20.3 SPY. For illustration, here is a chart of the AMEX Index Share, the SPY, or ETF based
on the S&P 500. After the crash of 1998 (the Asian Economic Flu crash), the fan lines tell a story, as
does the last phase of the chart where the market whips in what appears a Broadening Top. (EN9:
Note this Broadening Top was identified in 1999–2000 before the crash as documented in the http:/ /www.
edwards-magee.com archives. See Figure 20.4.)
$INX - Weekly US
A
B
C
D
1
2
3
1193.03
1077.90
938.57
1464 .00
1356.00
1255.00
1100 .001156.85
1076.00
996.00
922.00
854.00
790.00
1998
1999 2000 2001 2002 2003 2004 2005
Created with TradeStation
Figure 20.4 The S&P 500 in all its glory and tragedy. An especially good portrait by Holbein, the
younger. The Broadening Top pointed out in Figure 20.3 in 2000 foretold the decline of the S&P to
below 790—not quite 50% but close enough to catch the eye. Particularly fine lessons here, besides the
Broadening Top lesson. All of them screaming for action. The broken trendline at A, the broken trendline
at B, the broken “neckline” or horizontal line at C. Notice the close correspondence of the break at B and
C. The next lesson is not to buy downtrends until a clear bottom is made in a major bear market. Clearly
no bottom is made until the Kilroy Bottom at 1–2–3. Even then, the least risky trade for the long-term
investor is when the Kilroy Fenceline (Neckline) is broken at D. All of this was knowable at the time.
310 Technical Analysis of Stock Trends
how a stock will behave in the future as to the extent of its swing. (EN9: Or we might say,
short-term volatility and long-term range.)
Incidentally, for short-term trading (EN9: amusing in the modern context; by short-term
trading Magee means trading of trends of shorter length than Dow Waves) , we are thinking
about the habits of the stock that are only partly determined by the business it represents.
Purchase of stock in one company that has a somewhat uncertain or fluctuating profit
record may be more conservative than purchase of a highly leveraged stock of another
company whose basic business is steadier and more conservative. We will take up the
matter of determining these risk constants a little later.
One should also understand the short sale of a stock does not imply any feeling that the
country is going to the dogs or even that the concern represented is going to the dogs. Such
a sale merely indicates your belief the stock may be temporarily overpriced; that earnings
or dividends may have been abnormal in recent years and are likely to be reduced; or that
for one reason or another, the stock of the company may be worth a bit less than it has been
worth.
For technical trading, we want a fairly speculative stock, one that will make sizable
swings up in a Bullish Trend and down in a Bearish Trend. The very factors that tend to
make a stock safe and desirable to the investor may make it entirely unsuitable for trading.
Also, with certain reservations that will be taken up later on, the more speculative the stock
the better it is for our purposes.
(EN: Entering the third millennium (since we Anglo-Saxons started counting—the fourth
or fifth by other measures), the distinctions between “speculative” stocks and every other kind of
stock has grown increasingly blurry. Rather than apply a perhaps pejorative (in the minds of some
readers) term like “speculative” to otherwise-innocent stocks, we would do better to describe stocks
as wide ranging or narrow ranging, as volatile or nonvolatile. Stocks may then be evaluated one
against another by their betas and historical volatilities, statistical data easy to obtain. “Betas” and
“volatilities” are dealt with in Chapters 24 and 42.)
In line with this more current thinking, there is another question for readers of this book—the
choice of trading (or investment) instruments for the long-term investor.
The kind of stocks we want: the long-term investor’s viewpoint
Changing opinions about conservative investing
Virtually no one invests like the conservative investor described above in Chapter 20 —
except perhaps trust departments of antediluvian banks. There may be some investors
still out there who are so risk averse they still follow the method described. Bank trust
departments may be still doing it; they used to do it so the trust beneficiaries could not sue
them. This is the reason trust departments exist, to give legal cover (the so-called prudent
man rule) to trustees in case of suit by beneficiaries. Most enlightened trust departments
and trustees now probably follow indexing or other more productive strategies to cater to
new understandings of the prudent man rule.
“Indexing” refers to the practice of constructing a portfolio to replicate or closely
reproduce the behavior of a widely followed index such as the Standard & Poor’s (S&P)
500 or the Dow–Jones Industrials. These portfolios never track the Indexes exactly because
the advisors and funds who manage them take management fees and expenses. These
fees are generally less than fees and expenses on actively managed funds, but in fact are
not necessary for the private investor to pay because even the tyro investor can now use
“Index Shares” (e.g., DIAMONDS™ [DIA], S&P Depositary Receipts [SPDR; SPY, QQQ,] and
311Chapter twenty: The kind of sto cks we want: the speculator’s viewpoint
so on) or other proxy instruments to do what the funds and professionals do. Essentially
what indexing does is track the Averages, a strategy that was impossible or difficult
(expensive) when Magee examined it, as in Chapter 15. (EN9: In the opinion of this editor,
hiring a management company to run an indexing strategy is a waste of capital. Much better for the
investor to invest directly in ETFs and to exit the market when uptrends end and reverse. This is
a much better strategy than “passive indexing,” which cleverly manages to capture both losses and
profits in the Averages.)
The kin


examined it, as in Chapter 15. (EN9: In the opinion of this editor,
hiring a management company to run an indexing strategy is a waste of capital. Much better for the
investor to invest directly in ETFs and to exit the market when uptrends end and reverse. This is
a much better strategy than “passive indexing,” which cleverly manages to capture both losses and
profits in the Averages.)
The kinds of stocks long-term investors want:
the long-term investor’s viewpoint
Perhaps one of the most important actualizations of recent editions is to bring current this
book’s treatment of the Averages, noting that it is now possible to trade the Averages in
stock-like instruments. This fact deserves to be marked as a vitally important development
in modern markets. This chapter will confine itself to describing facilities for trading and
investing in the Averages and Indexes.
In 1993, the American Stock Exchange (AMEX) introduced trading in SPDRs™, an
Exchange-traded unit investment trust based on the S&P 500 Composite Stock Price Index.
The AMEX calls these securities Index Shares™, a name they also use for other similar
instruments. As noted above, large investors and funds have long traded “baskets” of
stocks representing the S&P 500, obviously an activity requiring large capital. In fact,
a certain class of investment managers and funds have practiced “passive investing”
meaning indexing, primarily for large clients. The purchase and liquidation of these and
other “baskets” is one form of “program trading.”
Recognizing the utility of this investment practice, the AMEX created the SPDR
as a proxy instrument to allow the smaller investor to practice the same strategy. The
effectiveness of this product introduction may be measured by public participation in the
trading of the SPDR (SPY). By 2000, almost $15 billion was invested in SPDRs with more
than 100,000,000 shares outstanding. These units allow the investor to buy or sell the entire
portfolio or basket of the S&P 500 stocks just as he would an individual stock, but the capital
required to do so is radically reduced.
In 1998, the AMEX introduced DIA, Index Shares on the Dow–Jones Industrial
Average™ (DJIA), which is analogous in every way to the SPDRs. Thus, an investor may
“buy the DJIA.” So in current financial markets, it is possible to “buy the market,” unlike
those conditions under which Edwards and Magee operated.
Construction of the Index Shares and similar instruments
The AMEX unit investment trusts are constructed to replicate the composition of their base
instrument. The SPDR, for example, is an instrument that represents one-tenth of the full
value of a basket of the S&P stocks and trades on the AMEX, just like a stock (SPY). Other
characteristics of stocks are also reproduced such as long life (the SPDR Trust lasts into
the twenty-second century) and quarterly dividends (cash paid on the SPDRs reproducing
dividends accumulated on the stocks of the S&P 500). Even dividend reinvestment is
possible, and the units may be traded on the AMEX during regular trading hours. Under
normal conditions, there should be little variance in the price of the SPY relative to the
S&P 500. (In 2008, the AMEX merged with the New York Stock Exchange. Trading and
instruments remain as described.)
312 Technical Analysis of Stock Trends
These elements, as discussed for SPDRs, are common to all the Index Shares—
DIAMONDS, World Equity Benchmarks (WEBs), and others. There are, of course, some
expenses and costs to using the Index Shares—a small price to pay for the use of the
instrument and generally less than the costs of a fund. Index Shares are also much more
flexible for the independent investor. Among other advantages, the private investor can
control the tax consequences of his investment, which is not possible in funds.
Other Exchanges have created similar security instruments or derivatives or futures to
replicate or track the well-known averages and indexes. Among these are tracking shares
or index shares or futures (let us call them “instruments”) on other indexes (Russell,
Nikkei, and so on) or options on the futures or indexes until there is a bewildering array
of instruments available for trading, investing, and hedging. Among the more important
exchanges and instruments traded are the Chicago Board of Trade (futures and options
on futures on the Dow); the Chicago Mercantile Exchange (futures on the S&P , Nikkei 225,
Mini S&P 500, S&P Midcap 400, Russell 2000, and NASDAQ 100); and the Chicago Board
Options Exchange (S&P 100 and 500 options). This, by no means, is an exhaustive list. All
the futures and options that matter will be found listed in the Wall Street Journal under
Futures Prices or Futures Options Prices.
This book does not deal in comprehensive detail with futures and options, but it is
worth mentioning these exchanges and their futures and options products because of
the facility they offer the investor and trader for hedging portfolios in Index Shares and
Average trading, not to mention opportunities for speculating.
Briefly, hedging is the practice of being neutral in the market. That is, one might be long
the DIAMONDS and buy a put option on the DJIA at the Chicago Board of Trade, meaning
that advances in the DJIA would result in profits in the DIAMONDS, and a loss of premium
in the put. Conversely, a decline in the Dow would result in profits in the put and losses in
the DIAMONDS. As this area is not the province of this book, this is a highly simplified
description of a hedge. Nevertheless, the reader should see and understand that hedging
can be an important strategy. Hedging can take the place of liquidation of a portfolio when
the analyst recognizes a change of trend or unstable conditions but does not wish to incur
taxes or wishes to defer them.
An outline of instruments available for trading and investing
It would be herculean to attempt to list the entire panoply of

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


theless, the reader should see and understand that hedging
can be an important strategy. Hedging can take the place of liquidation of a portfolio when
the analyst recognizes a change of trend or unstable conditions but does not wish to incur
taxes or wishes to defer them.
An outline of instruments available for trading and investing
It would be herculean to attempt to list the entire panoply of averages, indexes, futures,
and options available for trading—herculean due to the fact new trading instruments are
constantly in creation and due to the fact, now operating at internet speed, we may expect
the rate of change to accelerate. In addition to those listed above, there are WEBS (meaning
that exposure to world markets may be arranged).
In all, approximately 30 or more Index Share units or instruments were available
for trading on the AMEX at the turn of the century, in addition to DIAMONDS and
SPDRs. Similar instruments exist on the Philadelphia and in Chicago, and others are
being created daily. To reduce the confusion, the general investor will probably find the
major indices of the most importance. The more instruments one deals with the more
complicated the strategy and tactics become. Therefore, the Dow, the S&P 500, and the
NASDAQ composite (DIA, SPY, QQQ) are probably sufficient for the purposes of the
gentleman (or lady) investor. The Mid-Caps, the Nikkei, and others begin to come into
play when the trader begins to try to catch sector rotation, fads, short-term cycles, and
so on.
313Chapter twenty: The kind of stoc ks we want: the speculator’s viewpoint
The importance of these instruments: diversification,
dampened risks, tax, and technical regularity
It would be difficult to underestimate the importance of these new trading instruments.
First of all, they afford the private investor what was previously reserved for the large
capital trader—the ultimate in market diversification. The S&P 500 represents stocks
comprising 69% of the value of stocks on the New York Stock Exchange. Buying it is buying
the American economy. The 30 Dow Industrial stocks represent the most important symbol
in the American economy—and perhaps in the world. Investors are well advised to pay
attention to both Averages if they would fare well in the markets (Note the plural: markets).
These two Averages now have the influence or clout that once the Dow alone had to express
the state of the markets and stocks in general.
Buying the SPY or DIA then represents the immediate acquisition of a diversified
portfolio. And buying the NASDAQ or QQQ gives one immediate exposure to the more
speculative and volatile sector of the American economy. Given the long-term bullish bias
of the averages and the American economy, it is difficult to argue with this as both strategy
and tactics for the long-term investor. This does not mean positions should be taken blindly
without thought or not monitored. On the contrary, recall if you will the record of the Dow
Theory; even for the long-term investor, bear markets should not be allowed to destroy
liquidity and equity value. These questions are discussed at greater length in Chapter 18.
Although we believe these instruments are good vehicles, it is wise to remember
Magee’s frequent admonition (less important now than when spoken) that it is a market
of stocks, not a stock market. Meaning when the tide is flowing down with the Dow and
S&P , prudence and care must be used in taking long positions in stocks that are in doubt as
to direction. Additionally, it is worth noting investments in these instruments will be less
profitable than an astutely chosen individual stock. For example, Qualcomm appreciated
approximately 240% (temporarily) in 1999–2000 compared with about 24% in the S&P over
the same period. Those who bought Qualcomm at its top and sold it at the bottom of its
reaction lost about 75% or about $148 a share. Traders in Qualcomm tended to obsess and
pay hyper attention to the stock, whereas investors in the SPY reviewed it once a week or
less or told their computers or their brokers to give them a call if it broke the trendline or
entered stops. Then they slept at night and had eupeptic digestion.
Other advantages accrue to the trading of the SPDRs. Ownership of a fund can result in
tax liabilities as managers adjust portfolios to reflect changing membership in the fund or
withdrawals in capital by irate stockholders. Since Index Shares last into the twenty-second
century, the long-term investor has no need to realize gains and pay taxes. Bear markets
may be dealt with by hedging with other instruments—futures, options, or proxy baskets
of stock, or individual stocks, and accepting the tax consequences of these trades.
John Magee aptly observed before the direct trading of the Averages was possible that
the Dow–Jones Industrials were very regular and dependable from the technical point of
view. This observation is annotated at some length in comments on Dow Theory in Chapter
36. Therefore, the investor in the Index Shares may have a smoother time technically than
a trader of an individual stock.
Summary
The long-term investor and mid-term speculator attempt to capture long secular (as
well as cyclical) trends in the markets. They shun frequent trading and capital-eroding
314 Technical Analysis of Stock Trends
transactions. They recognize that risk fluctuates with time and trend, and they know that
frequent turnover benefits mainly the broker.
The strategy of the long-term investor may be to match the market by using funds or
SPDRs or baskets, but he does not like to participate in Bear trends. He hedges or liquidates
his positions on major trend shifts. In fact, he may even short the indexes if his analysis
indicates major bear markets.
If he desires to outperform the market (which will happen automatically if he follows
the methods of this work), he finds some individual speculative stocks to trade in addition


or
SPDRs or baskets, but he does not like to participate in Bear trends. He hedges or liquidates
his positions on major trend shifts. In fact, he may even short the indexes if his analysis
indicates major bear markets.
If he desires to outperform the market (which will happen automatically if he follows
the methods of this work), he finds some individual speculative stocks to trade in addition
to his foundation portfolio. Depending on his risk tolerance, he may always be somewhat
hedged. When long the indexes, he finds some stocks in downtrends to short. When he
is short the indexes, he finds some strong stocks to hold long. There is no excuse for a
moderately skilled and reasonably capitalized investor to lose money over the long term
in the market.
As a reminder, Chapters 5 and 28 describe powerful methods for the long-term investor
using Magee’s Basing Points Procedure.
315
chapter twenty-one
Selection of stocks to chart
The trader who operates on the “fundamental” basis, making his commitments on his
analysis of earnings, dividends, corporate management, prospects for the industry, and so
on, will usually (of necessity) confine himself to a few stocks or a single group of stocks in
the same field.
To the contrary, the technical trader, using daily charts, should have a large portfolio
of issues. Since he is primarily interested in the technical chart patterns, he will not try to
make an exhaustive study of the background of each company. In fact, the characteristics of
the stocks themselves, as they act in the market, are more important to him than what these
companies make or what they are earning. This is because, although the stocks represent
ownership in the company, the capital structure, “leverage,” and floating supply of the
stock may (and very often does) mean fluctuations in the stock price that are not directly
in proportion to changes in the affairs of the business.
You will also find many cases in which the stock of a well-regarded, well-managed,
long-established concern, whose latest earnings report shows increased profits, and with
a long record of dividends paid, would not be a good buy at the market price. It may be
overpriced and due for a serious depreciation. You will find other cases in which a stock,
which apparently represents no great promise of either earnings or dividends, suddenly
starts a series of spectacular moves upward, and is indicated clearly as a buy. Of course,
the answer, in each case, is the records available apply to the past, not the future; and very
often, chart action will indicate the inside knowledge of those who are in possession of facts
the public has not yet received.
To change our example to something more easily visualized, let’s assume there are
two houses for sale. One is a fine, well-built, modern home in an attractive part of town at,
say, $200,000—and the other property, a somewhat shabby six-family tenement in a less
attractive section, at the same price of $200,000. There is no question which is the “better”
house, but in a case like this, the market for well-built single homes at this price may be
poor, whereas the demand for apartments may be good. The six-family house may be the
better investment.
Then again, we have the question of what is conservative and what is highly speculative.
It is not always enough to judge from the type of business of the company itself. You may
have a highly conservative concern, carrying on a stable volume of business, with a long
record of successful operation. Yet, if there are bonds, debentures, preferred stocks, and
other senior obligations, the common stock may be subject to wide fluctuations. Also, if the
issue is small, or if a large part of it is closely held, you will have a “leverage” effect that
results in wide swings in the stock.
Therefore, in choosing your stock to chart, you will want to consider the kind of
stock and its character and habits in the market, rather than the business of the concern it
represents. We will come back to this point and show you how you can shape up a list that
will give you the kind of stocks you want for trading.
Meanwhile, the question “How many charts?” has been left hanging. One answer to
this is that the more stocks you chart, the more good opportunities you will have. Many
316 Technical Analysis of Stock Trends
stocks, even of active issues, will go through long periods when, indeed, there is nothing
much to tell. In a period of stability, the chart simply indicates it is a period of stability, and
the only possible trading activity would be purchases and sales at the Bottoms and Tops
of its undulations. The charts are more informative when a change in the situation occurs;
they will signal a change of trend as soon as (and usually before) the news of the changed
conditions has come out. If you have enough charts, you will always have some stocks
making decisive and clear-cut moves either up or down, at any time.
You should, therefore, keep as many charts as you can. Do not bite off more than you
can chew, however. A man with only 15 minutes to half an hour a day for this work might
have to confine himself to 20 or 30 charts. It would be much better if he could have 100. If he
is in a position to give a major part of his time to the work, he could very well run as many
as 300 charts. A most important word of caution is indicated here: Do not start anything
you cannot finish. It is better to have too few at the beginning than too many. Then, if you
find you can add others, you will be in a better position, from your experience, to pick out
the ones you want to include. However, if you start with too many charts or begin to run
behind with your analyses, you will not be getting the best use from your portfolio and it
would be better to cut down at once. (EN: Magee’s admonitions are still in effect for the manual
chartist. The modern computer-equipped investor has a different problem. He can


tion, from your experience, to pick out
the ones you want to include. However, if you start with too many charts or begin to run
behind with your analyses, you will not be getting the best use from your portfolio and it
would be better to cut down at once. (EN: Magee’s admonitions are still in effect for the manual
chartist. The modern computer-equipped investor has a different problem. He can chart every issue
in the market every day. The question becomes how many can he effectively study and analyze? There
is even a computer answer to this question. Namely, the cyber trader can program the computer to
report stocks on an exception basis. For example, “Computer, show me all the stocks which are above
their 50-day moving average and which have unusual volume.”)
From what we have already been over, you know it is possible to chart anything
that is sold in identical units in a free competitive market. This includes all kinds of
commodities, bonds, debentures, when-issued contracts, and so on, as well as stocks. You
may have some special interest that will call for charting something outside the field of
stocks—well and good.
In general, however, you will want to chart active, listed stocks of well-established
corporations. There is no reason an unlisted stock cannot be charted, but ordinarily, the
only figures you can obtain on it are the bid and offer prices. On these stocks, you do not
have a published statement of the volume of sales each day or any record of prices at which
sales actually took place, and those are essential to the charting of daily technical action.
Therefore, you will usually be charting stocks listed on some exchange. This is also an
advantage because concerns listed on the larger exchanges are required to meet certain
conditions, publish certain information, and comply with definite rules and practices.
In this book, most of the examples have been taken from stocks listed on the New
York Stock Exchange (NYSE). There are thousands of issues traded on the NYSE, and these
stocks represent every type of security, from the most conservative to the most speculative,
from the cheapest to the most expensive, and they include every principal type of industry
and business. There is no reason, however, that stocks should not be chosen from the
American Stock Exchange, the NASDAQ, or from any other exchange in this country, or
for that matter, in some other country. (EN: So far as the chart action is concerned, the patterns
and their meanings will be the same).
(EN9: In general the stocks to watch, or chart, will tend to leap out of the haystack of stocks. For
stock pickers Investor’s Business Daily is in the constant process of sifting the markets for nuggets
with its CANSLIM system. (Not a recommendation to use that system, only a recommendation
to examine every tool that might be of use.) Stocks that appear suddenly on the most active lists of
http://www.stockcharts.com might bear examination by the chart analyst. These include optionable
stocks that suddenly show a radical change in implied volatility,; stocks that pop up with suspicious
317Chapter twenty-one: Selection of s tocks to chart
volume spikes compared with average volume, and those with internet and software packages one
might construct a filter to be informed by the computer of stocks breaking their 14-, 44-, 150-, and
200-day moving averages: 14 because some professionals think the public thinks in this time frame;
44 because some think funds think in 44-day time frames. The others because everyone thinks they
are important.
In reality, if the investor aim is to beat the market, he may choose just to confine his activities
to the ETFs that represent the indices—DIAMONDS™ (DIA), Standard & Poor’s Depository
Receipts (SPY), and QQQ. ETFs are inherently less risky than any individual stock.)

319
chapter twenty-two
Selection of stocks to chart: continued
In choosing your stocks, you will probably look for the greatest diversity in the kind of
industry. As you are not specializing in the detailed study of a single group, you will
try to get stocks from as many different groups as possible. You will want to include
mines and oils, rails and chemicals, liquors and amusements, airlines, utilities, techs,
internets, biotechs, ad infinitum. The reason for this is simply that, very often, many
stocks in a particular industrial group will show the same or similar patterns, as the
entire industry is affected by certain Major conditions. You will often find, for instance,
when Allis-Chalmers (EN: or Dell) makes a Triangle or other Area Pattern, followed by
a sharp upward move, Deere (EN: or Compaq), Minneapolis-Moline, Harvester, and Case
will make similar Triangles, or possibly Rectangles or some other Consolidation Pattern,
followed by a similar upward move. When Schenley is moving in a long downtrend,
you will very likely find that Distillers—Seagram’s, National Distillers, Publicker, and
American Distilling—are also moving in a long downtrend. (EN: Metaphorical names, like
the names of Greek gods or Ulysses and Leopold Bloom. The present-day reader may read Intel,
Fairchild, and National Semiconductor or 3COM. The idea is the same.) (For an illustration in
this chapter, see Figure 22.1 .)
Therefore, unless you plan to keep enough charts to include several stocks of each
important group, it is best to pick your stocks to make up as widely diversified a list as
possible. In this way, during times when certain groups are moving indecisively, or are
inactive, you will have some representation in other groups that may be active. (Do not
infer from this that all stocks of a group move together at all times. Individual concerns
will frequently move according to special influences that bear on a single company. Where
the Major influence is some industry-wide condition, the group will move more or less as
a unit.)
We, therefore, choose stocks representing a wide variety


e representation in other groups that may be active. (Do not
infer from this that all stocks of a group move together at all times. Individual concerns
will frequently move according to special influences that bear on a single company. Where
the Major influence is some industry-wide condition, the group will move more or less as
a unit.)
We, therefore, choose stocks representing a wide variety of groups or basic industries.
Nevertheless, suppose we are limited as to the number of charts and we must choose one
stock from a group; which stock to choose? For instance, we must choose one stock from the
transportation group (EN: or Biotech, or internets.) As a matter of fact, you would probably
want more than one because this particular group is so important and so large, but for the
moment, let us choose just one. (EN9: Or, even better, why not one of the indexes—for example,
an ETF—for the desired group. An example of betting on all the horses rather than trying to pick the
winner, and there is no conflict between making both bets.)
Should it be a high-priced stock or a low-priced stock? Let us examine that point first.
If you examine the past records of stocks, you will generally find the lower priced
issues make much larger percentage moves than the higher priced stocks. It is not unusual
for a stock selling around 5 to make a rise of 100%, moving up to 10 sometimes within a
few weeks. On the other hand, you do not find 100% moves in days or weeks among the
stocks selling at 100 or 200. The same industry-wide move that carries your $5.00 stock
from 5 to 10 might carry your $100 stock from 100 to 140. Obviously, if you had put $1,000
into outright purchase of the stock at 5, the move would have increased the value of your
stock 100% or $1,000. In the other case, if you had put the same amount into a stock at 100,
320 Technical Analysis of Stock Trends
the move to 140 (although many more points) would have increased your capital to only
$1,400. The gain in the lower priced stock would be about two and one-half times as great.
The authors have worked out and tabulated the percentage moves of large groups of
stocks over long periods of time (see Appendix A, ninth edition) and have set up a table that
shows the relative average sensitivity of stocks at different price levels. This table pertains
only to the price level of stocks; thus, the same stock that today sells at 5 and makes wide
BALTIMORE & OHIO BO
1945
UNION PACIFICU P
1945
JANF EB MARA PR JUNEMAY JANF EB MARA PR JUNEMAY
34
32
30
28
26
24
22
20
19
18
17
16
15
14
13
12
136
128
120
112
104
96
88
80
Figure 22.1 Low-priced stocks move faster than high-priced stocks. Here are weekly charts of two
rail stocks, charted on ratio scale over the same six-month period. Baltimore and Ohio during this
time advanced from 12 3/8 to 28 7 /8, a gain of 16 1/2 points, while Union Pacific moved up from 109
to 137 , a gain of 28 points. The advance in “UP ,” however, compared with its price, is much less than
the advance in “BO.” A thousand dollars used for outright purchase of “UP” would show you a
capital increase of 25%. On the other hand, if you had put a thousand dollars into outright purchase
of “BO,” your increase would have been 133%, or more than five times as much.
 Bear in mind low-priced stocks not only go up much faster, but also come down much
faster than high-priced stocks. When you own a low-priced stock, you cannot safely “put it
away in the box and forget it.” For security and stability, you would do better to buy a few
shares of a high-priced, gilt-edge security. For trading purposes, you will want to strike a
compromise between the rather sluggish “blue chips” and the extremely erratic “cats and
dogs” in the lowest price bracket.
321Chapter twenty-two: Selection of s tocks to chart: continued
percentage swings will not swing so widely when it has moved up to a price level of 20–30.
(EN10: These concepts replaced by beta and volatility.)
Several questions may come to your mind at this point. Do not the costs of trading low-
priced stocks relative to high-priced issues have to be taken into account? (EN: Yes, they do.
Given the extreme changeability in these costs in the internet economy, calculation of those costs
here would be tantamount to wasting trees. This cost question may be researched quickly and easily
given the availability of search engines such as Google and access to the internet.)
In selecting the price level of the stocks you prefer to trade in, you cannot set too
arbitrary a limit because there are other factors to consider and you may have to make
some compromises on one score to get what you want in some other direction. Stocks from
20 to 30 are in a good trading price range. Very often, you will find stocks in the 10–20
range that are so interesting you will want to chart and trade in them. You will find good
situations in stocks selling at 30–40. Furthermore, you will understand, of course, the
stocks that are now selling at 10 may be selling next year at 40, or vice versa. Considering
you cannot be changing your portfolio of charts all the time, you must not be too “choosy”
in picking the price range of your stocks. You would not ordinarily pick out a stock that
was selling far above the price range of most stocks of its group, say at 150, when several
others in the same industry were selling at 15, 28, or 37 . For the high-priced stock, as we
have said, is likely to be sluggish as a trading medium. On the other hand, you would not
take the very lowest priced issues of the group, selling at, say, 4 or 2 when others were in
the 10–30 bracket. You would not only be faced with erratic and tricky chart action, and
much higher percentage costs for commissions, but also you might not be able to operate
on margin at all. There are, from time to time, limitations on the amount of margin on
stocks at all levels. In the lower priced issues, these limits are often more st


group, selling at, say, 4 or 2 when others were in
the 10–30 bracket. You would not only be faced with erratic and tricky chart action, and
much higher percentage costs for commissions, but also you might not be able to operate
on margin at all. There are, from time to time, limitations on the amount of margin on
stocks at all levels. In the lower priced issues, these limits are often more stringent. Plus,
in the lowest priced stocks, you are sometimes not permitted to trade on margin. (EN:
As these requirements are subject to the vagaries of the Federal Reserve Board, the investor must
inform himself at his personal broker or ECN. For quite some years, the general margin requirement
has been 50%. The Fed came in for some sharp criticism for not dampening speculation in the fin
de siècle bubble by raising margin rates to 100%, and its lack of action exacerbated the blow off
of 2000. A change in margin rates should get the immediate attention of the technical analyst.
Something will be up.)
Ordinarily, you will get the greatest effective leverage at some point in the 20s,
considering all these factors, and your trading can run down through the teens and up
through the 40s. Above 40 and below 10, you will have to have strong reasons for trading,
which might be, of course, ample capital. It would therefore be best for the moderately
financed investor to choose a majority of his stocks from the middle price range (10–40),
plus only those special situations you are particularly interested in watching among the
very low and very high brackets.
If, however, you will go back to the long-time past record of any group of stocks, you will
find that even among stocks moving at nearly the same price levels today, there are widely
different behavior patterns. You will find some stocks respond to a severe market setback
by reacting, let us say, 20%—that is, if they were selling at 30, they would move down to
around 24. Others will respond to the same setback in the general market by a reaction
of 50%—that is, if they were selling at 30, they would end up at around 15. Additionally,
if you examine the records, the same stocks that make these relatively different reactions
in one setback will make about the same moves, relative to each other, in other setbacks.
Furthermore, the same ones that make only moderate corrections on declines will make
only moderate advances on rises. The ones that go down sharply on setbacks will also
skyrocket in a Bullish Market. This has nothing to do with the phenomenon we discussed
322 Technical Analysis of Stock Trends
earlier, by which we saw that cheap stocks move faster than expensive stocks. This is due
to the habits of particular stocks, and these habits seem to be quite stable over periods of
many years.
We will find, for instance, volatile and speculative issues that make larger percentage
swings than most other stocks at their price level. On the other hand, we will find a stock,
selling for much less, that has smaller percentage swings than most stocks at its price level.
This fact may be obscured, as the comparatively low-priced stock may actually make larger
swings than the higher priced. It is only when we have taken the price level into account
that we can see the individual habit of the stock. Knowing this, we can project that habit
to other price levels.
We are not too interested, as we have said before, in stocks that do not ordinarily make
substantial moves. We are very much interested in those that make the wider moves. We
can compute the basic swing power of a stock, which we call the Sensitivity Index, and will
outline the method for doing this in Appendix A, ninth edition. (EN: The procedure Magee
speaks of here, of computing a “Sensitivity Index,” may be regarded as the historical predecessor
of what are now called “betas.” The beta of a stock compares its relative volatility with that of the
market as a whole, so if the beta of the market is 1.00 and the beta of the stock in question is 1.50, a
move of 1.00 in the market will probably be matched by a move of 1.50 in the higher beta stock. The
formula for beta will be found in Appendix B, Resources, and calculated betas at finance.yahoo.com.)
Therefore, you will have eliminated from your list stocks at the wrong price level and
stocks without enough swing power (for you want to chart only those stocks in which you
can trade profitably). Of the ones left, you will eliminate others and find that some stocks,
which make wide price moves and apparently offer large opportunities for profit, may be
very “thin.” The charts will be spotty, filled with gaps, days of “no sale,” and moves of
several points on only a few hundred shares of business. These stocks are thin because of
a small issue, because of ownership of a large block of shares by some corporation or by
insiders, or for other reasons. They are difficult to trade in because they are hard to buy
and hard to sell; you stand to lose heavily on the “spread” between bid and offer. It might
be hard to liquidate even 500 shares without driving the price down badly, to your loss,
and sometimes you will see changes of 1 or 2 full points between sales of single hundreds.
These you will want to eliminate, and if you do not know the habits before you choose
your portfolio, you will probably find it worthwhile to drop any stocks that prove too thin,
substituting new and more dependable choices.
After you have culled the list from all these angles you will find you have left a choice
of a number of stocks, all of them selling in a price range that is attractive, all of them
sufficiently active and responsive to market trends, and all of them available in sufficient
supply to provide a good trading medium. The final choice of any one (or several) of these
stocks is then a matter of personal preference.
After you pick out your stocks from one group, study the other groups—the motors
group, the amusemen


f them selling in a price range that is attractive, all of them
sufficiently active and responsive to market trends, and all of them available in sufficient
supply to provide a good trading medium. The final choice of any one (or several) of these
stocks is then a matter of personal preference.
After you pick out your stocks from one group, study the other groups—the motors
group, the amusements, the computers (EN: the internets) and so forth, until you have
finally made up your selection of stocks to follow. Try to get as complete and balanced a
representation of groups as the number of your charts will allow. (EN: In this context, the
process described here is made infinitely simpler by available software and by the proliferation of
group indexes, ETFs, and indicators. In fact, if the investor desires, rather than trading an individual
stock in an industry group, he may often choose to trade the average or index itself and cushion his
risks. This will almost never be as profitable as a well-chosen individual issue but will always be
better than a badly chosen individual issue. And ETFs never go broke (so far).)
In this connection, if you are not planning to represent all groups, there are some
groups more likely to provide good trading stocks than others. Foods and tobaccos, for
323Chapter twenty-two: Selection of st ocks to chart: continued
example, are generally less responsive to market swings than the rails, liquors, and airlines,
which are very responsive. Do not worry too much, however, about exactly which stocks
to choose for even if you took the first 50 or 100 stocks in the listed issues, you would have
among them at least 25 good trading stocks. You can start with almost any list, and, as time
goes on, you will drop some and add others, improving your portfolio and tailoring it to
your own needs.
(EN: As additional commentary here it is worth noting that “techs,” “biotechs” (or whatever
the mania of the moment is—probably space hotels and intergalactic travel in this millennium) will
present areas of risk and reward sufficient to excite the seventeenth-century tulip trader. The centered
investor and trader will consider vogues and manias as he chooses his active portfolio and choose
to participate (or not) depending on his appetite for risk and excitement. Or, as the popular maxim
has it, one man’s champagne is another man’s poison. This question is pursued in greater detail in
Chapter 23.)
By way of further simplification, the investor may choose to follow only one or two issues—
Standard & Poor’s Depositary Receipts (SPY) or DIAMONDS™ (DIA). If it were not only bought,
but also sold or hedged, the market would be outperformed. This would be a simple investor’s life
indeed.

325
chapter twenty-three
Choosing and managing high-risk
stocks: tulip stocks, Internet sector, and
speculative frenzies
Nothing could more vividly illustrate the timeless nature of chart patterns and situations
than the internet stocks that bloomed at the turn of the century. These stocks repeated that
eternal pattern—the Tulipomania, the Gold Rush, the can’t-fail-opportunity-to-get-rich-
quick. (For illustrations in this chapter, see Figures 23.1 through 23.17.)
It is almost impossible to resist comparing the speculative frenzy that took place in
the internet and technology issues to the famous seventeenth-century mania that Holland
experienced in the famous Tulipomania. In MacKay’s undying classic account (Extraordinary
Popular Delusions and the Madness of Crowds ), the trading of tulip bulbs replaced sober
commerce and business as the occupation of the country, and enormous fortunes were
made trading the tubers. Blocks of real estate, breweries, assets of real and large value
were traded for one tulip bulb. MacKay produced my favorite paragraph in the literature of
finance: “ A golden bait hung temptingly out before the people, and one after the other, they
rushed to tulip-marts, like flies around a honey pot. Every one imagined that the passion
for tulips would last forever, and that the wealthy from every part of the world would send
to Holland, and pay whatever prices were asked for them.”
That mania ended in ruin. A better long-term prospect may be in store for the internet,
as there is a basis of technology and economic substance to the sector. You could not, after
all, use your tulip to check the market for prices. In fact, there were those, admittedly a
small number, who struck it rich in the California Gold Rush of 1849. It is an ill wind, etc.
As an exercise in rueful perspective, the seventh edition of this book remarked, in the
words of Richard McDermott,
Companies like Lotus or Microsoft went public and grew into business
giants in a short period of time… A significant theme stock for the 1990s
has been Internet stocks. Names like America Online, CompuServe,
and Netscape have provided important products and services that
allow individuals to “surf the net” for information around the world.
Young students of the market will search in vain for Lotus, CompuServe, and Netscape
in the lists of stock symbols. The giant Lotus was swallowed by IBM, in part because
Microsoft, a ruthless competitor, disemboweled it. CompuServe and Netscape disappeared
into the belly of a larger fish, AOL, with some of the same factors involved. Later Microsoft
got its comeuppance—halving in value as the U.S. Justice Department brought successful
antitrust action against it.
There are those who fault the great Wall Street investment banks for having brought
half-baked potatoes (or unblooming tulips) to market. The Street firms, cashing in on the
mania, were willing to sell the public every immature profitless idea and company named
326 Technical Analysis of Stock Trends
“dot.com Inc.” that venture capitalists floated on a sea of seed money. Mining engineers will
recognize the phenomenon of “salting the mine.” It was the finest moment for the great old
firms o


tatoes (or unblooming tulips) to market. The Street firms, cashing in on the
mania, were willing to sell the public every immature profitless idea and company named
326 Technical Analysis of Stock Trends
“dot.com Inc.” that venture capitalists floated on a sea of seed money. Mining engineers will
recognize the phenomenon of “salting the mine.” It was the finest moment for the great old
firms of the Street since the investment trusts of the 1920s. The reader is most recommended
to look into The Great Crash, 1929 by John Kenneth Galbraith to compare the Street firms’
behavior from one mania to the next. It will be found most edifying. At the pinnacle of
great manias, no one can be trusted.
Managing tulipomanias and Internet frenzies and…Bitcoin
In a time of excess, the centered investor maintains his composure and focus. Probably
easier said than done. Nonetheless, many investors and traders profited from the internet
boom or were not severely damaged. Many managers and traders watched with envy from
the sidelines, and with schadenfreude when the bubble burst.
For technical analysts speculating and trading according to the principles of this
book, important opportunities arise in speculative frenzies and buying panics—namely,
important profits may be made by remaining calm and methodical while the uninformed
and naïve cause speculative blow-offs, which have some things in common with the ends
of great bull trends in substantive issues.
The question becomes that of realizing some of the profits to be made in these exciting
times. Of course, the first thing to do is not get excited. These manias come and go—
sometimes they are called biotechs, sometimes computers, sometimes internets, and
probably, at some point, human genome miracle drugs or Martian real estate. It should
be emphasized these profits are made on both sides, long and short. The crowd will only
MSFT(D) - Daily NASDAQ L = 27.56 +0.35 +1 .29% B = 27.55 A = 27.56 O = 27.67 Hi = 27.73 Lo = 27.44 C = 27.56 V = 57145012
Bull Trap
Runaway Days
Runaway Gap
Exhaustion Gap
Department of Justice Gap
48.00
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S O N D 00 F M A M J J A S O N
Created with TradeStation
Figure 23.1 Multitudinous lessons in Microsoft. However, short-lived joy. The top rounds over, price
makes another attempt, and then the momentum is clearly, if puzzlingly, down. The cancellation of
the runaway day in January definitely marked this move as a bull trap, and the short-term trendline
from October would also have taken the trader out of the trap. Use of the Basing Points technique
(see Chapter 28) would also have allowed escape from the trap. Failed signals, as this one, often are
excellent signals for a trade in the other direction.
327Chapter twenty-three: Choosin g and managing high-risk stocks
think of the riches to be made long. Professionals and skilled technicians, professional or
not, will take the profits on the short side.
Here is the most important concept in trading these runaway issues: all of the techniques
and methods described in this book remain valid for dealing with these kinds of stocks. In addition,
here are some other points that should be taken into consideration. The best way to control
risk in the Bitcoin market is by trading a position so small (like a roulette bet) that a 100% loss will
cause no distress or discomfort. The sector in question, tech-tech, web-tech, biotech, internet,
space travel, whatever, will be a market unto itself, and special technical factors will apply
to it. The phases of market lives, accumulation, attraction, markup, mania, and blow-off
will occur in compressed time spans—much shorter than the cyclical life of an issue with
fundamental data to attach it to reality (see Figure 23.4 of Palm Computing).
By the time the IPO occurs, the insiders are already prepared to begin the distribution
phase. For example, when Palm Computing was spun off from 3Com in 2000, only 3% of the
shares were sold—creating an artificial scarcity and propelling it to absurd heights—Palm
attained an instant market value greater than that of 3Com, which owned most of its stock.
(EN9: We have, since The Fall, learned of “laddering.” To let their inside clients in on the IPO, some of the
underwriters required the clients to buy more of the stock in the open market after the IPO at higher prices.
A clever way to throw gasoline on a raging bonfire. Whether Palm was laddered or not is not known.)
Microsoft Corporation-(Nasdaq NM) 26.86 0.03 0.11%
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1998-2004 Prophet Financial System, Inc. Term of use apply.
Figure 23.2 MSFT monthly. It is easy to lose perspective when looking at a daily chart of a bull trap
in which one has lost a leg. A monthly long-term look at Microsoft can help restore perspective.
Unfortunately, the Dow–Jones Company was looking at this chart, not the nearby, when they added
Microsoft to the Dow 30 in 2000. Expert timing? At the time, the John Magee Newsletter observed it
was a negative indicator of a major top in the Industrials.
328 Technical Analysis of Stock Trends
These issues must be traded with the utmost care and attention. For example, it is
the height of foolishness to enter a market order to buy on the issue of the IPO. An issue
going public at 12 might trade on the opening at 50 in these frenzies—a sign to the savvy
technician the sheep are headed for the shearing shed.
Certain factors must be kept in mind. Some IPOs collapse shortly after going public.
Others rocket off before distribution is complete. So stops must be carefully computed.
Once it is clear the rocket is taking off, as indicated by price and volume, some discreet
pyramiding might be possible for the experienced and skilled speculator.
Detailed techniques for management of the runaway issues
The technique described in Chapter 28 for tight progressive


shortly after going public.
Others rocket off before distribution is complete. So stops must be carefully computed.
Once it is clear the rocket is taking off, as indicated by price and volume, some discreet
pyramiding might be possible for the experienced and skilled speculator.
Detailed techniques for management of the runaway issues
The technique described in Chapter 28 for tight progressive stops is certainly one way
of dealing with these stocks. There, the method for finding Basing Points and raising
stops based on the three-days-away rule is detailed. Also, especially in the case of these
rocket stocks, the practice of raising stops based on new percentage highs should be
MSFT(D) - Weekly NASDAQ L = 25.27 +0.82 +3.35% B = 24.27 A = 26.28 O = 24.88 Hi = 25.30 Lo = 24.79 C = 25.30 V = 98849923
48.00
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B A
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Created with TradeStation
Figure 23.3 The editor learns a lesson. Never leave a chart unanalyzed, even if the implications are
obvious. Also, never be afraid to belabor the obvious. Obviously, this figure should have had a long-
term trendline drawn on it. No monumental bull market should be ignored. Why give the market its
money back? It should have been obvious from this figure that the Microsoft party was over and not
just the fat lady but the entire chorus was beating on anvils. Plus, the protective line must be drawn.
Here the broken line at A is the most important and saves a bit of capital rather than waiting for the
plaintive signal at C. Given the robust Bull Market in Microsoft, the long-term investor might have been
justified in waiting until the C trendline was broken. A matter of investing style and philosophy. There
appears to be some long-term support at 18. The five-year sideways market appears to be resolving
itself into a macro triangle that might break out one way or the other in 2005. This is a case in which an
investor might make a fundamental analysis to guide his position (always confirming with the chart
analysis). Microsoft is beset with howling wolves on all sides. Linux, Unix, sales of only one copy of
Windows in China, hackers playing hob with security holes in its software. Can it rise again? Only
the chart knows for sure, and it is silent at this recording. In 2011, MSFT was in an 11-year sidewave.
329Chapter twenty-three: Choosin g and managing high-risk stocks
PLMO(D) - Weekly NASDAQ L = 21.40 –0.40 –1.03 %O = 21.36C = 21.43
2001 2002 2003 2004 2005
18.23
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1010.00
633.00
397.00
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Created with TradeStation
Figure 23.5 Dealers palmed all the missing capital in PALM? Somebody made the money disappear
up a shirtsleeve. What makes you think the deck was stacked? Or that the initial public offering (IPO)
was laddered? Maybe it was just fools chasing tulips. Those investors (gamblers) playing the shell
game with PALM found themselves playing with six shells instead of three as like an insidious amoeba
PALM divided into two tulips, PLMO and PSRC. Keep your eye on the magician closely. For the analyst,
all the smoke and mirrors could not hide the fact gravity took PALM in all its manifestations down. The
downtrend lines are broken in 2003 and 2004 and a respectable Kilroy Bottom is made. Nevertheless,
the implications of the bottom may have already been carried out. A continuing story for speculators
or astute (very astute) investors who know something fundamental and have very long-term vision.
PALM
Created with MetaStock www.equis.com
2000 AprilM ay June July August September
21 32 02 73 10 17 24 18 15 22 30 51 21 92 63 10 17 24 31 71 42 12 84 11
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Figure 23.4 PALM. Fool’s gold. Fool’s gold with naiveté writ large on it. Here is a spike reversal
day on the initial day of trading. The accumulation, markup, and most of the distribution occurred
behind closed doors before this trick was perpetrated. After the matanza, the continuation takes on
the shape of a rounding bottom. Perhaps there is some real gold there—but only over the long term.
330 Technical Analysis of Stock Trends
implemented. Since these are “game” situations, and irrational, one may employ tactics
he might not ordinarily use with his serious capital—some light pyramiding and some
scaling out of the position based on continuous new highs. Additionally, in the blow-off
phase when close monitoring is necessary, one might want to exit on a long reversal day,
or on a key reversal pattern, and then go to the beach; or, if from Texas, one might want
to short the issue.
Essentially, I view these stocks as interesting aberrations in the early part of their lives.
So I would not look for long-term investment-type trades. Take the money and run. In
all likelihood, these stocks will explode like fireworks and then expire. There will be the
companies like Microsoft and—it remains to be seen—Yahoo!. After the fireworks show,
the patient technician may return to the scene of the crime to see whether there are any
burning embers. Once they have blown off, crashed, and made reasonable bottoms, then
one begins to look for investment possibilities, which there definitely will be. There is too
much potential in the technology of the internet—and biotech and the human genome—for
some phoenix not to rise from the ashes.
In the beginning it behooves the trader to regard them as speculative instruments of
exceptional risk and opportunity.
Several caveats are in order:
• The prudent speculator does not commit too much of his capital to such enterprises.
Probably no more than 5%–10%.
PSRC(D) -Daily NASDAQ L = 8.89 +0.02 +0.23% O = 8.85 C = 8.89
42.00
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OD 04 FM AM JJ AS ON D0 5F MA M
Created with TradeStation
Figure 23.6 PSRC in its amoeba-like glory. The


onal risk and opportunity.
Several caveats are in order:
• The prudent speculator does not commit too much of his capital to such enterprises.
Probably no more than 5%–10%.
PSRC(D) -Daily NASDAQ L = 8.89 +0.02 +0.23% O = 8.85 C = 8.89
42.00
35.00
29.00
24.00
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17.00
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OD 04 FM AM JJ AS ON D0 5F MA M
Created with TradeStation
Figure 23.6 PSRC in its amoeba-like glory. The failure of what might have been a rounding bottom,
especially with the breakdown gap in October and the failure to rally back to the neckline left no
doubt as to the fate of PALM by any other symbol. Broken trendlines are also indicative. Remember
that any large pattern can be broken down into smaller patterns susceptible to short trendline
analysis, as in this case. Sooner or later a palm-size computer, PDA, widget device is going to be the
wave of the future. (EN10: A visionary prediction of the iPhone.) The canny investor will not mistake the
company for the stock and will also not venture capital until there is a better chart story.
331Chapter twenty-three: Choosin g and managing high-risk stocks
• When selling them short, one should not be early. A definite top should be seen
because there might be a second stage of the rocket.
• Emotional involvement with tulips and internet stocks—or stocks of any kind
actually—can lead to a broken heart. In the charts, note the success in a number of
cases of trading the key reversal day.
(EN9: Reviewing charts from the apocalypse is a sobering experience. So many rash and mad
adventures. So much capital sucked into the black hole of underwriters and 21-year-old huckster CEO
wallets. Better than the South Seas Bubble. And, as definite proof that man is directly descended from geese
and sees no farther ahead than the next feeding bowl, the ghost of the mania oozes from the closet in 2005,
reborn as Google mania. Man (or goose if you will) never learns. That is why he is so much fun to watch.)
Google—what a creature is man! What a game is the market! Google, a wonderful
company, and a great concept goes public in 2004 after world-class hype (world class?
intergalactic class!). Floated as a red herring at 135, it eventually goes IPO at 85 in an
innovative public offering. Then the fun starts. Future readers of this book may observe the
markup made as of the date of this writing (November 2004) and judge whether the method
worked. A company on roller blades, impossible to dislike as a company. Remember, unless
you are Warren Buffet, you are buying the stock, not the company.
3com Corporation-(Nasdaq NM) 3.71 0.10 2.77%
Volume (Millions)
1998=2004 Prophet Financial Systems, Inc. I Terms of use apply.
AprJ ul Oct9 7A pr JulO ct 98 AprJ ul OctA pr JulO ct 00 AprJ ul Oct0 1A pr JulO ct99
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Figure 23.7 COMS. Underwriters cleverly doled out only 3% of 3Com-owned Palm stock onto the
market at the IPO. Palm wound up “worth” more than 3Com for a short time. Here the lesson of
tulipomania is vivid. The contrast in before and after volume. The necessity of analysis to deal with
tulips in bloom. The fatal lesson of heeding (or not heeding) gaps across horizontal trendlines.
Impossible to manage for the buy-and-hold investor.
332 Technical Analysis of Stock Trends
Hope springs eternal and there is one born every second
One might have thought the age of the tulip was over as we moved into the second decade
of the new millennium—but what naiveté! Not over at all. Investors rushed into the
LinkedIn and Groupon IPOs and stood quivering on the sideline begging for Facebook to
go public. But Facebook, the ultimate practitioner of chutzpah, satisfied itself by feeding on
the venture capital community, demanding ever higher valuations from venture capitalists
desperate to own a sliver of the deal at whatever cost. The public will have to wait to be
shorn. But have faith, it will be. Remember Palm.
You can buy these things, but you have to remain glued to the screen and the ride will
be rough. Unless you have your professional speculator’s license and have lost money on
these deals before, watch the snake pit from the sidelines—and do not buy any snake oil.
Oracle Corporation-(Nasdaq NM) 12.28 –0.04 –0.32%
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Figure 23.8 ORCL. True to the character of stocks during the Tulipomania, Oracle was difficult to
handle without careful analysis. Stock splits preceded a number of the sell-offs (note gaps post splits).
Bullish gaps are also frequent here, and the tulip top is obvious, and was at the time. An excellent
trading vehicle though a wreck for the casual investor.
333Chapter twenty-three: Choosin g and managing high-risk stocks
Inktomi Corp-(OTC)
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1999–2004 Prophet Financial Systems, Inc. Terms of use apply.
Figure 23.9 INKT. The pleasures and delights (and disappointments) of internet stocks. The last
trendline, in conjunction with the second horizontal trendline, clearly marks the end of the party
(AND WILL FOR ANY STOCK WHATSOEVER). The break of the long-term trendline is the last exit
signal, as if the previous signals were not clear enough. Is it not obvious that this issue was (and is)
manageable with technical analysis?
334 Technical Analysis of Stock Trends
Emulex Corp 19.74 0.01 0.05%
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96 AprJ ul OctAprJ ul Oct9 79 8A pr JulO ct 99 AprJ ul Oct0 0A pr JulO ct 01 AprJ ul
© 1999–2004 Prophet Financial Systems, Inc. Terms of use apply.
Figure 23.10 EMULEX (ELX). The message of 2000, a severe drubbing, and precipitous at that, would
have been lost on the non-technician. Those who continued to ride the roller coaster relearned a
lesson some technicians know—stocks often repeat the same behavior (or misbehavior). The less


O ct 99 AprJ ul Oct0 0A pr JulO ct 01 AprJ ul
© 1999–2004 Prophet Financial Systems, Inc. Terms of use apply.
Figure 23.10 EMULEX (ELX). The message of 2000, a severe drubbing, and precipitous at that, would
have been lost on the non-technician. Those who continued to ride the roller coaster relearned a
lesson some technicians know—stocks often repeat the same behavior (or misbehavior). The lesson
of monster breakaway gaps (or air gaps) may have needed relearning also. Oh well, after such a
gap the damage is done, the unenlightened investor says, only to see the damage continue down
to 10 (from 110!). These are signals of such magnitude that disaster awaits the trader who denies its
significance. The air gap here nicely complements those of Figures 12.9 and 37 .43.
335Chapter twenty-three: Choosing a nd managing high-risk stocks
Amazon.com Inc.-(Nasdaq NM) 47.15 –0.84 –1.75%
Volume (Millions)
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Figure 23.11 Amazon weekly. Amazing Amazon dances in the internet follies. The breathtaking
plunges are the direct result of the breathtaking speculative excess. See the daily chart (Figure 23.12)
for a closer look at the details of the blow-off.
AMZN (Amazon.com, Inc.)
08/26/2006 5:51 PM EDT
Mar Apr May Jun Jul Aug SepO ct Nov Dec9 9F eb 4
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Amazon.com Inc.–(Nasdaq NM) 28.03 0.06 0.21%
© 2002-2006 Prophet Financial Systems, Inc. All Rights Reserved.
Figure 23.12 Amazon daily. In cases of speculative blow-off, trendlines are of little use. A dozing
trader (presumably it was obvious this was not an investment issue) would have been mauled in the
plunge. An alert trader, knowing that in blow-offs the procedure is to sell strength, might have avoided
it. Other techniques include recognition of the second exhaustion gap and exit. Also, a trader using
the techniques described in Chapter 28, setting progressively tight stops, might have avoided the fall.
336 Technical Analysis of Stock Trends
AMZN(D) - Weekly NASDAQ L = 32.31 –0.21 –0.65 %O = 32.85C = 32.36
42.04
18.35
88.00
62.00
44.00
32.36
22.00
15.00
11.00
8.00
5.00
4.00
3.00
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1998 1999 2000 2001 2002 2003 2004 2005
Created with TradeStation
Figure 23.13 The wild frontier of the internet and of the gunslinger speculators (gamblers?). Amazon
bucks on. Give us a slug of rotgut whiskey and get out the ruler. A clear top for the rational analyst
with clear broken trendlines and broken horizontal lines and then a clear Bear Market with a clear
bottom resembling a Kilroy Bottom and then a clear breakout and another Bull Market and then
another downtrend. Talk about your fearless bull riders down at the rodeo. But this Bull–Bear is
ridable with a little technical analysis. Without technical analysis it is like being the target in a shooting
gallery—a sitting duck.
337Chapter twenty-three: Choosin g and managing high-risk stocks
Cisco Systems Inc.-(Nasdaq NM) 17.29 0.08 0.46%
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497 JunJ ul AugFeb Mar AprM ay SepO ct Nov Dec9 8J un JulA ugFebM ar AprM ay SepO ct Nov
© 1999–2004 Prophet Financial Systems, Inc. Terms of use apply.
Figure 23.14 CISCO (CSCO). Although the first long-term trendline beautifully intercepts the downtrend
in progress at a gap (a coincidence of indicators that occurs too often to be a coincidence), the trendlines
drawn later are of such strength that even the novice analyst should know how to exit. In fact, one of my
students, an employee of Cisco, did just that, saving himself thousands of paper dollars in this very case.
338 Technical Analysis of Stock Trends
CSCO LAST-Daily 08/22/2001
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4/2000 5/2000 6/2000 7/2000 8/2000 9/2000 10/200011/20001 2/20000 1 2/2001 3/2001 4/2001 5/20016 /2001 7/2001
Created with TradeStation 2000i by Omega Research1 999
Figure 23.15 Is there any way the trader (investors keep away) could avoid stepping off this cliff?
Extreme paranoia is one way. Another way is by being acutely conscious of the pattern of behavior
manifested by Cisco in Figure 23.14.
339Chapter twenty-three: Choosin g and managing high-risk stocks
GOOG(D) - Daily NASDAQ L = 219.75 +0.30 +0 14%O = 221.91 C = 220.00
204.79
163.99
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193.00
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AugS ep Oct Nov Dec0 5F eb Mar AprM ay
Created with TradeStation
Figure 23.16 You thought all the tulips and Bulls had been exhausted in the Tulipomania in 2000?
Silly you. There is an inexhaustible supply. All you need is a company and a story and an underwriter
to peddle it. Sometimes there are even earnings. Sometimes the earnings are even real. Sometimes
the earnings are skating uphill on roller blades. Then sometimes the characters are so appealing that
you are almost willing to buy the IPO at face value, but not if you are a cynic, as are all technical
analysts. Google was rumored at $200 or more on the IPO. The editor offered to sell all of it at that
price and throw in the Brooklyn Bridge for free. This offer (well, there may have been other factors
also) knocked the IPO down to $85 (still an errant speculation), but only insane, not unreasonable.
The oversubscription in an innovative offering revealed that the tulip virus was not dead, but very
much alive and infecting not just the same old suspects, but many new ones. We love a horse race,
and this is a great one. Notice the obvious defensive lines and support and resistance. How long
Google can defy gravity (a galactic price-earnings ratio) remains to be seen. Prudent gamblers will
have a stop identified. On this chart, for the long-term gambler, it might be in the 182 area. For the
more agile gambler, it might be failure of the support around 204, or closing of the breakaway gap
there. No opprobrium is attached to the term gambler. In


and support and resistance. How long
Google can defy gravity (a galactic price-earnings ratio) remains to be seen. Prudent gamblers will
have a stop identified. On this chart, for the long-term gambler, it might be in the 182 area. For the
more agile gambler, it might be failure of the support around 204, or closing of the breakaway gap
there. No opprobrium is attached to the term gambler. In fact, bolder investors (competent readers of
this book) should take a flyer from time to time with about 5% of their capital. This is the flyer that
should have been taken. The breakaway gaps in October and April, operating against disbelief, were
signals of enormous technical strength. And Google went to 475! The lesson here, which must be
learned and relearned and … ad infinitum … is this: trust the chart. Ignore the story. In 2008, GOOG
went to 700, halved in the Bush Bear Market, recovered to 600, and entered a two-year sidewave.
340 Technical Analysis of Stock Trends
Figure 23.17 Google, 2011. Google turned out to be the real thing and had a herd of cash cows that
produced and produced and produced. Mother’s milk? Or America’s love affair with advertising?
Whatever, the reader can see the simple-minded management of the issue with trendlines. Using
trendlines would have avoided bungee-like equity, which is never pleasant. Basing Points might have
been used the same way with the same effect. GOOG has essentially been in a large sidewave (very
large) since 2010. The exit from this sidewave should have dramatic consequences—up or down.
341
chapter twenty-four
The probable moves of your stocks
At first glance, all stocks appear to move helter-skelter without rhyme or reason, all over
the lot. All stocks go up at times, and all go down at times—and not always at the same
time. We already have seen in these rises and falls stocks do follow trends, make various
typical patterns, and behave in a not completely disorderly manner. (For illustrations in
this chapter, see Figures 24.1 and 24.2.)
It is also true that each stock has its own habits and characteristics, which are more
or less stable from year to year. Certain stocks normally respond to a Bullish Phase of the
market with a very large upsurge, whereas others, perhaps in the same price class, will
make only moderate moves. You will find that the same stocks that make wide upward
swings are also the ones that make large declines in Bear Markets, whereas the ones that
make less spectacular up-moves are more resistant to downside breaks in the market. There
are stocks that ordinarily move many, many times faster than others. We do not know,
for example, whether a year from now Glenn Martin (EN: read, Microsoft, eBay) will be
moving up or down, but we do know, and it is one of the most dependable things we know,
whichever way it is going, it will be covering ground much faster than American Telephone
and Telegraph. (EN9: Even T accelerated into hyperspace after its unfortunate divestment of
local Bells. And, unlike the leopard, completely changed its spots.) These differences of habit, of
course, are due to the size of issue, floating supply, nature of business, and leverage in the
capital structure, matters we have touched on briefly before. As a matter of fact, we are not
especially concerned with why the differences exist. We are interested mainly in what the
differences are, and how we can determine them.
This is important: stocks that habitually move in a narrow range, although excellent
for investment purposes in cases in which stability and income (dividends) are the chief
desiderata, are not good trading stocks. A fairly high degree of sensitivity (EN: volatility),
with wide percentage moves, is necessary to make possible profitable commitments that
will cover costs and leave a net gain. To be in a position to make a profit, you should see
the probability of at least a 15% move in your stock.
How then are you going to tell which stocks are most sensitive and potentially most
profitable?
By examining the record of a certain stock for a number of years back, and comparing
the percentage moves it has made with the percentage moves of the market as a whole, you
can obtain a fair picture of that stock’s habits. You will not be able to say, at any particular
moment, “This stock is now going to move up 25%,” but you can say, with a good deal of
confidence, “If the market as a whole makes an advance of 10%, this stock will probably
advance about 25%.” Or, conversely, “If the market goes down 10%, this stock will very
likely go down at least 25%.” (EN10: The concept of beta.)
Many methods have been used for measuring and checking these percentage-move
habits, differing only in detail. (EN10: With the ready availability of desktop and internet
software, the investor may call up a two- or five-year chart and see the potential range of the stock at
hand.) Indexes on several hundred important stocks listed on the New York Stock Exchange
have been computed by the authors and are presented in Appendix A, ninth edition.
342 Technical Analysis of Stock Trends
(EN10: Magee’s concept of “sensitivity” appears to combine some aspects of our modern concept of
beta and modern computation of volatility. The replacement for Magee’s Sensitivity Index is readily
available at finance.yahoo.com and http://www.abg-analytics.com as well as any number of other
sites findable by Google.)
Individual stocks have their characteristic habits, as do some entire industries. In
general, the food stocks, of which “CFG” is one, are stable and slow-moving. On the other
hand, liquor stocks make wide moves on any general advance or decline of the market. At
this time “CFG” had a Sensitivity Index (EN9: or beta equivalent) of 0.58, whereas Schenley’s
was 2.05.
(EN: Current-day betas or volatilities may be compared with these and/or substituted for them in
other computations suggested in this book, for example, in Composite Levera


e and slow-moving. On the other
hand, liquor stocks make wide moves on any general advance or decline of the market. At
this time “CFG” had a Sensitivity Index (EN9: or beta equivalent) of 0.58, whereas Schenley’s
was 2.05.
(EN: Current-day betas or volatilities may be compared with these and/or substituted for them in
other computations suggested in this book, for example, in Composite Leverage formulas. The reader
CORN PRODUCTS REF. CFG
1945 1946
80
76
72
68
64
60
56
MJ JA SO ND JF MA MJ JA SO
SCHENLEY DIST.S H
1945 1946
MJ JA SO ND JF MA MJ JA SO
100
96
92
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84
80
76
72
68
64
60
56
52
46
44
40
36
32
28
Figure 24.1 Some stocks move faster than others. We have already noticed that low-priced stocks
have much larger percentage moves than high-priced issues. Yet, even between two stocks that
may, at a particular time, be selling at the same price, there are enormous differences in their habits.
Furthermore, these habits change very little from year to year.
 Here we have a weekly chart of Corn Products Refining Company (left), covering an 18-month
period in the years 1945 and 1946. We also have a chart of Schenley Distillers (right) for the same
period. The average price between the high and low on these charts is about 64 1/2, the same for
both stocks.
 However, during this period, we see “CFG” moving between a low of 58 1/2 and a high of 71, a
range of 12 1/2 points, while at the same time, “SH” has moved between 28 1/2 and 100, a range of
71 1/2. A thousand dollars put into an outright purchase of “CFG” at its extreme low would have
grown to $1,210 at its extreme high, whereas the same amount used for outright purchase of “SH”
at its low would have grown to $3,510. Your gain of $2,510 in “SH” would be more than 10 times the
gain of $210 in “CFG,” and this without using margin.
 It is not likely you would actually purchase either stock at the extreme low, nor sell at
the extreme high. The point we are bringing out here is there are enormous differences in
the swing habits of stocks.
343Chapter twenty-four: The proba ble moves of your stocks
may read in the following text “beta” for “Sensitivity Index” and avoid the annoyance of excessive
notation by the editor.)
The Indexes are relative. They show stocks with a high Sensitivity Index (EN: beta) will
move much faster in either Bull Markets or Bear Markets than stocks with low Indexes, and
about how much faster, relative to the other stocks.
(EN: As is obvious to the experienced reader, and new to the inexperienced, Magee’s method
predates the modern compilation of betas and volatilities . Beta measures the systematic risk
of a stock, or for those who are not into financial industry jargon, the sensitivity of a stock to the
market. Volatility measures the dispersion of returns in the stock itself. Thus, if the market moves 1
point, a stock with beta of 1.5 will move 1.5 points. A stock with a beta of 0.5 will move 0.5 points,
approximately or more or less. Not surprisingly, high beta stocks are volatile. For readers who like
to roll their own, I offer here the formula for computing the beta of a stock, which is somewhat more
sophisticated than Magee’s method:
 ((N)(Sum of XY)) − ((Sum of X)(Sum of Y))
where
N = the number of observations,
X = rate of return for the S&P 500 Index,
Y = rate of return for stock or fund.
The general investor may not be avidly interested in this calculation, especially when the beta is
readily available at Value Line and finance.yahoo.com and is published regularly by Merrill Lynch.
Betas litter the internet, found by searching Google; seekingalpha.com has lists; and finance.yahoo.
com displays the stock beta in “Key Statistics” for each stock covered.
CUBAN - AMERICAN SUGARC SU
1945 1946
36
34
32
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28
26
24
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MJ JA SO ND JF MA MJ JA SO
ELECTRIC BOAT EB
1945 1946
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34
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30
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MJ JA SO ND JF MA MJ JA SO
Figure 24.2 Another example of the difference in swings between stocks. In this case also, the stocks
show the same average price between the high and low of the period, and both stocks are plotted for
the same 18 months in 1945 and 1946. Although in a lower price range and even though the disparity
in their Sensitivity Indexes is less, there is a considerable difference in their actions. Cuban–American
Sugar (left), a food stock, shows a range of 76% from its low of 16 1/2 to its high of 29, whereas Electric
Boat (right), a shipbuilding concern, advances more than 140%.
344 Technical Analysis of Stock Trends
Of equal or greater importance is the individual risk of a stock that professionals like to determine
by computing its volatility. Somewhat akin to Magee’s “normal range for price,” volatility measures
the variability of a stock’s returns (price movement). The general investor should be informed the
study of volatility is an extremely sophisticated subject, and professionals expend enormous resources
dealing with the question. Numerous methods are used to derive volatilities, but these mainly come
into play in options arbitrage and professional trading on exchange floors.
For the private investor, it is sufficient to know of the dangers of this arcane area. Before venturing
into “volatility plays,” the newcomer should take a postgraduate course. For the general investor
who wants to know enough to calculate his own volatilities (not recommended or necessary), I note
the formula here:
To calculate volatility, first find the difference between each return and the average. Then square
each difference and add them together. Divide the sum by the number of returns minus one. This
result is known as the variance. Finally, take the square root of the variance to get the volatility.
Combining these steps into a formula:

σ
µ
=
−
−
=
∑
i
n
iR
n
1
2
1
()
• Step 1: Calculate the average return.
• Step 2: Calculate the deviation of each return.
• Step 3: Square each period’s deviation.
• Step 4: Add them together.
• Step 5: Divide the


by the number of returns minus one. This
result is known as the variance. Finally, take the square root of the variance to get the volatility.
Combining these steps into a formula:

σ
µ
=
−
−
=
∑
i
n
iR
n
1
2
1
()
• Step 1: Calculate the average return.
• Step 2: Calculate the deviation of each return.
• Step 3: Square each period’s deviation.
• Step 4: Add them together.
• Step 5: Divide the sum by the number of periods – 1. This is the variance.
• Step 6: Take the square root.
The less punctilious (or more practical) investor may find volatilities at ht tp://www .
optionstrategist.com, ht tp: // www .cboe.com, and finance.yahoo.com, as well as other locations that
can be located by searching on Google.)
345
chapter twenty-five
Two touchy questions
This chapter is directed largely to the new trader, to the investor who has followed other
analytical methods, and to the investor type who is now, for the first time, taking up the
technical trading of stocks for the shorter term.
The use of margin
The first question here is the use of margin. There are many people who, knowing of the
disastrous margin calls of 1929 and the staggering way losses can be multiplied against one
in a margined account during a sharp break in the market, take the attitude that the use of
margin is intrinsically bad, dangerous, foolish, and unsound. They will tell you they are
willing to risk their own money, but they never speculate on borrowed funds. They will tell
you that by buying securities outright, they are safe against any kind of break in the market.
There is something to this line of argument, although very often you will find the
arguer has not really thought the case through all the way. If he had, he might realize
that, in buying outright stocks that are sensitive or highly leveraged, he is accomplishing
almost exactly the same thing as someone else who buys more conservative stocks on a
margin basis. Very often, despite his feeling that outright purchase is more conservative
than margin buying, he is a speculator at heart. He is not really interested in dividends and
a stable investment. Rather, he is looking for “something with appreciation opportunity.”
Considering he is not facing the issue squarely, he may fall into expensive errors.
To be thoroughly consistent here, a man who shuns the risks inherent in margin trading
should shun the risks of leverage and volatility. He should avoid risk, forget “opportunity
for appreciation,” and confine himself to sound, income-producing stocks of a sort that
will not fluctuate widely.
If we are looking for stability, we do not want excessive fluctuation and there are
securities that provide stability. In this work, however, we are looking for “swing power.”
We want the highest degree of fluctuation we can handle safely. We can secure this by
buying outright a stock that is normally subject to fairly broad swings—that is, a stock
with a high Sensitivity Index (EN: beta). We can get the same effect by trading in a stock of
more conservative habits but increasing the Composite Leverage (EN: or simply leverage) by
using margin. (The method of computing and comparing Composite Leverages in various
situations is covered in Appendix A, ninth edition and may be studied in Chapter 42.)
Let us assume, for example, we will buy 100 shares of a rather speculative stock, which
we will call UVW, on an outright basis. It has a Sensitivity Index of 1.50, and now sells (let
us say) at 20. At the same time, we buy a somewhat less speculative stock, XYZ, also selling
at 20; but in this case, we buy on 70% margin, putting up only three-quarters of the value of
the stock. In a general advance affecting both of these stocks, the probabilities would favor
a somewhat greater percentage move in UVW than in XYZ. If such a general rise should
bring UVW to 30, we might expect XYZ to rise to a lesser degree, say to 28. Now the advance
of 10 points on the $2,000 invested in outright purchase of UVW will represent a gain of
$1,000 or 50%. The advance of XYZ to 28 on the $1,400 invested at 70% margin will mean a
346 Technical Analysis of Stock Trends
gain of $800 or 57%. In other words, we have, by the use of margin, increased the effective
leverage of XYZ; we have made it, in fact, slightly more speculative than UVW.
The effect of margin use is simply to accentuate or increase the sensitivity of a situation.
It is a mechanism for assuming more risks and, therefore, more opportunities for faster
gains. Assuming you are willing to assume risk (as you must be if you intend to make
speculative commitments), it is simply a matter of knowing approximately what risks you
are taking and whether you can afford to take them. The danger in margin lies in cases
in which the customer grossly overextends himself, taking on a risk far beyond his ability
to protect himself. This will not happen if he sets a reasonable limit to his total leverage
(EN: put another way, his portfolio risk).
The margin transaction is simply a matter of buying (or selling short) more stock than
you have money to pay for in full. The purchase of a home on a mortgage is essentially a
margin transaction. The financing of business operations, using borrowed money for part
of the capital, is the same. The buying of anything for which the purchaser puts up part of
the capital and borrows the rest, using the value of the purchased property as security for
the loan, is exactly similar to the trading of stocks on margin. In each case, any change in
the value of the property will cause a larger net change in the value of the margin capital.
Thus, if a man buys a home for $100,000, paying $50,000 cash, and later sells it for $150,000
(an increase of 50% in the value of his property), he will benefit to the extent of $50,000
profit, or 100% on his invested capital.
The question of margin calls, being “wiped out” on margin transactions, will seldom, if
ever, come up if you protect your


net change in the value of the margin capital.
Thus, if a man buys a home for $100,000, paying $50,000 cash, and later sells it for $150,000
(an increase of 50% in the value of his property), he will benefit to the extent of $50,000
profit, or 100% on his invested capital.
The question of margin calls, being “wiped out” on margin transactions, will seldom, if
ever, come up if you protect yourself properly by maintaining stops at all times or by closing
out the transaction when it has violated certain predetermined danger points. Needless to
say, if you have allowed a trade to go so bad it reaches the minimum margin maintenance
range, the best thing is to take your loss and forget it; not try to meet the margin call. Yet
again—this need not ever happen.
As we will see in discussions of sensitivity and leverage, stop levels, and so on, there
are certain limits that can be fairly well defined, beyond which you cannot safely venture.
If you could buy stock on a 10% margin, as you could at one time, you might have visions
of highballing $1,000 up to $1 million in one Bull Market; that is not a reasonable hope and
it is not safe to risk your capital on a 10% margin because, in many cases, your perfectly
logical purchase would sag enough to wipe you out entirely before going ahead to the
normal advance you expected. (EN: In a nutshell, the risk of trading commodities and futures.)
In judging how much margin you can or should use within the limits of margin trading
laid down by law, you must take into account the method of trading you are using, the
amount of adverse fluctuation you must expect in the normal operation of your method,
and the nature of the stock you are dealing with, that is, its Sensitivity Index and Normal
Range-for-Price (EN: at the risk of being repetitive, beta and volatility), at the time you make
the original commitment.
Short selling
The other touchy question is that of short sales. A majority of traders avoid the short side
of the market. Six out of seven investors you meet, who have bought or sold stocks, will
tell you they would never sell a stock short under any conditions, at any time. In fact, short
selling is limited, very largely, to skilled professionals. (EN: The private investor, because of
his fears and prejudices, voluntarily grants this “edge” or advantage to professionals. Magee dealt
with this subject at length in Winning the Mental Game on Wall Street, which I wholeheartedly
recommend to the reader. EN9: The widespread proliferation of hedge funds in the new century
347Chapter twenty-five: Two touchy q uestions
attests to the frustration of professional managers with mutual fund rules requiring them to maintain
only long positions. Even with this development, short selling by the general investor remains a
limited technique—to the disadvantage of the nonprofessional.)
Now, if you have studied long-term charts (weekly and monthly), and the daily charts
in this book, you will recognize several facts about the action of markets. Most stocks go
up most of the time. There are almost always more advances than declines in the list of the
most active stocks published each day. Stocks, in general, advance about two-thirds of the
time, and go down only about one-third of the time. (EN9: Probably a truth over the long term,
but in the modern context, ample short opportunities exist.)
Furthermore, most of the news releases, rumors, and comments in the press related to
stocks and corporate affairs have to do with the brighter side of industry. It is only natural
that executives, public relations people, and the reporters themselves should be interested in
forward-looking developments, new processes, expansion of facilities, increased earnings,
and the like, and that such items should prove more newsworthy than less optimistic
reports.
These various factors may explain why “the public” is always Bullish. The public is
always hoping and expecting stocks to go up all the time. If stocks are rising and in a Bullish
Phase, the public expects them to still go higher. If stocks have declined sharply, the public
will argue they are now better buys than before and must surely go up soon. It is up, up,
UP, always up, in the mind of the public.
Yet, examination of the long-term charts covering the action of the Averages over many
years will show you that, through these long periods, the levels rise and fall about the same
amount. This being the case, it must follow that stocks come down as far as they go up
and because they go up about two-thirds of the time, they must come down much faster
than they go up. This you will find is true. The angles of decline in the Averages and also
in individual stocks are usually steeper in Bear Market Moves than the advances are in
Bull Market Moves. A corollary to that is that profits can be made faster on the downside of the
market than on the upside.
Such profits are made by selling short. It is important if you are a trader to understand
the meaning of a short sale. When you sell a stock short, you borrow that stock from
someone who owns it, and then you turn around and sell it to someone else, agreeing
with the original owner to replace his shares at some unspecified time in the future. All
of the details of this transaction is handled by your broker. Shares of most stocks of large
outstanding issue are available for loan at all times in the hands of brokers, and your broker
has access to them. The mechanics of this borrowing and sale are interesting; you may
wish to get from your broker the whole story of how these operations are carried out. For
all practical purposes, however, all you need to do is tell your broker what you wish to sell
and leave the rest to him.
He will advise you if, by any chance, the stock you have selected for short sale is not
available for loan. Another practical point, although of minor consequence, is that a slight
additional tax is assessed against