the laggard performance of the Rails when the IndustrialAverage pushed up to a new high in April and again at the end of May. At the latter date, theFebruary lows were still the critical downside “signal” levels according to the Dow Theory.
Yet the Dow theorist was not concerned with causes. The Bull Market had been reaffirmed byboth Averages in early February, canceling all previous “signal” levels. Bullish Forces were stillevidently in effect because the February 26 lows held and prices began to recover. The Industrialscame back quickly and by April 9 had closed in new high ground at 208.03. The Rails dragged;when the market showed signs of weakening at the end of April, the Rail Average was still nearly5 points below its early February high. Was this another “failure to confirm” to worry about?
Appendix B: Resources
• Section 1: Important and indispensable sites
• Section 2: References for further study
• Section 3: Investment-oriented sites
• Section 4: The Sharpe Ratio
• Section 5: Calculating volatility and examples of professional risk analysis
• Section 6: The essence of fundamental analysis
• Section 7: Software packages and Internet technical analysis sites
• Section 8: The Leverage Space Portfolio Model of Ralph Vince
Section 1: Important and indispensable sites
Contact information for John Magee:
John Magee technical analysis::Delphic options research ltd (jmta::dor)
E-mail bassetti@edwards-magee.com
bassetti@att.net
Edwards-Magee website
SEC Enforcement
http://www.www.edwards-magee.com
http://www.enforcement@sec.gov
(Whenever I receive touts or investment spam, I immediately forward it to this important branch ofthe SEC. All responsible investors should do the same.)
Volatilities and options:http://www.optionstrategist.com
Portfolio hedge computationhttp://www.cboe.com/portfoliohedge http://www.cboe.comhttp://www.abg-analytics.com
Software reviews andinformation
Software demonstrations andpackages
http://www.traders.com http://www.omegaresearch.comhttp://www.comstar.com http://www.aiqsystems.comhttp://www.tradestation.com http://www.equis.com
Web chart analysis site
Morningstar
Industry evaluations Mutualfund cost calculator Internetanalysis
http://www.stockcharts.com http://www.morningstar.nethttp://www.gomez.com http://www.sec.gov/mfcc-int.htmhttp://www.stockcharts.com
Section 2: References for further study
On Volatilities and Options:http://www.optionstrategist.com
(and futures) http://www.cboe.com
DOW futures and optionshttp://www.cbot.com
AMEX iShares (DIA, QQQ, etc.)http://www.amex.com
On betas http://www.finance.yahoo.com
On risk
Value at Risk, Phillipe Jorion, New York: John Wiley & Sons, 1996 Against the Gods, Peter Bernstein,New York: John Wiley & Sons, 1996 Risk Management 101 (software), Zoologic, Inc., 1997.
See also Chapter 42
On candlesticks
Japanese Candlestick Charting Techniques, Steve Nison, New Yo


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 (andother titles by Schwager in References).
On portfolio management
The Journal of Portfolio Management
Risk Management 101 (software), Zoologic, Inc., 1997
Chapter 42
Section 5, this appendix
Section 8, this appendix
Section 3: Investment-oriented sites
AARP Investment Program
Accutrade
ADR.com
American Association of Individual Investors
American Century
American Express Financial Services
American Stock Exchange
Ameritrade (has little-advertised free trade site)
Annual Report Gallery
Barron's
BigCharts
Bloomberg Financial
Bonds Online
http://www.aarp.scudder.com http://www.accutrade.com http://www.adr.com http://www.aaii.comhttp://www.americancentury.com http://www.americanexpress.com/directa http://www.amex.comhttp://www.tdameritrade.com http://www.reportgallery.com http://www.barrons.comhttp://www.bigcharts.com http://www.bloomberg.com http://www.bondsonline.com
Briefing.com
Brill's Mutual Funds Interactive
Business Week
CBS MarketWatch
Chicago Board of Options Exchange
CNNFN
DailyStocks
Excite
Federal Deposit Insurance Corporation
Federal Trade Commission
Fidelity Investments
Financial Times
Forrester Research
FundFocus
Fund Spot
Gomez Advisers
H&R Block
Hoover's StockScreener
IPO Central
Lombard
Marketplayer
Market Technician's Association
Microsoft MoneyCentral
Morningstar
National Association of Securities Dealers National Discount Brokers
Net Investor
New York Stock Exchange
Online Investor
Philadelphia Stock Exchange
Quick & Reilly
Quicken
Quicken Financial Network
Realty Stocks
Reuters
Schwab, Charles
Securities and Exchange Commission
Securities and Exchange Commission Enforcement
Securities Industry Association
Securities Investor Protection Corporation SmartMoney
Social Security Online
Standard & Poor's Fund Analyst
Standard & Poor's Ratings Services
Stock Guide
Stockpoint
Suretrade
http://www.briefing.com http://www.fundsinteractive.com http://www.businessweek.comhttp://www.marketwatch.com http://www.cboe.com http://www.cnnfn.com http://www.dailystocks.comhttp://www.excite.com http://www.fdic.gov http://www.ftc.gov http://www.fidelity.comhttp://www.ft.com http://www.forrester.com http://www.fundfocus.com http://www.fundspot.comhttp://www.gomez.com http://www.hrblock.com http://www.stockscreener.comhttp://www.ipocentral.com http://www.lombard.com http://www.marketplayer.com http://www.mta.orghttp://www.moneycentral.com http://www.morningstar.net http://www.nasd.com http://www.ndb.comhttp://www.netinvestor.com http://www.nyse.com http://www.onlineinvestor.com http://www.phlx.comhttp://www.quickwaynet.com http://www.quicken.com http://www.qfn.com http://www.realtystocks.comhttp://www.reuters.com http://www.schwab.com http://www.sec.gov http://enforcement@sec.govhttp://www.sia.com http://www.sipc.org http://www.smartmoney.com http://www.ssa.govhttp://www.micropal.com http://www.ratingsdirect.com http://www.stockguide.comhttp://www.stockpoint.com http://www.suretrade.com
1040.com http://www.1040.com
The Motley Fool http://www.fool.com
TheStreet.com http://www.thestreet.com
Technical Securities Analysis Association of San
Francisco http://www.tsaasf.org
T. Rowe Price http://www.troweprice.com
Treasury Direct http://www.publicdebt.treas.gov
Vanguard Brokerage Serviceshttp://www.vanguard.com
Wall Street Access http://www.wsaccess.com
Wall Street Journal Interactive Edhttp://www.wsj.com
Yahoo! Finance http://www.finance.yahoo.com
Zacks Investment Researchhttp://www.zacks.com
ZD Interactive Investor http://www.zdii.com
a American Express now advertises free trades for some accounts.
Brokerage houses
Waterhouse Securitieshttp://www.tdameritrade.com
800-934-4134
A. B. Watley http://www.abwatley.com
888-229-2853
Web Street Securitieshttp://www.webstreetsecurities.com
800-932-0438
Jack White http://www.jackwhiteco.com
800-753-1700
WitCapital http://www.witcapital.com
888-494-8227
Net Investor http://www.netinvestor.com
800-638-4250
Quick & Reilly http://www.quickwaynet.com
800-672-7220
Charles Schwab http://www.schwab.com
800-435-4000
Suretrade http://www.suretrade.com
401-642-6900
Vanguard Brokerage Serviceshttp://www.vanguard.com
800-992-8327
Wall Street Access http://www.wsaccess.com
888-925-5782
Empire Financial Group, Inc.http://www.lowfees.com
800-900-8101
E*TRADE http://www.etrade.com
800-786-2575
Lombard http://www.lombard.com
National Discount Brokershttp://www.ndb.com
800-888-3999
Accutrade
Ameritrade
See also
Discover Brokerage
DLJ Direct
Datek Online
DLJ Direct
Dow Jones Markets
DRIP Central
Empire Financial Group
http://www.accutrade.com
800-494-8939
http://www.tdameritrade.com
800-326-7507
http://www.freetrade.com http://www.discoverbrokerage.com 800-688-3462 http://www.dljdirect.com
800-825-5723
http://www.datek.com
http://www.dljdirect.com http://www.djmarkets.com http://www.dripcentral.com http://www.lowfees.com
Section 4: The Sharpe Ratio
Although this formula is flawed, it will not hinder the reader to know about it and understand it. Believingin it would be quite a different matter, however. The Sharpe Ratio itself is as follows:
SR = (E - I)/sd
where
E is the expected return, I is the risk-free interest rate, Sd is the standard deviation of returns.
The effect of this inflexible formula is to stick the trader with a measuring tool of little use to the practicaltrader. It assumes volatility of returns as measured by sd equals risk (the common academic problem). Inthe inflexibility of the sd ca


e Ratio itself is as follows:
SR = (E - I)/sd
where
E is the expected return, I is the risk-free interest rate, Sd is the standard deviation of returns.
The effect of this inflexible formula is to stick the trader with a measuring tool of little use to the practicaltrader. It assumes volatility of returns as measured by sd equals risk (the common academic problem). Inthe inflexibility of the sd calculation, it fails to measure the most important fact in trading, the maximumdrawdown, or, the inevitable fluctuations in gains and losses. Specifically, the greatest expected orexperienced loss, the retracement from greatest high to greatest low, and the sequences of theseexperiences.
Section 5: Calculating volatility
To calculate the volatility of a portfolio or of an individual instrument, first find the difference betweeneach return and the average. Then square each difference and add them together. Divide the sum by the
number of returns minus one. This result is known as the variance. Finally, take the square root of thevariance to get the volatility. Combining these steps into a formula (see Diagram B.1):
Step 1: Calculate the average return.
Step 2: Calculate the deviation of each return.
Step 3: Square each period's deviation.
Step 4: Add them together.
Step 5: Divide the sum by the number of periods minus 1.
Step 6: Take the square root.
a =
£ (Ri - M )2
i=1
n-1
Diagram B.1 Volatility formula. Illustrated is the formula for computing volatility. (1) Calculate theaverage return; (2) calculate the deviation of each return; (3) square each period's deviation; (4) add themtogether; (5) divide the sum by the number of periods minus 1 to get the variance; and (6) take the squareroot.
Note this is the formula to use when you have experience with the portfolio. There is quite a morecomplex procedure in Modern Portfolio Theory.
Section 6: The essence of fundamental analysis
From the John Magee Market Letters, December 15, 1984
by Richard McDermott
The Elliott Wave Theory: perspective and comments
We had the pleasure of attending the December meeting of the Market Technicians Association of NewYork.
Long-term subscribers will remember the MTANY as the organization that honored John Magee with its“Man of the Year” award in 1978. The speaker was Robert Prechter, publisher of “The Elliott WaveTheorist,” an investment advisory which bases its forecasts on interpretations of R. N. Elliott's work onthe stock market.
Of primary interest to SAS subscribers are Prechter's comments on technical analysis itself. The ElliottWave Theory, it must be remembered, is really no more than a “catalog” of stock market price
movements, laid one on top of the other, so to speak, until a grand, underlying, and enduring pattern isobserved; in short, pure technical analysis. Among Prechter's definitions and observations regardingfundamental analysis are the following:
1. “First let's define ‘technical' versus ‘fundamental' data .. technical data is that which is generatedby the action of the market under study.”
2. “The main problem with fundamental analysis is that its indicators are removed from the marketitself. The analyst assumes causality between external events and market movements, a conceptwhich is almost certainly false. But, just as important, and less recognized, is that fundamentalanalysis almost always requires a forecast of the fundamental data itself before conclusions about themarket are drawn. The analyst is then forced to take a second step in coming to a conclusion abouthow those forecasted events will affect the markets! Technicians only have one step to take, whichgives them an edge right off the bat. Their main advantage is that they don't have to forecast theirindicators.”
3. “What's worse, even the fundamentalists' second step is probably a process built on quicksand....The most common application of fundamental analysis is estimating companies' earnings for boththe current year and next year and recommending stocks on that basis.. And the record on that basisalone is very poor, as Barron's pointed out in a June 4 article, which showed that earnings estimatesaveraged 18% error in the thirty DJIA stocks for any year already completed and 54% error for theyear ahead. The weakest link, however, is the assumption that correct earnings estimates are a basisfor choosing stock market winners. According to a table in the same Barron's article, a purchase ofthe ten DJIA stocks with the best earnings estimates would have produced a ten-year cumulative gainof 40.5%, while choosing the ten DJIA with the worst earnings estimates would have produced awhopping 142.5% gain.”
We enjoyed Prechter's polished exposition of a technical approach, which differed from our own. As forhis observations about fundamental analysis, we simply could not agree more.
Key: portfolio risk report. The Portfolio Risk Analysis screen summarizes delta, profit, and severalmeasures of risk for a portfolio of user-specified stocks and options.
The screen displays:
STOCK SYM = The stock symbol;
STOCK POS = The stock position, or number of shares owned;
DELTAS TOTAL = The sum of the stock deltas and option deltas;
BETA = The stock beta for each stock (implementation pending);
$BETA = $The dollar risk due to movement of the general market: $Beta = (Delta x Stock Price) x Beta;
$DELT = An annualized risk figure based on Position imbalance: $Delta = (Total Delta x Stock Price) xVolatility;
Portfolio Analysis Screens
Diagrams B.2 and B.3 deal with portfolio risk and profit analysis. Illustrated are the sophisticatedquantitative portfolio Profit and Risk reports of Delphic Options Research as implemented forStandard & Poor's trading systems and Prudential Securities to give the reader an appreciation of
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