government regulations, loans, and purchases completely subject to the changing (and
often conflicting) policies and acts of the several governmental agencies concerned with
grains and other commodities had seriously distorted the normal evaluative machinery of
the market. At that time, radical reversals of trend could and did happen overnight without
any warning so far as the action of the market could show. The ordinary and orderly
fluctuations in supply–demand balance, which create significant definite patterns for the
technician to read, did not exist. Yet, while fortunes were made (and lost) in wheat, corn,
and cotton futures during the World War II period, it is safe to say they were not made
from the charts.
During the past five or six years, however, the application of technical methods to
commodity trading has been reexamined. Under 1956 conditions, it appears that charts
can be a most valuable tool for the commodity trader. The effects of present government
regulation have apparently resulted in “more orderly” markets without destroying their
evaluative function. Allowing for the various essential differences between commodities
and stocks, the basic technical methods can be applied.
246 Technical Analysis of Stock Trends
It may be in order here to discuss briefly some of the intrinsic differences between
commodity futures and stocks referred to above and to some of the special traits of
commodity charts. First, the most important difference is the contracts for future delivery,
which are the stock-in-trade of the commodity exchange, have a limited life. For example,
the October cotton contract for any given year has a trading life of about 18 months. It
comes “on the board” as a “new issue,” is traded with volume increasing more or less
steadily during that period, and then vanishes. Theoretically, it is a distinct and separate
commodity from all other cotton deliveries. Practically, it seldom gets far out of line with
such other deliveries as are being bought and sold during the same period, or with the
“cash” price of the physical cotton in warehouses. Nevertheless, it has this special quality
of a limited independent life, as a consequence of which long-term Support and Resistance
Levels have no meaning whatever. (EN10: This absolute may not be absolute. Evaluate the long-
term charts for your issue to see whether influence is evident.)
Second, a very large share of the transactions in commodity futures—as much as
80% certainly in normal times—represents commercial hedging rather than speculation.
(EN10: Less true in the twenty-first century.) It is, in fact, entered in to obviate risk and to
avoid speculation. Hence, even near-term Support and Resistance Levels have relatively
less potency than with stocks. Also, because hedging is to a considerable degree subject to
seasonal factors, there are definite seasonal influences on the commodity price trends that
the commodity speculator must keep in mind, even if only to weigh the meaning of their
apparent absence at any given period.
A third difference is in the matter of volume. The interpretation of volume with respect
to trading in stocks is relatively simple, but it is greatly complicated in commodities by the
fact that there is, in theory, no limit to the number of contracts for a certain future delivery
that may be sold in advance of the delivery date. In the case of any given stock, the number
SEPTEMBER OATS Chicago
1947
G
G G
JANUARYF EBRUARYM ARCH APRILM AY JUNEJ ULY
H SS
104
96
88
80
76
72
68
64
60
Sales
100’s
12510075
50
25
4 11 18 25 1 8 15 22 1 8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9
Figure 16.1 Oats, for obvious reasons, traced more “normal” patterns than Wheat during the 1940s.
This chart contains an H & S bottom, a Symmetrical Triangle that merged into the Ascending form,
a gap through a former top level, and an interesting trendline. The Island shake-out through the
trendline was an extremely deceptive development.
247Chapter sixteen: Technica l analysis of commodity charts
of shares outstanding is always known. As this is written (1956), there are in the hands of
stockholders 13,700,203 common shares of Consolidated Edison, and that quantity has not
varied for many years nor is it likely to change for several years to come. Every transaction
in Consolidated Edison involves an actual transfer of one or more of those existing shares.
In the case of commodity future contracts—say, September wheat—trading begins long
before anyone knows how many bushels of wheat will exist to be delivered that coming
September, and the open interest at some time during the life of the contract may exceed
the potential supply many times over, and all quite legitimately. (EN9: As always, volume
data is a supplementary indicator to price. No one makes a profit on it.)
One more important difference may be mentioned. Certain kinds of news—about
weather, drought, floods, and so on that affect the growing crop, if we are dealing with
an agricultural commodity—can change the trend of the futures market immediately
OCTOBER COTTON 1947
FEBRUARY MARCHA PRIL MAY JUNE JULY AUGUST SE PTEMBER
S7
S7
H7
35.00
34.00
33.00
32.00
31.00
30.00
29.00
28.00
27.00
8 15 22 1 8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 6 13 20
?? ??
Figure 16.2 In contrast with the grains, the technical action of the Cotton futures markets has been fairly
consistent with normal supply–demand functioning ever since prices rose well above government
support levels. In this daily chart of the 1947 October delivery (New York Cotton Exchange), the
reader will find a variety of familiar technical formations, including critical trendlines, a Head-and-
Shoulders top that was never completed (no breakout), and Support–Resistance phenomena much
the same as appear in stock charts. Double trendlines are not at all unusual in Cotton charts.
248 Technical Analysis of Stock Trends
and d


t of the 1947 October delivery (New York Cotton Exchange), the
reader will find a variety of familiar technical formations, including critical trendlines, a Head-and-
Shoulders top that was never completed (no breakout), and Support–Resistance phenomena much
the same as appear in stock charts. Double trendlines are not at all unusual in Cotton charts.
248 Technical Analysis of Stock Trends
and drastically and are not foreseeable given the present stage of our weather knowledge.
Analogous developments in the stock market are extremely rare. (EN: Except for acts of God
and Alan Greenspan [and Ben Bernanke]).
It is not the purpose of this book to explain the operation of commodity futures
markets, nor to offer instruction to those who wish to trade therein. This brief chapter
is included only as a starter for readers who may want to pursue the study further. They
should be advised that successful speculation in commodities requires far more specialized
knowledge and demands more constant daily and hourly attention. The ordinary individual
can hope to attain a fair degree of success in investing in securities by devoting only his
spare moments to his charts, but he might better shun commodity speculation entirely
unless he is prepared to make a career of it.
(EN: The editor has been, during his checkered career, a registered commodity trading advisor.
At the beginning of that career, I discussed these subjects with Magee and received essentially the
above comments, which are here reproduced from the fifth edition. Subsequently, I observed among
my associates and partners, and on my own, that futures are eminently tradable with the adaptation
of techniques and methods described in this book. It is also true, as Magee says, that futures trading
is so different in tempo, leverage, and character that the novice risks life, limb, and capital in entering
the area unescorted. Resource references are essential reading, but the beginner is urged to educate
himself before beginning trading with extensive study and paper trading.)
@GC.C(D) - Weekly COMEX L = 419.30 –0.70 –0.17% O = 419.80 C = 419.30
419.30
397.00
377.00
359.00
341.00
325.00
309.00
394.00
 279.00
266.00
1997 1998 1999 2000 2001 2002 2003 2004
Created with TradeStation
380.30
Figure 16.3 A Rounding Bottom in Gold 1997–2004. “These patterns, when they occur after an extensive
decline, are of outstanding importance, for they nearly always denote a change in Primary Trend
and an extensive advance yet to come. That advance, however, seldom carries in a ‘skyrocket’ effect,
which completes the entire Major Move in a few weeks. On the contrary, the uptrend that follows the
completion of the pattern itself is apt to be slow and subject to frequent interruptions, tiring out the
impatient trader, but yielding eventually a substantial profit.” So said Robert Edwards in remarking
on Rounding Bottoms in stock charts. As may be seen here, this Rounding Bottom consists of a
downtrend, a false signal off the Double Bottom (upon which a pretty penny might have been made
by the agile trader), and a handsome uptrend—and it all looks like a huge Rounding Bottom.
249Chapter sixteen: Technica l analysis of commodity charts
Technical analysis of commodity charts,
part 2: a 21st-century perspective
In the search for the Philosopher’s Stone, more sweat and money have been put into the
area of commodities and futures than were ever expended in the securities arena. There
is a simple reason for this—great fortunes are made and lost with much greater rapidity
in the futures area than in securities. Of all the great dramatic moments in stock market
history, few are so memorable as the great Hunt silver market, or Soros facing off against
the Bank of England, or of gold soaring to $1,000 an ounce (deferred contracts). And the saga
continues in 2005: $50 oil? $60? $70? $100? And the effects, economic and psychological! In
dimly lit garrets and brightly lit computer rooms thousands of researchers concoct systems
to trade these markets—corn, soybeans, silver, copper …
Rocket scientists
At times, individual traders and groups of traders have plundered (harvested?) these markets
for fairy tale profits. I know whereof I speak, having been a principal in California’s first
licensed commodity trading advisor that was founded by the NASA rocket scientist R. T.
Wieckowicz. During the 1970s, as the stock markets ground futilely around the 1,000 level on
the Dow, the futures markets returned yearly gains in the 100% range. Consistently. For years.
Those were the years of the California systems traders and the beginning of computerized
trading. From the primeval slime of NASA, rocket scientists emerged to create a renaissance in
market technology. At the time it seemed clear that science and genius had at last conquered
the markets and that clients would come buzzing from the world over like bees to a honey
Figure 16.4 Gold, October 2011. The momentous earth-shaking power of a massive rounding bottom
is vividly dramatized by the gold chart since 2005, as well as the power of chart analysis to anticipate
it. Regrettably, the editor did not compute the price target implications of the pattern in the ninth
edition in 2005. That computation was made at the http:/ /www.edwards-magee.com website at the
time. There it was computed as follows (and the reader can do it for himself): depth of pattern, 248.20
plus neckline 507 .40, target 755.60. In fact, the possibility was entertained that the entire formation
from 1980 to 2008 might be a Rounding Bottom. In which case, the depth was 700.70, added to the
neckline of 959 and resulted, actually achieve, in a target of 1,660. Remember Edwards said these
were probable minimum measurements.
250 Technical Analysis of Stock Trends
pot and that the rivers of profits would last forever. They did last for some time, and then the
markets changed. Mechanical systems that cut through the markets lik

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


Bottom. In which case, the depth was 700.70, added to the
neckline of 959 and resulted, actually achieve, in a target of 1,660. Remember Edwards said these
were probable minimum measurements.
250 Technical Analysis of Stock Trends
pot and that the rivers of profits would last forever. They did last for some time, and then the
markets changed. Mechanical systems that cut through the markets like a reaper in a wheat
field in Bull Markets grind up capital like sausage in sideways markets. Science and genius
were revealed as the happy combination of man, moment, system, and market.
Turtles?
During the 1980s from the sea came crawling the Turtles. Progeny of the protean trading
wizard, Richard Dennis, the Turtles again harvested outsize profits from the markets,
reportedly running in the 80% yearly range. The so-called Turtles got their name from a
comment that Dennis is reported to have made that traders were made not born, and he
was going to raise traders like turtles. Additional reading about the Turtles is available in
Jack Schwager’s fascinating books, including Market Wizards and others. Schwager’s books
are required reading for aspiring futures traders. Additionally, the trading manual of the
Turtles will be found online at http:/ /www.originalturtles.org. This workbook, written by
@SI.P(D) - Weekly COMEX L = 7.035 +0.077 +1.11% B = 0.000 A = 0.000 O = 6.985 Hi = 7.085 Lo = 6.980 C = 7.045 V = 145
8.000
7.045
6.000
5.000
1998 1999 2000 2001 2002 2003 2004 2005
Created with TradeStation
6.00
Figure 16.5 A Rounding Bottom in Silver, 1998–2005. The apparent Rounding Bottom in silver,
combined with the same pattern in gold, would seem to cast a pall over the economic situation for
some time to come in 2005. This coincides with the apparent long-term patterns setting up in the
securities markets. If the best that can be hoped for in securities is a 1965–1982 kind of widely whipping
market, commodities may react as they did in the 1970s—with tidal wave markets. These markets can
be traded by the well-capitalized chart analyst who is well seasoned. Tyros will lose money learning
the game whatever markets they trade. Their chances will be immeasurably improved by applying
the techniques taught in this book. In addition to the technical pattern pictured here, there is every
reason to suspect that a large fundamental shortage of silver bullion exists and will worsen. Ted
Butler, at http:/ /www.doomgloom.com, is a long-term silver analyst (and associate of the editor) who
anticipates a new silver blow-off is coming. One wonders what Nelson and Bunker Hunt are doing
at present. A very cautious investor (like Warren Buffet who is reported to have invested $1 billion
in silver bullion) may defeat futures silver volatility by buying the bullion.
251Chapter sixteen: Technica l analysis of commodity charts
Curtis Faith, an original Turtle, contains virtually all of the elements necessary in a trader’s
systems and procedures manual. The manual was prepared according to the training
Dennis gave his Turtles. Serious traders do not operate without some such document.
Certainly all of the serious traders I have known (a considerable number) have had fully
developed manuals like the Turtle workbook. I cite the Turtle workbook rather than others
in my possession because it is publicly available at http:/ /www.originalturtles.org (as well
as in the 9th edition of this book) and because it is beautifully articulated.
In the late 1990s, the Turtles were made into turtle soup in the futures markets as
the majority of systems traders wound up as hamburger meat. Is there a moral? Yes. The
markets giveth and the markets taketh away. Science and genius are again revealed to be the happy
combination of man, method, moment, and market.
The Turtle system is basically an adaptation of Richard Donchian’s channel breakout
system. In the Donchian system, the trader goes long when the 20-day high is broken
and sells and goes short when the 20-day low is broken. In the 1970s, Dunn and Hargitt
evaluated a number of mechanical trading systems and found that Donchian’s system
was superior to the others evaluated at that time. Will Donchian’s system still work? Yes,
SIK05(D) -Daily COMEX L = 6.900 –0.003 –0.04% B = 6.920 A = 6.935 O = 6.900 Hi = 6.905 Lo = 6.900 C = 6.900 V = 6
8.000
7.500
7.000
6.903
6.500
6.000
AM JJ AS ON D0 5F MA M
Created with TradeStation
2
3 4
1
Figure 16.6 Silver, May 2005. Although the long-term silver outlook may be Bullish, the short term
will be very volatile, especially for the thinly capitalized trader. Then short-term tactics must be
adopted. The Island Top here at 1 is a gentle invitation to the trader to take his profits and be gone.
Even to short, with a stop just above the high. The run day after 1 adds a note of urgency to the
invitation. The gap is punishment for the hard of hearing and a bonus for the quick-witted (everybody
who survives in futures is either quick witted or extremely well financed). The stop moves down
to the top of the gap day, then to the top of the next gap day, and for the very apt profits are taken
on the next run day down, on the principle of sell weakness, buy weakness. The tight trendline at
2 crossed by the heavy run day is a buy signal with the stop moving to the bottom of the gap at 3,
where it is taken out a few days later by the long-range day down. The run day at 4 is a short signal
with the stop being at the day’s high. Is it necessary to say short-term futures trading can be quite
rapid? There is always bullion or associated stock plays.
252 Technical Analysis of Stock Trends
in broadly trending markets. Will the Turtle system still work? Yes, in broadly trending
markets. Plus, like virtually all mechanical systems, they do not know whether they are
in a broadly trending market or not. They are blind—all they see are ones and zeros. The
addition to these systems of prudently applied chart analysis will im


ssociated stock plays.
252 Technical Analysis of Stock Trends
in broadly trending markets. Will the Turtle system still work? Yes, in broadly trending
markets. Plus, like virtually all mechanical systems, they do not know whether they are
in a broadly trending market or not. They are blind—all they see are ones and zeros. The
addition to these systems of prudently applied chart analysis will immeasurably improve
their performance and risk characteristics.
The application of Edwards and Magee’s
methods to 21st-century futures markets
During my career as a commodity trading advisor, I have known a number of successful
traders and advisors who used what I would describe as Magee-type chart analysis to
make their trades. Often, other elements were input into their decision-making process, but
manual charting was a key factor in their operations. Some of these traders used simple
trendline analysis with price or volume filters and some used a combination of trendlines
and support and resistance. All were trend followers.
Having looked at the futures markets with some attention over the past several years, it
seems to me there is no reason why chart analysis should not work as well now in futures
as it has always worked in stocks. Essentially, the questions raised by securities trading are
the same as those presented by futures trading in the analysis of a chart. Is there a trend?
Where are support and resistance? Is there a breakout? Are there waves and wavelets? How
do you enter and how do you exit?
The great bug-a-boo of securities traders coming to the futures trading is the speed of
the game. Like college football players stepping up to the NFL, there is a brutal learning
curve and rookies are the most likely to get killed. I am not going to make any effort
here to present a primer for new futures traders, but rather, I will look at some futures
charts at the end of this chapter to show the journeyman that chart analysis can be used
Figure 16.7 Silver, October 2011. Here is what happened in silver after the ninth edition was
published. Could there be any greater vindication of the value of charts looking at the issue six
years later? Just as in the case of gold, the analysis allowed the analyst to anticipate a monster Bull
Market. On http:/ /www.edwards-magee.com, the authors wrote letters all during this time pointing
out the silver Bull. Measuring the entire formation, the depth is 33.96, added to the neckline of 37 .5
equals 71.46. This seems quite fanciful to us, but that is the measurement.
253Chapter sixteen: Technical a nalysis of commodity charts
as a decision-making method in these dramatic markets. Again, chart analysis has the
weakness (or strength) of being a qualitative process. It will not make decisions for the
average trader, as a mechanical system will.
On the other hand, a breakout is a breakout. A gap is a gap, leaving aside the question
of limit move gaps for the moment. A trend is a trend. And here is the great advantage that
a firm grasp of charting methods can give the practitioner. It can give him the perspective
to recognize the essential nature of the market at hand and choose to wait or to enter. Mechanical
methods not having the qualitative discrimination of an experienced chartist will blindly
take every trade until they are out of money. The experienced chart analyst can sit back and
say, this market has not yet made a bottom and the time to begin trading it long has not
yet come. Or, he can recognize the essential differences between a trading and a trending
market and adjust his tactics accordingly. As Magee noted in Chapter 16:
Under what might be called normal market conditions, those chart
patterns which reflect trend changes in most simple and logical
fashion work just as well with commodities as with stocks. Among
these we would list Head-and-Shoulders formations, Rounding Tops
Figure 16.8 Treasury Bonds. The double-pump triple-nod head fake is a specialty of futures markets.
The fear and greed factor are multiplied by 10, like the leverage. But here in September 2004 Bonds, we
can see how simple chart analysis can serve the trader. The downtrend from March (1) is completely
manageable with a simple trendline and trend analysis. The end of the downtrend in May is marked
by two strong run days. At any rate, the stop would have been at May 1, using a Basing Point kind
of analysis. If we were going to trade it long, this would have been traded for a scalp (because we do
not know whether or not there is a bottom). The break of the trendline at 2 is an engraved invitation
to get long and the trendline at 3 keeps us long until broken by the signal day at the end of July. This
would put us short again, whereas a two-day trade as the signal day on the trendline at 4 puts us
long again. Obviously, we are using very tight, short trendlines and long-range days (or run days)
as signals. The use of the run day as a signal, combined with other indicators, is common in my
experience among traders.
254 Technical Analysis of Stock Trends
and Bottoms, and basic trendlines. Trendlines, in fact, are somewhat
better defined and more useful in commodities than in stocks. Other
types of chart formations which are associated with stocks with
short-term trading or with group distribution and accumulation,
such as the Triangles, Rectangles, Flags, etc., appear less frequently in
commodities and are far less reliable as to either direction or extent of
the ensuing move. Support and Resistance Levels, as we have already
noted, are less potent in commodities than in stocks; sometimes they
seem to work to perfection, but just as often they don’t. For similar
reasons, gaps have relatively less technical significance.
These words remain true today, as do virtually all the principles enunciated in this
book by Edwards and Magee and myself. In fact, if most futures charts were given to an
CR0504-CRB Index (Apr 2005) 306.00 2.


less potent in commodities than in stocks; sometimes they
seem to work to perfection, but just as often they don’t. For similar
reasons, gaps have relatively less technical significance.
These words remain true today, as do virtually all the principles enunciated in this
book by Edwards and Magee and myself. In fact, if most futures charts were given to an
CR0504-CRB Index (Apr 2005) 306.00 2.25 0.74%
306
303
300
297
294
291
288
285
282
279
276
273
270
SepO ct Nov Dec0 5F eb Mar
1998–2004 Prophet Financial Systems, Inc. Terms of use apply.
Figure 16.9 Commodity Research Bureau Index, April 2005 Futures. Just as Triangles often work in
securities, they often work in futures. Breakaway gap, second breakaway gap, runaway gap, second
runaway gap—this is the formation before the second runaway gap is somewhat quizzical—it might
be considered a flag, but it has the same effect, and depending on the trader’s operating methods,
the stop would be just under the gap/run day anyway. It will not take much study for the reader to
see the principles of chart analysis used in this entire book are validated here. The main difference
is in the setting of stops, and in fact, the same stop methods may be used if the trader is sufficiently
well financed.
255Chapter sixteen: Technical a nalysis of commodity charts
$CRY0(D) -Weekly NYBOT L = 294.09 +1.03 +0.35% B = 0.00 A = 0.00 O = 293.08 Hi = 294.12 Lo = 292.96 C = 294.09 V = 0
307.00
294.09
288.00
270.00
253.00
237.00
222.00
208.00
195.00
1998 1999 2000 2001 2002 2003 2004 2005
Created with TradeStation
234.65
Figure 16.10 Commodity Research Bureau (CRB), long-term view. It does not take much analysis of
this 10-year CRB chart to see a huge Double Bottom and to consider its implications. If China and
India are going to compete with us for natural resources, we could see an entirely new economic
paradigm, if the reader will excuse the term. Clearly, there is a Bull market in commodities. In
Chapter 42, Pragmatic Portfolio Management, it is suggested that capital should flow to markets
that are moving, rather than remaining committed to markets that are mired in mulish trends.
Furthermore, it is suggested in that chapter that a good natural hedge is to go long on the uptrend
of an index and short the components of it that are in downtrends. The CRB is somewhat thin but
might lend itself to this strategy.
Figure 16.11 The 20-year bonds as expressed in the TLT; ETF Bonds display classical signals of
absolute clarity.
256 Technical Analysis of Stock Trends
Figure 16.12 September, 1994. Coffee was so easy in retrospect that it should be engraved on a brass plate. The long is taken on the breakout of the
horizontal trendline. The position is never in any danger, as there is no down-wave of significance until May when stops are advanced to stay 5%
under lows (Basing Points). The May down-wave allows a Basing Point stop to be established. The breakaway gap is a windfall profit. The flag tells
us that more is coming—as it does with another gap and run days—until the spike reversal, which is a clear signal to be out on the close. A gap up
on the open, an exploration up, and a close down—an absolutely clear message of reversal from the market.
257Chapter sixteen: Technica l analysis of commodity charts
Figure 16.13 The May 11 top in silver. In the first quarter of 2011, silver took off in a roaring uptrend. Any surprise here, after looking at the
Bounding Bottom? As seen in the chart, it came near to going parabolic. The top notice came on April 25—interestingly on a reversal bar. Reading
the Candlestick, the market gapped wide on the opening and took a long excursion down to close the opening gap. Then bargain hunters thought
they were getting a good price on silver and drove the price back up, so it did not close on the lows. The next day, it gapped down on the open and
basically wandered down all day long—the party was over. The signs were subtle.
258 Technical Analysis of Stock Trends
analyst, without issue identification and dates would not be identifiable as commodity
charts. When limit moves appear, the difference slaps one in the face. On this point I might
differ from Magee slightly as regards to gaps. Obviously, limit move gaps have breathtaking
significance. All in all, it seems to me gaps often say the same thing to futures analysts as
they do to stock analysts.
Another mathematical reason might be adduced for the practicality of using simple
chart analysis to trade futures. That is the tautological nature of the method. A trend is a
trend, and a trendline is a trendline. If you enter a suspected trend (setting a protective
stop at a technically analyzed place) and follow the trend using Basing Points or observing
the trendline and exiting on a break and reversal there will be no difference from doing
the same with a stock. Well, some difference. Due to the leverage, you will be required to
be hyperaware of risk. In futures, the penalty for holding a position through “a normal
reaction” can be extremely harsh. That is why stops are so important.
The TLT chart from late 2008 is a spectacular display of patterns and signals. This
pattern has appeared many times before and will appear again in the future.
Prices break out of a sideways pattern on a strong gap. The gap is across the trendline,
which is what makes the signal significant. Every gap is not a signal. In this case, the gap
is extra significant because there is a power bar on the gap day—it should be bought. This
is called a breakaway gap. Prices continue to progress, and a few days later another gap
occurs. This is a runaway gap and is another signal.
Shortly thereafter, prices drift sideways for a few days. This is a flag. Flags are vivid
messages to traders. Robert Edwards described how they are used. He said, “The flag
flies at half-mast,” meaning after a rocket-like advance and this formation, prices should
advance on at least as far as they had co


ss, and a few days later another gap
occurs. This is a runaway gap and is another signal.
Shortly thereafter, prices drift sideways for a few days. This is a flag. Flags are vivid
messages to traders. Robert Edwards described how they are used. He said, “The flag
flies at half-mast,” meaning after a rocket-like advance and this formation, prices should
advance on at least as far as they had come.
Power bars (signals) exit from the flag, and then another gap occurs. This is the
exhaustion gap. This is a message to exit longs and to short the issue. The message could
not have been clearer.
The skilled trader, first of all, catches the original signal—the power bar exiting from
the sideways pattern. He then pyramids on the subsequent signals. Exiting from the flag, a
good trader should have a boatload of this issue, and at the top, selling after the exhaustion
gap, he should have made at least a small killing.
Stops
Some traders set their stops using money management rules rather than technically
identified points. I believe it is always better to find the technical point using a Basing Point,
or support and resistance. To me it makes better sense to adjust position size to control risk
as I describe in Chapter 26. The use of money management stops has been very successful
for many traders. If some logical and disciplined method of setting and observing stops is not
installed, the trader is assured of failure.
A money management stop is, simply enough, a stop calculated by deciding to risk
2% (or 3% or 4% or x%) of capital on a trade. For example, William O’Neil says that when a
stock trader enters a position, he should set a stop 8% under his entry price. This is a little
crude, and not strictly speaking, a money management stop, but it is better than no risk
calculation at all. In a stricter sense, if we said we wanted to limit the risk of the trade to
3% of capital, we would use the 8% rule to set the stop and the Scott Procedure in Chapter
26 to determine the number of shares or contracts. The Turtle system contains similar
259Chapter sixteen: Technical a nalysis of commodity charts
procedures. Numerous studies have proven the size of the risk per trade—1%, 2%, 3%—is
directly correlated to equity volatility.
The 25th looked like a reversal day. The gap down on the 26th could have been
considered the closing of an exhaustion gap—not apparent here because the tails (shadows)
of the candlesticks obscure the complete price behavior.
(EN10: In the 10th edition, a new section on stops in Chapter 27 examines a number of stop
methods.)
A variety of methods
As noted above, a competent chart analyst may, in my opinion (and in Magee’s opinion),
perform profitably in the futures markets. There are other questions, of course, namely of
character, temperament, intelligence, judgment, and so on. Let us leave those questions
to Dr. Elder and confine ourselves to the method question. Chart analysts proved their
abilities in the futures markets long before computers existed. In fact, long before in the
case of Japanese rice traders, enlightening their efforts with candlesticks in the eighteenth
century.
In the 1970s, I saw point and figure chartists enjoy great success at Dean Witter and
Merrill Lynch and other major firms in futures. I have seen least squares curve fitters,
moving average calculators, and abstruse statistical analysts all enjoy profitable outings
in commodities. Not to speak of the Turtles who, using naturalistic high–low systems,
harvested good profits in the markets. As the saying goes, gateless is the gate and many are
the ways to the great Dow. Although I have enjoyed great success myself using mechanical
number-driven systems over the years, I have become more and more attracted to “natural”
systems. Chart analysis is essentially natural, as is the Turtle system. The Dow Theory is
a natural system in which no mathematical algorithm comes between the analyst and the
data. The essential, more, quintessential, weakness of all number-driven systems is their
blindness. They do not have the ability to discriminate between the forest and the trees.
The experienced human chartist can see (and hear) the changing rhythms of the market
and respond to them, responding to factors too subtle (and even subconscious) to program.
Nevertheless, even natural systems, like the Turtle systems, can fall into this trap. When
the markets learn a lot of capital is waiting just above the 20-day high, they will set a trap
for it. For “markets” you may read “they.” If you apply the knowledge of this book to such
situations, you may avoid the trap.
Everything you need to know as a chart analyst trading futures
“Jack be nimble, Jack be quick, Jack jump over the Candlestick.” Yes, it is true, as the
leverage is 10 times greater and the speed is 10 times faster. I have illustrated in Figure 16.9
the combination of a very tight trendline with a run day, which it seems to me is a good
current (twenty-first century) combination. Otherwise, the same qualities that make a good
securities trader make a good futures trader once the great leap to leveraged quick-fire
markets is made. If you have been successful trading stocks, you will probably be successful
trading futures, and you probably should practice on stocks while studying futures. A
sobering fact I often recount to my graduate students is that Richard Wyckoff worked in
the securities business for eight years before making his first investment; he studied the
markets an additional six years before trading.
260 Technical Analysis of Stock Trends
The Magee methodology will serve as a valuable cornerstone of your futures operations
and you must never cease studying. Mechanical systems have their attractions, especially
when seasoned with experienced chart analysis. No method will survive unless practiced
with diligence, persistence, judgment, and patience. Time and again you will hear famous
traders say di


nical Analysis of Stock Trends
The Magee methodology will serve as a valuable cornerstone of your futures operations
and you must never cease studying. Mechanical systems have their attractions, especially
when seasoned with experienced chart analysis. No method will survive unless practiced
with diligence, persistence, judgment, and patience. Time and again you will hear famous
traders say discipline is the secret of their success. What they mean by discipline is their
ability to measure and contain the risk, set a stop based on technical or money management
procedures, and then honor the stop. The most important lesson the futures trader has to
learn from Edwards and Magee is the ability to see the character of the market, trading or
trending, and then to adjust his tactics accordingly.
In the next great Bull Market in commodities, which is inevitable, these methods and
systems derived from them will once again reap windfall profits.
I have attempted in the ninth edition of this classic book to show the book’s usefulness
to the intelligent futures trader. Simple classical chart analysis alone can be successful in
the futures markets in the hands of an experienced competent analyst. Natural mechanical
systems such as the Turtle system have been effective and will be again, perhaps with some
tweaking (such as imposing a chart analysis superstructure). Wave analysis methods such
as the Basing Points Procedure of Chapter 28 can be used. Even number-driven systems,
such as moving averages, can be successful, especially if combined with chart analysis.
261
chapter seventeen
A summary and concluding comments
We began our study of technical stock chart analysis in Chapter 1 with a discussion of the
philosophy underlying the technical approach to the problems of trading and investing.
We could ask the reader to turn back now and review those few pages to recapture a
perspective on the subject that must have been dimmed by the many pages of more or less
arduous reading that have intervened. (For illustrations in this chapter, see Figures 17.1
through 17.4.)
It is easy, in a detailed study of the many and fascinating phenomena that stock charts
exhibit, to lose sight of the fact they are only the rather imperfect instruments by which
we hope to gauge the relative strength of supply and demand, which, in turn, exclusively
determines what way, how fast, and how far a stock will go.
Remember, in this work, it does not matter what creates the supply and the demand.
The fact of their existence and the balance between them are all that count. No man, no
organization (and we mean this verbatim et literatim ) can hope to know and accurately
appraise the infinity of factual data, mass moods, individual necessities, hopes, fears,
estimates, and guesses that, with the subtle alterations ever proceeding in the general
economic framework, combine to generate supply and demand. Nevertheless, the
summation of all these factors is reflected virtually instantaneously in the market.
The technical analyst’s task is to interpret the action of the market itself—to read the
flux in supply and demand mirrored therein. For this task, charts are the most satisfactory
tools thus far devised. Lest you become enrapt, however, with the mechanics of the chart—
the minutiae of daily fluctuations—ask yourself constantly, “What does this action really
mean in terms of supply and demand?”
Judgment, perspective, and a constant reversion to first principles is required. A chart,
as we have said and should never forget, is not a perfect tool nor a robot; it does not give
all the answers quickly, easily, or positively, in terms anyone can read and translate at once
into certain profit.
We have examined and tested exhaustively many technical theories, systems, indexes,
and devices that have not been discussed in this book (chiefly because they tend to short-
circuit judgment) to see the impossible by a purely mechanical approach to what is far from
a purely mechanical problem. The methods of chart analysis that have been presented are
those that have proved most useful because they are relatively simple and easily rationalized
since they stick closely to first principles. Additionally, they are of a nature that does not
lead us to expect too much of them and they supplement each other and work well together.
Let us review these methods briefly. They fall roughly into four categories:
 1. The Area Patterns or formations of price fluctuation that, with their concomitant
volume, indicate an important change in the supply–demand balance. They can
signify Consolidation, a recuperation or gathering of strength for renewed drive in
the same direction as the trend that preceded them. Or they can indicate Reversal, the
playing out of the force formerly prevailing, and the victory of the opposing force,
resulting in a new drive in the reverse direction. In either case, they may be described
as periods during which energy is brewed or pressure is built up to propel prices in
262 Technical Analysis of Stock Trends
SPIEGEL , INCORPORATED SM
1946–1947
APRILM AY JUNE JULY AUGUST SEPTEMBERO CTOBER NOVEMBER DECEMBER JANUARYF EBRUARY MARCH
38
36
34
32
30
28
26
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Sales
100’s
12510075
50
25
6 13 20 2 1 471 18 25 18 15 22 29 61 32 0 27 31 0 17 24 31 71 42 1 28 5 12 19 26 2 9 16 23 30 7 14 21 28 4 11 18 25 18 15 22 811 52 22 9
G
Figure 17.1 Spiegel’s Bear Market started in April 1946 from a Symmetrical Triangle that changed into a Descending Triangle. Note the Pullback
in June and two Flags. This history is carried on in Figure 17.2 , which overlaps Fig u r e 17.1; this chart shows the move that ensued from the wide
Descending Triangle of early 1947 , culminating in a Reversal Day on May 19. Note various Minor and Intermediate Resistance Levels.
263Chapter seventeen: A summary a nd concluding comments
SPIEGEL, INC. SM 1946–1947
GG
OCTOBERN OVEMBERD ECEMBERJ ANUARY FEBRUARY MARCHA PRI


This history is carried on in Figure 17.2 , which overlaps Fig u r e 17.1; this chart shows the move that ensued from the wide
Descending Triangle of early 1947 , culminating in a Reversal Day on May 19. Note various Minor and Intermediate Resistance Levels.
263Chapter seventeen: A summary a nd concluding comments
SPIEGEL, INC. SM 1946–1947
GG
OCTOBERN OVEMBERD ECEMBERJ ANUARY FEBRUARY MARCHA PRIL MAY JUNEJ ULYA UGUST SEPTEMBER
20
19
18
17
16
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Sales
100’s
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5 12 19 26 2 9 16 23 30 7 14 21 28 4 11 18 25 1 8 15 22 1 8 15 22 29 51 21 9 26 31 01 72 4 7 14 21 28 51 2 19 26 2 9 16 23 30 6 13 2031
Figure 17.2 Overlapping Fig u r e 17.1, this chart shows the move that ensued from the wide Descending Triangle of early 1947 , culminating in a
Reversal Day on May 19. Note various Minor and Intermediate Resistance Levels.
264 Technical Analysis of Stock Trends
a move (up or down) that can be turned to profit. Some of them provide an indication
as to how far their pressure will push prices. These chart formations, together with
volume, furnish the technician with most of his “get-in” and many of his “get-out”
signals.
 Volume, which has not been discussed in this book as a feature apart from price
action, and which cannot, in fact, be utilized as a technical guide by itself, deserves
some further comment. Remember it is relative that it tends naturally to run higher
near the top of a Bull Market than near the bottom of a Bear Market. Volume
“follows the trend,” meaning it increases on rallies and decreases on reactions in
an overall uptrend, and vice versa. But use this rule judiciously; do not place too
much dependence on the showing of a few days and bear in mind that even in a Bear
Market (except during Panic Moves), there is always a slight tendency for activity
to pick up on rises. (“Prices can fall of their own weight, but it takes buying to put
them up” as Edwards said.)
 A notable i ncrease in activity, as compared with previous days or weeks, may
signify either the beginning (breakout) or the end (climax) of a move, temporary or
final. (More rarely, it may signify a “shakeout.”) Its meaning, in any given case, can
be determined by its relation to the price pattern.
 2. Trend and trendline studies supplement Area Patterns as a means of determining the
general direction in which prices are moving and of detecting changes in direction.
Although lacking the nice definition of Area Formations, they may frequently be used
for “get-in” and “get-out” purposes in short-term trading, as well as provide a defense
against premature relinquishment of profitable long-term positions.
 3. Support and Resistance Levels are created by the previous trading and investment
commitments of others. They may indicate where it should pay to take a position,
but their more important technical function is to show where a move is likely to slow
down or end, and at what level it should encounter a sudden and important increase
in supply or demand.
 Before entering a trade, look both to the pattern of origin for an indication of the
power behind the move and to the history of Support–Resistance for an indication
as to whether it can proceed without difficulty for a profitable distance. Support–
Resistance studies are especially useful in providing “cash-in” or “switch” signals.
 4. Broad market background, including the Dow Theory, should not be scorned. This
time-tested device designates the (presumed) prevailing Major Trend of the market.
Its signals are “late,” but with all its faults (like the greatly augmented following it has
acquired in recent years resulting in a considerable artificial stimulation of activity at
certain periods), it is still an invaluable adjunct to the technical trader’s toolkit.
The general characteristics of the various stages in the stock market’s great Primary
Bull and Bear cycles, which were discussed in our Dow Theory chapters, should never be
lost to view. This brings us back to the idea of perspective, which we emphasized as essential
to successful technical analysis at the beginning of our summary. The stock that does not, to
some degree, follow the Major Trend of the market as a whole is an extraordinary exception.
More money has been lost by buying perfectly good stocks in the later and most exciting
phases of a Bull Market, and then selling them, perhaps from necessity, in the discouraging
conditions prevailing in a Bear Market, than from all other causes combined.
Hence, keep your perspective on the broad market picture. The basic economic tide is one
of the most important elements in the supply–demand equation for each individual stock.
It may pay to buck “the public,” but it does not ever pay to buck the real underlying trend.
265Chapter seventeen: A summary a nd concluding comments
Major Bull and Bear Markets have recurred in fairly regular patterns throughout all
recorded economic history, and there is no reason to suppose they will not continue to recur
for as long as our present system exists. It is well to keep in mind that caution is in order
whenever stock prices are at historically high levels and that purchases will usually work
out well eventually when they are at historically low levels.
If you make known your interest in your charts, you will be told the chart analyst (like
the Dow theorist) is always late—buying after prices have already started up (maybe not
until long after the “smart money” has completed its accumulation) and sells after the trend
has unmistakably turned down. Partly true, as you have no doubt already discovered for
yourself. The secret of success lies not in buying at the very lowest possible price and selling
at the absolute top, but rather in the avoidance of large losses. (Small losses you will have to
take, and as quickly as possible as warranted by the situation.)
One of the most successful “operators” Wall Street has ever seen, Bernard Baruch, a
multimill


as you have no doubt already discovered for
yourself. The secret of success lies not in buying at the very lowest possible price and selling
at the absolute top, but rather in the avoidance of large losses. (Small losses you will have to
take, and as quickly as possible as warranted by the situation.)
One of the most successful “operators” Wall Street has ever seen, Bernard Baruch, a
multimillionaire and a nationally respected citizen today, is reputed to have said never in
his entire career had he succeeded in buying within 5 points of the bottom or selling within
5 points of the top! (EN: For perspective, the 5 points mentioned constituted roughly 10% of the
market at that time.)
Before we leave this treatise on theory and proceed to the more practical matters of
application and market tactics that are the province of Section II of this book, the reader will,
we hope, forgive one more admonition. There is nothing in the science of technical analysis
that requires one always to have a position in the market. There is nothing that dictates
something must happen every day. There are periods—sometimes long months—when
the conservative trader’s best policy is to stay out entirely. What is more there is nothing in
technical analysis to compel the market to go ahead and complete (in a few days) a move
the charts have foretold; it will take its own good time. Patience is as much a virtue in stock
trading as in any other human activity.
Technical analysis and technology in the 21st
century: the computer and the internet: tools of
the investment/information revolution
The purpose of this section is to put computer and information technology into proper
context and perspective for chart-oriented technical analysts.
In John Magee’s time, in his office in Springfield, Massachusetts, there was a chart
room—a room filled with all-age chartists from teenagers to senior citizens. These people
spent all their time keeping charts and assisting Magee in interpretation. These were
wonderful and intelligent people who developed marvelous insights into the stocks they
charted as well as created the manual charts that adorn this book.
Today, that room and all those technicians have been replaced by a beige (sometimes
lime) box that sits crowded on our desktops and that is often worshipped as a fount of
insight and wisdom: “Computer, analyze my stocks.”
Unfortunately, the computer does not have the discrimination and pattern recognition
ability of the people in that chart room. Undeterred by this weakness in computer
technology, traders and investors have poured incalculable money and effort into computer-
aided research, attempting to discover the keys to market success. More money has been
spent in this effort than was ever put into the search for the philosopher’s stone. Much of it
was wasted, but it has not all been spent in vain. In some areas, it has been quite productive.
But no fail-safe algorithm, in spite of all this effort, has been found for investment success,
266 Technical Analysis of Stock Trends
and certainly not for stock trading. The research has demonstrated that even the algorithm
of “buy low, sell high” has fatal flaws in it.
To fully understand the importance of the computer, the reader should appreciate some
basic differences in participants’ approach to the markets, or, we might say, schools of
analysts and investors. We will not bother with fundamental analysts here, as they are of
a different religious persuasion. Chart analysts, or Magee-type technical analysts, pretty
much confine their analysis of the market to the interpretation of bar charts. (This does not
mean their minds must be closed to other inputs. On the contrary—anything that works.)
Another chart analyst school uses point and figure charts, and another candlestick charts.
Another breed of technical analysts takes basic market data, price and volume, and uses
them as the input to statistical routines that calculate everything from moving averages to
mystically designated indicators like %R or Bollinger Bands (see Glossary); they are known
as statistical or number-driven technical analysts. All these analysts attempt to invest or
trade stocks and other financial instruments (not including options) using some form of
what is called technical analysis—that is, they all take hard data that people cannot lie
about, misrepresent, and manipulate, (unlike the data inputted to fundamental analysis
like earnings, cash flow, sales, etc.) as input to their analysis.
Using number-driven or statistical technical analysis, these latter schools attempt, just
as chart analysts do, to predict market trends and trading opportunities. This can be more
than a little difficult because the stock and bond markets are behavioral markets driven
by human emotion, perhaps the most important of many variables influencing price. Plus,
human emotion and behavior dictates manic and depressive elements, which have not yet
been quantified. Yet, some chart analysts believe they can recognize it when they see it on
the charts.
In another area, the computer has yielded much more dramatic and profitable results,
but that is in a model-driven market, namely the options markets. Quantitative analysts,
those who investigate and trade the options markets, are a breed apart from technical
analysts. In an interesting irony, emotion-driven markets, the stock markets, are used as
the basis for derivatives, or options, whose price is determined largely by the operation of
algorithms called “models;” for example, the Black Scholes model. Quantitative analysts
believe, as does this editor, the options markets can be successfully gamed through
quantitative analysis. Results of skilled practitioners indicate this belief is accurate.
Alas, life is not so simple for the simple stock trader. Stock prices having nothing to do
with mathematics, except for being expressed as natural numbers, are not susceptible to
eas


ck Scholes model. Quantitative analysts
believe, as does this editor, the options markets can be successfully gamed through
quantitative analysis. Results of skilled practitioners indicate this belief is accurate.
Alas, life is not so simple for the simple stock trader. Stock prices having nothing to do
with mathematics, except for being expressed as natural numbers, are not susceptible to
easy prediction as to their future direction. Not even with Magee chart analysis or any other
form of analysis—technical, fundamental, or psychic. (From a theoretical point of view,
each trade made on the basis of a chart analysis should be looked at as an experiment made
to confirm a probability. The experiment is ended quickly if the trend does not develop.)
The fact chart analysis is not mechanizable is important. It is one reason chart analysis
continues to be effective in the hands of a skilled practitioner. Not being susceptible to
mechanization, counterstrategies cannot be brought against it, except in situations whose
meaning is obvious to everyone, for instance, a large important Support or Resistance Level
or a glaringly obvious chart formation. These days everyone looks at charts to trade even
if they do not believe in their use. In these obvious cases, some market participants will
attempt to push prices through these levels to profit from volatility and confusion. Indeed,
human nature has not changed much since Jay Gould and Big Jim Fisk.
When these manipulations of price occur, they create false signals—Bull and Bear
traps. Interestingly, the failure of these signals may constitute a reliable signal in itself—but
in the direction opposite to the original signal.
267Chapter seventeen: A summary a nd concluding comments
The importance of computer technology
Of what use and importance then is this marvelous tool—the most interesting tool man
(homo) has acquired since papyrus? (Numerous computer software packages available are
capable of executing the functions described in the following discussion.) If the computer
cannot definitively identify profitable opportunities, what good is it?
Probably the most important function the computer has for the Magee analyst is the
automation of rote detail work. Data can be gathered by downloading from database
servers. Charts can be called up in an instant. Portfolio accounting, maintenance, and tax
preparation can be disposed of with one hand while drinking coffee with the other. All in
all, this might make it sound as though the computer is a great tool, but with a pretty dull
edge. Not strictly true. There is at least one great leap forward for Magee analysts with this
tool, leaving aside the rote drudgery it saves. This great advantage is portfolio analysis. In
Appendix B, Resources, a complex portfolio analysis of the kind used by professional traders
(Blair Hull and Options Research Inc.) is illustrated. Even simpler portfolios of the average
investor can benefit from the facilities afforded by most portfolio programs, either on the
net or in commercial software packages (locations and software identified in Appendix B,
Resources).
Another advantage is the ability to see basic data displayed in many different forms:
point and figure charts, candlestick charts, close-only charts—these are prepared in the
flick of an eyelash and may indeed contribute to understanding the particular situation
under the magnifying glass. The effortless quantification of some aspects of analysis may
be useful—volume studies, for instance, and given the popularity of moving averages,
seeing the 50- and 200-day moving averages can be interesting. These moving averages
are considered significant by many market participants—even fundamental analysts. The
analysis of any of these should be considered in relation to the current state of the market
as understood by the careful chart analyst.
But what about (the strangely named) stochastics, Bollinger Bands, %R, MACD, Moving
Averages (plain vanilla, exponential, crossover, etc.), price/volume divergence, RSI (plain
vanilla and Wilder), VP Trend, TCI, OBV , Upper/Lower Trading Bands, ESA Trading Bands,
and AcmDis? Well, there is a certain whiff of alchemy to some of them, and some have some
usefulness sometimes. What is more, all systems work beautifully at least twice in their
lives: in research and in huge monumental Bull Markets. These number-driven indicators
are also the times when trading genius is most likely to be discovered. (EN9: It is also true, as
I have said, that you can drive a nail with a screwdriver. And the inventor of a tool may be fabulously
successful with it while its adopters lose their assets.)
It is also possible the excess of technical information created by these indicators may be
like the excess of fundamental information—another shell to hide the pea under, another
magician’s trick to keep the investor from seeing what is truly important, and what is
necessary and sufficient to know to trade well. Perhaps the investor would be better off with
a behavioral model because the markets are behavioral. Number-driven technical analysis
can do many things, some like Dr. Johnson’s dog, which walked on its hind legs, but they
cannot put the market in perspective—only the human mind can do that. Number-driven
models after all do not consider skirt lengths, moon cycles, sun spots, the length of the
economic cycle, or the Bullish or Bearish state of the market (if Bear Markets still exist) (EN9:
A wry ironical comment written before the market crash of the 2000s .) In the end, the human
brain is still the only organ capable of synthesizing all this quantitative and qualitative
information and assessing those elements that cannot be reduced to ones and zeros. The
educated mind is still the best discriminator of patterns and their contexts.
268 Technical Analysis of Stock Trends
Summary 1
The computer is a tool, a powerful tool, but a tool nonetheless. It i


In the end, the human
brain is still the only organ capable of synthesizing all this quantitative and qualitative
information and assessing those elements that cannot be reduced to ones and zeros. The
educated mind is still the best discriminator of patterns and their contexts.
268 Technical Analysis of Stock Trends
Summary 1
The computer is a tool, a powerful tool, but a tool nonetheless. It is not an intelligent problem
solver or decision maker. We use a mechanical ditch digger to dig a ditch, but not to figure
out where the ditch should be.
The multitude of indicators and systems should be viewed with a skeptical eye and
evaluated within the context of informed chart analysis. Sometimes an indicator or
technique will work for one user or its inventor but strangely mislead the chart analyst
who tries to use it—or buys it, even based on a verified track record.
Therefore, the experienced investor keeps his methods and analysis simple until he
has definitive knowledge of any technique, method, or indicator he would like to add to
his repertoire. Most of all, he depends on his own observations and experience to evaluate
his and others’ trading techniques.
Other technological developments of importance to
the technical Magee analyst and all investors
The computer is not the only technological development of interest to the technical investor.
A number of information revolution technologies need to be put in perspective. These are,
in broad categories, the internet and all its facilities, developments in electronic markets,
and advances in finance and investment theory and practice. This last is treated in the final
section of this chapter.
Owing to the enormous body of material on these subjects, no attempt will be made to
explore these subjects exhaustively, but the general investor will be given the information
he needs to know to put these subjects in their proper perspective. Resources will point the
analyst to avenues for further investigation if the need is felt.
First of all, are there any technological developments of whatever sort that have made
charting obsolete? No. Are there any developments that have made trading a guaranteed
success? No. The only sure thing is some huckster will claim to have a sure thing. Those
who believe such claims are the victims of their own naiveté.
The Internet: the eighth wonder of the modern world (EN9: Appendix
B, Resources, for the ninth edition has been enormously expanded
and is of paramount importance to modern investors.)
The internet has been called the most complex project ever built by man, which is probably
true. Complex, sprawling, and idiosyncratic, it has something for everyone, especially the
investor. Every form of investment creature known to man has set up a site on the internet
and waits like the hungry arachnid for the casual surfer: brokers and advisors—technical
and fundamental; newspapers, news magazines, newsgroups, and touts; mutual funds,
mutual fund advisories, critics and evaluators of all the above; database vendors, chat
rooms, electronic marketplaces and exchanges, and Exchange Traded Notes (ECNs)—the
only unfilled niche that seems to exist is investment pornography. Perhaps naked options
will be able to satisfy this need.
This is a bewildering array of resources. How does one sort them out? The implications
of all this for the electronic or cyber investor may be further expanded to indicate the
services and facilities available: quotes and data; portfolio management and accounting;
online interactive charting; automatic alerts to PBDAs (personal body digital assistants
or gizmos carried on the body, for example, cell phones and handheld computers, and
269Chapter seventeen: A summary a nd concluding comments
so on); analysis and advice; electronic boardrooms; and electronic exchanges where
trading takes place without intermediaries. Appendix B, Resources, supplies the specifics
on these categories while this chapter supplies perspective. It is one thing to contemplate
this cornucopia of facilities and another thing to appreciate the importance and priority
of its elements. What good are real-time quotes if you are only interested in reviewing
your portfolio once a week, except for special occasions? What good are satellite alerts and
virtual reality glasses to a long-term investor? It is easy for the investor with no philosophy
or method to be drawn into the maelstrom of electronic wonders and stagger out of it a
little wiser and much poorer.
Observe then the goods and services of all of this are of importance to the levelheaded
investor with his feet on the ground and his head out of the clouds (or Cloud). This, hopefully
not, abstract investor, the object of our attention here, needs what? He needs data, charts, and
a connection to a trading place. Data are available at the click of a mouse. A chart occupies the
screen in another click. Another click and a trade is placed. In the Internet Age, it would be
tautological to attempt to describe this process in prose when live demonstrations are as
close as the desktop computer and an internet connection. A demonstration of this rather
simple process (easy to say when one does it without thinking) may be seen at locations
linked in Appendix B, Resources. The trade will be made, of necessity, through a broker of
some sort, perhaps an electronic broker or even a non-virtual broker who communicates
via telephone. This will occur shortly, if not already, an electronic pit where one matches
wits with a computer instead of a market maker or specialist.
How long brokers will be necessary is a question that is up in the air in the new century.
(The broker who earns his keep will always be with us, and welcome, too.) Electronic
marketplaces where investors meet without the necessity of a broker or specialist are
already proliferating (see Appendix B, Resources) and will continue to gain the advantage for
the investor over


maker or specialist.
How long brokers will be necessary is a question that is up in the air in the new century.
(The broker who earns his keep will always be with us, and welcome, too.) Electronic
marketplaces where investors meet without the necessity of a broker or specialist are
already proliferating (see Appendix B, Resources) and will continue to gain the advantage for
the investor over the trading pit, which is one of the last remaining edges the professionals
hold over off-floor traders. Suffice it to say, their initial phases will undoubtedly be periods
of dislocation, risk, and opportunity as their glitches are ironed out.
Placing electronic orders, whether to an electronic exchange or to the New York Stock
Exchange, has certain inherent advantages over oral orders. No one can quarrel about a
trade registered electronically as opposed to orally where the potential for disagreement
exists. In addition, the trader has only handled the data once—rather than making an
analysis, calling a broker, recording the trade, and passing it to the portfolio. If he just hits
the trade button and the transaction is routed through his software package, no one will
have any doubt as to where an error might lie. The manual method presents an opportunity
for error at each step. Rest assured, errors occur and can be disastrous to trading.
The efficiency and ease of the process with a computer have much to recommend it—
automation of trade processing, elimination of confusion and ambiguities, audit tracks,
automation of portfolio maintenance, and, perhaps most important of all, automatic mark-
to-market of the portfolio (the practice of valuing a portfolio at its present market value
whether trades are open or closed).
Marking-to-market
This book might have been entitled Zen and the Art of Technical Analysis if that title were
not so hackneyed and threadbare. It conveys, nonetheless, the message of Zen in the art
of archery, that of direct attachment to reality and the importance of the present moment.
In his seminal book The General Semantics of Wall Street (now Winning the Mental Game on
Wall Street), John Magee inveighed at some length against the very human tendency to
270 Technical Analysis of Stock Trends
keep two sets of books in the head—one recording profits, open and closed, and another
recording losses, but only closed losses. Open losses were not losses until booked. Having
an electronic portfolio accountant that refuses to participate in such self-deception has
much to recommend it. If the portfolio is always marked to the market when the computer
communicates with the data vendor, or the trade broker, it is difficult not to see red ink,
and to see the equity of the account reflects all trades, open and closed.
Separating the wheat from the chaff
It requires a gimlet-eyed investor to pick his way through the minefield of temptations in
electronic investing and number-driven technical analysis. Playing with the toys, seeing
what the pundits have to say, and fiddling with “research” can subtly replace profitable
trading as the activity. Actually, almost all the research the Magee analyst must do is
addressed in this book.
Chaff
Chat rooms, touts, news, predictions, punditry, brokerage house buy, sell, hold, strong hold,
weak buy, strong buy, and any other species of brokerage house recommendation should
be taken at face value. Remember, brokerage firms survive by selling securities and make
their money in general on activity. Actually, much of their money is made servicing their
institutional clients and distributing their clients’ shares to their retail clientele—a blatant
conflict of interest that blew up in their faces in the early 2000s, resulting in many fines and
some jail terms (plus ça change
 … ). In the surging Clinton–Gore Bull Markets of the 1990s,
all of these worked. In a serious Bear Market, none of them will work. (EN9: A serious Bear
Market started in earnest in 2000 and was correctly identified with Magee chart analysis as may be
seen from the John Magee Letters at the http:/ /www.edwards-magee.com.)
Summary 2
Never in the history of the markets have so many facilities for private investors been
available. The computer is necessary to take advantage of those facilities.
Data may be acquired automatically via internet or dial-up sites at little or no cost. A (as
they say) plethora of websites offer cyber investors everything from portfolio accounting to
alerts sent to their personal body-carried devices (cell phones, pagers, handheld PDAs, and
so on). Some of these even offer real-time data, which is a way for the unsophisticated trader
to go broke in real time. Many of these sites offer every kind of analysis from respectable
technical analysis (usually too complicated) to extraterrestrial channeling.
Internet chat rooms will provide real-time touting and numerous rumors to send the
lemmings and impressionable scurrying hither and yon. But, one expects, not the readers
of this book.
Of more importance, the information revolution and the computer will:
 1. Relieve the analyst of manual drudgery, accelerate all the steps of analysis:
data gathering, chart preparation, portfolio accounting, and analysis and tax
preparation.
 2. Give the analyst virtually effortless portfolio accounting and mark-to-market
prices—a valuable device to have to keep the investor from mixing his cash and
accrual accounting, as Magee says.
271Chapter seventeen: A summary an d concluding comments
 3. Enable processing of a hitherto unimaginable degree. An unlimited number of stocks
may be analyzed. Choosing those to trade with a computer will be dealt with in
Chapter 21, Selection of Stocks to Chart.
 4. Allow the investor to trade on ECNs or in electronic marketplaces where there are no
pit traders or locals to fiddle with prices.
Advancements in investment technology, part 1:
developments in finance theory and practice
Numerous pernicious and


nlimited number of stocks
may be analyzed. Choosing those to trade with a computer will be dealt with in
Chapter 21, Selection of Stocks to Chart.
 4. Allow the investor to trade on ECNs or in electronic marketplaces where there are no
pit traders or locals to fiddle with prices.
Advancements in investment technology, part 1:
developments in finance theory and practice
Numerous pernicious and useless inventions, services, and products litter the internet
and the financial industry marketplace; but modern finance theory and technology are
important and must be taken into consideration by the general investor. This chapter will
explore the minimum the moderately advanced investor needs to know about advances
in theory and practice. And it will point the reader to further resources if he desires to
continue more advanced study.
Instruments of limited (or non) availability during the time of Edwards and Magee
included exchange traded options on stocks, futures on averages and indexes, options
on futures and indexes, and securitized indexes and averages, as a partial list of only the
most important instruments. Undoubtedly, one of the most important developments of
the modern era is the creation of trading instruments that allow the investor to trade and
hedge the major indexes. Of these, the instruments created by the Chicago Board of Trade
(CBOT
®) are of singular importance. These are the CBOT® DJIASM Futures and the CBOT®
DJIASM Futures Options, which are discussed in greater detail at the end of this chapter.
(EN9: Not so singular, perhaps. Probably of greater importance to readers of this book are the AMEX
iShares, particularly DIA, SPY, and QQQ, which are instruments (ETFs) that offer the investor
direct participation in the major indexes as though they were stocks.)
General developments of great importance in finance theory and practice are found in
the following sections.
Options
From the pivotal moment in 1973 when Fischer Black (friend and college classmate) and his
partner, Myron Scholes, published their—excuse the usage—paradigm-setting Model, the
options and derivatives markets have grown from negligible to trillions of dollars a year.
The investor who is not informed about options is playing with half a deck. The subject,
however, is beyond the scope of this book, which hopes only to offer some perspective on
the subject and guides to the further study necessary for most traders and many investors.
Something in the neighborhood of 30% or more of options expire worthless. This is
probably the most important fact to know about options. (There is a rule of thumb about
options called the 60–30–10 rule: 60% are closed out before expiration, 30% are “long at
expiration,” meaning they are worthless, and 10% are exercised.) Another fact to know
about options occurred in the Reagan Crash of 1987; the money puts bought at $0.625 on
October 16 were worth hundreds of dollars on October 19—if you could get the broker to
pick up the telephone and trade them. (The editor had a client at Options Research, Inc.
during that time who lost $57 million in three days and almost brought down a major
Chicago bank; he had sold too many naked puts.)
The most sophisticated and skilled traders in the world make their livings (quite
sumptuous livings, thank you) trading options. Educated estimates have been made that
as many as 90% of retail options traders lose money. That combined with the fact that by far
272 Technical Analysis of Stock Trends
it is the general public that buys (rather than sells) options should suggest some syllogistic
reasoning to the reader.
With these facts firmly fixed in mind, let us put options in their proper perspective
for the general investor. Options have a number of useful functions, such as offering the
trader powerful leverage. With an option, he can control much more stock than by the direct
purchase of stock—his capital stretches much further. So options are an ideal speculative
instrument (Exaggerated leverage is almost always a characteristic of speculative
instruments.), but they can also be used in a most conservative way—as an insurance
policy. For example, a position on the long security side may be hedged by the purchase of
a put on the option side. (This is not a specific recommendation to do this. Every specific
situation should be evaluated by the prudent investor with professional assistance as to its
monetary consequences.)
The experienced investor may also use options to increase yield on his portfolio of
securities. He may write covered calls or naked puts on a stock to acquire it at a lower cost
(e.g., he sells out of the money put options. This is a way of being long the stock; if the stock
comes back to the exercise price, he acquires the stock. If not, he pockets the premium.)
There are numerous tactics of this sort that may be played with options. Played because,
for the general investor, the options game can be disastrous, as professionals are not
playing. They are seriously practicing skills the amateur can never hope to master. Many
floor traders, indeed, would qualify as idiot savants—they can compute the “fair value”
of options in their heads and make money on price anomalies of 1/16, or, as they call
it, a “teenie.” For perspective, the reader may contemplate a conversation the editor had
with one of the most important options traders in the world who remarked casually that
his fortune was built on teenies. The reader may imagine at some length what would be
necessary for the general investor to make a profit on anomalies of 1/16. (EN10: The advent
of digital pricing has given market makers and specialists even more flexibility to beat the investor
by shaving spreads, theoretically, to $0.01.)
This does not mean the general investor should never touch options; it just means he
should be thoroughly prepared before he goes down to play that game. In options trading,
traders speak of bull


ake a profit on anomalies of 1/16. (EN10: The advent
of digital pricing has given market makers and specialists even more flexibility to beat the investor
by shaving spreads, theoretically, to $0.01.)
This does not mean the general investor should never touch options; it just means he
should be thoroughly prepared before he goes down to play that game. In options trading,
traders speak of bull spreads, bear spreads, and alligator spreads. The alligator spread is
an options strategy that eats the customer’s capital in toto.
Among these strategies is covered call writing. This strategy is touted as being an
income producer on a stock portfolio. There is no purpose in writing a call on a stock in
which the investor is long—unless that stock is stuck in a clear congestion phase that is not
due to expire before the option expires. Besides, if the stock is in a downtrend, it should
be liquidated, but to write a call on a stock in a clear uptrend is to make oneself beloved of
the broker, whose good humor improves markedly with account activity and commission
income. The outcome of a covered call on an ascending stock is that the writer (you, dear
reader) has the stock called at the exercise price, losing his position and future appreciation,
not to mention costs. The income is actually small consolation, a sort of booby prize—a
way of cutting your profits while increasing your costs. Nevertheless, covered writes are
justified and profitable in some cases.
Quantitative analysis
The investor should be aware of another area of computer and investment technology
that has yielded much more dramatic and profitable results, but that is in a model-driven
market—namely, the options markets. Quantitative analysts, those who investigate and
trade the options markets, are a breed apart from technical analysts. In an interesting
273Chapter seventeen: A summary a nd concluding comments
irony, behavioral markets, the stock markets, are used as the basis for derivatives, or
options whose price is determined largely by the operation of algorithms called “models.”
The original model that created the modern world of options trading was the Black–
Scholes options analysis model, which assumed the “fair value” of an option could be
determined by entering five parameters into the formula: the strike price of the option,
the price of the stock, the “risk-free” interest rate, the time to expiration, and the volatility
of the stock.
The eventual universal acceptance of this model resulted in the derivatives industry we
have today. To list all the forms of derivatives available for trading today would be to expand
this book by many pages, and it is not the purpose of this book anyway. The purpose of this
paragraph is to sternly warn general investors who are thinking of “beating the derivatives
markets” to undergo rigorous training first. The alternative could be extremely expensive.
At first, the traders who saw the importance of this model and used it to price options
virtually skinned older options traders and the public, who traded pretty much by the seat
of the pants or the strength of their convictions, meaning human emotion. But professional
losers learn fast and now all competent options traders use some sort of model or anti-model,
or anti-antimodel to trade. True to form, options sellers, who are largely professionals, take
most of the public’s (the buyers) money. This is the way of the world.
Options pricing models and their importance
After the introduction of the Black–Scholes model, numerous other models followed, among
them the Cox–Ross–Rubinstein, the Black Futures, and others. For the general investor, the
message is this: he must be acquainted with these models and what their functions are if
he intends to use options. Recall, the model computes the “fair value” of the option. One
way professionals make money off amateurs is by selling overpriced options and buying
underpriced options to create a relatively lower risk spread (for themselves). Not knowing
what these values are for the private investor is like not knowing where the present price is
for a stock; it is a piece of ignorance for which the professional will charge him a premium
to be educated about. Unfortunately, many private options traders never get educated, in
spite of paying tuition over and over again. But ignorance is not bliss—it is expensive.
Technology and knowledge works its way from innovators and creative geniuses
through the ranks of professionals and sooner or later is disseminated to the general public.
By that time, the innovators have developed new technology. Nonetheless, even assuming
that professionals have superior tools and technology, the general investor must thoroughly
educate himself before using options. As it is not the province of this book to dissect options
trading, though the reader may find references in Appendix B, Resources.
Here it would not be untoward to mention one of the better books on options as a
starting point for the moderately advanced and motivated trader. Lawrence McMillan’s
Options as a Strategic Investment is necessary reading. In addition, the newcomer may contact
the Chicago Board Options Exchange (the CBOE) at http:/ /www.cboe.com , which has
tutorial software.
Futures on indexes
Futures, like options, offer the speculator intense leverage—the ability to control a
comparatively large position with much less capital than the purchase of the underlying
commodity or index. Futures salesmen are fond of pointing out the fact that, if you are
margined at 5% or 10% of the contract value, a similar move in the price of the index will
274 Technical Analysis of Stock Trends
double your money. They are often not so conscientious about pointing out a similar move
against your position will wipe out your margin (actually earnest money). Unlike (long)
options, a mishap in the market can result in more than the loss of margin; it can become a
def


ed at 5% or 10% of the contract value, a similar move in the price of the index will
274 Technical Analysis of Stock Trends
double your money. They are often not so conscientious about pointing out a similar move
against your position will wipe out your margin (actually earnest money). Unlike (long)
options, a mishap in the market can result in more than the loss of margin; it can become a
deficit account and debts to the broker—in other words, losses of more than 100%. For this,
among other reasons, it is wise not to plunge into futures without considerable preparation.
This preparation might well begin, for the adroit investor, with the reading of Schwager’s
Technical Analysis, Schwager on Futures, currently one of the better books on the subject.
Let us say that, instead of using futures to speculate, we want to use them as a hedge
for our portfolio of Dow–Jones DIAMONDS (DIA) or portfolio of Dow–Jones stocks. Now
we are purchasing insurance, rather than speculating. As an oversimplified example, the
investor might see the failure of the DJIA to break through a top as the beginning of a
congestion zone (a consolidation or reversal pattern). He could then hedge his position by
shorting the Dow–Jones futures. Now he is both long and short—long the cash, short the
futures. He would place a stop on the futures above his purchase price to close the trade
if the market continued rising. If the market fell, he would maintain the futures position
until he calculated that the reaction had passed its worst point, or until it were definitely
analyzed to have reversed. He would then take his profits on the futures position (taxable),
but his cash position would be intact, and presumably, the greater capital gains on those
positions would be safe from taxation, and also safe from the costs, slippage, and difficulties
of reestablishing the stock position.
Options on futures and indexes
Conservative as well as speculative use may be made of options. For example, the investor
might, after a vigorous spike upwards, feel the Standard & Poor’s (S&P) 500, or the SPYs
which he is long, were overbought. He might then buy an index put on the S&P as a hedge
against the expected decline. If it occurs, he collects his profit on the option and his cash
position in the S&P is undisturbed. If the index continues to climb, he loses the option
premium—an insurance policy he took out to protect his stock portfolio.
Note: The tactics described here are for the reader’s conceptual education. Before
executing tactics of this kind, or any other unfamiliar procedure, the investor should
thoroughly inform himself and rehearse the procedure, testing outcomes through paper
trading before committing real capital. He must, in short, figure out how you lose. A number of
websites offer facilities of this kind, and the investor may also build on his own computer
a research or paper-trading portfolio segregated from his actual transactions.
The trader might also choose to buy an option on a future. At the CBOT
®, the trader
can trade both options and futures on the DJIA. These can be used as the above examples
for speculating or hedging, except in this case, the successful option buyer might wind
up owning a futures contract instead of the cash position. This could be disconcerting
to one not accustomed to the futures market, especially if large price anomalies between
futures and cash occurred, as happened in 1987 and 1989 when futures prices went to huge
discounts to cash. A primary reason for employing the futures would be for leverage and
the reason for using the options on futures would be the analysis that uncertainty was in
store and the wish to only risk the amount of the options premium.
Obviously, a speculator can choose to forget the stock or futures part of the portfolio
and trade only options. Before taking such a step, the trader should pass a postgraduate
course. The proportion of successful amateur option traders to successful professional
traders is extremely skewed. In fact, one might say all successful options traders are
professionals.
275Chapter seventeen: A summary an d concluding comments
Modern Portfolio Theory
Modern Portfolio Theory (MPT) is a procedure and process whereby a portfolio manager
may classify and analyze the components of his portfolio in such a way as to, hopefully, be
aware of and control risk and return. It attempts to quantify the relationship between risk
and return. Rather than analyzing only the individual instruments within a portfolio, MPT
attempts to determine the statistical relationships among the members of the portfolio and
their relationships to the market.
The processes involved in MPT analysis are as follows (1) portfolio valuation , or
describing the portfolio in terms of expected risk and expected return; (2) asset allocation,
determining how capital is to be allocated among the classes of instruments (bonds, stocks,
and so on); (3) optimization, or finding the trade-offs between risk and return in selecting the
components of the portfolio; and (4) performance measurement, or the division of each stock’s
risk into systemic and security-related classes.
How important is this for the general investor? Not very and there is a large question
among pragmatic analysts, such as the editor, as to its pragmatic usefulness for professionals,
although they cling to it as to a life ring in a shipwreck. Mandelbrot observed in articles
(“ A Multifractal Walk Down Wall Street”) and letters in the Scientific American (February
1999 and June 1999) that MPT discards about 5% of statistical experience as if it did not
exist (although it [the experience] does). He also observed the ignored experience includes
10-sigma market storms that are blamed for portfolio failures as though it were the fault of
the data instead of the fault of the process.
The wonders and joys of investment technology
Are there any other innovations in finance an


999) that MPT discards about 5% of statistical experience as if it did not
exist (although it [the experience] does). He also observed the ignored experience includes
10-sigma market storms that are blamed for portfolio failures as though it were the fault of
the data instead of the fault of the process.
The wonders and joys of investment technology
Are there any other innovations in finance and investment theory of which the general
investor should be aware? (See Chapter 42 for discussion of Value at Risk and Pragmatic
Portfolio Theory.) Well, it never hurts to know everything, and the very best professionals
not only are aware of everything, but also are in the constant process of finding new
wrinkles and glitches and anomalies. Though, as Magee would ask, what is necessary and
sufficient to know (see Winning the Mental Game on Wall Street )? Absolute certainty is the
hallmark of religious extremists and the naïve, who do not know what they do not know.
So I will remark that probably this book contains either what is necessary and sufficient for
the investor to know about these matters or guides the reader to further study.
Not to mention, nota bene, any number of little old ladies with a chart, a pencil, a ruler,
and previous editions of this book have beaten the pants off professional stock pickers with
supercomputers and MPT and Nobel Laureates and who knows what other resources.
I personally know investment groups that have thrown enormous resources into the
development of real-time systems that, in research, were 100% successful in beating the
market. The only real glitch was the systems required so much computer power they could not
be run quickly enough in real time to actually trade in the markets. Philosopher’s stone redux.
Advancements in investment technology, part 2:
futures and options on futures on the Dow–Jones
Industrial Index at the CBOT
(EN9: The general investor must be aware that the methods and techniques described in this chapter
are for advanced practitioners. Careless use of the described instruments can be extremely damaging
to a portfolio.)
276 Technical Analysis of Stock Trends
Investment and hedging strategies using the CBOT® DJIASM futures contract
A futures contract is the obligation to buy or sell a specific commodity on or by some
specified date in the future. For example, if one went long corn futures, he would be
obligated to accept delivery of corn on the delivery date, unless he sold the contract before
the settlement date. Shorting the contract would obligate the seller to deliver corn unless
he offset (by repurchase) the contract. The “commodity” in our present case is the basket
of stocks represented by the DJIA futures index. All futures contracts specify the date
by which the transaction must conclude, known as the “settlement date,” and how the
transaction will be implemented, known as “delivery.” The DJIA futures contract price
closely tracks the price of the Dow–Jones Industrials as computed from stock market values.
The value of the future is found by multiplying the index price of the futures contract
by $10.00. For example, if the futures index price is 10,000, the value of the contract is
10,000 × $10.00 = $100,000. So the buyer or seller of the futures contract is trading
approximately $100,000 worth of stocks at that Dow futures level. The value may be higher
or lower owing to several factors, for example, cost of carry, which will be discussed below.
Settlement of futures contracts
All futures contracts must be “settled.” Some futures are settled by delivery, the famous
nightmare of finding 5,000 bushels of soybeans delivered on your front lawn. Dow Index
futures “settle” (are delivered) in cash. The short does not dump a basket of Dow stocks
on the yard of the long. Thus, on the settlement date of the contract, the settlement price is
$10.00 times a figure called the “Special Opening Quotation,” a value calculated from the
opening prices of the member stocks of the Dow Future following the last day of trading in
the futures contract. This value is compared with the price paid for the contract when the
trade initiated. For example, if the Dow Future is 10,000 at expiration, a long who bought
the contract at 9,000 receives $10,000 ($10.00 × 1000) from the short.
Marking-to-market
This $10,000, however, is paid daily over the life of the contract, rather than in one payment
upon expiration of the contract. It is paid as successive daily “margin” payments. These
payments are not really margin but are in effect “earnest money” or a performance bond.
The practice of squaring up accounts at the end of every day’s trading is called “marking-to-
market.” These daily payments are determined based on the difference between the previous
day’s settlement price and the contract settlement price at the close of trading each day.
As a practical example, if the settlement price of June Dow Index futures increases
from 9,800 to 9,840 from May 17 to May 18, the short pays $400 ($10.00 × 40) and the long’s
account is credited $400. If the futures settlement price decreases 10 points the following
day, the long pays $100 to the short’s account—and so on each day until expiration of the
contract, when the futures price and the index price achieve parity.
At any time, the trader can close his position by offsetting the contract, that is, by
selling to close an open long, or buying to close an open short. At the expiration date, open
contracts are settled in cash at the final settlement price.
Fungibility
One of the great contributions of the great established exchanges like the CBOT ® and the
Chicago Mercantile Exchange is their institutionalization of contract terms and relationships
277Chapter seventeen: A summary a nd concluding comments
is known as “fungibility.” Any one futures contract for corn, or an index, or any other
commodity is substitutable for another of the same commodity. Similarly, the E