e whether the method
worked. A company on roller blades, impossible to dislike as a company.
Remember, unless you are Warren Buffet, you are buying the stock, not the
company.
45
39
36
33
30
27
24
21
18
15
12
Figure 23.8 ORCL. True to the character of stocks during the Tulipomania,
Oracle was difficult to handle without careful analysis. Stock splits
preceded a number of the sell-offs (note gaps post splits). Bullish gaps are
also frequent here, and the tulip top is obvious, and was at the time. An
excellent trading vehicle though a wreck for the casual investor.
Hope springs eternal and there is one born every second
One might have thought the age of the tulip was over as we moved into the
second decade of the new millennium—but what naivete! Not over at all.
Investors rushed into the LinkedIn and Groupon IPOs and stood quivering
on the sideline begging for Facebook to go public. But Facebook, the
ultimate practitioner of chutzpah, satisfied itself by feeding on the venture
capital community, demanding ever higher valuations from venture
capitalists desperate to own a sliver of the deal at whatever cost. The public
will have to wait to be shorn. But have faith, it will be. Remember Palm.
You can buy these things, but you have to remain glued to the screen and
the ride will be rough. Unless you have your professional speculator's
license and have lost money on these deals before, watch the snake pit from
the sidelines—and do not buy any snake oil.
260
220
180
160
140
120
100
80
60
40
20
2
Figure 23.9 INKT. The pleasures and delights (and disappointments) of
internet stocks. The last trendline, in conjunction with the second horizontal
trendline, clearly marks the end of the party (AND WILL FOR ANY
STOCK WHATSOEVER). The break of the long-term trendline is the last
exit signal, as if the previous signals were not clear enough. Is it not
obvious that this issue was (and is) manageable with technical analysis?
Figure 23.10 EMULEX (ELX). The message of 2000, a severe drubbing,
and precipitous at that, would have been lost on the non-technician. Those
who continued to ride the roller coaster relearned a lesson some technicians
know—stocks often repeat the same behavior (or misbehavior). The lesson
of monster breakaway gaps (or air gaps) may have needed relearning also.
Oh well, after such a gap the damage is done, the unenlightened investor
says, only to see the damage continue down to 10 (from 110!). These are
signals of such magnitude that disaster awaits the trader who denies its
significance. The air gap here nicely complements those of Figures 12.9 and
37.43.
10
120
100
80
60
50
40
30
20
1
120
100
80
60
40
20
0
Figure 23.11 Amazon weekly. Amazing Amazon dances in the internet
follies. The breathtaking plunges are the direct result of the breathtaking
speculative excess. See the daily chart (Figure 23.12) for a closer look at the
details of the blow-off.
AMZN (Amazon.com, Inc.)
Figure 23.12 Amazon daily. In cases of speculative blow-off, trendlines are
of little use. A dozing trader (presumably it was obvious this was not an
investment issue) would have been mauled in the plunge. An alert trader,
knowing that in blow-offs the procedure is to sell strength, might have
avoided it. Other techniques include recognition of the second exhaustion
gap and exit. Also, a trader using the techniques described in Chapter 28,
setting progressively tight stops, might have avoided the fall.
Figure 23.13 The wild frontier of the internet and of the gunslinger
speculators (gamblers?). Amazon bucks on. Give us a slug of rotgut
whiskey and get out the ruler. A clear top for the rational analyst with clear
broken trendlines and broken horizontal lines and then a clear Bear Market
with a clear bottom resembling a Kilroy Bottom and then a clear breakout
and another Bull Market and then another downtrend. Talk about your
fearless bull riders down at the rodeo. But this Bull-Bear is ridable with a
little technical analysis. Without technical analysis it is like being the target
in a shooting gallery—a sitting duck.
Figure 23.14 CISCO (CSCO). Although the first long-term trendline
beautifully intercepts the downtrend in progress at a gap (a coincidence of
indicators that occurs too often to be a coincidence), the trendlines drawn
later are of such strength that even the novice analyst should know how to
exit. In fact, one of my students, an employee of Cisco, did just that, saving
himself thousands of paper dollars in this very case.
Created with TradeStation 2000i by Omega Research '.s'-1999
Figure 23.15 Is there any way the trader (investors keep away) could avoid
stepping off this cliff? Extreme paranoia is one way. Another way is by
being acutely conscious of the pattern of behavior manifested by Cisco in
Figure 23.14.
Figure 23.16 You thought all the tulips and Bulls had been exhausted in the
Tulipomania in 2000? Silly you. There is an inexhaustible supply. All you
need is a company and a story and an underwriter to peddle it. Sometimes
there are even earnings. Sometimes the earnings are even real. Sometimes
the earnings are skating uphill on roller blades. Then sometimes the
characters are so appealing that you are almost willing to buy the IPO at
face value, but not if you are a cynic, as are all technical analysts. Google
was rumored at $200 or more on the IPO. The editor offered to sell all of it
at that price and throw in the Brooklyn Bridge for free. This offer (well,
there may have been other factors also) knocked the IPO down to $85 (still
an errant speculation), but only insane, not unreasonable. The
oversubscription in an innovative offering revealed that the tulip virus was
not dead, but very much alive and infecting not just the same old suspects,
but many new ones. We love a horse race, and this is a great one. Notice the
obvious defensive lines and support and resistance. How long Google can
defy gravity (a galactic price-earnings ratio) remains to be seen. Prudent
gamblers will have a stop ide


bscription in an innovative offering revealed that the tulip virus was
not dead, but very much alive and infecting not just the same old suspects,
but many new ones. We love a horse race, and this is a great one. Notice the
obvious defensive lines and support and resistance. How long Google can
defy gravity (a galactic price-earnings ratio) remains to be seen. Prudent
gamblers will have a stop identified. On this chart, for the long-term
gambler, it might be in the 182 area. For the more agile gambler, it might be
failure of the support around 204, or closing of the breakaway gap there. No
opprobrium is attached to the term gambler. In fact, bolder investors
(competent readers of this book) should take a flyer from time to time with
about 5% of their capital. This is the flyer that should have been taken. The
breakaway gaps in October and April, operating against disbelief, were
signals of enormous technical strength. And Google went to 475! The
lesson here, which must be learned and relearned and ... ad infinitum ... is
this: trust the chart. Ignore the story. In 2008, GOOG went to 700, halved in
the Bush Bear Market, recovered to 600, and entered a two-year sidewave.
Figure 23.17 Google, 2011. Google turned out to be the real thing and had
a herd of cash cows that produced and produced and produced. Mother's
milk? Or America's love affair with advertising? Whatever, the reader can
see the simple-minded management of the issue with trendlines. Using
trendlines would have avoided bungee-like equity, which is never pleasant.
Basing Points might have been used the same way with the same effect.
GOOG has essentially been in a large sidewave (very large) since 2010. The
exit from this sidewave should have dramatic consequences—up or down.
chapter twenty-four
The probable moves of your stocks
At first glance, all stocks appear to move helter-skelter without rhyme or
reason, all over the lot. All stocks go up at times, and all go down at times
—and not always at the same time. We already have seen in these rises and
falls stocks do follow trends, make various typical patterns, and behave in a
not completely disorderly manner. (For illustrations in this chapter, see
Figures 24.1 and 24.2.)
It is also true that each stock has its own habits and characteristics, which
are more or less stable from year to year. Certain stocks normally respond
to a Bullish Phase of the market with a very large upsurge, whereas others,
perhaps in the same price class, will make only moderate moves. You will
find that the same stocks that make wide upward swings are also the ones
that make large declines in Bear Markets, whereas the ones that make less
spectacular up-moves are more resistant to downside breaks in the market.
There are stocks that ordinarily move many, many times faster than others.
We do not know, for example, whether a year from now Glenn Martin (EN:
read, Microsoft, eBay) will be moving up or down, but we do know, and it
is one of the most dependable things we know, whichever way it is going, it
will be covering ground much faster than American Telephone and
Telegraph. (EN9: Even T accelerated into hyperspace after its unfortunate
divestment of local Bells. And, unlike the leopard, completely changed its
spots.) These differences of habit, of course, are due to the size of issue,
floating supply, nature of business, and leverage in the capital structure,
matters we have touched on briefly before. As a matter of fact, we are not
especially concerned with why the differences exist. We are interested
mainly in what the differences are, and how we can determine them.
This is important: stocks that habitually move in a narrow range, although
excellent for investment purposes in cases in which stability and income
(dividends) are the chief desiderata, are not good trading stocks. A fairly
high degree of sensitivity (EN: volatility), with wide percentage moves, is
necessary to make possible profitable commitments that will cover costs
and leave a net gain. To be in a position to make a profit, you should see the
probability of at least a 15% move in your stock.
How then are you going to tell which stocks are most sensitive and
potentially most profitable?
By examining the record of a certain stock for a number of years back, and
comparing the percentage moves it has made with the percentage moves of
the market as a whole, you can obtain a fair picture of that stock's habits.
You will not be able to say, at any particular moment, “This stock is now
going to move up 25%,” but you can say, with a good deal of confidence,
“If the market as a whole makes an advance of 10%, this stock will
probably advance about 25%.” Or, conversely, “If the market goes down
10%, this stock will very likely go down at least 25%.” (EN10: The concept
of beta.)
Many methods have been used for measuring and checking these
percentage-move habits, differing only in detail. (EN10: With the ready
availability of desktop and internet software, the investor may call up a
two- or five-year chart and see the potential range of the stock at hand.)
Indexes on several hundred important stocks listed on the New York Stock
Exchange have been computed by the authors and are presented in
Appendix A, ninth edition.
44

46
40
36
32
28
72
68
64
60
56
52
Figure 24.1 Some stocks move faster than others. We have already noticed
that low-priced stocks have much larger percentage moves than high-priced
issues. Yet, even between two stocks that may, at a particular time, be
selling at the same price, there are enormous differences in their habits.
Furthermore, these habits change very little from year to year.
Here we have a weekly chart of Corn Products Refining Company (left),
covering an 18-month period in the years 1945 and 1946. We also have a
chart of Schenley Distillers (right) for the same period. The average price
between the high and low on these charts is about 64 1/2, the same for both
stocks.
However, during this period, we see “CFG” moving b

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


ese habits change very little from year to year.
Here we have a weekly chart of Corn Products Refining Company (left),
covering an 18-month period in the years 1945 and 1946. We also have a
chart of Schenley Distillers (right) for the same period. The average price
between the high and low on these charts is about 64 1/2, the same for both
stocks.
However, during this period, we see “CFG” moving between a low of 58
1/2 and a high of 71, a range of 12 1/2 points, while at the same time, “SH”
has moved between 28 1/2 and 100, a range of 71 1/2. A thousand dollars
put into an outright purchase of “CFG” at its extreme low would have
grown to $1,210 at its extreme high, whereas the same amount used for
outright purchase of “SH” at its low would have grown to $3,510. Your gain
of $2,510 in “SH” would be more than 10 times the gain of $210 in “CFG,”
and this without using margin.
It is not likely you would actually purchase either stock at the extreme low,
nor sell at the extreme high. The point we are bringing out here is there are
enormous differences in the swing habits of stocks.
(EN10: Magee's concept of “sensitivity” appears to combine some aspects
of our modern concept of beta and modern computation of volatility. The
replacement for Magee's Sensitivity Index is readily available at
finance.yahoo.com and http://www.abg-analytics.com as well as any
number of other sites findable by Google.)
Individual stocks have their characteristic habits, as do some entire
industries. In general, the food stocks, of which “CFG” is one, are stable
and slow-moving. On the other hand, liquor stocks make wide moves on
any general advance or decline of the market. At this time “CFG” had a
Sensitivity Index (EN9: or beta equivalent) of 0.58, whereas Schenley's was
2.05.
(EN: Current-day betas or volatilities may be compared with these and/or
substituted for them in other computations suggested in this book, for
example, in Composite Leverage formulas. The reader
CUBAN - AMERICANSUGAR CSU
36
34
32
30
28
X MJI
24 Pftirww
r •
22
20 4. UL J L I d
1
18
164 --------------r
141945 1946
4
llliiil
"TO
Figure 24.2 Another example of the difference in swings between stocks. In
this case also, the stocks show the same average price between the high and
low of the period, and both stocks are plotted for the same 18 months in
1945 and 1946. Although in a lower price range and even though the
disparity in their Sensitivity Indexes is less, there is a considerable
difference in their actions. Cuban-American Sugar (left), a food stock,
shows a range of 76% from its low of 16 1/2 to its high of 29, whereas
Electric Boat (right), a shipbuilding concern, advances more than 140%.
may read in the following text “beta” for “Sensitivity Index” and avoid the
annoyance of excessive notation by the editor.)
The Indexes are relative. They show stocks with a high Sensitivity Index
(EN: beta) will move much faster in either Bull Markets or Bear Markets
than stocks with low Indexes, and about how much faster, relative to the
other stocks.
(EN: As is obvious to the experienced reader, and new to the inexperienced,
Magee's method predates the modern compilation of betas and volatilities.
Beta measures the systematic risk of a stock, or for those who are not into
financial industry jargon, the sensitivity of a stock to the market. Volatility
measures the dispersion of returns in the stock itself. Thus, if the market
moves 1 point, a stock with beta of 1.5 will move 1.5 points. A stock with a
beta of 0.5 will move 0.5 points, approximately or more or less. Not
surprisingly, high beta stocks are volatile. For readers who like to roll their
own, I offer here the formula for computing the beta of a stock, which is
somewhat more sophisticated than Magee's method:
((N)(Sum of XY)) - ((Sum of X)(Sum of Y))
where
N = the number of observations,
X = rate of return for the S&P 500 Index,
Y = rate of return for stock or fund.
The general investor may not be avidly interested in this calculation,
especially when the beta is readily available at Value Line and
finance.yahoo.com and is published regularly by Merrill Lynch. Betas litter
the internet, found by searching Google; seekingalpha.com has lists; and
finance.yahoo. com displays the stock beta in “Key Statistics” for each
stock covered.
Of equal or greater importance is the individual risk of a stock that
professionals like to determine by computing its volatility. Somewhat akin to
Magee's “normal range for price,” volatility measures the variability of a
stock's returns (price movement). The general investor should be informed
the study of volatility is an extremely sophisticated subject, and
professionals expend enormous resources dealing with the question.
Numerous methods are used to derive volatilities, but these mainly come
into play in options arbitrage and professional trading on exchange floors.
For the private investor, it is sufficient to know of the dangers of this arcane
area. Before venturing into “volatility plays,” the newcomer should take a
postgraduate course. For the general investor who wants to know enough
to calculate his own volatilities (not recommended or necessary), I note the
formula here:
To calculate volatility, first find the difference between each return and the
average. Then square each difference and add them together. Divide the
sum by the number of returns minus one. This result is known as the
variance. Finally, take the square root of the variance to get the volatility.
Combining these steps into a formula:
^(Ri -|i)2
• Step 1: Calculate the average return.
• Step 2: Calculate the deviation of each return.
• Step 3: Square each period's deviation.
• Step 4: Add them together.
• Step 5: Divide the sum by the number of periods - 1. This is the
variance.
• Step 6: Take the square root.
The less punctilious (or more practical) investor may find volatilities at ht
tp://www . optionstrategist.com, ht tp: // www .cboe.com, and
finance.yahoo.com, as well as other locati


lculate the deviation of each return.
• Step 3: Square each period's deviation.
• Step 4: Add them together.
• Step 5: Divide the sum by the number of periods - 1. This is the
variance.
• Step 6: Take the square root.
The less punctilious (or more practical) investor may find volatilities at ht
tp://www . optionstrategist.com, ht tp: // www .cboe.com, and
finance.yahoo.com, as well as other locations that can be located by
searching on Google.)
chapter twenty-five
Two touchy questions
This chapter is directed largely to the new trader, to the investor who has
followed other analytical methods, and to the investor type who is now, for
the first time, taking up the technical trading of stocks for the shorter term.
The use of margin
The first question here is the use of margin. There are many people who,
knowing of the disastrous margin calls of 1929 and the staggering way
losses can be multiplied against one in a margined account during a sharp
break in the market, take the attitude that the use of margin is intrinsically
bad, dangerous, foolish, and unsound. They will tell you they are willing to
risk their own money, but they never speculate on borrowed funds. They
will tell you that by buying securities outright, they are safe against any
kind of break in the market.
There is something to this line of argument, although very often you will
find the arguer has not really thought the case through all the way. If he had,
he might realize that, in buying outright stocks that are sensitive or highly
leveraged, he is accomplishing almost exactly the same thing as someone
else who buys more conservative stocks on a margin basis. Very often,
despite his feeling that outright purchase is more conservative than margin
buying, he is a speculator at heart. He is not really interested in dividends
and a stable investment. Rather, he is looking for “something with
appreciation opportunity.” Considering he is not facing the issue squarely,
he may fall into expensive errors.
To be thoroughly consistent here, a man who shuns the risks inherent in
margin trading should shun the risks of leverage and volatility. He should
avoid risk, forget “opportunity for appreciation,” and confine himself to
sound, income-producing stocks of a sort that will not fluctuate widely.
If we are looking for stability, we do not want excessive fluctuation and
there are securities that provide stability. In this work, however, we are
looking for “swing power.” We want the highest degree of fluctuation we
can handle safely. We can secure this by buying outright a stock that is
normally subject to fairly broad swings—that is, a stock with a high
Sensitivity Index (EN: beta). We can get the same effect by trading in a
stock of more conservative habits but increasing the Composite Leverage
(EN: or simply leverage) by using margin. (The method of computing and
comparing Composite Leverages in various situations is covered in
Appendix A, ninth edition and may be studied in Chapter 42.)
Let us assume, for example, we will buy 100 shares of a rather speculative
stock, which we will call UVW, on an outright basis. It has a Sensitivity
Index of 1.50, and now sells (let us say) at 20. At the same time, we buy a
somewhat less speculative stock, XYZ, also selling at 20; but in this case,
we buy on 70% margin, putting up only three-quarters of the value of the
stock. In a general advance affecting both of these stocks, the probabilities
would favor a somewhat greater percentage move in UVW than in XYZ. If
such a general rise should bring UVW to 30, we might expect XYZ to rise
to a lesser degree, say to 28. Now the advance of 10 points on the $2,000
invested in outright purchase of UVW will represent a gain of $1,000 or
50%. The advance of XYZ to 28 on the $1,400 invested at 70% margin will
mean a gain of $800 or 57%. In other words, we have, by the use of margin,
increased the effective leverage of XYZ; we have made it, in fact, slightly
more speculative than UVW.
The effect of margin use is simply to accentuate or increase the sensitivity
of a situation. It is a mechanism for assuming more risks and, therefore,
more opportunities for faster gains. Assuming you are willing to assume
risk (as you must be if you intend to make speculative commitments), it is
simply a matter of knowing approximately what risks you are taking and
whether you can afford to take them. The danger in margin lies in cases in
which the customer grossly overextends himself, taking on a risk far
beyond his ability to protect himself. This will not happen if he sets a
reasonable limit to his total leverage (EN: put another way, his portfolio
risk).
The margin transaction is simply a matter of buying (or selling short) more
stock than you have money to pay for in full. The purchase of a home on a
mortgage is essentially a margin transaction. The financing of business
operations, using borrowed money for part of the capital, is the same. The
buying of anything for which the purchaser puts up part of the capital and
borrows the rest, using the value of the purchased property as security for
the loan, is exactly similar to the trading of stocks on margin. In each case,
any change in the value of the property will cause a larger net change in the
value of the margin capital. Thus, if a man buys a home for $100,000,
paying $50,000 cash, and later sells it for $150,000 (an increase of 50% in
the value of his property), he will benefit to the extent of $50,000 profit, or
100% on his invested capital.
The question of margin calls, being “wiped out” on margin transactions,
will seldom, if ever, come up if you protect yourself properly by
maintaining stops at all times or by closing out the transaction when it has
violated certain predetermined danger points. Needless to say, if you have
allowed a trade to go so bad it reaches the minimum margin maintenance
range, the best thing is to take your loss and forget it; not try to meet the
margin call. Yet again—this need not ever happe


f ever, come up if you protect yourself properly by
maintaining stops at all times or by closing out the transaction when it has
violated certain predetermined danger points. Needless to say, if you have
allowed a trade to go so bad it reaches the minimum margin maintenance
range, the best thing is to take your loss and forget it; not try to meet the
margin call. Yet again—this need not ever happen.
As we will see in discussions of sensitivity and leverage, stop levels, and so
on, there are certain limits that can be fairly well defined, beyond which
you cannot safely venture. If you could buy stock on a 10% margin, as you
could at one time, you might have visions of highballing $1,000 up to $1
million in one Bull Market; that is not a reasonable hope and it is not safe to
risk your capital on a 10% margin because, in many cases, your perfectly
logical purchase would sag enough to wipe you out entirely before going
ahead to the normal advance you expected. (EN: In a nutshell, the risk of
trading commodities and futures.) In judging how much margin you can or
should use within the limits of margin trading laid down by law, you must
take into account the method of trading you are using, the amount of
adverse fluctuation you must expect in the normal operation of your
method, and the nature of the stock you are dealing with, that is, its
Sensitivity Index and Normal Range-for-Price (EN: at the risk of being
repetitive, beta and volatility), at the time you make the original
commitment.
Short selling
The other touchy question is that of short sales. A majority of traders avoid
the short side of the market. Six out of seven investors you meet, who have
bought or sold stocks, will tell you they would never sell a stock short under
any conditions, at any time. In fact, short selling is limited, very largely, to
skilled professionals. (EN: The private investor, because of his fears and
prejudices, voluntarily grants this “edge” or advantage to professionals.
Magee dealt with this subject at length in Winning the Mental Game on
Wall Street, which I wholeheartedly recommend to the reader. EN9: The
widespread proliferation of hedge funds in the new century attests to the
frustration of professional managers with mutual fund rules requiring them
to maintain only long positions. Even with this development, short selling
by the general investor remains a limited technique—to the disadvantage of
the nonprofessional.)
Now, if you have studied long-term charts (weekly and monthly), and the
daily charts in this book, you will recognize several facts about the action of
markets. Most stocks go up most of the time. There are almost always more
advances than declines in the list of the most active stocks published each
day. Stocks, in general, advance about two-thirds of the time, and go down
only about one-third of the time. (EN9: Probably a truth over the long term,
but in the modern context, ample short opportunities exist.)
Furthermore, most of the news releases, rumors, and comments in the press
related to stocks and corporate affairs have to do with the brighter side of
industry. It is only natural that executives, public relations people, and the
reporters themselves should be interested in forward-looking developments,
new processes, expansion of facilities, increased earnings, and the like, and
that such items should prove more newsworthy than less optimistic reports.
These various factors may explain why “the public” is always Bullish. The
public is always hoping and expecting stocks to go up all the time. If stocks
are rising and in a Bullish Phase, the public expects them to still go higher.
If stocks have declined sharply, the public will argue they are now better
buys than before and must surely go up soon. It is up, up, UP, always up, in
the mind of the public.
Yet, examination of the long-term charts covering the action of the
Averages over many years will show you that, through these long periods,
the levels rise and fall about the same amount. This being the case, it must
follow that stocks come down as far as they go up and because they go up
about two-thirds of the time, they must come down much faster than they
go up. This you will find is true. The angles of decline in the Averages and
also in individual stocks are usually steeper in Bear Market Moves than the
advances are in Bull Market Moves. A corollary to that is that profits can be
made faster on the downside of the market than on the upside.
Such profits are made by selling short. It is important if you are a trader to
understand the meaning of a short sale. When you sell a stock short, you
borrow that stock from someone who owns it, and then you turn around and
sell it to someone else, agreeing with the original owner to replace his
shares at some unspecified time in the future. All of the details of this
transaction is handled by your broker. Shares of most stocks of large
outstanding issue are available for loan at all times in the hands of brokers,
and your broker has access to them. The mechanics of this borrowing and
sale are interesting; you may wish to get from your broker the whole story
of how these operations are carried out. For all practical purposes, however,
all you need to do is tell your broker what you wish to sell and leave the rest
to him.
He will advise you if, by any chance, the stock you have selected for short
sale is not available for loan. Another practical point, although of minor
consequence, is that a slight additional tax is assessed against short sales.
(EN: In that gains on short sales are not eligible for long-term capital gains
tax.)
It is important also, if you are a trader, to accept opportunities to sell short
as readily as you go long stock. Unfortunately, there are psychological
barriers to short selling. There are, for example, the unintelligent and
entirely irrelevant slogans about “selling America short.” There is the
feeling on the part of many who are poorly informed that short selling i


long-term capital gains
tax.)
It is important also, if you are a trader, to accept opportunities to sell short
as readily as you go long stock. Unfortunately, there are psychological
barriers to short selling. There are, for example, the unintelligent and
entirely irrelevant slogans about “selling America short.” There is the
feeling on the part of many who are poorly informed that short selling is the
somewhat unethical trick of the manipulator. Others have the impression
that, in selling short, one is hoping to profit by the misfortunes of others at
times of disaster and Panic. It is not the purpose of this book to persuade
anyone to sell stocks short, any more than it is our purpose to advise anyone
who should not to speculate on the long side of the market. Nevertheless, so
many questions are constantly raised, even by fairly sophisticated investors,
about the ethics, as well as the practical procedure of short selling, that we
may perhaps be pardoned for saying a few more words in its defense.
All of the popular ideas about short selling mentioned in the preceding
paragraph may be branded as so much nonsense. There is nothing more
reprehensible about selling short than buying long. Each is a speculation in
relative values. The truth is money is a commodity, just as much as a share
of stock. There is no moral or practical difference between borrowing
money to buy stock because you believe the latter will go up in value in
terms of the former and borrowing stock to “buy” money because you
believe the latter is going to go up in value in terms of the former. In each
case, you are obligated eventually to repay the loan whether it be money or
stock. In each case, you are taking a risk on the basis of your considered
forecast as to the future trend of relative values.
There are, in fact, many common business practices that are more or less
analogous to selling stocks short. For example, every time the publisher of a
magazine accepts cash in advance for a subscription, he is making
something like a short sale. His ultimate profit or loss will depend on what
the magazines he will eventually supply have cost him by the time the
subscription runs out.
When you sell stocks short, you (or rather your broker) receive the proceeds
of the sale at once but you are obligated to turn back an equal number of the
same shares at some future date to the man from whom the stock
certificates were borrowed. (EN: One of the advantages or edges that
professionals enjoy over private investors is the credit of short sales to their
accounts and the payment of interest thereon. Although the proceeds are
credited to the private investor, no interest is generally paid on it, unless the
investor has influence with the broker. A favorable situation is created,
however, if a short sale of $100,000 were made on, say, 50% margin, a
credit of $150,000 would be made to his account, and no interest would be
charged. Any dividends the trader paid on the transaction would be
expensable.) Consequently, sooner or later, you have to go into the market
again and buy those shares. When you buy them, you (or rather your
broker) return the shares to the original lender, thus discharging your
obligation. If the cost of your purchase was less than the proceeds of the
earlier sale, the difference is your profit. If it costs you more to buy in the
shares—or as it is termed, cover your short—the difference represents a
loss. You do not enter into a short-side transaction unless you expect the
price of the stock to go down; hence, showing you a profit.
One of the little-appreciated results of a large volume of short selling is
actually to strengthen the market. Every short seller is a potential buyer.
Most short sellers are glad to cover and take their profits on a relatively
Minor Decline. Consequently, if there is a big short interest at any given
time in a particular issue, it means there are many people waiting to buy
that stock when it goes down. This situation tends to “cushion” bad breaks.
Some astute operators will actually buy a stock when they learn there is a
very large short interest in it, meaning a great many shares of it have been
sold short and not yet covered, because they realize competition among the
short sellers to buy the stock whenever it has a small decline may result in a
very fast and profitable Short-Covering Rally. Any stock is stronger,
technically, if there is a good-size short interest in it.
There is one further objection raised against short selling. It will be pointed
out when you buy stock that your loss, if worse comes to worst, can be no
more than the total amount you paid for it. In the case of a short sale, the
price of your stock could, theoretically, rise against you to $50.00, $100,
$1,000, $10,000 a share; in other words, it could rise without limit. This
argument sounds much more alarming than it really is. Certainly there is no
occasion to lose sleep over it. Stocks do not go up without limit all of a
sudden. It is just
as easy to set a stop on the loss you are willing to take on a short-side
transaction as it is on a long purchase. Such situations as the famous 1901
corner in Northern Pacific are not likely ever to occur again under present
regulations. (EN: The famous “short squeeze.” Short squeezes still occur
but are extremely rare in big liquid issues. A famous short squeeze occurred
in the silver markets of the 1980s when the Hunt brothers trapped Exchange
members and almost bankrupted them. The members, being in control,
retaliated by quintupling margin requirements and bankrupted the Hunts.)
The authors realize nothing said, and probably no amount of cold-blooded
analysis on the part of the reader himself, will remove entirely the
trepidation that most nonprofessional traders experience when they sell
short. The mental hazards will always be slightly greater than in buying
long. Nevertheless, from every practical angle, a short sale is exactly the
same thing (although in a reverse dire


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


t so much a matter of cost disadvantage in
trading odd lots as it is a much deeper question—that of risk and portfolio
management. So how does the aware investor determine the size of any
individual trade?
I am indebted to a longtime friend, colleague, broker, and fellow trader,
William Scott, for articulating the common-sense procedure here for
calculating trade size and controlling risk.
First, we determine the percentage of our capital we want to risk on any
given trade. Among many professional traders of our acquaintance, this
figure is often 2% or 3%. For the sake of illustration, using round numbers,
if we have $100,000 capital this means we will be risking $3,000 on a trade.
Let us say we are going to buy a $20.00 stock and defend our position with
a stop-loss order $5.00 away. Our formula for computing position size is as
follows:
3,000/5 = n number of shares (600 shares)
If we were going to accept a $10.00 risk, our trade size would be 3,000/10
= 300 shares. Thus, we adjust our trade size to fit our risk parameters.
This is a simple, practical, and elegant way to implement risk control at the
individual trade level.
Trade size is, without doubt, one of the most crucial factors in success for
the general investor. Ignorance, or denial, of its importance is a major
reason for the failure of many traders. In short, overtrading. Other
perspectives on risk and trade size are found in Chapter 42 and in Appendix
B, where the Leverage Space Model is explained.)
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter twenty-seven
Stop orders
We are going to take up two kinds of stop orders, or, rather, two entirely
different uses of the mechanism of stop orders.
First, let us look at the protective stop order. At best, it is not a happy
subject. Stop orders of this type are like fire extinguishers; the occasions
when they are put into operation are not times of rejoicing. Stop orders are
used for emergency rescue when things get so bad there seems no
reasonable hope for a situation.
Wherever you set your protective stop, it is likely to be touched off at what
seems to be the worst possible moment. You will set it at a safe distance
under a certain bottom; the stock will break through, catch your stop, and
then proceed to build a new bottom at this level for the next rise, or to rally
at once and make new highs. No matter, you had your reasons for setting
the stop. The stock did not act the way it should have. The situation is not
working out according to Hoyle and certainly not the way you hoped it
would. Better to be out of it, even at a loss, rather than face a period of
uncertainty and worry. If the stock has started to act badly, you cannot tell
how much worse it is going to behave. If you fail to set a stop, you may go
on day after day hoping for a rally that never comes while your stock sinks
lower and lower until, eventually, you find (as millions have found) that
what started to be a small reaction, and an annoying but trivial loss, has
turned out to be a ruinous catastrophe. Stop orders cannot always be placed;
in certain cases in active stocks, the exchanges may even restrict the use of
stop orders.
The question is where and when to set the stop, realizing there is no perfect
and absolutely satisfactory rule. If the stop is too close, you will take
unnecessary losses; you will lose your holdings of stocks that eventually
forge ahead and complete the profitable rise you hoped for. If stops are too
wide (too far away), you will take larger losses than necessary in those
cases in which your stock definitely has broken out of pattern.
Now, it will be obvious, as the setting of stop orders depends on the price of
the stock and its habits. You would not place your stop level at the same
percentage distance under a Bottom in a conservative, high-priced stock
when it is selling at 80 that you would to protect a speculative issue at a
time when it is selling at 8.
The higher priced stocks, as we have already seen, make smaller percentage
moves. Conversely, the lower-priced stocks make wider percentage moves.
Therefore, the lower-priced stocks should have more leeway for their
gyrations. We will need a wider stop for them than we will for the less
volatile “blue chips.”
Similarly, we can take our Sensitivity Indexes (EN: betas in considering a
stock relative to the market, and volatilities for absolute measure of one
stock against another) to give us a picture of the individual habits of the
stock. Although two stocks may be selling at the same price at a given
moment, you would expect a high-beta, high-volatility stock to make wider
swings than a low-beta, low-volatility stock; therefore, you will set your
stops wider on the higher volatility stock.
We must take these factors into account and work out some sort of simple
rule of thumb to follow. Let us arbitrarily assume an imaginary stock of
“average” habits and a price of 25 and further assume we will be satisfied,
in this particular case, with stop protection 5% below the last established
Minor Bottom.
For a stock of the same sensitivity selling at 5, we would need about half
again as much stop leeway (on a percentage basis). That is, the stop would
be placed 7.5% below the last Bottom (EN9: significant low).
(EN10: Here Magee gave an account of how, using his Sensitivity Index and
his normal range for price, he computed stop positions. The process is too
convoluted for modern investors—and unnecessary because Magee boiled
the procedure down to a table I have modernized below. The Procedure is
intact in the eighth and ninth editions for the scholarly (or obsessed)
investor or academic.)
For most ordinary purposes, a simplified table of stop distances will be
sufficient. Table 27.1 gives you the approximate stop distance you would
get by the method outlined above, for stocks in various price classifications
and of various degrees of sensitivity (volatility).
(EN10: Magee originally constructed this table based on h


th editions for the scholarly (or obsessed)
investor or academic.)
For most ordinary purposes, a simplified table of stop distances will be
sufficient. Table 27.1 gives you the approximate stop distance you would
get by the method outlined above, for stocks in various price classifications
and of various degrees of sensitivity (volatility).
(EN10: Magee originally constructed this table based on his Sensitivity
Index. The informed reader may consider an alternative to Magee's
Sensitivity Index, which I have conjectured here for the modern context—
that is, basing the stop distance on volatility, which would present a
dynamic method of adjustment.)
The stop level should be marked on your chart as a horizontal line as soon
as an actual or theoretical transaction has been entered into, and it should be
maintained until the transaction is closed, or until progressive stops (which
we will explain in a moment) have been started to close it out. In the case of
purchases, the stop level ordinarily will be at the indicated distance below
the last previous Minor Bottom. In the case of short sales, it ordinarily
would be at the indicated distance above the last Minor Top.
To determine the position of this stop level, simply figure what the
percentage distance would amount to at the price of the stock. If you are
dealing with a stock selling at 30 and the stop distance comes out 10%, then
allow 3 points under your last Minor Bottom.
In no case would we ever set a protective stop level at less than a 5%
interval, even for the most conservative, high-priced stocks.
These questions remain: What constitutes a Minor Bottom? What makes an
established Minor Top? How do we know how to choose the Basing Point
(EN9: see Chapter 28) from which to measure off our stop level interval?
The constitution of a Bottom or a Top (EN10: wave high, wave low) will be
taken up in the next chapter. For the present, let us accept the proposition
we will determine the correct Basing Point and will always, always set our
stop level at the moment we make the commitment.
Table 27.1 Table of stop distances (expressed in percent of the price of the
stock)
Price Conservative
sensitivity
Median
sensitivity
Speculative
sensitivity
Volatility
under 0.40
Volatility
0.41-0.79
Volatility
over 0.79
Over
100 5% 5% 5%
40-1005% 5% 6%
20-40 5% 5% 8%
10-20 5% 6% 10%
5-10 5%a 7% 12%
Under 55%a 10% 15%
a Ordinarily, stocks in these price ranges would not be in the conservative
group.
It is understood protective stops under long stock are never moved down,
nor are protective stops over shorts ever moved up. As soon as the stock has
moved in the right direction far enough to establish a new Basing Point, the
stop level is moved up (on longs) or down (on shorts), using the same rules
for determining the new stop level as were used in fixing the original level.
The progressive stop
There is another use of a stop that is properly considered here. This is the
progressive stop, which is used to close out a stock that has made a
profitable move, or in some cases, where a stock has given a danger signal
before either completing a profitable move or violating a previous Minor
Bottom.
You will find on many moves, the stock will progress in the primary
direction for several days and then may develop exceptional volume. Often,
this occurs just as the stock reaches an important trendline or pattern border
or Resistance Area. This heavy volume means one of two things: usually,
that the Minor Move has come to an end, being this is the top of the rise for
the moment; occasionally, the volume may signal the start of a breakaway
move that may run up several (and perhaps many) points, almost vertically.
(The reverse situation may develop on downside moves.)
If, noticing the heavy volume following a good rise, and assuming this day
marks the end of the move, you sell the stock at the market or at a limit, you
are going to be dreadfully disappointed if this should be one of those rare
cases in which the stock opens the next day on an upside gap and continues
3, 5, or 20 points up in the following days. On the other hand, experience
will have shown you it will not pay to expect that sort of move very often.
You will know that, 9 times out of 10, you will be better off out of the
stock.
After such a day when volume is exceptionally high (provided this is not
the first day of breakout into new high ground beyond the last previous
Minor Top), cancel your protective stop and set a stop order, for the day
only, just 1/8 (0.125) point under the closing price. For example, you have
bought a stock at 21; it goes up on moderate volume, smashes through the
old Minor Top one day at 23 on very heavy volume, the next day continues
to 23 3/4 on moderate volume, the third day advances on moderate volume
to 24 1/4, and, finally, the fourth day makes a rise to 25 on much heavier
volume than it has shown on any day of the rise except the day it broke
through 23. The morning after this close at 25, you will notice the volume
signal. You will cancel your protective stop, which may be at 18, and you
will place a stop order, for the day only, to sell on stop at 24 7/8. In most
cases, this will mean your stock will be stopped out on the first sale of the
day. Plus, you may get a slightly lower price than you would get with a
straight market order. On the other hand, after a day of high volume
activity, you are not likely to be left in a thin market; there should be bids
enough, near the top, to get you out at or near your stop price.
Meanwhile, you are protected against losing the stock if there should be a
continued move in the right direction. Suppose the opening the morning
after you set your stop at 24 7/8 should be a gap at 25 1/4, and that prices
then move up further, closing at 26. (On “runaway” moves of this sort, the
closing for the day during the move is likely to be at the top.) You will then
set your stop, again for a single day only, at 25 7/8. If the stock then opens
at 26 3/8


ould be a
continued move in the right direction. Suppose the opening the morning
after you set your stop at 24 7/8 should be a gap at 25 1/4, and that prices
then move up further, closing at 26. (On “runaway” moves of this sort, the
closing for the day during the move is likely to be at the top.) You will then
set your stop, again for a single day only, at 25 7/8. If the stock then opens
at 26 3/8 and moves up to 28, you will set another day stop at 27 7/8,
which, let us assume, is caught at the opening the following day at 27 5/8.
In this example, you risked only 1/8 point on the first day, and eventually
netted an extra gain of 2 5/8 points. This, it should be pointed out, is all net
gain because your commissions are approximately the same in either case.
A progressive stop of this sort can be indicated on the chart by any mark
you choose to use—for example, a band of short diagonal lines. When a
stock moves for several days in a runaway move, you may repeat this mark
each day, indicating a tight stop 1/8 point under the close for each
successive day, until finally, one of these stops is caught. In the case of
short sales, a buy stop is used in precisely the same way as the selling stop,
by following the stock down on a sharp runaway dive.
This use of tight progressive stop orders is indicated wherever a stock has
reached its reasonable objective on high volume, or where it has exceeded
its objective and is moving out of the Trend Channel in free air, so to speak,
and in some cases, where the stock has failed to reach its objective.
If your stock, for instance, is rising in a Trend Channel, and, about halfway
between the lower and upper trendlines, suddenly develops great volume,
then a progressive tight stop will protect you against the threatened failure
of the move. Extreme volume in such a case, before there has been a
breakout to a new high above the last Minor High, is definitely a warning
and a threat. This would be especially true if there were also a gap or a One-
Day Reversal at this point.
The one day on which a tight stop would not be applied after heavy volume
had appeared would be the day the stock made a new high, running entirely
through the previous Minor Top and closing above it. This action generally
means the move is not yet completed. Should the move continue higher and
again show heavy volume, even if it is the very next day, we would then
protect with a progressive stop.
In this chapter, as throughout the book, the expression “heavy volume”
means heavy only with respect to the recent volume of sale in the stock you
are watching. A thousand shares may be significantly heavy volume in
some thin issues, whereas 10,000 shares would be no more than a normal
turnover in more actively traded stocks. The volume chart itself will show,
by a market peak, when a day of abnormally heavy volume occurs.
It should be understood the progressive stops we have been discussing are
intended to take short-term gains, or to close out an exceptionally profitable
runaway move terminating in an Intermediate Climax. Although the
extreme conditions that call for this type of operation are by no means rare,
they are not the usual, everyday action of the market. In the case of ordinary
Minor Tops, even when they are fairly apparent on the basis of Trend
Channels, volume peak, and other indications, many traders and investors
will prefer to wait out the expected reaction rather than pay additional
commissions and lose a position that is still presumably in a favorable
Major Trend.
In short, the progressive stop is a device that may be very useful on
occasion, but it is intended to cope with a special and somewhat unusual
move.
The protective stops, on the other hand, offer the average trader, the man
who is not able to spend his entire time studying the market, or who has not
had long experience, a device by which he can limit his possible loss. He
will be protected from his own reluctance to close out the bad holding, and
he will avoid the ruinous condition of becoming frozen into a hopeless
situation. Since he will be taken out automatically, regardless of whether he
has an ultimate gain or loss, he will have the capital to use in better-looking
issues and will not have to worry about the prospects of recovery in his
stock after it has gone many points against him.
If one has sufficient knowledge and sufficient determination to get out as
soon as the trend has shown convincing evidence on a turn, there is less
need for the stop orders. (EN: This editor believes that only the proven
trader-investor should trade without a stop in the market. The reader may
determine whether he meets this criterion by examining his portfolio to see
whether he has ever let a loss run or allowed a significant profit to slip
away. If so he, or she, or they, or it, is not proven.) It is possible for such a
person to operate successfully without them; and there are some advantages
in doing this because a stop order will occasionally be caught by a false
move or an extended dull reaction. There are also advantages in not using
stop orders for the experienced technician who is looking toward a possible
long-term gain and who is willing to wait out a Secondary Reaction. Yet it
is a thousand times better for the person who is not sure of his methods to
be stopped out early, than to be left holding a stock bought at, say 60, when
it has declined to 29—or to 5!
Stop systems and methods
The two most important concepts in investing and trading are trends and
stops. Being right, the trend immeasurably diminishes risk and increases
our probability of profit. However, without skillful setting of stops, all our
work and study can easily result in nothing as the markets dodge and
weave, deceive, and throw off false signals. If our analysis has not resulted
in skillful stop setting, we will be no better off than that unfortunate fellow
who is acting on a tip from his brother-in-law—or his bootblack.
Consequently, let us first at


our probability of profit. However, without skillful setting of stops, all our
work and study can easily result in nothing as the markets dodge and
weave, deceive, and throw off false signals. If our analysis has not resulted
in skillful stop setting, we will be no better off than that unfortunate fellow
who is acting on a tip from his brother-in-law—or his bootblack.
Consequently, let us first attack this question from the viewpoint of the
trend-following investor and deal with trading stops thereafter. In Magee's
systems for the trend follower, there are two basic stop methods. One is
based on trendlines (sloped and horizontal), and the other is rooted in
Basing Points. Chart patterns interact with these two methods. This entire
book treats the former at length in too many chapters to mention here. The
second, Basing Points, is discussed exhaustively in Chapter 28.
The breaking of trendlines is always significant. Magee tested the validity
of the break by requiring that prices penetrate the line by 2%-3%. This may
not be perfect, but it serves for the majority of situations. The longer the
trendline the more important the break, as illustrated in the market breaks of
2008 and 2011 (a trendline of more than 700 days). The downwaves
(crashes?) resulting from these trendline breaks were recognized and
commented on at the time at http://www/edwards-magee.com. Figure 5.1
illustrates the serendipitous convergence of all three methods combining to
exit longs and short the market in 2008. Trendline analysis, pattern analysis,
and Basing Points analysis by their very nature are complementary and lead
to similar conclusions, as, for example, in August 2011 when the long-term
trendline from March 2009 was broken, a Head-and-Shoulders Top was
identified, and the Basing Point stops were taken out.
Therefore, we have three ways of setting stops in extended trends—
trendlines, patterns, and Basing Points. Are there other stop methods for
trend following? Indeed. A multitude. A plethora. A cornucopia. An excess.
First, let us remark on the crucial question of stop setting in trends.
Stops set too close to the market result in the trader losing his position. The
stop must be set to give the market room to move against his position, thus
(crocodile tears) apparently surrendering precious profits. As the market
advances in waves (truism)—wave up, wave down—stops must be, as in
the Basing Points Procedure, set sufficiently below wave-low points to
avoid being exercised. In an interview in Market Wizards, Jack Schwager
asked a major trader, Bruce Kovner, where he set his stops. “Where they're
hard to get to,” replied Kovner.
This is the principle at work in Basing Point stops. Knowing that locals and
market mischief-makers probe for stops at wave lows and support zones,
the stop is set with a filter, thus some distance below the wave low (or wave
high). This stop is hard to access.
The same thing is true if using a moving average. Magee used a 2% or 3%
stop for trendlines and a stop of this type is probably good for a moving
average, too. At the same time, if volatility and excitement are running
high, the trader must adjust the size of his filter. In a rising market tracked
with a moving average, the trailing stop would be moving every day the
dotted line moved up. Naturally, with a filter that might be enlarged if
market volatility became excessive.
A brief survey of stop methods
Here we are going to deal primarily in exit stops. (EN: My book Signals
[available on Amazon's Kindle platform] analyzes at length methods for
entering trades and trends.) Many traders use stops to enter positions, but
that is not our interest at this moment. We want to know how to protect our
initial entry and how to advance our stops so as to lock in our profits when
the trade has gone our direction. The initial stop may be set as with Basing
Points (as described in Chapter 28), or it may be set above or below a
Support-Resistance zone, or as a percentage (William O'Neil says a stop
should be set 8% below the entry), or even as a percentage of capital—for
example, 2% risk per trade—a $2,000 stop ($100,000 capital) is a common
money management system.
If the market moves against our trade, the protective stop limits the loss. If
the market moves with us and begins to accumulate profits for us, we have
a different, and happy, problem. It is only a matter of time until the market
throws us a downwave to test our mettle—or to dislodge us altogether. We
are trend followers, so we buy strength and sell weakness, but our
antagonists are contrarians—they do the opposite. Thus, after a reasonable
upwave, contrarians will be taking profits and driving prices down. Swing
traders will be doing the same thing. We want to stick to the trend until it
changes, even taking these “corrective” waves against our position. Basing
Point stops will do this, and the inevitable result is fluctuation in equity.
Long experience has shown that fleeing from downwaves and exiting
invariably results in smaller long-range profits. Accepting downwaves and
fluctuations in profit leads to greater long-range profits. Look at the tables
of Dow and Basing Points performance. It is not unusual to see downwaves
of 10%-30% without a change of trend occurring. We have seen how we
can stop these trends with trend analysis and Basing Points analysis—and
there are other philosophies and other methods.
Some other stop methods
Average True Range
Average True Range (ATR) is an interesting concept and tool. It is a
measure of volatility, in actuality, and tracking it gives us some interesting
information. True Range is defined as the largest of the following:
Today's high minus today's low.
Today's high minus yesterday's close.
Today's low minus yesterday's close.
ATR is the average of True Range over some defined period. Twenty days is
a not uncommon parameter, as is 14. Five days is very sensitive, which has
advantages and disadvantages.
ATR may be used to set stops. For e


nteresting
information. True Range is defined as the largest of the following:
Today's high minus today's low.
Today's high minus yesterday's close.
Today's low minus yesterday's close.
ATR is the average of True Range over some defined period. Twenty days is
a not uncommon parameter, as is 14. Five days is very sensitive, which has
advantages and disadvantages.
ATR may be used to set stops. For example, we might set our initial
protective stop 2 (or x) ATRs below our entry. We might set our trailing
profit protection stop in the same way: x ATRs below the recent high—or
the low of the recent high.
Stops set this close are typical of trading situations. There is at least one
practitioner of my knowledge (Eric Crittenden,
http://www.blackstarfunds.com) who judges if prices take out the stop 10
ATRs below the most recent high, the trend has changed. This is sometimes
called a Chandelier Exit. This kind of concept can be examined using
trendlines and reversal formations. ATR is a natural way of measuring
market volatility and it rhythmically adjusts to market behavior. This makes
a system more flexible than fixed percentages or fixed dollar amounts. An
interesting paper on Crittenden's method is found at http://www.
trendfollowing.com/whitepaper/Does_trendfollowing_work_on_stocks.pdf.
Feature this, relevant to my point, that the market must be given room to
work: Crittenden found that a 10-ATR filter averaged a space of 27%. So
what we have here is an inherent stop system that posits a 27% reversal to
indicate a change of trend.
Parabolic stop and reverse
Welles Wilder's (1978) parabolic stop and reverse (SAR) technique uses an
“acceleration factor.” Consequently, the stop rises parabolically, which has
its strengths and weaknesses as the reader can imagine. Chuck LeBeau has
conjectured a Modified Parabolic Exit, which tweaks the acceleration factor
at http://lcchong.files.wordpress.com/2011/05/precise-exits-entries-
manual.pdf. This presentation includes other interesting comments on stop
methods.
Target stops
I am not a great proponent of target stops, but many traders analyze a
formation or market situation and compute a possible target and exit the
market when their target is reached. Other target criteria may be used—a
dollar or point amount, or as in Bill Scott's method, five days down causes
liquidation of half the position, six days the other half.
Similar to the target method, the trailing stop is raised when x% of profits
are achieved and raised again as prices advance. An old Japanese saying has
it as follows: “Sell half at 8 new prices, half again at 10 new prices, and the
rest at 12 new prices.”
Of a similar nature, some traders will close the trade when an extreme move
occurs in their direction.
A natural method used by the Turtles
The Turtles used the breakdown from a 10-day channel to exit their long
trades. This can be modified to as little as three days, in which case the
trader would set a very tight stop based on the three-day low if a market
were running away. Such a situation might also be managed with Magee's
tight progressive stops—raising the stop each day to just under the low of
the day to be in effect for the next day.
In the end, as the reader can see, there are as many stop methods as there
are traders. For our purposes, the more natural and less algorithmic the
method, the better—so it comes back down to trendlines, formations, and
Basing Points, which can be tweaked to the individual taste.
If there is a truism about the markets it is this: a trader without stops will
soon be a trader without capital.
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter twenty-eight
What is a Bottom and what is a Top?
(EN9: In this extremely important chapter, I have left intact Magee's usage
of “Tops and Bottoms.” It will be less potentially confusing for the reader
to think of “highs and lows” as that terminology is commonly used in the
business in the modern era. Also, thinking in terms of highs and lows is an
important concept in itself. Thus, for a Bull trend, higher highs, higher
lows. When this pattern is broken in an important way, the trader should be
alert for a trend change. Also, as the use of eighths is of the essence in
Figure 28.1, I have left the discussion in eighths, although the reader knows
decimals are now used in the markets.)
In this chapter, we are not talking about what makes a Major Top or Bottom
or what makes an Intermediate Top or Bottom. We are speaking of the
Minor Tops and Bottoms that give us important hooks on which to hang our
technical operations. Stop-order levels, trendlines, objectives, and Supports
and Resistances are determined by these Minor Tops and Bottoms. They are
of prime importance to us as traders. (For illustrations in this chapter, see
Figures 28.1 through 28.4.)
Usually, these Minor Tops and Bottoms are well marked and perfectly clear,
though often they are not. Sometimes, it is not possible to say definitely that
this or that place is or is not a Top or Bottom, but it is possible to set certain
standards and practical working rules that will help us in making these
points, and these rules will not fail us too often.
A good rule for setting stop levels is to consider a Bottom has been made
when the stock has moved “three days away” from the day marking the
suspected low of the Bottom. If a stock reacts for some days and finally
makes a low at 24, with a high for that day at 25, then we will not have an
established Bottom until we have had three days in which the stock sells at
no lower than 25 1/8. The entire price range for three full days must be
entirely above the top price for the day making the low. This is the three-
days-away rule, and it would apply in reverse in declining markets, in
which the range for three days must be entirely below the entire range of
the day making the high.
This gives a rule for setting an original stop order. It also gives a rule for
changing the stop order. As soon as


rice range for three full days must be
entirely above the top price for the day making the low. This is the three-
days-away rule, and it would apply in reverse in declining markets, in
which the range for three days must be entirely below the entire range of
the day making the high.
This gives a rule for setting an original stop order. It also gives a rule for
changing the stop order. As soon as the stock has moved three days away
from a new Bottom, we move the stop order to a position below that
Bottom. (We have already explained in Chapter 27 how we determine the
distance this stop level should be below the Bottom.)
Protective stops for long stocks can move only up. A stop level, once
established, is never to be moved down except when the stock goes ex-
dividend or ex-rights; then, the stop may be dropped the amount of the
dividend or rights. Similarly, protective stops for short sales are to be
moved only down and may not be raised. (In the case of ex-dividends and
ex-rights, the short-sale stop would be dropped the amount of the dividend
or rights.)
There are certain situations in which it is difficult to determine Bottoms and
Tops; where, indeed, it seems as though a Consolidation or Correction had
been made without any significant move in the Secondary Direction. In
such cases (as contrasted to the obvious situation in which the stock moves
up or down in series of well-marked steps and reactions, like a staircase),
you will need all your judgment and experience to determine the point at
which the Minor Basing Points actually occur.
17
16
15
14
JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER
7 14 21 28 4 11 18 25 1'8 15 22 29 6 13 20 29 3 :10 17:24' 1 8 15 22 29 5 ’
Figure 28.1 Advance of a protective stop order in a long commitment. The
daily chart of American Cable and Radio in the summer of 1945 made a
Rounded Bottom, part of a long period of Consolidation following the
advance that ended in July 1944. A breakout on heavy volume occurred
September 12, and purchases were then possible on any Minor Reactions.
13
12
11
10
Sales
100's
250
200
150
100
50

The first protective stop would immediately be placed 6% below the
previous Minor Bottom of August 21, using Table 27.1 in Chapter 27. This
would put the stop level at 9 7/8. On September 19 and 20, we would have
two days of market action entirely “away” from the September 17 Minor
Bottom, and, on September 28, a third day. We would then move the stop
up to 6% under the September 17 Bottom, or to 10 5/8. The next move
would come after the new high closing of October 11, which is more than
3% higher than the October 1 Minor Peak. The stop would now be placed at
11 7/8. On November 2, a new high close was registered more than 3% over
the October 15 Minor Peak; the stop would be raised to 12 3/4. On
November 15, another high closing topped by more than 3% the Minor
Peak made on November 7. The stop would be moved up again, this time to
13 1/2. November 29 made the third day the entire range was “three days
away” from the November 26 Bottom, and the stop was upped to 13 3/4.
The closing on December 5 gave us a 3% advance over the November 17
high, and again we moved the stop, raising it to 14 7/8. Finally, on January
3, 1946, this stop was caught as shown on the chart. In a Bear Market,
protective stops would be moved down in exactly the same manner to
protect a short sale. (EN9: A number of inconsistencies exist in this figure
and caption that are clarified later in the text.)
Basing Points
Let us call the levels that determine where stops should be placed Basing
Points. In a Bull Market Move, we will consider the Bottom of each Minor
Reaction as a Basing Point, from which we will figure our stop-order level
as soon as the stock has moved up to “three days away.” We will also use
each Minor Top as a Basing Point in a Bull Move. In a Bear Market, we
will consider the Tops of each rally and also each Minor Bottom as Basing
Points for the protective stops in the same way.
Where a stock makes a substantial move in the Primary Direction, say a
move of 15% or more, and then moves back at least 40% of the distance
covered from the previous Basing Point to the end of the Primary Move,
that surely gives us a Basing Point as soon as the stock again starts off in
the Primary Direction. If the stock reacts less than 40%, however, perhaps
even marks time at the same level for a week or more, that should also be
considered a Basing Point as soon as the move in the Primary Direction is
continued (provided the volume indications are right).
The daily volume, as we have seen, is like the trained nurse's clinical
thermometer; it tells a great deal about what is happening in a stock, more
than the superficial symptoms of price alone. There are three times at which
you may look for exceptionally heavy volume: (1) on the day of breakout
from a pattern or a period of inaction, especially if the breakout is on the
upside; (2) on the day on which the stock goes into new ground in the
Primary or Intermediate Direction, that is, goes above the last Minor Top in
a Bull Market or below the last Minor Bottom in a Bear Market; and (3) on
the day on which the Minor Move is completed or nearly completed, that is,
the new Minor Top in a Bull Market and the Minor Bottom in a Bear
Market. To this we might add that extra heavy volume on any other day
during a move in the Primary Direction is likely to indicate the move is at
an end and will not complete the hoped-for advance or decline.
Now, after a Minor Top has occurred, the stock now being in new high
ground, and the Top having been made on very heavy volume, we may look
for the corrective move. Ordinarily, that would be a decline of several days,
a week, sometimes longer. Occasionally, the correction, as we said a few
paragraphs back, will take the form of a horizontal hesitation lasting a week
or more without any particular corrective move in the downward direction.
Where there is a downward correction, it is likely


ng been made on very heavy volume, we may look
for the corrective move. Ordinarily, that would be a decline of several days,
a week, sometimes longer. Occasionally, the correction, as we said a few
paragraphs back, will take the form of a horizontal hesitation lasting a week
or more without any particular corrective move in the downward direction.
Where there is a downward correction, it is likely to come down to or near
the Top of the last previous Minor High (support). Also, and often at the
same time, the corrective move will carry down to the Basic Trendline
drawn through two or more previous Minor Bottoms; or to the “parallel”; or
to a trendline drawn through the last two or more previous Minor Tops. If
the corrective move is horizontal, it is likely to run out until it meets one of
these lines.
In any case, the thing to watch for is the decline of volume. If the trading
shrinks, perhaps irregularly, but on the whole, steadily, for some days after a
new Top has been made, during which time the stock either reacts or, at any
rate, makes no progress in the Primary Direction, then you are justified in
considering this as a Minor Correction. If the stock now continues the
Primary Move and gets to a point that is “three days away,” you can
consider the Bottom (i.e., the point you draw your trendline through, not
necessarily the extreme low point in the case of horizontal moves) as a new
Basing Point.
Where a stock is starting what appears to be a new move or a breakout from
a period of vacillating moves, it is sometimes hard to say precisely what
point should be considered the Bottom. There may be several small and
indecisive moves on low volume preceding the real breakout. In such a
case, we would consider the appearance of high volume as the breakout
signal and set our Basing Point at the low point immediately preceding this
signal. There usually will be such a point on one of the low-volume days in
the three or four days just before the breakout.
All that has been said about Basing Points in a Bull Market would also be
true, in reverse, in a Bear Market, except that heavy volume does not
always accompany a downside breakout.
Now comes the difficult and distressing situation in which the stock, having
made a long runaway move (let us assume it is an upward move), starts out
to make a Flag; is bought after a sufficient correction of 40% with a decline
of volume; and then continues to go down steadily, without any rallies and
without any clear volume indications. This is an unusual situation, but it
does happen on both the upside and the downside, from time to time. In the
case we have just mentioned, we would look for Support Levels
(Consolidation Patterns, Multiple Tops, and so on) formed on the way down
in the previous trend and lying below the level at which we purchased the
stock. We would use these supports as Basing Points rather than hold a stop
under the extreme Bottom of the vertical move.
In many cases of this type, you will not be able to find adequate Basing
Points. Therefore, it seems unwise to try to get in on corrections after long
runaway moves except in the following cases: (1) the stock has risen well
above good Support that can serve as a Basing Point, or (2) the stock is
completely above all prices for several years and is moving “in the clear.”
(And the reverse: in Bear Markets, the stock should have fallen below a
strong Resistance Area or must be in new low ground for the past several
months before you consider a short sale.) In any case of this sort in which
you are thinking of a trade in a stock that appears to be making a
Consolidation after a fast, long, vertical move, you must have pronounced
and conspicuous drying up of volume throughout the formation of the Flag
or Pennant Correction.
There is one more word of caution needed here regarding trading in an
Intermediate Trend. A series of moves in a trend will often take place in
very regular form. There may be a good trendline, and the reactions may be
about 40%-50% and may come back to the previous Minor Tops. The
volume on the Corrections may shrink with increasing volume on the new
Tops. It is easy to start trading on such a “staircase” in the expectation the
moves will continue to be regular and consistent, but trends do not go on
forever. Any Minor Top may be the last. The importance of finding your
Basing Points is to enable you to get out, at best, on any closing violation of
one of these points, and at worst, on your protective stop order. The volume
may again come to your aid in this question of when to stop trading on a
trend. Although you look for high volume on the Tops, you will be
exceedingly suspicious of volume that is much higher than on any of the
preceding Minor Tops (or Bottoms in a Bear Market). The final, or the next-
to-final, “blow-off” of a trend usually will show more volume than any of
the Minor blow-offs along the way. When you see such climactic volume,
you should prepare to retire into your shell and wait for a full Correction of
the entire series of moves making up your Intermediate Trend. Later, weeks
later, or perhaps months later, you may find the stock has corrected 40% or
more of the whole Intermediate Move and is resting quietly with very little
activity. Then is the time to watch it for new opportunities and a new trend
in the Primary Direction.
(EN9: In a book composed of nothing but important chapters, this Chapter
28 might not get the emphasis it deserves from the unwary reader. In fact,
the procedure outlined here is of absolutely basic importance in analyzing
and trading trends. I have added to this chapter material that has been of
great importance to my trading and to the trading of my students.)
Basing Points: a case analyzed
The longer one thinks about the chart so casually tossed off in Figure 28.1,
the more he realizes it embodies a profound and natural understanding of
trends and the market. Consider—wave up, wave recedes, wave up, wave
recedes, and so on. As l


ds. I have added to this chapter material that has been of
great importance to my trading and to the trading of my students.)
Basing Points: a case analyzed
The longer one thinks about the chart so casually tossed off in Figure 28.1,
the more he realizes it embodies a profound and natural understanding of
trends and the market. Consider—wave up, wave recedes, wave up, wave
recedes, and so on. As long as the trader or investor is not chased from his
position by the corrective wave, he will, under normal circumstances, ride
the trend to its natural end. Nevertheless, locals and hedge funds and those
who profit from volatility know the previous low is where investors and
traders set their stops. So in the ordinary flow of trading, if they see an
opportunity to take out an important low, they will do it—if possible.
Indeed, it is sometimes possible and the low sometimes falls from the
natural flow of trading.
Bruce Kovner, on being interviewed by Jack Schwager (Market Wizards),
was asked where he set his stops. “Where they're hard to get to,” he said. A
twice told tale for its importance a stop set on a Basing Point with a
prudently calculated filter is hard to get to unless the market has truly
reversed direction. In fact, what is a long-term moving average but a
lagging stop with a filter built in?
Basing Points are merely the marking of highs and lows in full realization
that a pattern of higher highs and higher lows is a Bull trend, and when that
pattern changes to one of lower highs and lower lows the trend is changing
or has changed. This is the principle behind Dow Theory, and it is the
principle behind trading trends of lesser duration than Dow trends.
Moreover, as is quickly realized, a pattern of lower highs and lower lows
means inevitably the trendline has been broken.
As for Figure 28.1, Mark Twain had some cogent comments on it. He said
anyone trying to make sense of it would go crazy, and anyone trying to
justify the prices with the chart would be shot. Figure 28.1 preserves
unexplainable conundrums and conflicts carefully preserved since the
earliest editions. The reader is urged to take it as a concept rather than using
it as a lesson (See Figure 28.2). Let me codify the rules implicitly presented
in the figure:
• A high is made, being recognized by no higher prices occurring for the
moment.
• Prices recede and a low is made. This low is found by watching each day
after the previous high until no lower prices are made. As prices begin to
rise again, we note each day on which prices are completely outside the
range of our low day candidate.
• When three such days are observed (three days away) before a new low is
made, we mark the candidate day as a Basing Point and raise our stop to 6%
(or x%) under the low of the Basing Point day (see Chapter 27).
• If a new high is 3% greater than the previous high, a new Basing Point is
found at the low of the new high day.
The Basing Points paradigm
By no means will every issue be amenable to this kind of analysis.
However, the method is so paradigmatic, it is worth examining at greater
length. Similar to virtually every other method of classical chart analysis, it
must be used with caution and good, thoughtful judgment. Sometimes some
stocks will seem to work as smooth as silicon lubricant, while other issues
will appear to be useless. Even on recalcitrant issues, however, the
principles underlying the method will be of use, if not the actual method
itself. With this in mind, Figure 28.2 is presented; the careful reader will see
the chart in this example uses only bottoms or lows in stop setting and does
not advance stops on the making of new highs as in Figure 28.1. This is
done for instructional purposes and to keep the example simple for the
general investor. More advanced traders will want to study and perhaps
utilize the new high techniques in Figure 28.1.
Figure 28.2 actually serves more than one instructional purpose. It
illustrates a pictureperfect case of the use of Basing Points, as well as a
complete analysis of a Bull Market from entry to exit with keys marking
events in the life of the market. Thus, the observation of Basing Points, the
setting of the stops, the tracking of potentially false turns are all noted. The
chart is accompanied by the keys. Originally the marked and keyed chart
was used in graduate seminars at Golden Gate University for instructional
purposes. Shortly, it became obvious that marking the chart in this manner
was extremely useful in trading. Thus, it is suggested to the reader as a way
of making his charts more communicative and more useful.
Key to Figure 28.2 analysis
1. A rounding bottom, or perhaps a scallop.
2. Resistance or breakout line.
3. Wake-up call on volume.
4. Run day, big volume. Breakout through line 2. Sure entry signal.
5. First Basing Point (BP). Notice prior volume fall-off in
consolidation and surge on run day. A stop was entered before this BP
using the low of the formation before the entry.
6. BP.
7. A weak BP (because of shallowness of retracement).
8. BP.
9. Test of BP at 8.
10. A trendline drawn after point 9.
11. BP.
12. BP candidate that fails the three-day-away rule.
13. BP.
14. A potential BP, but not a very good one because a new high has not
been made from 13.
15. A Support-Resistance line.
16. A test of 16 BP.
17. BP.
18. A Resistance-Support line.

Figure 28.2 Apple Computer, Bull Market of 1987. A near-perfect
example of the use of Basing Points for trading of a reasonably regular
and smooth Bull Market. Only wave-low Basing Points are illustrated.
19. Flag that becomes BP.
20. Trendline, but too steep to last.
21. Trendline.
22. BP.
23. Trendline.
24. BP.
25. BP.
26. Horizontal trendline.
27. BP at 26.75 (stop 25.41). Stopped out at 25.41.
A narrative of the events in the chart
1-3. Had we been asleep, the event at number 3 should have awakened us; a
volume day like this should catch our attention. We begin paying attention
to the stock and note the pattern that has


0. Trendline, but too steep to last.
21. Trendline.
22. BP.
23. Trendline.
24. BP.
25. BP.
26. Horizontal trendline.
27. BP at 26.75 (stop 25.41). Stopped out at 25.41.
A narrative of the events in the chart
1-3. Had we been asleep, the event at number 3 should have awakened us; a
volume day like this should catch our attention. We begin paying attention
to the stock and note the pattern that has been developing—the rounding
bottom, or scallop.
4. At number 4 we see a run day on heavy volume. A good signal for
entry with the breaking of the horizontal line at number 2. When we
enter, we set our stop 5% under the recent low. After entering on
strength, there is every possibility that some profit-taking will occur as
well as probing by locals to chase out arrivistes.
5. We watch with interest for the first reaction. Each day we observe as
a candidate for a possible Basing Point. This occurs at 5, and we now
begin to count “days away” from the Basing Point—days whose range
is entirely outside the range of the candidate day and occur before a
lower low is made. When the Basing Point at 5 is confirmed, we raise
our stop to 5% under the low of 5.
6. A higher high is made after 5 with a subsequent reaction to 6, which
proves to be another Basing Point. Therefore, we raise our stop to 5%
under 6.
7. Prices continue to climb and another Basing Point is made at 7. The
procedure is becoming clear: find a Basing Point and establish a stop a
prudent distance under it. If a new Basing Point is made, raise the stop.
Watch with interest the reactions against the trend. Either they allow
you to establish a new higher Basing Point, or they end your trade.
8-10. We find a new Basing Point at 9, raise our stop and draw the trendline
at 10. At 9 we have a lower low than 8, but our “filter,” our 5% padding,
keeps our position intact. We do not lower our stops using 9 as a new
Basing Point. One of the inviolable rules is stops are never lowered. The
filter is important because traders try to take out nearby lows and
exacerbate volatility. It is called the running of the sheep.
11. At 11 we find a new, if tenuous, Basing Point. An advance with a
thin higher high.
12. At 12 we have a candidate for a Basing Point that fails the three-
day-away rule.
13. At 13 we find the Basing Point that is good and raise our stop.
14. At 14 we are confronted with a marginal situation. It is a potential
Basing Point, but a marginal one because a higher high was not made
after 13.
15. At 15 we are able to draw a line defining resistance—a line that
will become a support line.
16. At 16 we have a new Basing Point that would have tested a point at
14.
17-21. At 17 we find a new Basing Point, and at 18, we can identify a
resistance line. The spurt across this line is both gratifying and a warning
because it becomes a flagpole from which the flag at 19 flies. Flags and
flagpoles are messages the market has heated up and now wants close
watching. A flag can serve as a Basing Point, so we move our stop again,
fully aware the end may be approaching. The trendline at 20 is further
confirmation of this environment because of its steepness, but we see two
good anchor points in 16 and 17 and draw trendline 21—a better line to
defend.
22, 23. A good reaction finally occurs at 22, giving a strong Basing
Point and good rationale for raising the stop. Notice the interesting fact
that points 22 and 24 have come back to rest on the trendline we drew
at 10.
24. As the tempo has increased and the volatility 24 furnishes us
another valid Basing Point.
25, 26. Even 25 is a valid point, and we can now see the clear support
line at 26.
27. When this line is pierced at 27 upon extraordinary volume, and in the
process takes out our Basing Point stop from 25, it is clearly time to exit the
train. The Basing Points concept is even more thoroughly explored in the
book entitled, StairStops, which is available on the John Magee Technical
Analysis website at http://www.edwards-magee.com and on
http://www.amazon.com, including Kindle edition.
The complete Basing Points Procedure: taking into consideration the
setting of Basing Points on both wave lows and new highs As previously
discussed by Magee, the Basing Points Procedure may set Basing Points on
both wave lows and on new highs. We find the wave-low Basing Point by
the three-days-away rule; we find the new high Basing Point, by marking
wave highs and subsequent new highs so when price exceeds by 3% the old
wave high, or recent high, whether or not an intervening wave low has
occurred, we may set the new Basing Point at the low of the new high day.
If a new high were made subsequent to this new high, we would reset the
Basing Point again if we were using this variant of the procedure, which I
call Variant 2.
Once again, the one-armed economist rules. On the one hand, raising the
stops like this on new highs may easily result in being ejected from the
position by a price dip; then you watch the train leaving the station on the
way to incredible new highs amid much teeth gnashing and irritation.
(Incidentally, if emotional distress occurs in this or other like situations it is
a message to you are too emotionally attached to the market. Complete
market maturity is not achieved until such situations can be viewed with
relative equanimity so the event is viewed with detached interest and a plan
to set things right.)
On the other hand, after having accumulated large paper profits, the issue
collapses and snatches back from you a third (or more) of your hard-earned
profits. (If you had only advanced stops based on new highs!) Remember,
the problem with Dow Theory (and trend following) is you give up the first
third of the move and the last third of the move and sometimes there is not a
middle third, as conventional market wisdom has it.
What essentially occurs when using Variant 2 of the procedure is as follows:
when blow-off or runaway conditions occur, the procedure changes from
selling weakness to selling stren