s 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.
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 naivete.
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


the victims of their own naivete.
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
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 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
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

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


untant 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 ga 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.
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 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


mportant 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 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 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 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 stre


rpose 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 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 m


ties
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.
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 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 naive, 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.)
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 x $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


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 x $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 x 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 x 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 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 Exchange
has negated counterparty risk by placing a Clearing Corporation between all
parties to trades. Thus, even if the other party to a trade went broke, the
Clearing Corporation would assume his liability and, using the mechanism
of daily settlement, whereby losers pay winners daily, the danger of major
default is avoided.
Futures “margins” (or “earnest money”) are deposited with the broker on
opening a trade. The leverage obtainable is quite extreme for a stock trader.
The initial margin is usually 3%-5% of the total value of the contract. Each
day thereafter, margins vary according to the process described above of
marking-to-market.
As the reader can see, the purchase or sale of a Dow Future is the
equivalent of a fairly large portfolio transaction, with the understanding it is
a transaction that will be closed in the future, unlike a stock purchase,
which may be held indefinitely.
Differences between cash and futures
The main two differences between the cash and the futures transactions are
as follows:
1. In cash, the value of the portfolio must be paid up front or financed
in a stock margin account.
2. The owner of the cash portfolio receives cash dividends.
These are not the only differences. The leverage employed in the futures
transaction is a two-edged sword. If the trader has no reserves, a minor
move in the index wipes him out. Such a minor move would be barely
noticed by the owner of a cash portfolio.
Dow Index futures
The price of the future and the price of the index are closely linked. Any
price anomaly is quickly corrected by arbitragers. On any significant price
difference, arbitragers will buy the underpriced and sell the overpriced,
bringing the relationship back in line. Their prices are not exactly the same
because the futures contract value must reflect the costs of short-term
financing of stocks and the dividends paid by index stocks until futures
expiration, known as the “cost of carry.” The “theoretical value” of the
future should equal the price of the index plus the carrying cost, what is
called the “fair” or “theoretical” value.
Using stock index futures to control exposure to the market
The owner of a cash portfolio in the Dow, or of DIAMONDS, can control
his exposure, his risk, by using futures to hedge. If, for example, he is
pessimistic about the market, or more to the point, a lot of uptrend lines
have been broken and the technical situation seems to be deteriorating, he
can sell a futures contract equivalent to his portfolio and be flat the market.
Readers will immediately recognize the advantages of this strategy. Tax
consequences on the cash portfolio are avoided, as are the other negative
consequences of trading— slippage, errors, and so on. Long-term positions
are better left alone. By flattening his position, the investor has now insured
the future value of his portfolio, and the capital involved is now earning the
money market rate of return.
What happens if the forecast market decline occurs? The portfolio is
protected from loss and the capital earns the market rate of re


ative
consequences of trading— slippage, errors, and so on. Long-term positions
are better left alone. By flattening his position, the investor has now insured
the future value of his portfolio, and the capital involved is now earning the
money market rate of return.
What happens if the forecast market decline occurs? The portfolio is
protected from loss and the capital earns the market rate of return; however,
the investor should monitor his hedge closely, lifting it when he calculates
the correction has run its course. Taxes will then be due on the profits on the
hedge.
In monitoring the hedge, the possibility the market rises instead of falls
must be considered. In planning the hedge in the first place, the investor
must plan for this eventuality and determine at which point he will lift the
hedge on the losing side. At worst, the investor has surrendered portfolio
appreciation. Not considering cash flow implications.
It is worth emphasizing, in fact strongly emphasizing, that these techniques
require knowledge, expertise, and study. Careless use of techniques of this
nature can bloody the amateur investor. Hence, it is probably best to have a
professional guide for the first several of these expeditions and to execute
first a number of paper transactions.
The canny investor can increase his exposure to the market and the risk to
his capital by buying index futures. But the canny investor must be careful
not to turn into a burned speculator. Futures trading, because of the extreme
leverage, is an area for dedicated and experienced speculators.
A Dow futures transaction costs less than if you had to buy or sell a whole
basket of stocks. Professional fund managers—as well as other
professionals—regularly use futures for asset allocation and reallocation. In
all likelihood, they are not using the extreme leverage afforded by futures.
In other words, if they have a $1 million cash portfolio, they do not buy $10
million worth of futures. It is not the leverage in which they are interested,
but rather it is the extreme convenience and agility offered by doing short-
term allocations in futures. The ability to almost instantaneously move in
and out of the market without disturbing the underlying portfolio is a
powerful feature of these “proxy markets.”
Figure 17.3 Diamonds and Futures. The 2% plus break at the arrow of an
11-month trendline is an unmistakable invitation to hedge the DIAMONDS
by shorting the futures. Profits on the short would have offset losses in the
DIAMONDS. This convenient drill would have preserved liquidity,
postponed capital gains taxes, and avoided loss of equity. Notice the return
to the trendline after the break. More of the foolish virgin syndrome?
Investment uses of Dow Index futures
The following examples describe the basic mechanics of using Dow futures
contracts. These can be used to adjust equity exposure in anticipation of
volatile market cycles and to rebalance portfolios among different asset
classes. The futures also may be used for other purposes not illustrated here.
The following examples are not intended to be absolutely precise, but only
to illustrate the mechanics involved. For the sake of simplicity, mark-to-
market payments and cost of carry have been eliminated from the examples.
Situation 1: Portfolio protection
You are a long-term Magee-type investor and you have old and profitable
positions with which you are satisfied. Yet, you have seen the broadening
top of the Dow Jones (ca. 2000) and it is almost October, so you would not
be surprised to see a little bloodshed. You have $400,000 in the Dow and
$100,000 in money market instruments. You decide to reverse this ratio, but
you do not want to liquidate the Dow portfolio, as there is no sign of a
confirmed downtrend, only that of consolidation. You sell $300,000 of
index futures, leaving yourself with a $100,000 kicker in case you are
wrong about the market's declining. At the time, the market is 10,000 and
the futures are 10,500, meaning the cost of carry is approximately 0.5%
(10,500/10,000 - 1).
You sell three futures contracts [$300,000/($10 x 10,000)]. You now have
reversed your position and are long $100,000 Dow stocks and long
$400,000 money market equivalents.
Validating your technical analysis, the market has begun to swing in broad
undulations and, at the expiration of the futures, the Dow is at 10,000. On
your stocks, you have a return of -0.5%, and the money market position has
a rate of return of 0.5%.
What would have been the situation had you not hedged?
Stock Portfolio $400,000 x 0.95$380,000
Money Market + 100,000 x 1.005$100,500
Total $480,500
How the futures position affects the portfolio:
Short three futures 3 x $10.00 x (10,000-9,500)+$15,000
Total $495,000
Value of portfolio with reallocation of assets in cash market:
Stocks $100,000 x 0.95 $95,000
Money market + $400,000 x 1.005$402,000
Total $497,000
By hedging in the futures market, you now have the equivalent of a
$100,000 investment in Dow futures stocks and a $400,000 investment in
the money market instrument. The stock market decline now affects only
$100,000 of your stock portfolio rather than $400,000; in addition, you earn
a money market rate of return of 0.5% on the $300,000 difference.
Without the futures transaction, the portfolio is worth $480,500. The
$15,000 profit on the short futures position offsets the loss on the $300,000
of the portfolio that was moved out of equities by the short futures position.
In brief, by selling futures, you are able to protect $300,000 of your initial
portfolio value from a stock price decline, nearly breaking even, an
achievement given these market conditions. Had you been more confident
of the market decline, you might have completely neutralized the equity
risk on the portfolio by selling more futures contracts. This would have
converted the entire stock position to a $400,000 investment in the money
market. The amount of protection you should obtain depends on your
assessme


decline, nearly breaking even, an
achievement given these market conditions. Had you been more confident
of the market decline, you might have completely neutralized the equity
risk on the portfolio by selling more futures contracts. This would have
converted the entire stock position to a $400,000 investment in the money
market. The amount of protection you should obtain depends on your
assessment of the market and your tolerance for risk.
Situation 2: Increasing exposure with futures
Now let us look at the other side of the coin. The market has come off its
highs in a predictable and controlled secondary reaction and your technical
analysis is that the Bull Market will continue. At 10,000, it appears headed
for 11,000, and you want to increase your commitment. Your portfolio is as
previously described, split 80/20 between Dow stocks and money markets.
It is time to go whole hog, you decide. You are acutely aware of the market
maxim (bulls make money and bears make money and hogs wind up
slaughtered), but there is also a market maxim that no market maxim is true
100% of the time, which is also true of this maxim.
Rather than liquidate your money market holdings, you buy one futures
contract, which puts you long another $100,000 of stocks. The rate of return
on the money markets in your portfolio is 0.5%. To get a $500,000 exposure
in blue chips, you buy the following number of contracts: $100,000/($10 x
10,000) = 1 contract.
Results: Your technical analysis of the direction of the market is correct,
and the Dow future rises to 11,000 at the September expiration, or by 10%.
Value of portfolio with passive management:
Stocks $400,000 x 1.10$440,000
Money market+$100,000 x 1.005$100,500
Total $540,500
Value of portfolio with futures position:
Long DJIA futures 1 x $10.00 x (11,000 - 10,000)$10,000
Total $550,500
Value of portfolio with reallocation of assets in cash market:
Stocks $500,000 x 1.10$550,000
Money market $0
Total $550,000
In buying Dow Index futures, you are able to “equitize” $100,000 of your
money market investment, effectively increasing your return from the
money market rate of 0.5%-10%. If you had not bought futures, the total
value of your portfolio at the September expiration would have been
$540,500 instead of $550,500. Not only do you have a $10,000 extra gain in
your portfolio, but also you have taken advantage of the market's continuing
upward climb without having to adjust your portfolio.
Situation 3: Using bond and index futures for asset allocation
Speculation in bonds can be quite profitable, notwithstanding David
Dreman's assertion that long-term investments in bonds are net losers.
(EN9: An oversimplification of a sophisticated thesis by an important
figure.) Subsequently, it is not unusual for an investor to have both bonds
and stocks in his portfolio. In this event, the portfolio can be managed with
facility by using both Index futures and Treasury bond futures.
Many investors consider it prudent to reallocate their capital commitments
based on inflation rates, interest rates, and the reported expression on Alan
Greenspan's (or Bernanke's) face before congressional testimony.
An efficient and inexpensive way to reallocate assets between stocks and
bonds is to put on spreads of Treasury bond futures and Dow Index futures.
Analysis of recent long- and medium-term trends in the market, however,
has led you to consider increasing your equity portfolio and decreasing your
bond portfolio. You have $200,000 invested in Dow stocks and $200,000
invested in Treasury bonds. You would like to take advantage of the
sustained market rally by increasing your equities exposure to 75% and
decreasing your bond holdings to 25%.
As for tactics, you can reallocate both sides of your portfolio—buying
$100,000 of stocks and selling $100,000 of bonds—with the sale of
Treasury bond futures and the purchase of Dow Index futures.
The Treasury bonds in your portfolio have a market price of 103-20. The
price of September Treasury bond futures is 102-20 per $100 of face value,
and $100,000 of face value must be delivered against each contract. The
value of the Dow futures is 10,000, and the price of the Dow Index futures
contract is 10,000 (ignoring the cost of carry).
The number of T-bond futures to sell is: short T-bond futures: $100,000/
(102 - 20 x $1,000) = 1 (number of futures is rounded to the nearest whole
number). The number of stock index futures to buy is as follows: long stock
index futures: $100,000/ ($10.00 x 10,000) = 1 (number of futures is
rounded to the nearest whole number).
Results: at the September futures expiration, the value of the Dow future is
11,000, a rate of return of 10%, and the market value of the bonds is 101-
08, a rate of return of -1%.
Portfolio value with no market action taken:
Stocks $200,000 x 1.10$220,000
Money market$200,000 x 0.99$198,000
Total $418,000
Value of futures positions:
Long Dow futures$10 x 1 x (11,000 - 10,000)$10,000
Short bond futures+$1000 x 1 x (102-20 - 101-08)$1375
Total $11,375
Grand total $429,375
Value of portfolio had transaction been done in cash market:
Stocks$300,000 x 1.10$330,000
Bonds+$100,000 x 0.99$99,000
Total $429,000
By this simple maneuver, you have quickly and easily changed your market
posture to add an additional $100,000 exposure to stocks and subtract
$100,000 exposure to bonds.
Figure 17.4 Dow-Jones Futures and Options. A put purchased at the arrow
on the break would have protected patiently won gains over the previous 11
months. The increase in the value of the put can be seen as futures track
declining Dow cash. A theoretical drill, but theoretical drills precede actual
tactics in the market.
Having correctly analyzed market trends, your action results in an increase
in portfolio value from $418,000 to $429,375. You could have
accomplished the same result by buying and selling bonds and stocks, but
not without tax consequences and the attendant transaction headaches. The
use of futures to accomplish yo


h. A theoretical drill, but theoretical drills precede actual
tactics in the market.
Having correctly analyzed market trends, your action results in an increase
in portfolio value from $418,000 to $429,375. You could have
accomplished the same result by buying and selling bonds and stocks, but
not without tax consequences and the attendant transaction headaches. The
use of futures to accomplish your goals allowed you to implement your
Perspective
Although there can be no argument about the importance of CBOT®
DJIASM Index futures— they are markets of enormous usefulness and
importance—there can also be no doubt the futures novice should
thoroughly prepare himself before venturing into these pits. In such a highly
leveraged environment, mistakes will be punished much more severely than
an error in the stock market. By the same token, ignorance of this vital tool
is the mark of an investor who is not serious about his portfolio, or who is
less intense in his investment goals. “They” (the infamous “they”) use all
the weapons at their disposal; so should “we.”
Options on Dow Index futures
The buyer of this instrument has the choice, or the right, to assume a
position. It is his option to do so—unlike a futures contract in which he has
an obligation once entered. There are two kinds of options: calls (the right
to buy the underlying instrument) and puts (the right to sell). Also, options
can be bought (long) or sold (short) like futures contracts.
A long call option on Dow Index futures gives the buyer the right to buy
one futures contract at a specified price which is called the “exercise” or
“strike” price. A long put option on Dow Index futures gives the buyer the
right to sell one futures contract at the strike price. For example, a call at a
strike price of 10,000 entitles the buyer to be long one futures contract at a
price of 10,000 when he exercises the option. A put at the same strike price
entitles the buyer to be short one futures contract at 10,000. The strike
prices of Dow Index futures options are listed in increments of 100 index
points, giving the trader the flexibility to express his opinions about upward
or downward movement of the market.
The seller, or writer, of a call or put is short the option. Effectively selling a
call makes the writer short the market, just as selling a put makes the writer
long the market. As in a futures contract, the seller is obligated to fulfill the
terms of the option if the buyer exercises. If you are short a call, and the
long exercises, you become short one futures contract at 10,000. If you are
short one put and the long exercises, you become long one futures contract
at 10,000.
Buyers of options enjoy fixed risk. They can lose no more than the premium
they pay to go long an option. On the other hand, sellers of options have
potentially unlimited risk. Catastrophic moves in the markets often
bankrupt imprudent option sellers.
Option premiums
The purchase price of the option is called the option premium. The option
premium is quoted in points, each point being worth $100. The premium for
a Dow Index option is paid by the buyer at initiation of the transaction.
The underlying instrument for one CBOT® futures option is one CBOT®
DJIASM futures contract; so the option contract and the futures contract are
essentially different expressions of the same instrument, and both are based
on the Dow-Jones Index.
Options premiums consist of two elements: intrinsic value and time value.
The difference between the futures price and strike price is the intrinsic
value of the option. If the futures price is greater than the strike price of a
call, the call is said to be “in-the-money.” In fact, you can be long the
futures contract at less than its current price. For example, if the futures
price is 10,020 and the strike price is 10,000, the call is in-the-money and
immediate exercise of the call pays $10.00 times the difference between the
futures and strike price, or $10 x 20 = $200. If the futures price is less than
the strike price, the call is “out-of-the-money.” If the two are equal, the call
is “at-the-money.” A put is in-the-money if the futures price is less than the
strike price and out-of-the-money if the futures price is greater than the
strike price. It is at-the-money when these two prices are equal.
Since a Dow Index futures option can be exercised at any date until
expiration, and exercise results in a cash payment equal to the intrinsic
value, the value of the option must be at least as great as its intrinsic value.
The difference between the option price and the intrinsic value represents
the time value of the option. The time value reflects the possibility that
exercise will become more profitable if the futures price moves farther
away from the strike price. Generally, the more time until expiration, the
greater the time value of the option because the likelihood of the option
becoming profitable to exercise is greater. At expiration, the time value is
zero and the option price equals the intrinsic value.
Volatility
The degree of fluctuation in the price of the underlying futures contract is
known as “volatility” (see Appendix B, Resources, for the formula). The
greater the volatility of the futures, the higher the option premium. The
price of a futures option is a function of the futures price, the strike price,
the time left to expiration, the money market rate, and the volatility of the
futures price. Of these variables, volatility is the only one that cannot be
observed directly. Considering all the other variables are known, however, it
is possible to infer from option prices an estimate of how the market is
gauging volatility. This estimate is called the “implied volatility” of the
option. It measures the market's average expectation of what the volatility
of the underlying futures return will be until the expiration of the option.
Implied volatility is usually expressed in annualized terms. The significance
and use of implied volat


ossible to infer from option prices an estimate of how the market is
gauging volatility. This estimate is called the “implied volatility” of the
option. It measures the market's average expectation of what the volatility
of the underlying futures return will be until the expiration of the option.
Implied volatility is usually expressed in annualized terms. The significance
and use of implied volatility is potentially complex and confusing for the
general investor, professionals having a decided edge in this area. Their
edge can be removed by serious study.
Exercising the option
At expiration, the rules of optimal exercise are clear. The call owner should
exercise the option if the strike price is less than the underlying futures
price. The value of the exercised call is the difference between the futures
price and the strike price. Conversely, the put owner should exercise the
option if the strike price is greater than the futures price. The value of the
exercised put is the difference between the strike price and the futures price.
To illustrate, if the price of the expiring futures contract is 7,600, a call
struck at 7,500 should be exercised, but a put at the same or lower strike
price should not. The value of the exercised call is $1,000. The value of the
unexercised put is $0.00. If the price of the expiring futures contract is
7,500, a 7,600 put should be exercised but not a call at 7,600 or a higher
strike. The value of the exercised put is $1,000 and that of the unexercised
call is $0.00.
The profit on long options is the difference between the expiration value
and the option premium. The profit on short options is the expiration value
plus the option premium. The expiration values and profits on call and put
options can often be an important tool in an investment strategy. Their
payoff patterns and risk parameters make options quite different from
futures. Their versatility makes them good instruments to adjust a portfolio
to changing expectations about stock market conditions. Moreover, these
expectations can range from general to specific predictions about the future
direction and volatility of stock prices. Effectively, there is an option
strategy suited to virtually every set of market conditions.
Using futures options to participate in market movements
Traders must often react to rapid and surprising events in the market. The
transaction costs and price impact of buying or selling a portfolio's stocks
on short notice inhibit many investors from reacting to short-term market
developments. Shorting stocks is an even less palatable option for average
investors because of the margin and risks involved and semantical
prejudices.
The flexibility that options provide can allow one to take advantage of the
profits from market cycles quickly and conveniently. A long call option on
Dow Index futures profits at all levels above its strike price. A long put
option similarly profits at all levels below its strike price. Let us examine
both strategies.
Profits in rising markets
In August, the Dow Index is 10,000 and the Dow Index September future is
10,050. You expect the current Bull Market to continue, and you would like
to take advantage of the trend without tying up too much capital and also
undertake only limited risk.
You buy a September call option on Dow Index futures. These options will
expire simultaneously with September futures, and the futures price will be
the same as the cash index at expiration.
Your analysis is bullish, so the 10,500 call (out-of-the-money strike price) is
a reasonable alternative at a quoted premium of 10.10. You pay $1,010 for
the call ($100 x 10.10).
The payoff: at the September expiration, the value of the Dow Future is
10,610. Now, your call is in-the-money, and you exercise it and garner the
exercise value less the premium, or $90.00 = $10.00 x (10,610 - 10,500) -
$100 x (10.10) = $1,100 - $1,010. If the Dow future stays at or below
10,500, you let the call expire worthless and simply lose the premium. This
is the maximum possible loss on the call. If the Dow future increases by
101 points above the strike price, you break even.
Instead of buying the call option, the trader could have invested $100,500
directly in the Dow stocks. Given a value of the Dow future of 10,110 in
September, he would have had a gain of $3,030. If he had invested directly
in the stocks, however, an unexpected market decline would have led to a
loss.
Exploiting market reversals
The trader expects a reversal of the Bull Market now at 7,800 and would
like some downside protection.
He buys a put with a strike price of 7,700 (out-of-the-money). The put
premium is 9.80, for a total cost of $980 = $100 x 9.80. If the Index
decreases to 7,600, with a corresponding decrease in the futures contract in
September, the put is worth $1,000. The maximum loss is the premium cost,
which is lost if the Dow future is above 7,700 at expiration. The trader
breaks even if the Dow future decreases by 98 points below the strike price.
Using puts to protect profits in an appreciated portfolio
During a sustained Bull Market, investors often search for ways to protect
their paper profits from a possible market break. Even when fundamental
economic factors tend to support a continued market upside, investors have
to guard against unpredictable “technical market corrections” and market
over-reactions to news.
Selling stocks to reduce downside risk is costly in fees and taxes and
sacrifices potential price gains. What is desirable in a sideways market
environment is an instrument that protects the value of a portfolio against a
market drop but does not constrain upside participation. This is precisely
what put options are designed to do.
Situation 1
The market is in an uptrend in August, which is when the market lives with
the anxiety the Federal Reserve will tighten short-term interest rates further
in the coming months. The trader has $78,000 invested in the Dow
portfolio, and the Dow Future is at 7,


ortfolio against a
market drop but does not constrain upside participation. This is precisely
what put options are designed to do.
Situation 1
The market is in an uptrend in August, which is when the market lives with
the anxiety the Federal Reserve will tighten short-term interest rates further
in the coming months. The trader has $78,000 invested in the Dow
portfolio, and the Dow Future is at 7,800.
To hedge his portfolio, he purchases a put option on September futures
against a possible market downturn. He buys a 7,600 put at a premium of
6.60, cost $100 x 6.60 = $660.
Buying the put places a floor on the value of the portfolio at the strike price.
Buying a put with a strike price of 7600 effectively locks in the value of the
portfolio at $76,000. Above its strike price, a put is not exercised and the
portfolio value is unconstrained. If the trader is wrong, and the market goes
up, he loses the premium paid for the put. Depending on which strike price
he chooses, he increases or decreases downside risk. He breaks even when
the Dow future reaches a value of 7,534 = 7,600 - 66, the strike price less
the put premium. At this level, the unprotected and put-protected portfolios
are equally profitable.
The similarity to life insurance is striking. If you do not die, the premium is
wasted. But if you do...
Improving portfolio yields
Situation 2
All markets, as the reader is perhaps aware, are not trending. Days, weeks,
months, sometimes years can pass while the markets grind up and down in
what are euphemistically known as trading range markets. When the astute
technician identifies one of these market doldrums and judges that it will
continue, he can reap other returns on his portfolio by selling puts and calls
on Dow Index futures.
For example, when the Dow Index is 10,000 and the trader calculates it will
not break out for the next month above 10,200, he sells calls at a strike price
of 10,200. The quoted premium of the 10,200 call is, say, 10.10; selling a
10,200 call generates $1010 income.
The trader pockets the entire premium as a profit if the index remains below
10,200 at the September expiration. The downside of this trade is that the
trader gives up price appreciation above 10,200. Above 10,200, the
combined value of the portfolio and short call premium is $101,010. The
break-even point is 10,301, where the Dow Future is equal to the sum of the
strike price and call premium. Above this point the covered call portfolio
becomes less profitable than the original portfolio. Since the short call is
covered by the portfolio, this strategy is not exposed to the risk represented
by a naked call. The main risk is the trader giving up the profit potential
above the strike price of the call. As is obvious to the technician, this is a
bad strategy in trending markets. Only in clearly range-bound markets
would an enlightened trader want to write covered calls. The call premium
collected is some compensation for this risk, but cold comfort when the
trader has misanalyzed the market. The best strike price of the call depends
on the probabilities you have assigned to future increases and behavior of
the Dow.
Using option spreads in high- or low-volatility markets
Long and short stock positions reflect definite market opinions or analyses.
The market will go up or the market will go down and the moderately
competent technician should be right about this more often than the
unwashed general public. In markets of coiling volatility (i.e., lower than
average volatility and declining), it is sometimes possible to exploit
uncertainty by putting on a long straddle. The long straddle combines a long
put and a long call at the same strike price. This spread generates a return
over two ranges of market values: values below the strike price of the put
and values above the strike price of the call. It is a profitable strategy given
sufficient volatility; the editor's company used such a strategy immediately
before the crash of 1987 for managed accounts and collected
disproportionate profits on a very low-risk position. Experienced
speculators and traders generally sell high-volatility markets and try to
backspread (go long) in chosen less-volatile markets, expecting volatility to
return to the mean. Sometimes they do this by writing a short straddle, a
position with a short put and a short call at the same strike price.
Situation 3
In August, a technical analysis predicts that volatility will increase, and the
market is in a coiling process. The direction of prices is uncertain but
potentially explosive. The trader buys a straddle of a long put at 7,800 and a
long call at 7,800. The quoted call premium is 18.90 and the quoted put
premium is 13.90. The total cost of the straddle is $3280 = $100 x 32.80.
This is the maximum loss if the Dow Future stalls at 7,800.
The straddle makes a profit when the Dow Future moves enough to recover
the cost of the straddle, either below 7,472 = 7,800 - 328 or above 8,128 =
7,800 + 328. The potential upside profit is unlimited. The maximum profit
on the downside is $10.00 x (7,800 - 328), or $74,720, if the Dow future
goes to zero (somewhat unlikely, but one never knows what Chicken Little
the investor will do if he thinks the sky is falling).
Situation 4
In August, the investor calculates options are overvalued and volatility will
be lower than implied volatility. He expects a dormant market to continue
through the end of the summer. He decides to sell the September put and
call at 7,800, collecting $3,280. The return on this short straddle will turn
negative if the Dow future in September goes below 7,472 or above 8,128.
The maximum loss on the downside is $10.00 x (7,800 - 328), or $74,720,
and the loss on the upside is unlimited. The investor, however, perceives the
risk as limited because he believes the Dow future will neither increase nor
decrease to these levels within the next month when the options expire. In
these cases, the trader must also consider catastrophic r


ptember goes below 7,472 or above 8,128.
The maximum loss on the downside is $10.00 x (7,800 - 328), or $74,720,
and the loss on the upside is unlimited. The investor, however, perceives the
risk as limited because he believes the Dow future will neither increase nor
decrease to these levels within the next month when the options expire. In
these cases, the trader must also consider catastrophic risk—as, for
example, the editor's client who was short puts in the crash of 1987 and lost
$57 million.
Perspective
(EN9: Once again, do not practice the methods and techniques described in
this chapter without complete confidence in their use. A course in futures
and options is recommended, or professional consultation.)
I like to tell these stories so prospective options traders and general
investors are made dramatically aware of the potential dangers, as well as
the potential profits. As stated elsewhere in this book, the novice should
work to achieve competence and experience before attempting advanced
tricks in futures and options. On the other hand, the investment use of these
instruments for prudent hedging and insurance is recommended to the
investor willing to do his homework, acquire competence, and grow in
investment skills.
Dow Index futures and futures options present new techniques of portfolio
protection and profit-making for the general investor. Numerous strategies
can be practiced by the moderately competent investor using these
instruments. Keep in mind always that all the methods of analytical
investing espoused in this book are the base discipline—that is, knowledge
of the instruments and their use, prudent trade management, stop-loss
discipline, and close attention to the dynamics of the situation. Above all,
the existence of these instruments allows the most conservative of investors
insurance and hedging techniques not previously available.
In summation, knowledge of the DJIA futures and options on futures is
absolutely essential for the competent technical investor and trader.
Recommended further study
In view of the importance of this chapter, noted here are references to
advanced material, which are also found in Appendix B, Resources.
The CBOE has a website explaining the math behind hedging. To hedge a
portfolio of $500,000 tracking the S&P 500, you need four puts. The
address for the calculation of the hedging ratio is available at
http://www.cboe.com/portfoliohedge.
For further study, see the following:
• Options as a Strategic Investment by Lawrence Macmillan,
http://www.optionstrategist. com
• Chicago Board Options Exchange, http://www.cboe.com
• Chicago Board of Trade, 312-435-3558 or 800-THE-CBOT; 312-341-
3168 (fax); http:// www.cbot.com
part two
Trading tactics
Midword
As a kind of foreword to Section II of this book, we might mention a
commentary, “On Understanding Science: An Historical Approach,” by
James Bryant Conant, president emeritus of Harvard.
Dr. Conant points out that, in school, we learn science is a systematic
collection of facts that are classified in orderly array, broken down,
analyzed, examined, synthesized, and pondered; and then lo! a Great
Principle emerges—pat, perfect, and ready for use in industry, medicine, or
what-have-you.
He further points out that all of this is a mistaken point of view held by
most laymen. Discovery takes form little by little, shrouded in questioning,
and only gradually assumes the substance of a clear, precise, well-supported
theory. The neat tabulation of basic data, forming a series of proofs and
checks, does not come at the start but much later. In fact, it may be the work
of other men entirely, men who, being furnished with the conclusions, are
then able to construct a complete, integrated body of evidence. Theories of
market action are not conceived in a flash of inspiration; they are built, step
by step, out of the experience of traders and students, to explain the typical
phenomena that appear over and over again through the years.
In market operations, the practical trader is not concerned with theory as
such. The neophyte's question, “What is the method?” probably means,
actually, “What can I buy to make a lot of money easily and quickly?” If
such a trader reads this book, he may feel there is “something in it.” He may
feel “It's worth a try” (a statement, incidentally, that reflects little credit on
his own previous tries). He may also start out quite optimistically, without
any understanding of theory or any experience in these methods, and
without any basis for real confidence in the method.
In such cases, the chances are great he will not immediately enjoy the easy
success he hopes for. His very inexperience in a new approach will result in
mistakes and failures. Yet, even with the most careful application of these
methods, in correctly entered commitments, he may encounter a series of
difficult market moves that may give him a succession of losses.
Whereupon, having no solid confidence in what he is doing, he may sigh,
put the book back on the shelf, and say, “Just as I thought. It's no damn
good.”
Now, if you were about to go into farming for the first time, you might be
told (and it would be true) the shade tobacco business offers spectacular
profits. But you would not expect to gain these profits without investing
capital, without studying how shade tobacco is grown and in what kinds of
soils and what localities, nor without some experience with the crop.
Furthermore, you would need confidence—faith in the opportunity and also
in the methods you were using. If your first season's crop were blighted
(and these things do happen), you would naturally be disappointed. If it
should happen that your second year's crop were destroyed by a hailstorm,
you would be hurt and understandably despondent. Moreover, if your third
season's crop were to be a total loss because of drought, you would
probably be very gloomy indeed (and who could blame you?). But you
would not say, “There's nothing to it. It's no d


d these things do happen), you would naturally be disappointed. If it
should happen that your second year's crop were destroyed by a hailstorm,
you would be hurt and understandably despondent. Moreover, if your third
season's crop were to be a total loss because of drought, you would
probably be very gloomy indeed (and who could blame you?). But you
would not say, “There's nothing to it. It's no damn good.”
You would know (if you had studied the industry and the approved
cultivation methods) that you were right, regardless of any combination of
unfavorable circumstances, and you would know the ultimate rewards
would justify your continuation, no matter how hard the road, rather than
turn to some easier but less potentially profitable crop.
So it is with technical methods in the stock market; anyone may encounter
bad seasons. The Major Turns inevitably will produce a succession of losses
to Minor Trend operators using the methods suggested in this book. There
will also be times when a man who has no understanding of basic theory
will be tempted to give up the method entirely and look for a “system” that
will fit into the pattern of recent market action nicely, so he can say, “If I
had only averaged my trades ... . If I had followed the Dream Book ... . If I
had taken Charlie's tip on XYZ ... . If I had done it this way or that way, I
would have come out with a neat profit.”
It would be better, and safer, to understand at the start that no method ever
devised will unfailingly protect you against a loss, or sometimes even a
painful succession of losses. You should realize what we are looking for is
the probability inherent in any situation. Likewise, just as you would be
justified in expecting to draw a white bean from a bag which you knew
contained 700 white beans and 300 black beans (even though you had just
drawn out 10 black beans in succession!), so too you are justified in
continuing to follow the methods that, over long periods, seem most surely
and most frequently to coincide with the mechanism of the market.
Thus, this book should not be given a quick “once-over” and adopted
straightaway as a sure and easy road to riches. It should be read over and
over, a number of times, and it should be consulted as a reference work.
Furthermore, and most importantly, you will need the experience of your
own successes and failures so you will know what you are doing is the only
logical thing you can do under a given set of circumstances. In such a frame
of mind, you will have your portion of successes and your failures, which
you can take in stride, as part of the business, will not ruin either your
pocketbook or your morale.
In short, the problem stated and analyzed through this whole volume is not
so much a matter of “systems” as it is a matter of philosophy. The end result
of your work in technical analysis is a deep understanding of what is going
on in the competitive free auction, what is the mechanism of this auction,
and what is the meaning of it all. Be mindful this philosophy does not grow
on trees; it does not spring full-bodied from the sea foam either. It comes
gradually from experience and from sincere, intelligent, hard work.
Section II of this book, which follows, is concerned with tactics. Up to this
point, we have been studying the technical formations and their
consequences. We should have a good general understanding of what is
likely to happen after certain manifestations on the charts. Knowing that,
however, we will still need a more definite set of guides as to when and
how it is best to execute this or that sale.
These chapters are based on one man's experience and his analysis of
thousands of specific cases. It takes up questions of method, of detail, and
of application, and should provide you with a workable basis for your actual
market operations. As time goes on, you will very likely adopt refinements
of your own or modify some of the suggested methods according to your
own experience. However, the authors feel the suggestions made here will
enable you to use technical analysis in an intelligent and orderly way that
should help to protect you from losses and increase your profits.
John Magee
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter eighteen
The tactical problem
(EN: In this chapter, Magee addresses the question of tactics for the
“speculator” who follows short and medium-term trends. The later sections
of the chapter address the question of strategy and tactics for the long-term
investor and provide a discussion of the term “speculator.”)
It is possible (as many traders have discovered) to lose money in a Bull
Market—and, likewise, to lose money trading short in a Bear Market. You
may be perfectly correct in judging the Major Trend; your long-term
strategy, let us say, may be 100% right. Except, without tactics, without the
ability to shape the details of the campaign on the field, it is not possible to
put your knowledge to work to your best advantage.
There are several reasons why traders, especially inexperienced traders, so
often do so poorly. At the time of buying a stock, if it should go up, they
have no objectives and no idea of what policy to use in deciding when to
sell and take a profit. If it should go down, they have no way of deciding
when to sell and take a loss. Result: they often lose their profits; and their
losses, instead of being nipped off quickly, run heavily against them. Also,
there is this psychological handicap: the moment a stock is bought (or sold
short), commissions and costs are charged against the transaction. The
trader knows the moment he closes the trade there will be another set of
charges. Also, since he is not likely to catch the extreme top of a rally or the
extreme bottom of a reaction, he is bound, in most cases, to see the stock
running perhaps several points against him after he has made his
commitment. Even on a perfectly sound, wise trade, he may see a 10% or
more paper loss before the expec


he
trader knows the moment he closes the trade there will be another set of
charges. Also, since he is not likely to catch the extreme top of a rally or the
extreme bottom of a reaction, he is bound, in most cases, to see the stock
running perhaps several points against him after he has made his
commitment. Even on a perfectly sound, wise trade, he may see a 10% or
more paper loss before the expected favorable move gets under way (see
Figure 18.1). Obviously, if he weakens and runs for cover without sufficient
reason before the stock has made the profitable move he looked for, he is
taking an unnecessary loss and forfeiting entirely his chance to register a
gain.
The long-term investor who buys in near the bottom and remains in the
market to a point near the top, to later liquidate and remain in cash or bonds
until (perhaps several years later) there is another opportunity to buy in at
the bottom, does not face the continual problem of when to buy and when to
sell. This assumes one can tell precisely when such a bottom has been
reached and when the trend has reached its ultimate top (and those are very
broad assumptions indeed). The long-term investment problem for large
gains over the Major Trends is by no means as simple as it sounds when
you say, “Buy them when they're low, and sell them near the top.” However,
such large gains have been made over the long pull, and they are very
impressive. (EN: Note the record of the Dow Theory in Chapters 4 and 5.)
This section of the book is concerned more particularly with the speculative
purchase and sale of securities.
There are some basic differences between the “investment” point of view
and the “speculative.” It is a good thing to know these differences and make
sure you know exactly where you stand (see Figure 18.2). Either viewpoint
is tenable and workable, but you can create serious problems for yourself,
and sustain heavy losses, if you confuse them.
One difference is a speculator deals with stocks as such. A stock, to be sure,
represents ownership in a company, but the stock is not the same thing as
the company. The securities
76
72
68
64
60 Sales 100's 125 100
75
50
25
CUX
CUDAHY PACKING
JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER
I 7 114 I 211 28> 4 i 111181 251 1 1 8 115122 ■ 29 I 6 113 120 127 1 3
110117 >241 1 * 8 11^ 22 • 29 •
Figure 18.1 It is possible to lose money owning stocks in a Bull Market.
Notice this Major Top Formation did not occur in 1929, but in the summer
of 1928. For more than a year after this, a majority of stocks and the
Averages continued the Bull Market Advance. But Cudahy declined
steadily, reaching a price below 50 well before the 1929 Panic, and
continued in its Bearish course for more than four years, ultimately selling
at 20. Except for the somewhat unusual volume on the head on August 21,
this is a typical Head-and-Shoulders Pattern with a perfect Pullback Rally in
mid-November. It underscores what we have mentioned before—a Head-
and-Shoulders Top in a stock, even when other stocks look strong, cannot
safely be disregarded.
The Head-and-Shoulders Pattern, either in its simple form or with multiple
heads or shoulders, is likely to occur at Major and Intermediate Tops, and in
reverse position at Major and Intermediate Bottoms. It has the same general
characteristics as volume, duration, and breakout as the Rectangles and the
Ascending and Descending Triangles. In conservative stocks, it tends to
resemble the Rounding Turns.
of a strong company are often weak, and sometimes the securities of a very
weak concern are exceedingly strong. It is important to realize the company
and the stock are not precisely identical. The technical method is concerned
only with the value of the stock as perceived by those who buy, sell, or own
it.
A second difference is in the matter of dividends. The “pure investor,” who,
by the way, is a very rare person, is supposed to consider only the “income”
or potential income from stocks—the return on his investment in cash
dividends. (EN: This rara avis is largely extinct now.) Nevertheless, there
are many cases of stocks that have maintained a steady dividend while
losing as much as 75% or more of their capital value. There are other cases
in which stocks have made huge capital gains while paying only nominal
dividends or none at all. If the dividend rate were as important as some
investors consider it, the only research tool one would need would be a
calculator to determine the percentage yields of the various issues; hence,
their “value,” which, on this basis, stocks paying no dividends would have
no value at all.
From the technical standpoint, “income,” as separate from capital gains and
losses, ceases to have any meaning. The amount realized in the sale of a
stock, less the price paid and plus total dividends received, is the total gain.
Whether the gain is made entirely in capital increase, entirely in dividends,
or in some combination of these, makes no difference. In the case of short
sales, the short seller must pay the dividends. Although, here again, this is
simply one factor to be lumped with the capital gain or loss in determining
the net result of the transaction.
Figure 18.2 What would you have done with Hudson Motors? The great
Panic Move of October-November 1929 carried the Dow-Jones Industrial
Average down from its September all-time high of 386.10 to a November
low of 198.69. A rally, bringing the Average back to 294.07 in April 1930,
recovered 95 points, or 51% of the ground lost, a perfectly normal
correction.
Suppose you had bought HT after the decline from its 1929 high of 93 1/2,
say at 56, in the belief that the 37-point drop had brought it into a “bargain”
range. On your daily chart, you would have seen the pattern shown above
(which you will now recognize as a Descending Triangle) taking shape in
the early months of 1930. Would you have had a protective stop at 51?
Would you have sold at the market the day after HT broke and closed below
54? Or would y


9 high of 93 1/2,
say at 56, in the belief that the 37-point drop had brought it into a “bargain”
range. On your daily chart, you would have seen the pattern shown above
(which you will now recognize as a Descending Triangle) taking shape in
the early months of 1930. Would you have had a protective stop at 51?
Would you have sold at the market the day after HT broke and closed below
54? Or would you have hoped for a rally, perhaps even bought more
“bargains” at 50, at 48, at 40? Would you still have been holding onto your
“good long-term investment” when HT reached 25 1/2 in June? Would you
still have been holding HT when it reached its ultimate 1932 bottom at less
than 3 (see Figure 8.22)? (EN: See Figure 18.4 for a recapitulation of the
lesson from the 2000s.)
There is a third source of confusion; very often, the “pure investor” will
insist he has no loss in the stock he paid $30.00 for, which is now selling at
$22.00, because he has not sold it. Usually he will tell you he has
confidence in the company and he will hold the stock until it recovers.
Sometimes he will state emphatically that he never takes losses.
How such an investor would justify his position if he had bought
Studebaker at more than $40.00 in 1953 and still held Studebaker Packard
at around $5.00 in 1956 (EN: Or Osborne at $25.00 and $0.00 in the 1980s
or Visacalc at similar prices in the same decade. EN9: Or Enron and
WorldCom in the 2000s. Or Bear Stearns, or Lehman, or ... ) is hard to say;
however, for him, the loss does not exist until it becomes a “realized” loss.
Actually, his faith the stock will eventually be worth what he paid for it may
be no more than a speculative hope—and a forlorn one at that.
Furthermore, one may question whether his reasoning is always consistent.
For example, suppose another stock this investor had bought at $30.00 was
now selling at $45.00. Would he tell you he did not consider a profit or loss
until the stock was sold? Or would he be tempted to speak of the “profit” he
had in this purchase?
It is all right to consider gains or losses either on the basis of “realized” or
completed transactions, or on the basis of the market values “accrued” at a
particular time? Yet, it is not being honest with yourself to use one method
to conceal your mistakes and the other method to accentuate your
successes. The confusion of these concepts is responsible for many
financial tragedies. (EN: One might almost say, in the modern context, such
confusion amounts to willful or neurotic behavior. Given the easy
availability of portfolio software that marks-to-market positions, avoidance
of this knowledge can only be regarded as self-defeating.)
As a trader using technical methods, you will probably find the most
realistic view is to consider your gains and losses “as accrued.” In other
words, your gain or loss at a given time will be measured with reference to
the closing pricing of the stock on that day.
Recapitulating, it is important (1) to avoid regarding a stock and the
company it represents as identical or equivalent; (2) to avoid the conscious
or unconscious attribution of “value” to a stock on the basis of dividend
yield, without regard to market prices; and (3) to avoid confusing “realized”
and “accrued” gains or losses.
The technical trader is not committed to a buy-and-hold policy. There are
times when it is clearly advantageous to retain a position for many months
or for years, but there are also times when it will pay to get out of a stock,
either with a profit or with a loss. The successful technician will never, for
emotional causes, remain in a situation that, on the evidence at hand, is no
longer tenable.
An experienced trader using technical methods can take advantage of the
shorter Intermediate Trends, and it can be shown that the possible net gains
are larger than the entire net gains on the Major Trend, even after allowing
for the greater costs in commissions and allowing for the greater income tax
liability on short-term operations.
It should be understood that any such additional profits are not easily won.
They can be obtained only by continual alertness and adherence to
systematic tactical methods. For the market, regarded as a gambling
machine, compares very poorly with stud poker or roulette, and it is not
possible to “beat the market” by the application of any simple mathematical
system. If you doubt this, it would be best to stop at this point and make a
careful study of any such “system” that may appeal to you, checking it
against a long record of actual market moves. Ask yourself whether you
have ever known anyone who followed such a system alone, as a guide to
market operations, and was successful. (EN: After Magee wrote this, many
successful traders, aided by computer technology and advances in finance
theory, have created algorithmic systems that have been successful in the
financial markets. However, the markets usually become aware of the
success of these systems and develop counterstrategies to defeat them. So
there is a tendency for the performance of mechanical systems to
degenerate or totally fail over time. It is the happy combination of the
system with markets hospitable to it that makes mechanical systems
successful over defined periods of time.)
The practice of technical analysis, on the other hand, is not a mathematical
process, although it does involve mathematics. It is intended to search out
the significance of market moves in the light of past experience in similar
cases, by means of charts, with a full recognition of the fact that the market
is a sensitive mechanism by which all of the opinions of all interested
persons are reduced by a competitive democratic auction to a single figure,
representing the price of the security at any particular moment. The various
formations and patterns we have studied are not meaningless or arbitrary.
They signify changes in real values, the expectations, hopes, fears,
developments in the industry, and all other factors th