968 Glossary
types of diagonal spreads are diagonal bull spreads, diagonal bear spreads, and
diagonal butterfly spreads.
Discount: an option is trading at a discount if it is trading for less than its intrinsic
value. A future is trading at a discount if it is trading at a price less than the cash
price of its underlying index or commodity. See also Intrinsic Value, Parity.
Discount Arbitrage: a riskless arbitrage in which a discount option is purchased
and an opposite position is taken in the underlying security. The arbitrageur may
either buy a call at a discount and simultaneously sell the underlying security
(basic call arbitrage), or buy a put at a discount and simultaneously buy the under
lying security (basic put arbitrage). See also Discount.
Discretion: see Limit Order, Market Not Held Order.
Dividend Arbitrage: in the riskless sense, an arbitrage in which a put is purchased
and so is the underlying stock. The put is purchased when it has time value pre
mium less than the impending dividend payment by the underlying stock. The
transaction is closed after the stock goes ex-dividend. Also used to denote a form
of risk arbitrage in which a similar procedure is followed, except that the amount
of the impending dividend is unknown and therefore risk is involved in the trans
action. See also Ex-Dividend, Time Value Premium.
Divisor: a mathematical quantity used to compute an index. It is initially an arbitrary
number that reduces the index value to a small, workable number. Thereafter the
divisor is adjusted for stock splits (price-weighted index) or additional issues of
stock (capitalization-weighted index).
Downside Protection: generally used in connection with covered call writing, this
is the cushion against loss, in case of a price decline by the underlying security, that
is afforded by the written call option. Alternatively, it may be expressed in terms
of the distance the stock could fall before the total position becomes a loss (an
amount equal to the option premium), or it can be expressed as percentage of the
current stock price. See also Covered Call Write.
Dynamic: for option strategies, describing analyses made during the course of
changing security prices and during the passage of time. This is as opposed to an
analysis made at expiration of the options used in the strategy. A dynamic break
even point is one that changes as time passes. A dynamic follow-up action is one
that will change as either the security price changes or the option price changes or
time passes. See also Break-Even Point, Follow-Up Action.
Early Exercise (assignment): the exercise or assignment of an option contract
before its expiration date.

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Glossary 969
Equity Option: an option that has common stock as its underlying security. See also
Non-Equity Option.
Equity Requirement: a requirement that a minimum amount of equity must be
present in a margin account. Normally, this requirement is $2,000, but some bro
kerage firms may impose higher equity requirements for uncovered option writing.
Equivalent Positions: positiohs that have similar profit potential, when measured
in dollars, but are constructed with differing securities. Equivalent positions have
the same profit graph. A covered call write is equivalent to an uncovered put write,
for example. See also Profit Graph.
Escrow Receipt: a receipt issued by a bank in order to verify that a customer ( who has
written a call) in fact owns the stock and therefore the call is considered covered.
European Exercise: a feature of an option that stipulates that the option may be
exercised only at its expiration. Therefore, there can be no early assignment with
this type of option.
Exchange-Traded Fund (ETF): an index fund that is listed on a stock exchange.
Options are listed on some ETFs. See also Index Fund.
Ex-Dividend: the process whereby a stock's price is reduced when a dividend is
paid. The ex-dividend date (ex-date) is the date on which the price reduction takes
place. Investors who own stock on the ex-date will receive the dividend, and those
who are short stock must pay out the dividend.
Exercise: to invoke the right granted under the terms of a listed options contract.
The holder is the one who exercises. Call holders exercise to buy the underlying
security, while put holders exercise to sell the underlying security.
Exercise Limit: the limit on the number of contracts a holder can exercise in a fixed
period of time. Set by the appropriate option exchange, it is designed to prevent
an investor or group of investors from "cornering" the market in a stock.
Exercise Price: the price at which the option holder may buy or sell the underlying
security, as defined in the terms of his option contract. It is the price at which the
call holder may exercise to buy the underlying security or the put holder may exer
cise to sell the underlying security. For listed options, the exercise price is the
same as the striking price. See also Exercise.
Expected Return: a rather complex mathematical analysis involving statistical dis
tribution of stock prices, it is the return an investor might expect to make on an
investment if he were to make exactly the same investment many times through
out history.

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974 Glossary
Monte Carlo Simulation: a model designed to simulate a real-world event that can
not be approximated merely with a mathematical formula. The Monte Carlo sim
ulation approximates such an event (the movement of the stock market, for exam
ple) and then it is simulated a great number of times. The net result of all the sim
ulations is then interpreted as the result, generally expressed as a probability of
occurrence. For example, a Monte Carlo simulation can be used to determine how
stocks might behave under certain stock price distributions that are different from
the lognormal distribution.
Naked Option: see Uncovered Option.
Narrow-Based: Generally referring to an index, it indicates that the index is com
posed of only a few stocks, generally in a specific industry group. Narrow-based
indices are not subject to favorable treatment for naked option writers. See also
Broad-Based.
"Net" Order: see Contingent Order.
Neutral: describing an opinion that is neither bearish or bullish. Neutral option
strategies are generally designed to perform best if there is little nor no net change
in the price of the underlying stock. See also Bearish, Bullish.
Non-Equity Option: an option whose underlying entity is not common stock; typi
cally refers to options on physical commodities, but may also be extended to
include index options.
"Not Held": see Market Not Held Order.
Notice Period: the time during which the buyer of a futures contract can be called
upon to accept delivery. Typically, the 3 to 6 weeks preceding the expiration of the
contract.
Open Interest: the net total of outstanding open contracts in a particular option
series. An opening transaction increases the open interest, while any closing trans
action reduces the open interest.
Opening Transaction: a trade that adds to the net position of an investor. An open
ing buy transaction adds more long securities to the account. An opening sell
transaction adds more short securities. See also Closing Transaction.
Option Pricing Curve: a graphical representation of the projected price of an
option at a fixed point in time. It reflects the amount of time value premium in the
option for various stock prices, as well. The curve is generated by using a mathe
matical model. The delta ( or hedge ratio) is the slope of a tangent line to the curve
at a fixed stock price. See also Delta, Hedge Ratio, Model.

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Glossary 975
Options Clearing Corporation (OCC): the issuer of all listed option contracts that
are trading on the national option exchanges.
Original Issue Discount (O1D): the initial price of a zero-coupon bond. The owner
owes taxes on the theoretical interest, or phantom income, generated by the annu
al appreciation of the bond toward maturity. In reality, no interest is paid by the
zero-coupon bond, but the government is taxing the appreciation of the bond as if
it were interest.
Out-of-the-Money: describing an option that has no intrinsic value. A call option is
out-of-the-money if the stock is below the striking price of the call, while a put
option is out-of-the-money if the stock is higher than the striking price of the put.
See also In-the-Money, Intrinsic Value.
Over-the-Counter Option (OTC): an option traded over-the-counter, as opposed
to a listed stock option. The OTC option has a direct link between buyer and sell
er, has no secondary market, and has no standardization of striking prices and expi
ration dates. See a'lso Listed Option, Secondary Market.
Overvalued: describing a security trading at a higher price than it logically should.
Normally associated with the results of option price predictions by mathematical
models. If an option is trading in the market for a higher price than the model indi
cates, the option is said to be overvalued. See a'/so Fair Value, Undervalued.
Pairs Trading: a hedging technique in which one buys a particular stock and sells
short another stock. The two stocks are theoretically linked in their price history,
and the hedge is established when the historical relationship is out of line, in hopes
that it will return to its former correlation.
Parity: describing an in-the-money option trading for its intrinsic value: that is, an
option trading at parity with the underlying stock. Also used as a point of refer
ence-an option is sometimes said to be trading at a half-point over parity or at a
quarter-point under parity, for example. An option trading under parity is a dis
count option. See a'/so Discount, Intrinsic Value.
PERCS: Preferred Equity Redemption Cumulative Stock. Issued by a corporation,
this preferred stock pays a higher dividend than the common and has a price at
which it can be called in for redemption by the issuing corporation. As such, it is
really a covered call write, with the call premium being given to the holder in the
form of increased dividends. See Call Price, Covered Call Write, Redemption Price.
Physical Option: an option whose underlying security is a physical commodity that
is not stock or futures. The physical commodity itself, typically a currency or

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976 Glossary
Treasury debt issue, underlies that option contract. See also Equity Option, Index
Option.
Portfolio Insurance: a method of selling index futures or buying index put options
to protect a portfolio of stocks.
Position: as a noun, specific securities in an account or strategy. A covered call writ
ing position might be long 1,000 XYZ and short 10 XYZ January 30 calls. As a verb,
to facilitate; to buy or sell-generally a block of securities-thereby establishing a
position. See also Facilitation, Strategy.
Position Limit: the maximum number of put or call contracts on the same side of
the market that can be held in any one account or group of related accounts. Short
puts and long calls are on the same side of the market. Short calls and long puts
are on the same side of the market.
Premium: for options, the total price of an option contract. The sum of the intrinsic
value and the time value premium. For futures, the difference between the
futures price and the cash price of the underlying index or commodity.
Present Worth: a mathematical computation that determines how much money
would have to be invested today, at a specified rate, in order to produce a desig
nated amount at some time in the future. For example, at 10% for one year, the
present worth of $ll0 is $100.
Price-Weighted Index: a stock index that is computed by adding the prices of each
stock in the index, and then dividing by the divisor. See also Capitalization
Weighted Index, Divisor.
Profit Graph: a graphical representation of the potential outcomes of a strategy.
Dollars of profit or loss are graphed on the vertical axis, and various stock prices
are graphed on the horizontal axis. Results may be depicted at any point in time,
although the graph usually depicts the results at expiration of the options involved
in the strategy.
Profit Range: the range within which a particular position makes a profit. Generally
used in reference to strategies that have two break-even points-an upside break
even and a downside break-even. The price range between the two break-even
points would be the profit range. See also Break-Even Point.
Profit Table: a table of results of a particular strategy at some point in time. This is
usually a tabular compilation of the data drawn on a profit graph. See also Profit
Graph.

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992
Option purchase and spread, combining, 339-341 (see
also Spreads combining calls and puts)
Options:
arbitrageurs, role of, 19-21
risk arbitrage, 21
assignment, 7, 16-17
anticipating, 18-22 (see also Assignment)
margin requirements, 15-17
classes and series, 5-6
closing transaction, 6
commissions, 17-18
definition, 3-4
as derivative security, 4
"European" exercise options, 7
exercising, 6-7, 15-16
after, 17
early, due to discount, 19-20
early, due to dividends on underlying stock, 20-22
premature, 19-22
holder, 6
in-the-money, 7, 8
LEAPS, 5
symbols, 26-27
markets, 22 (see also Option markets)
open interest, 6
opening transaction, 6
option price and stock price, relationship of, 7-9
order entry, 32-34
good-until-canceled order, 34
information, 32
limit order, 33
market order, 32
market not held order, 33
stop-limit order, 33-34
stop order, 33
out-of-the-money, 7
parity, 8-9
premature exercise, 19-22 (see also Options, exercis
ing)
premium, 7-8
price, factors influencing, 9-15 (see also Price of
option)
profits and profit graphs, 34-35
specifications, four, 4
standardization, 4-5
expiration dates, 5
striking price, 5
symbology, 23-27
CBOE's Web site, 23
expiration month code, 23
LEAPS, 26-27
option base symbol, 23
stock splits, 27
striking price code, 24-25
summary, 27
wraps, 25-26
time value premium, 7-8, 11
trading details, 27-32
limit order, 28
one-day settlement cycle, 28
position limit and exercise limit, 31-32
rotation, 28
value, 4
as "wasting" asset, 4
writer, 6
Index
Options to buy, selecting, 101-103 (see also Call buying)
Options Clearing Corp. (OCC), 6, 15-16, 673
Options on futures, 660-673 (see also Futures and
futures options)
Options and Treasury bills, buying, 413-421
advantages, 413, 421
annualized risk, 416-418
excessive risk, avoiding, 420-421
how strategy works, 413-421
risk adjustment, 418-420
risk level, keeping even, 415-416
summary, 421
synthetic convertible bond, 414
Order entry for options, 32-34 (see also Options)
Original Issue Discount (OID), 592-593
Out-of-the-money:
call spread, 222-225
covered writes, 43-45, 93
definition, 7
for put options, 246-247
Outright option purchases and sales, effect of, on
implied volatility changes on, 757-762
Pairs trading, 454-455
Parity, 8-9
Percentile of implied volatility approach, 814-818
composite implied volatility reading, 815
historical and implied volatility, comparing, 817-818
PERCS (Preferred Equity Redemption Cumulative
Stock), 91, 619-637
call feature, 620-622
redemption price, 622
sliding scale, 620-621
covered call write, equivalent to, 622-623
definition, 619
life span, 619
owning as equivalent to sale of naked put, 626
price behavior, 623-625
strategies, 625-636
delta of imbedded call, using, 630-631
hedging PERCS with common stock, 631-6:32
issue price, determining, 633-634

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Index
PERCS (Preferred Equity Redemption Cumulative
' Stock) (continued)
pricing, 634-636
protecting PERCS with listed options, 625-626
redemption feature, removing, 626-627
redemption price, changing, 627-629
rolling down/up, 628-629
selling call against long PERCS as ratio write,
629-631
selling short, 632-633
summary, 636-637
Phantom interest, 592
Philadelphia Stock Exchange (PHLX), 671, 673,
678-679
Portfolio hedge, 539-541
Portfolio insurance, 563-564
Position delta, 162-163, 167
Position limit rule, 253
Position vega, 757
POT system of NYSE, 555-556
Premium, 7-8
time value, 7-8
Price of option, factors influencing, 9-15
cash dividend rate of underlying stock, 14-15
dividends and lower call option price, 14-15
call option price curve, 10-13
market dynamics, nonquantitative, 15
risk-free interest rate, 14
striking price of option, 9-10
time remaining until expiration, 11-13
time value premium decay, 13-14
underlying stock, price of, 9-10
volatility of underlying stock, 13-14
Price-weighted indices, 497-500
computing, 497-498
divisor, 497-500
Dow Jones indices, 499
each stock with equal number of shares, 497, 499
Major Market Index (XMI), 499
Probability calculator, 798-799, 824, 827-829
Probability of stock price movement, 798-809 (see also
Stock prices)
Profits, locking in, four strategies for, 108-111
Program trading, 537-547 (see also Stock index
hedging)
Protected short sale, 118-121, 270 (see also Call buying
strategies)
Protective collar, 275
no-cost, 278-280
and splitting strikes, 328
Put, sale of, 291-301
buying stock below its market price, 299-300
caution, 299-300
covered put, 300
follow-up action, 295-296
naked put write, evaluating, 296-298
ratio put writing, 300-301
uncovered, 292-295
cash-based put writing, 294-295
993
covered call writing, similarity to, 293-294
naked put writing, differences between, 294-295
Put arbitrage, 445 (see also Arbitrage)
Put bear spreads, effects on of implied volatility
changes, 777-778
Put buying:
in conjunction with call purchases, 281-291
mathematical calculations of volatility, applying to,
478-479
straddle buying, 282-288
equivalences, 283-284
follow-up action, 285-288
reverse hedge, equivalent to, 283
reverse hedge with puts, 284
selecting, 285
strangle, buying, 288-291
trading against straddle, 287
Put buying in conjunction with common stock owner
ship, 271-280
as protection for covered call writer, 275-278
bull spread as equivalent, 278
long-term effects, 277-278
protective collar, 275, 278-280
rolling down, 276
no-cost collars, 278-280
lower strikes as partial covered write, 279-280
synthetic long call, 271
tax considerations, 275
which put to buy, 273-274
equivalent strategies, 27 4
slightly out-of-the-money put preferable, 27 4
Put option:
effects on of implied volatility changes, 765-766
pricing, applying mathematical calculations of
volatility to, 4 77-4 78
Put option basics, 245-255
assignment, 250-253
anticipating, 251-252
and dividend payment dates, 252
position limits, 253
conversion, 253-255
no risk, 254
reversal. 254
dividends, effect of on premiums, 248-250
exercise, 250-253
in-the-money, 246-247
out-of-the-money, 246-247
pricing, 247-248, 249
implied volatility, 248

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994
Put option basics (continued)
strategies, 245-247
time value premium, 246-247
Put option buying, 256-270
as alternative to short sale of stock, 256-258
purpose, 256
equivalent positions, 270
protected short sale, 270
follow-up action, 262-266
call option, 264
listed call, buying, 263
profits, five tactics for locking in, 262-266
loss-limiting actions, 267-270
calendar spread strategy, 269-270
"rolling-up" strategy, 267-269
margin account required, 269
ranking prospective purchases, 261-262
selection of which put to buy, 258-261
delta, 260-261
in-the-money puts, concentrating on, 259
Put option strategies, 243-410 (see also under particular
heading)
basics, 245-255
buying, 256-270
call and put strategies, similarities between, 244
LEAPS, 367-410
listed put options newer than listed call options, 244
put, sale of, 292-301
put buying in conjunction with call purchases,
281-291
put buying in conjunction with common stock own-
ership, 271-280
put spreads, basic, 329-335
ratio spreads using puts, 358-366
spreads combining calls and puts, 336-357
straddle, sale of, 302-320
summary, 366
synthetic stock positions created by puts and calls,
321-328
Put options, assignment of, 7
Put spreads, basic, 329-335
bear spread, 329-332
advantage over call bear spread, 330-332
as debit spread, 329
bull spread, 332-333
as credit spread, 332
formulae, 333
risk limited, 333
calendar spread, 333-335
bearish, 334-335
neutral, 334
option spreads, three simplest forms of, 329
Index
Qualified covered calls, 961-962
Ratio calendar combination, 364-366 (see also Ratio
spreads using puts)
Ratio calendar spread, 222-225 (see also Calendar and
ratio spreads)
Ratio call spreads, 210-221
and calendar spreads, combining, 222-229 (see also
Calendar and ratio spreads)
combination of bull spread and naked call write, 212
definition, 210
follow-up action, 217-221
delta, adjusting with, 219-221
equivalent stock position (ESP), using, 220-221
profits, taking, 221
ratio, reducing, 218-218
philosophies, three differing, 213-217
altering ratio, 215-216
as ratio write, 213-214
"delta spread," 213, 216-217
for credits, 213, 214-215
preferred over ratio writes, 211-212
ratio write, similarity to, 210
dissimilarity, 210-211
summary, 221
Ratio call write equivalent to naked straddle write, 306
Ratio call writing, 146-171
call spread strategies, introduction to, 168-171
credit/debit spread, 170
diagonal spread, 169
horizontal spread, 169
kicker, 169
"leg" into spread, 171
long/short side, 170
splitting quote, 171
spread, definition, 168
spread order, 169-171
vertical spread, 169
combination of covered call writing and naked call
writing, 146, 150
definition, 146
delta-neutral trading, 167-168
follow-up action, 158-168
altering ration of covered write, 160
closing out write, 166-167
delta, adjusting with, 160-163
equivalent stock position (ESP), 162-163, 167
position delta, 162-163, 167
rolling up/down as defensive action, 160
stop orders, using as defensive strategy, 163-166
"telescoping" action points, 166-167
investment required, 150-151
and ratio call spreads, similarity to, 210

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Index
Ratio call writing (continued)
dissimilarity, 210-211
ratio write, 146-149
objections, two, 148-149
probability curve for stock movement, 149
profit range, 14 7
ratio spread as, 213-214 (see also Ratio call
spreads)
and reverse hedge (simulated straddle), similarity of,
154
risk, two-sided, 146
selection criteria, 151-155
break-even points of position, 151-152
neutral ratio, 152-154
volatile stocks preferred, 152
summary, 168
not suitable for all investors, 168
variable, 155-157
trapezoidal hedge, 155, 156, 157
Ratio put spread, 358-361 (see also Ratio spreads)
calendar spread, 361-364
Ratio put writing, 300-301
Ratio spreads, effects on of implied volatility changes,
780-781
Ratio spreads using puts, 358-366
ratio calendar combination, 364-366
ratio put spread, 358-361
deltas, 361
follow-up action, 360-361
limited upside risk, large downside risk, 358, 359
ratio put calendar spread, 361-364
and naked options, 362-363
Ratio strategies, applying mathematical calculations of
volatility to, 480-482
Regression analysis, 566
Reversals, 254-255, 428-430, 431-438 (see also
Arbitrage)
risks in, four, 433-437
Reverse calendar spread, 230-232 (see also Reverse
spreads)
selling, 833-834
Reverse carrying charge market, 697
Reverse conversion, 428-430, 431-438
risks in, four, 433-437
Reverse hedge 123-128, 130, 131 (see also Call buying
strategies)
ratio writing, similarity to, 154-155
straddle buying, equivalent to, 283
Reverse ratio spread (backspread), 232-235 (see also
Reverse spreads)
Reverse spreads, 230-235
backspread, 232-235 (see also Reverse spreads,
reverse ratio spread)
reverse calendar spread, 230-232
margin requirements onerous, 230, 231-232
used infrequently, 230
reverse ratio spread (backspread), 232-235
and delta-neutral spread, 234-235
early exercise, possibility of, 235
established for credits, 233
investment small, 233-234
limited risk, 233
volatile stocks preferable, 235
Rho, 864-865
for LEAPS or warrants, 873
Risk arbitrage, 21, 426-427, 445-454 (see also
Arbitrage)
"hooks," 449-450
limits on merger, 448-450
mergers, 445-448
tender offers, 451-454
Risk-free interest rate, 14
Rolling action, 71-80, 94, 158-160
alternative, 76-77
debit incurred in roll-up, 80-81
different expiration series, using, 78-79
partial, 77
Rolling for credits, 140-144
Martingale strategy, 140, 145
Rolling down strategy, 112-116, 628-629
LEAPS, 394
and protective put, 276
Rolling forward/down, 83-85
Rolling up, 109-110, 267-269, 628-629
"Round-tum" commission, 665-666
Rubenstein, Professor Mark, 797
Russell 2000 Growth Fund, 638, 788
Russell 2000 Value Fund, 638, 788
S&P: see also Standard & Poor
Scientific American, 796
Sector, 500
Semiconductor Index ($SOX), 588, 6,39
HOLDRS, 639
Serial options, 663-666
Series of options, ,5-6
Short-sale rule, 923-924
Short tendering, 453
Short-term trading, call buying and, 102
Sigma, 783-786
Simpson's Rule, 471
Simulated straddle, 123-128 (see also Call buying
strategies)
ratio writing, similarity to, 154-155
SIS (Stock Index return Security), 596-601
cash value formula, 596-597
imbedded call, 597-598
issued in 1993 and matured in 2000, 596
995

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996
SIS (Stock Index return Security) (continued)
track record, 598, 599
trading at discount to cash value, 598-600
trading at discount to guarantee price, 600-601
60/40 rule, 919-920
SPAN (Standard Portfolio Analysis of Risk), 514-515,
667-671
advantages,667
example, 668, 669, 670
how it works, 667-671
maintenance margin, 667
purpose, 667
risk array, 667, 668, 669
Speculating in futures contracts, 655-656
Splitting quote, 171
Splitting strikes, 325-328 (see also Synthetic stock
positions)
Spot/spot price for futures contracts, 658
Spread, diagonalizing, 236-241
advantage,236,241
backspreads,240-241
even-money spread, 240
bear spread, 239-240
bull spread, 236-239
often improvement over normal bull spread, 239
definition, 236
for any type of spread, 241
Spreads, 76, 168-171 (see also under particular head)
backspread,232-235
diagonal, 240-241
bear, using call options, 186-190
bull, 110-111, 113-116, 117, 172-185
butterfly, 200-209
calendar, 116-117, 191-199
categories, three, 169
definition, 168
diagonal, 169, 236-241 (see also Spreads,
diagonalizing)
even money, 240
horizontal, 169
using LEAPS, 403-409 (see also LEAPS)
"leg" into, 171
out of, 180, 207
out-of-the-money call spread, 222-225
ratio call, 210-221
reverse, 230-235
reverse calendar, 230-232
reverse ratio, 232-235
unequal tax treatment on, 929-930
vertical, 169
Spread order, 169-171
Spreads combining calls and puts, 336-357
butterfly spread, 336-338
arbitrageur, role of, 338
box spread, 338
commissions high, 338
Index
equivalent of completely protected straddle write,
338
establishing, four ways for, 336-338
striking prices, three, 336
calendar combination, 345-348, 353-354, 356-357
superior to calendar straddle, 349-350
calendar straddle, 348-350, 354, 356-357
as neutral strategy, 349
criteria for, three, 354
inferior to calendar combination, 349-350
diagonal butterfly spread, 350-353, 354-355, 356-357
criteria, four, 355
legging out, 351-352
follow-up action for bull or bear spreads, 341-344
option purchase and spread, combining, 339-341
bearish scenario, 341, 342
bullish scenario, 339-340, 342
selecting, 353-356
criteria, five, 353-354
summary, 356-357
Standard Portfolio Analysis of Risk (SPAN), 514-515
Standard & Poor (S&P):
Depository Receipt (SPDR), 637-638
expiration, 510-511
100 Index (OEX), 497, 500-501, 582-583
400 Index, 497
500 Futures, 532
500 Index (SPX), 497, 502, 507, 583, 584
Standard & Poor's Stock/Bond Guide, 88
Stock:
buying below its market price, 299-300
underlying, price of as related to option price, 9-10
Stock index hedging strategies, 531-578
follow-up strategies, 557-559
rolling to another month, 557-559
impact on stock market, 561-565
"circuit breaker" of NYSE, 562
at expiration, 564-565
before expiration, 561-563
portfolio insurance, 563-564
regulatory bodies, concern of, 562
trading ban, 562
index, simulating, 566-574
hedge, monitoring, 572-573
high-capitalization stocks, using, 566-571
largest-capitalization stocks, four, 567
options instead of futures, using, 573-57 4
regression analysis, 566
tracking error risk, 571-572
index arbitrage, 547-556
commissions, 552-554
computerized method of order entry, 555-556

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1064


Major Downtrends
From the technical analyst's point of view, it is regrettable that few Bear Markets have produced Major Trendlines of any practical significance on the charts of individual stocks. A notable exception was the long Bear Market of 1929-1932, which produced magnificently straight trendlines on the arithmetic plotting of a host of issues (as well as in the Averages, to which we shall refer later). But it is almost impossible to find other instances in which a Bear Trendline having any forecasting value can be drawn on either arithmetic or semilogarithmic scale.
The
normal
Major Bear Market Trend is not only steeper than the normal Bull Trend (because Bear Markets last, on the average, only about half as long as Bull Markets), but it is also accelerating or down-curving in its course. This feature is accentuated and, hence, particularly difficult to project effectively on the semilogarithmic scale.
The technician cannot expect to obtain much in the net of it, help from his
Major
Trendlines in determining the change from a Primary
Downswing
to a Primary
Upswing.
This should not be taken, however, as advice to not draw trendlines on a Major Down Move, or to disregard entirely any trendlines that may develop with some appearance of authority. If you do not expect too much of them, they may, nevertheless, afford some useful clue as to the way in which conditions are tending to change.
The student of stock market action who is not altogether concerned with dollars and cents results from his researches will find Bear Market Trendlines a fascinating field of inquiry. They do some strange things even though they fail in the practical function of calling the actual Major Turn and go shooting off into space, they sometimes produce curious reactions (or, at least, appear to produce what would be otherwise inexplicable market action) when the real price trend catches up with them months or years later. But such effects, interesting as they may be, are, in our present state of knowledge, uncertain and unpredictable.
(EN: This fact may persist into the mists of the future and be thought of like Fermat's Last Theorem. Our present state of knowledge in the twenty-first century is no further advanced than it was in Magee's time.)
We must dismiss this rather unfruitful topic with the reminder that one clue to the end of a Primary Bear Market is afforded by the Intermediate Trendline of its final phase, which we cited in the preceding chapter.
Major Trend Channels
Another difficulty is met when trying to draw Return Lines and construct channels for Major Trends on an arithmetic chart. Owing to the marked tendency for prices to fluctuate in ever-wider swings (both Intermediate and Minor) as they work upward in a Primary Bull Market, their channel grows progressively broader. The Return Line does not run parallel to the Basic Trendline (assuming there is a good Basic Trendline to begin with) but diverges from it. Occasionally, a stock produces a clear-cut Major Channel Pattern, but the majority do not.
A large Rectangle base was made on this weekly chart in April, May, and June 1937, but observe the poor volume that accompanied the breakout and rise from that formation—an extremely Bearish indication for the Major Trend. The “measurement” of the Rectangle was carried out by August, but that was all.
As is usually the case, it was impossible to draw a Major Down Trendline that had any forecasting value on this chart. The beautiful straight trendlines that appeared in the 1929-1932 Primary Bear Market led many chart students to expect similar developments in every Bear Market, but the fact is that 1929-1932 was unique in that respect.
Semilogarithmic scaling will correct, in many cases, for the Widening Channel effect in Bull Trends, but then we run into the opposite tendency in Primary Bear Markets, and for that, neither type of scaling will compensate.
Trendlines in the Averages
Practically everything stated in the preceding chapter regarding Intermediate Trendline development in individual stocks applies, as well, to the various Averages. The broad Averages or Indexes, in fact, produce more regular trends and, in consequence, more exactly applicable trendlines. This may be partly due to the fact most Averages are composed of active, well-publicized, and widely owned issues whose market action individually is “normal” in the technical sense. Another reason is the process of averaging smooths out the vagaries of component stocks, and the result more truly reflects the deep and relatively steady economic trends and tides.
In any event, it is a fact that such averages as the Dow-Jones Rails, Industrials, and 65-Stock Composite,
The New York Times
50, and Standard & Poor's Average of 90 stocks (the last two named being probably the most scientifically composed to typify the entire broad market) do propagate excellent trendlines on their charts.
(EN: As the reader will note, most of these indices are obsolete. In the mod

eBooks\Technical Analysis of Stock Trends 11thed\Converted\Technical Analysis of Stock Trends, Eleventh Edition.epub#section:main-22.xhtml


te,
The New York Times
50, and Standard & Poor's Average of 90 stocks (the last two named being probably the most scientifically composed to typify the entire broad market) do propagate excellent trendlines on their charts.
(EN: As the reader will note, most of these indices are obsolete. In the modern age, the S&P 500 probably best fulfills this function.)
The very accuracy of their trends, particularly their Intermediate Moves, permits us to construe their trendlines more tightly. Less leeway need be allowed for doubtful penetrations. Thus, although we ask for a 3% penetration in the case of an individual stock of medium range, 2% is ample in the Averages to give a dependable break signal.
Experienced traders know it pays to heed the Broad Market Trend. It is still easier to swim with the tide than against it.
EN: Trendlines in the Averages and Trading in the Averages
Numerous averages and indexes have come online since the fifth edition, including the S&P 100, S&P 500, Russell 2000, and so on. It would be an exercise in daily journalism to attempt to list all the indexes now available, as new ones spring up like weeds after the spring rain. This is because the invention of a widely adopted index can be very lucrative for its creator S&P and Dow-Jones collect licensing fees from the “use” of their indexes by the exchanges. The constant addition of new trading instruments requires that current lists be kept in Resources, and the reader may also consult the
Wall Street Journal, Barron's,
and the
Investor's Business Daily
where prices of indexes and averages are reported. Online brokerages and financial news sites also offer up-to-the-minute lists and quotes on virtually all trading instruments. A list and links to these sites may also be found in Appendix B, Resources, and at
http://www.edwards-magee.com
.
As of the turn of the century, the most important of these indexes joining the Dow are probably the S&P 500, the S&P 100, and the NASDAQ. In fact, these are probably sufficient for economic analysis and forecasting purposes, and certainly good trading vehicles by means of surrogate instruments, options, and futures. Some would include the Russell 2000 in this list. These indexes and averages have been created to fill needs not addressed adequately by the Dow-Jones Averages.
With this proliferation of measures of the market and various parts of it, a different question arises questioning the value of the Dow alone in indicating the Broad Market Trend. Limited research has been done on this question; however, my opinion is the Broad Market Trend must now be determined by examining the Dow Industrials, the S&P 500, and the NASDAQ Composite.
Trading the Averages in the 21st century
As pointed out in other new chapters and notes in the eighth edition, the ability to trade the Averages instead of individual stocks is a powerful choice offered by modern markets. The index ETFs offer ideal vehicles for investing: The DIA, SPY, QQQ and IWM give the modern investor unparalleled flexibility and convenience. Magee was of the opinion that the Averages offered technical smoothness often lacking in individual issues. This would seem to be true intuitively. After all, just as a moving average smooths data, the average of a basket of stocks should dampen price volatility. Of course, as Mandelbrot pointed out, in a 10-sigma market storm everything sinks.
Illustrated in this chapter are several detailed cases following Magee's suggestion of Average trading. I attempt to demonstrate here two perspectives: one, the horror of the immediate, what the crash and panic look like as they occur; and two, what the crash and panic look like in retrospect. We all live in the present, except for the great billionaires who can afford to doze through horrific Bear Markets. Bill Gates' net worth varied by $16 billion or $17 billion in early 2000. This would put the ordinary investor out of business.
So the ordinary investor, you and I, have to respect the great yawning Bear Market. We must step to the sidelines and let the bear eat the foolish virgins, to borrow a Biblical metaphor.
You will remember Magee opined that a trendline break of 2% was sufficient to cause liquidation of longs when analyzing the Averages. In the accompanying figures, this hypothesis is examined.
EN9: In respect to the breaking of trendlines (by 2% or 3%), I should note the breaking of a trendline is as much a
warning
as a signal to act. The break, instead of a change of trend to the reverse, may indicate a change of trend to the sideways—into a reversal or continuation pattern.
chapter sixteen
Technical analysis of commodity charts
(EN9: Following the practice of allowing the reader to discriminate between the work of Edwards and Magee and that of the editor, a section on commodity trading,
Chapter 16
, has been added to the ninth edition. See same.)
A little thought suggests the variously interesting and significant patterns we have examined in the foregoing chap


ng the reader to discriminate between the work of Edwards and Magee and that of the editor, a section on commodity trading,
Chapter 16
, has been added to the ninth edition. See same.)
A little thought suggests the variously interesting and significant patterns we have examined in the foregoing chapters on stock charts should logically appear as well in the charts of any other equities and commodities that are freely, constantly, and actively bought and sold on organized public exchanges. In general, this is true. The price trends of anything for which market value is determined solely (or for all practical purposes within very wide limits) by the free interplay of supply and demand will, when graphically projected, show the same pictorial phenomena of rise and fall, accumulation and distribution, congestion, consolidation, and reversal that we have seen in stock market trends. Speculative aims and speculators' psychology are the same whether the goods dealt in are corporate shares or contracts for the future delivery of cotton bales. (For illustrations in this chapter, see Figures
16.1
through
16.13
.)
It should be possible in theory, therefore, to apply our principles of technical analysis to any of the active commodity futures (wheat, corn, oats, cotton, cocoa, hides, eggs, etc.) for which accurate daily price and volume data are published. It should be, that is, if proper allowance is made for the intrinsic differences between commodity futures contracts and stocks and bonds.
In previous editions of this book
(EN9: up to the eighth)
, traders who cast longing eyes on the big, quick profits apparently available in wheat, for example, were warned that commodity charts were “of very little help,” as of 1947.
It was pointed out that successful technical analysis of commodity futures charts had been possible up to about 1941 or 1942, but the domination of these markets thereafter by government regulations, loans, and purchases completely subject to the changing (and often conflicting) policies and acts of the several governmental agencies concerned with grains and other commodities had seriously distorted the normal evaluative machinery of the market. At that time, radical reversals of trend could and did happen overnight without any warning so far as the action of the market could show. The ordinary and orderly fluctuations in supply-demand balance, which create significant definite patterns for the technician to read, did not exist. Yet, while fortunes were made (and lost) in wheat, corn, and cotton futures during the World War II period, it is safe to say they were not made from the charts.
During the past five or six years, however, the application of technical methods to commodity trading has been reexamined. Under 1956 conditions, it appears that charts can be a most valuable tool for the commodity trader. The effects of present government regulation have apparently resulted in “more orderly” markets without destroying their evaluative function. Allowing for the various essential differences between commodities and stocks, the basic technical methods can be applied.
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Figure 16.1
Oats, for obvious reasons, traced more “normal” patterns than Wheat during the 1940s. This chart contains an H & S bottom, a Symmetrical Triangle that merged into the Ascending form, a gap through a former top level, and an interesting trendline. The Island shake-out through the trendline was an extremely deceptive development.
It may be in order here to discuss briefly some of the intrinsic differences between commodity futures and stocks referred to above and to some of the special traits of commodity charts. First, the most important difference is the contracts for future delivery, which are the stock-in-trade of the commodity exchange, have a limited life. For example, the October cotton contract for any given year has a trading life of about 18 months. It comes “on the board” as a “new issue,” is traded with volume increasing more or less steadily during that period, and then vanishes. Theoretically, it is a distinct and separate commodity from all other cotton deliveries. Practically, it seldom gets far out of line with such other deliveries as are being bought and sold during the same period, or with the “cash” price of the physical cotton in warehouses. Nevertheless, it has this special quality of a limited independent life, as a consequence of which long-term Support and Resistance Levels have no meaning whatever.
(EN10: This absolute may not be absolute. Evaluate the longterm charts for your issue to see whether influence is evident.)
Second, a very large share of the transactions in commodity futures—as much as 80% certainly in normal times—represents commercial hedging rather than speculation.
(EN10: Less true in the twenty-first century.)
It is, in fact, entered in to


harts for your issue to see whether influence is evident.)
Second, a very large share of the transactions in commodity futures—as much as 80% certainly in normal times—represents commercial hedging rather than speculation.
(EN10: Less true in the twenty-first century.)
It is, in fact, entered in to obviate risk and to avoid speculation. Hence, even near-term Support and Resistance Levels have relatively less potency than with stocks. Also, because hedging is to a considerable degree subject to seasonal factors, there are definite seasonal influences on the commodity price trends that the commodity speculator must keep in mind, even if only to weigh the meaning of their apparent absence at any given period.
A third difference is in the matter of volume. The interpretation of volume with respect to trading in stocks is relatively simple, but it is greatly complicated in commodities by the fact that there is, in theory, no limit to the number of contracts for a certain future delivery that may be sold in advance of the delivery date. In the case of any given stock, the number
Figure 16.2
In contrast with the grains, the technical action of the Cotton futures markets has been fairly consistent with normal supply-demand functioning ever since prices rose well above government support levels. In this daily chart of the 1947 October delivery (New York Cotton Exchange), the reader will find a variety of familiar technical formations, including critical trendlines, a Head-and-Shoulders top that was never completed (no breakout), and Support-Resistance phenomena much the same as appear in stock charts. Double trendlines are not at all unusual in Cotton charts.
of shares outstanding is always known. As this is written (1956), there are in the hands of stockholders 13,700,203 common shares of Consolidated Edison, and that quantity has not varied for many years nor is it likely to change for several years to come. Every transaction
In the case of commodity future contracts—say, September wheat—trading begins long before anyone knows how many bushels of wheat will exist to be delivered that coming September, and the open interest at some time during the life of the contract may exceed the potential supply many times over, and all quite legitimately.
(EN9: As always, volume data is a supplementary indicator to price. No one makes a profit on it.)
One more important difference may be mentioned. Certain kinds of news—about weather, drought, floods, and so on that affect the growing crop, if we are dealing with an agricultural commodity—can change the trend of the futures market immediately
1997      1998      1999      2000      2001      2002      2003      2004
Created with TradeStation
Figure 16.3
A
Rounding Bottom in Gold 1997-2004. “These patterns, when they occur
after an extensive decline
, are of outstanding importance, for they nearly always denote a change in Primary Trend and an extensive advance yet to come. That advance, however, seldom carries in a ‘skyrocket' effect, which completes the entire Major Move in a few weeks. On the contrary, the uptrend that follows the completion of the pattern itself is apt to be slow and subject to frequent interruptions, tiring out the impatient trader, but yielding eventually a substantial profit.” So said Robert Edwards in remarking on Rounding Bottoms in stock charts. As may be seen here, this Rounding Bottom consists of a downtrend, a false signal off the Double Bottom (upon which a pretty penny might have been made by the agile trader), and a handsome uptrend—and it all looks like a huge Rounding Bottom.
and drastically and are not foreseeable given the present stage of our weather knowledge. Analogous developments in the stock market are extremely rare.
(EN: Except for acts of God and Alan Greenspan [and Ben Bernanke])
.
It is not the purpose of this book to explain the operation of commodity futures markets, nor to offer instruction to those who wish to trade therein. This brief chapter is included only as a starter for readers who may want to pursue the study further. They should be advised that successful speculation in commodities requires far more specialized knowledge and demands more constant daily and hourly attention. The ordinary individual can hope to attain a fair degree of success in investing in securities by devoting only his spare moments to his charts, but he might better shun commodity speculation entirely unless he is prepared to make a career of it.
(EN: The editor has been, during his checkered career, a registered commodity trading advisor. At the beginning of that career, I discussed these subjects with Magee and received essentially the above comments, which are here reproduced from the fifth edition. Subsequently, I observed among my associates and partners, and on my own, that futures are eminently tradable with the
adaptation
of techniques and methods described in this book. It is also true, as Magee says, that futures trading is so different i


which are here reproduced from the fifth edition. Subsequently, I observed among my associates and partners, and on my own, that futures are eminently tradable with the
adaptation
of techniques and methods described in this book. It is also true, as Magee says, that futures trading is so different in tempo, leverage, and character that the novice risks life, limb, and capital in entering the area unescorted. Resource references are essential reading, but the beginner is urged to educate himself
before
beginning trading with extensive study and paper trading.)
Figure 16.4
Gold, October 2011. The momentous earth-shaking power of a massive rounding bottom is vividly dramatized by the gold chart since 2005, as well as the power of chart analysis to anticipate it. Regrettably, the editor did not compute the price target implications of the pattern in the ninth edition in 2005. That computation was made at the
http://www.edwards-magee.com
website at the time. There it was computed as follows (and the reader can do it for himself): depth of pattern, 248.20 plus neckline 507.40, target 755.60. In fact, the possibility was entertained that the entire formation from 1980 to 2008 might be a Rounding Bottom. In which case, the depth was 700.70, added to the neckline of 959 and resulted, actually achieve, in a target of 1,660. Remember Edwards said these were probable minimum measurements.
Technical analysis of commodity charts,
part 2: a 21st-century perspective
In the search for the Philosopher's Stone, more sweat and money have been put into the area of commodities and futures than were ever expended in the securities arena. There is a simple reason for this—great fortunes are made and lost with much greater rapidity in the futures area than in securities. Of all the great dramatic moments in stock market history, few are so memorable as the great Hunt silver market, or Soros facing off against the Bank of England, or of gold soaring to $1,000 an ounce (deferred contracts). And the saga continues in 2005: $50 oil? $60? $70? $100? And the effects, economic and psychological! In dimly lit garrets and brightly lit computer rooms thousands of researchers concoct systems to trade these markets—corn, soybeans, silver, copper ...
Rocket scientists
At times, individual traders and groups of traders have plundered (harvested?) these markets for fairy tale profits. I know whereof I speak, having been a principal in California's first licensed commodity trading advisor that was founded by the NASA rocket scientist R. T. Wieckowicz. During the 1970s, as the stock markets ground futilely around the 1,000 level on the Dow, the futures markets returned yearly gains in the 100% range. Consistently. For years. Those were the years of the California systems traders and the beginning of computerized trading. From the primeval slime of NASA, rocket scientists emerged to create a renaissance in market technology. At the time it seemed clear that science and genius had at last conquered the markets and that clients would come buzzing from the world over like bees to a honey
@SI.P(D) - Weekly COMEX L = 7.035 +0.077 +1.11% B = 0.000 A = 0.000 O = 6.985 Hi = 7.085 Lo = 6.980 C = 7.045 V = 145
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1998     1999     2000     2001     2002     2003     2004     2005
Created with TradeStation
Figure 16.5
A
Rounding Bottom in Silver, 1998-2005. The apparent Rounding Bottom in silver, combined with the same pattern in gold, would seem to cast a pall over the economic situation for some time to come in 2005. This coincides with the apparent long-term patterns setting up in the securities markets. If the best that can be hoped for in securities is a 1965-1982 kind of widely whipping market, commodities may react as they did in the 1970s—with tidal wave markets. These markets can be traded by the well-capitalized chart analyst who is well seasoned. Tyros will lose money learning the game whatever markets they trade. Their chances will be immeasurably improved by applying the techniques taught in this book. In addition to the technical pattern pictured here, there is every reason to suspect that a large fundamental shortage of silver bullion exists and will worsen. Ted Butler, at
http://www.doomgloom.com
, is a long-term silver analyst (and associate of the editor) who anticipates a new silver blow-off is coming. One wonders what Nelson and Bunker Hunt are doing at present. A very cautious investor (like Warren Buffet who is reported to have invested $1 billion in silver bullion) may defeat futures silver volatility by buying the bullion.
pot and that the rivers of profits would last forever. They did last for some time, and then the markets changed. Mechanical systems that cut through the markets like a reaper in a wheat field in Bull Markets grind up capital like sausage in sideways markets. Science and genius were revealed as the happy combination of man, moment, system, and market.
Turtles?
During the 1980s from the sea came crawling the Turtles. Pr


al systems that cut through the markets like a reaper in a wheat field in Bull Markets grind up capital like sausage in sideways markets. Science and genius were revealed as the happy combination of man, moment, system, and market.
Turtles?
During the 1980s from the sea came crawling the Turtles. Progeny of the protean trading wizard, Richard Dennis, the Turtles again harvested outsize profits from the markets, reportedly running in the 80% yearly range. The so-called Turtles got their name from a comment that Dennis is reported to have made that traders were made not born, and he was going to raise traders like turtles. Additional reading about the Turtles is available in Jack Schwager's fascinating books, including
Market Wizards
and others. Schwager's books are required reading for aspiring futures traders. Additionally, the trading manual of the Turtles will be found online at
http://www.originalturtles.org
. This workbook, written by
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Figure 16.6
Silver, May 2005. Although the long-term silver outlook may be Bullish, the short term will be very volatile, especially for the thinly capitalized trader. Then short-term tactics must be adopted. The Island Top here at 1 is a gentle invitation to the trader to take his profits and be gone. Even to short, with a stop just above the high. The run day after 1 adds a note of urgency to the invitation. The gap is punishment for the hard of hearing and a bonus for the quick-witted (everybody who survives in futures is either quick witted or extremely well financed). The stop moves down to the top of the gap day, then to the top of the next gap day, and for the very apt profits are taken on the next run day down, on the principle of sell weakness, buy weakness. The tight trendline at 2 crossed by the heavy run day is a buy signal with the stop moving to the bottom of the gap at 3, where it is taken out a few days later by the long-range day down. The run day at 4 is a short signal with the stop being at the day's high. Is it necessary to say short-term futures trading can be quite rapid? There is always bullion or associated stock plays.
Curtis Faith, an original Turtle, contains virtually all of the elements necessary in a trader's systems and procedures manual. The manual was prepared according to the training Dennis gave his Turtles. Serious traders do not operate without some such document. Certainly all of the serious traders I have known (a considerable number) have had fully developed manuals like the Turtle workbook. I cite the Turtle workbook rather than others in my possession because it is publicly available at
http://www.originalturtles.org
(as well as in the 9th edition of this book) and because it is beautifully articulated.
In the late 1990s, the Turtles were made into turtle soup in the futures markets as the majority of systems traders wound up as hamburger meat.
Is there a moral? Yes. The markets giveth and the markets taketh away. Science and genius are again revealed to be the happy combination of man, method, moment, and market.
The Turtle system is basically an adaptation of Richard Donchian's channel breakout system. In the Donchian system, the trader goes long when the 20-day high is broken and sells and goes short when the 20-day low is broken. In the 1970s, Dunn and Hargitt evaluated a number of mechanical trading systems and found that Donchian's system was superior to the others evaluated at that time. Will Donchian's system still work? Yes,
Figure 16.7
Silver, October 2011. Here is what happened in silver after the ninth edition was published. Could there be any greater vindication of the value of charts looking at the issue six years later? Just as in the case of gold, the analysis allowed the analyst to anticipate a monster Bull Market. On
http://www.edwards-magee.com
, the authors wrote letters all during this time pointing out the silver Bull. Measuring the entire formation, the depth is 33.96, added to the neckline of 37.5 equals 71.46. This seems quite fanciful to us, but that is the measurement.
in broadly trending markets. Will the Turtle system still work? Yes, in broadly trending markets. Plus, like virtually all mechanical systems, they do not know whether they are in a broadly trending market or not. They are blind—all they see are ones and zeros. The addition to these systems of prudently applied chart analysis will immeasurably improve their performance and risk characteristics.
The application of Edwards and Magee's
methods to 21st-century futures markets
During my career as a commodity trading advisor, I have known a number of successful traders and advisors who used what I would describe as Magee-type chart analysis to


improve their performance and risk characteristics.
The application of Edwards and Magee's
methods to 21st-century futures markets
During my career as a commodity trading advisor, I have known a number of successful traders and advisors who used what I would describe as Magee-type chart analysis to make their trades. Often, other elements were input into their decision-making process, but manual charting was a key factor in their operations. Some of these traders used simple trendline analysis with price or volume filters and some used a combination of trendlines and support and resistance.
All were trend followers.
Having looked at the futures markets with some attention over the past several years, it seems to me there is no reason why chart analysis should not work as well now in futures as it has always worked in stocks. Essentially, the questions raised by securities trading are the same as those presented by futures trading in the analysis of a chart. Is there a trend? Where are support and resistance? Is there a breakout? Are there waves and wavelets? How do you enter and how do you exit?
The great bug-a-boo of securities traders coming to the futures trading is the speed of the game. Like college football players stepping up to the NFL, there is a brutal learning curve and rookies are the most likely to get killed. I am not going to make any effort here to present a primer for new futures traders, but rather, I will look at some futures charts at the end of this chapter to show the journeyman that chart analysis can be used
Figure 16.8
Treasury Bonds. The double-pump triple-nod head fake is a specialty of futures markets. The fear and greed factor are multiplied by 10, like the leverage. But here in September 2004 Bonds, we can see how simple chart analysis can serve the trader. The downtrend from March (1) is completely manageable with a simple trendline and trend analysis. The end of the downtrend in May is marked by two strong run days. At any rate, the stop would have been at May 1, using a Basing Point kind of analysis. If we were going to trade it long, this would have been traded for a scalp (because we do not know whether or not there is a bottom). The break of the trendline at 2 is an engraved invitation to get long and the trendline at 3 keeps us long until broken by the signal day at the end of July. This would put us short again, whereas a two-day trade as the signal day on the trendline at 4 puts us long again. Obviously, we are using very tight, short trendlines and long-range days (or run days) as signals. The use of the run day as a signal, combined with other indicators, is common in my experience among traders.
as a decision-making method in these dramatic markets. Again, chart analysis has the weakness (or strength) of being a qualitative process. It will not make decisions for the average trader, as a mechanical system will.
On the other hand, a breakout is a breakout. A gap is a gap, leaving aside the question of limit move gaps for the moment. A trend is a trend. And here is the great advantage that a firm grasp of charting methods can give the practitioner.
It can give him the perspective to recognize the essential nature of the market at hand and choose to wait or to enter.
Mechanical methods not having the qualitative discrimination of an experienced chartist will blindly take every trade until they are out of money. The experienced chart analyst can sit back and say, this market has not yet made a bottom and the time to begin trading it long has not yet come. Or, he can recognize the essential differences between a trading and a trending market and adjust his tactics accordingly. As Magee noted in
Chapter 16
:
Under what might be called normal market conditions, those chart patterns which reflect trend changes in most simple and logical fashion work just as well with commodities as with stocks. Among these we would list Head-and-Shoulders formations, Rounding Tops
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Isi 1998-2004 Prophet Financial Systems, Inc. I Terms of use apply.
Figure 16.9
Commodity Research Bureau Index, April 2005 Futures. Just as Triangles often work in securities, they often work in futures. Breakaway gap, second breakaway gap, runaway gap, second runaway gap—this is the formation before the second runaway gap is somewhat quizzical—it might be considered a flag, but it has the same effect, and depending on the trader's operating methods, the stop would be just under the gap/run day anyway. It will not take much study for the reader to see the principles of chart analysis used in this entire book are validated here. The main difference is in the setting of stops, and in fact, the same stop methods may be used if the trader is sufficiently well financed.
and Bottoms, and basic trendlines. Trendlines, in fact, are somewhat better defined and more useful in commodities than in stocks. Other types of chart formations which are associated with stocks wit


f stops, and in fact, the same stop methods may be used if the trader is sufficiently well financed.
and Bottoms, and basic trendlines. Trendlines, in fact, are somewhat better defined and more useful in commodities than in stocks. Other types of chart formations which are associated with stocks with short-term trading or with group distribution and accumulation, such as the Triangles, Rectangles, Flags, etc., appear less frequently in commodities and are far less reliable as to either direction or extent of the ensuing move. Support and Resistance Levels, as we have already noted, are less potent in commodities than in stocks; sometimes they seem to work to perfection, but just as often they don't. For similar reasons, gaps have relatively less technical significance.
These words remain true today, as do virtually all the principles enunciated in this book by Edwards and Magee and myself. In fact, if most futures charts were given to an
Figure 16.10
Commodity Research Bureau (CRB), long-term view. It does not take much analysis of this 10-year CRB chart to see a huge Double Bottom and to consider its implications. If China and India are going to compete with us for natural resources, we could see an entirely new economic paradigm, if the reader will excuse the term. Clearly, there is a Bull market in commodities. In
Chapter 42
, Pragmatic Portfolio Management, it is suggested that capital should flow to markets that are moving, rather than remaining committed to markets that are mired in mulish trends. Furthermore, it is suggested in that chapter that a good natural hedge is to go long on the uptrend of an index and short the components of it that are in downtrends. The CRB is somewhat thin but might lend itself to this strategy.
Figure 16.11
The 20-year bonds as expressed in the TLT; ETF Bonds display classical signals of absolute clarity.
Figure 16.12
September, 1994. Coffee was so easy in retrospect that it should be engraved on a brass plate. The long is taken on the breakout of the horizontal trendline. The position is never in any danger, as there is no down-wave of significance until May when stops are advanced to stay 5% under lows (Basing Points). The May down-wave allows a Basing Point stop to be established. The breakaway gap is a windfall profit. The flag tells us that more is coming—as it does with another gap and run days—until the spike reversal, which is a clear signal to be out on the close. A gap up on the open, an exploration up, and a close down—an absolutely clear message of reversal from the market.
256                                                       Technical Analysis of Stock Trends
Figure 16.13
The May 11 top in silver. In the first quarter of 2011, silver took off in a roaring uptrend. Any surprise here, after looking at the Bounding Bottom? As seen in the chart, it came near to going parabolic. The top notice came on April 25—interestingly on a reversal bar. Reading the Candlestick, the market gapped wide on the opening and took a long excursion down to close the opening gap. Then bargain hunters thought they were getting a good price on silver and drove the price back up, so it did not close on the lows. The next day, it gapped down on the open and basically wandered down all day long—the party was over. The signs were subtle.
Chapter sixteen: Technical analysis of commodity charts                                  257
analyst, without issue identification and dates would not be identifiable as commodity charts. When limit moves appear, the difference slaps one in the face. On this point I might differ from Magee slightly as regards to gaps. Obviously, limit move gaps have breathtaking significance. All in all, it seems to me gaps often say the same thing to futures analysts as they do to stock analysts.
Another mathematical reason might be adduced for the practicality of using simple chart analysis to trade futures. That is the tautological nature of the method. A trend is a trend, and a trendline is a trendline. If you enter a suspected trend (setting a protective stop at a technically analyzed place) and follow the trend using Basing Points or observing the trendline and exiting on a break and reversal there will be no difference from doing the same with a stock. Well, some difference. Due to the leverage, you will be required to be hyperaware of risk. In futures, the penalty for holding a position through “a normal reaction” can be extremely harsh. That is why stops are so important.
The TLT chart from late 2008 is a spectacular display of patterns and signals. This pattern has appeared many times before and will appear again in the future.
Prices break out of a sideways pattern on a strong gap. The gap is across the trendline, which is what makes the signal significant. Every gap is not a signal. In this case, the gap is extra significant because there is a power bar on the gap day—it should be bought. This is called a breakaway gap. Prices continue to progress, and a


ern on a strong gap. The gap is across the trendline, which is what makes the signal significant. Every gap is not a signal. In this case, the gap is extra significant because there is a power bar on the gap day—it should be bought. This is called a breakaway gap. Prices continue to progress, and a few days later another gap occurs. This is a runaway gap and is another signal.
Shortly thereafter, prices drift sideways for a few days. This is a flag. Flags are vivid messages to traders. Robert Edwards described how they are used. He said, “The flag flies at half-mast,” meaning after a rocket-like advance and this formation, prices should advance on at least as far as they had come.
Power bars (signals) exit from the flag, and then another gap occurs. This is the exhaustion gap. This is a message to exit longs and to short the issue. The message could not have been clearer.
The skilled trader, first of all, catches the original signal—the power bar exiting from the sideways pattern. He then pyramids on the subsequent signals. Exiting from the flag, a good trader should have a boatload of this issue, and at the top, selling after the exhaustion gap, he should have made at least a small killing.
Stops
Some traders set their stops using money management rules rather than technically identified points. I believe it is always better to find the technical point using a Basing Point, or support and resistance. To me it makes better sense to adjust position size to control risk as I describe in
Chapter 26
. The use of money management stops has been very successful for many traders.
If some logical and disciplined method of setting and observing stops is not installed, the trader is assured of failure.
A money management stop is, simply enough, a stop calculated by deciding to risk 2% (or 3% or 4% or x%) of capital on a trade. For example, William O'Neil says that when a stock trader enters a position, he should set a stop 8% under his entry price. This is a little crude, and not strictly speaking, a money management stop, but it is better than no risk calculation at all. In a stricter sense, if we said we wanted to limit the risk of the trade to 3% of capital, we would use the 8% rule to set the stop and the Scott Procedure in
Chapter
26
to determine the number of shares or contracts. The Turtle system contains similar procedures. Numerous studies have proven the size of the risk per trade—1%, 2%, 3%—is directly correlated to equity volatility.
The 25th looked like a reversal day. The gap down on the 26th could have been considered the closing of an exhaustion gap—not apparent here because the tails (shadows) of the candlesticks obscure the complete price behavior.
(EN10: In the 10th edition, a new section on stops in
Chapter 27
examines a number of stop methods.)
A variety of methods
As noted above, a competent chart analyst may, in my opinion (and in Magee's opinion), perform profitably in the futures markets. There are other questions, of course, namely of character, temperament, intelligence, judgment, and so on. Let us leave those questions to Dr. Elder and confine ourselves to the method question. Chart analysts proved their abilities in the futures markets long before computers existed. In fact, long before in the case of Japanese rice traders, enlightening their efforts with candlesticks in the eighteenth century.
In the 1970s, I saw point and figure chartists enjoy great success at Dean Witter and Merrill Lynch and other major firms in futures. I have seen least squares curve fitters, moving average calculators, and abstruse statistical analysts all enjoy profitable outings in commodities. Not to speak of the Turtles who, using naturalistic high-low systems, harvested good profits in the markets. As the saying goes, gateless is the gate and many are the ways to the great Dow. Although I have enjoyed great success myself using mechanical number-driven systems over the years, I have become more and more attracted to “natural” systems. Chart analysis is essentially natural, as is the Turtle system. The Dow Theory is a natural system in which no mathematical algorithm comes between the analyst and the data. The essential, more, quintessential, weakness of all number-driven systems is their blindness. They do not have the ability to discriminate between the forest and the trees. The experienced human chartist can
see
(and hear) the changing rhythms of the market and respond to them, responding to factors too subtle (and even subconscious) to program. Nevertheless, even natural systems, like the Turtle systems, can fall into this trap. When the markets learn a lot of capital is waiting just above the 20-day high, they will set a trap for it. For “markets” you may read “they.” If you apply the knowledge of this book to such situations, you may avoid the trap.
Everything you need to know as a chart analyst trading futures
“Jack be nimble, Jack be quick, Jack jump over the Candlestick.” Yes, it is true, as the lever


will set a trap for it. For “markets” you may read “they.” If you apply the knowledge of this book to such situations, you may avoid the trap.
Everything you need to know as a chart analyst trading futures
“Jack be nimble, Jack be quick, Jack jump over the Candlestick.” Yes, it is true, as the leverage is 10 times greater and the speed is 10 times faster. I have illustrated in
Figure 16.9
the combination of a very tight trendline with a run day, which it seems to me is a good current (twenty-first century) combination. Otherwise, the same qualities that make a good securities trader make a good futures trader once the great leap to leveraged quick-fire markets is made. If you have been successful trading stocks, you will probably be successful trading futures, and you probably should practice on stocks while studying futures. A sobering fact I often recount to my graduate students is that Richard Wyckoff worked in the securities business for eight years before making his first investment; he studied the markets an additional six years before
trading.
The Magee methodology will serve as a valuable cornerstone of your futures operations and you must never cease studying. Mechanical systems have their attractions, especially when seasoned with experienced chart analysis. No method will survive unless practiced with diligence, persistence, judgment, and patience. Time and again you will hear famous traders say discipline is the secret of their success. What they mean by discipline is their ability to measure and contain the risk, set a stop based on technical or money management procedures, and
then honor the stop.
The most important lesson the futures trader has to learn from Edwards and Magee is the ability to see the character of the market, trading or trending, and then
to adjust his tactics accordingly.
In the next great Bull Market in commodities, which is inevitable, these methods and systems derived from them will once again reap windfall profits.
I have attempted in the ninth edition of this classic book to show the book's usefulness to the intelligent futures trader. Simple classical chart analysis alone can be successful in the futures markets in the hands of an experienced competent analyst. Natural mechanical systems such as the Turtle system have been effective and will be again, perhaps with some tweaking (such as imposing a chart analysis superstructure). Wave analysis methods such as the Basing Points Procedure of
Chapter 28
can be used. Even number-driven systems, such as moving averages, can be successful, especially if combined with chart analysis.
chapter seventeen


A summary and concluding comments
We began our study of technical stock chart analysis in
Chapter 1
with a discussion of the
philosophy
underlying the technical approach to the problems of trading and investing. We could ask the reader to turn back now and review those few pages to recapture a perspective on the subject that must have been dimmed by the many pages of more or less arduous reading that have intervened. (For illustrations in this chapter, see Figures
17.1
through
17.4
.)
It is easy, in a detailed study of the many and fascinating phenomena that stock charts exhibit, to lose sight of the fact they are only the rather imperfect instruments by which we hope to gauge the relative strength of supply and demand, which, in turn, exclusively determines what way, how fast, and how far a stock will go.
Remember, in this work, it does not matter what creates the supply and the demand. The fact of their existence and the balance between them are all that count. No man, no organization (and we mean this
verbatim et literatim
) can hope to know and accurately appraise the infinity of factual data, mass moods, individual necessities, hopes, fears, estimates, and guesses that, with the subtle alterations ever proceeding in the general economic framework, combine to generate supply and demand. Nevertheless, the summation of all these factors is reflected virtually instantaneously in the market.
The technical analyst's task is to interpret the action of the market itself—to read the flux in supply and demand mirrored therein. For this task, charts are the most satisfactory tools thus far devised. Lest you become enrapt, however, with the mechanics of the chart— the minutiae of daily fluctuations—ask yourself constantly, “What does this action really mean in terms of supply and demand?”
Judgment, perspective, and a constant reversion to first principles is required. A chart, as we have said and should never forget, is not a perfect tool nor a robot; it does not give all the answers quickly, easily, or positively, in terms anyone can read and translate at once into certain profit.
We have examined and tested exhaustively many technical theories, systems, indexes, and devices that have not been discussed in this book (chiefly because they tend to shortcircuit judgment) to see the impossible by a purely mechanical approach to what is far from a purely mechanical problem. The methods of chart analysis that have been presented are those that have proved most useful because they are relatively simple and easily rationalized since they stick closely to first principles. Additionally, they are of a nature that does not lead us to expect too much of them and they supplement each other and work well together.
Let us review these methods briefly. They fall roughly into four categories:
1. The
Area Patterns
or formations of price fluctuation that, with their concomitant volume, indicate an important change in the supply-demand balance. They can signify Consolidation, a recuperation or gathering of strength for renewed drive in the
same direction
as the trend that preceded them. Or they can indicate Reversal, the playing out of the force formerly prevailing, and the victory of the opposing force, resulting in a new drive in the
reverse direction
. In either case, they may be described as periods during which energy is brewed or pressure is built up to propel prices in
Figure 17.1
Spiegel's Bear Market started in April 1946 from a Symmetrical Triangle that changed into a Descending Triangle. Note the Pullback in June and two Flags. This history is carried on in
Figure 17.2,
which overlaps Figure 17.1; this chart shows the move that ensued from the wide Descending Triangle of early 1947, culminating in a Reversal Day on May 19. Note various Minor and Intermediate Resistance Levels.
Technical Analysis of Stock Trends
Figure 17.2
Overlapping Figure 17.1, this chart shows the move that ensued from the wide Descending Triangle of early 1947, culminating in a Reversal Day on May 19. Note various Minor and Intermediate Resistance Levels.
Chapter seventeen: A summan/ and concluding comments
a move (up or down) that can be turned to profit. Some of them provide an indication as to how far their pressure will push prices. These chart formations, together with volume, furnish the technician with most of his “get-in” and many of his “get-out” signals.
Volume, which has not been discussed in this book as a feature apart from price action, and which cannot, in fact, be utilized as a technical guide by itself, deserves some further comment. Remember it is
relative
that it tends naturally to run higher near the top of a Bull Market than near the bottom of a Bear Market. Volume “follows the trend,” meaning it increases on rallies and decreases on reactions in an overall uptrend, and vice versa. But use this rule judiciously; do not place too much dependence on the showing of a few days and bear in mind that even in a Bear Market (except durin

eBooks\Technical Analysis of Stock Trends 11thed\Converted\Technical Analysis of Stock Trends, Eleventh Edition.epub#section:main-23.xhtml


ottom of a Bear Market. Volume “follows the trend,” meaning it increases on rallies and decreases on reactions in an overall uptrend, and vice versa. But use this rule judiciously; do not place too much dependence on the showing of a few days and bear in mind that even in a Bear Market (except during Panic Moves), there is always a slight tendency for activity to pick up on rises. (“Prices can fall of their own weight, but it takes buying to put them up” as Edwards said.)
A notable increase in activity, as compared with previous days or weeks, may signify either the beginning (breakout) or the end (climax) of a move, temporary or final. (More rarely, it may signify a “shakeout.”) Its meaning, in any given case, can be determined by its relation to the price pattern.
2.
Trend and trendline
studies supplement Area Patterns as a means of determining the general direction in which prices are moving and of detecting changes in direction. Although lacking the nice definition of Area Formations, they may frequently be used for “get-in” and “get-out” purposes in short-term trading, as well as provide a defense against premature relinquishment of profitable long-term positions.
3.
Support and Resistance Levels
are created by the previous trading and investment commitments of others. They may indicate where it should pay to take a position, but their more important technical function is to show where a move is likely to slow down or end, and at what level it should encounter a sudden and important increase in supply or demand.
Before entering a trade, look both to the pattern of origin for an indication of the power behind the move and to the history of Support-Resistance for an indication as to whether it can proceed without difficulty for a profitable distance. SupportResistance studies are especially useful in providing “cash-in” or “switch” signals.
4.
Broad market background
, including the
Dow Theory
, should not be scorned. This time-tested device designates the (presumed) prevailing Major Trend of the market. Its signals are “late,” but with all its faults (like the greatly augmented following it has acquired in recent years resulting in a considerable artificial stimulation of activity at certain periods), it is still an invaluable adjunct to the technical trader's toolkit.
The general characteristics of the various stages in the stock market's great Primary Bull and Bear cycles, which were discussed in our Dow Theory chapters, should never be lost to view. This brings us back to the idea of
perspective
, which we emphasized as essential to successful technical analysis at the beginning of our summary. The stock that does not, to some degree, follow the Major Trend of the market as a whole is an extraordinary exception. More money has been lost by buying perfectly good stocks in the later and most exciting phases of a Bull Market, and then selling them, perhaps from necessity, in the discouraging conditions prevailing in a Bear Market, than from all other causes combined.
Hence, keep your perspective on the broad market picture. The basic economic tide is one of the most important elements in the supply-demand equation for each individual stock. It may pay to buck “the public,” but it does not ever pay to buck the real underlying trend.
Major Bull and Bear Markets have recurred in fairly regular patterns throughout all recorded economic history, and there is no reason to suppose they will not continue to recur for as long as our present system exists. It is well to keep in mind that caution is in order whenever stock prices are at historically high levels and that purchases will usually work out well eventually when they are at historically low levels.
If you make known your interest in your charts, you will be told the chart analyst (like the Dow theorist) is always late—buying after prices have already started up (maybe not until long after the “smart money” has completed its accumulation) and sells after the trend has unmistakably turned down. Partly true, as you have no doubt already discovered for yourself. The secret of success lies not in buying at the very lowest possible price and selling at the absolute top, but rather in the
avoidance of large losses
. (Small losses you will have to take, and as quickly as possible as warranted by the situation.)
One of the most successful “operators” Wall Street has ever seen, Bernard Baruch, a multimillionaire and a nationally respected citizen today, is reputed to have said never in his entire career had he succeeded in buying within 5 points of the bottom or selling within 5 points of the top! (
EN: For perspective, the 5 points mentioned constituted roughly 10% of the market at that time
.)
Before we leave this treatise on theory and proceed to the more practical matters of application and market tactics that are the province of Section II of this book, the reader will, we hope, forgive one more admonition. There is nothing in the science of technical analysi


the market at that time
.)
Before we leave this treatise on theory and proceed to the more practical matters of application and market tactics that are the province of Section II of this book, the reader will, we hope, forgive one more admonition. There is nothing in the science of technical analysis that requires one always to have a position in the market. There is nothing that dictates something must happen every day. There are periods—sometimes long months—when the conservative trader's best policy is to stay out entirely. What is more there is nothing in technical analysis to compel the market to go ahead and complete (in a few days) a move the charts have foretold; it will take its own good time. Patience is as much a virtue in stock trading as in any other human activity.
Technical analysis and technology in the 21st
century: the computer and the internet: tools of
the investment/information revolution
The purpose of this section is to put computer and information technology into proper context and perspective for chart-oriented technical analysts.
In John Magee's time, in his office in Springfield, Massachusetts, there was a chart room—a room filled with all-age chartists from teenagers to senior citizens. These people spent all their time keeping charts and assisting Magee in interpretation. These were wonderful and intelligent people who developed marvelous insights into the stocks they charted as well as created the manual charts that adorn this book.
Today, that room and all those technicians have been replaced by a beige (sometimes lime) box that sits crowded on our desktops and that is often worshipped as a fount of insight and wisdom: “Computer, analyze my stocks.”
Unfortunately, the computer does not have the discrimination and pattern recognition ability of the people in that chart room. Undeterred by this weakness in computer technology, traders and investors have poured incalculable money and effort into computer-aided research, attempting to discover the keys to market success. More money has been spent in this effort than was ever put into the search for the philosopher's stone. Much of it was wasted, but it has not all been spent in vain. In some areas, it has been quite productive. But no fail-safe algorithm, in spite of all this effort, has been found for investment success, and certainly not for stock trading. The research
has
demonstrated that even the algorithm of “buy low, sell high” has fatal flaws in it.
To fully understand the importance of the computer, the reader should appreciate some basic differences in participants' approach to the markets, or, we might say, schools of analysts and investors. We will not bother with fundamental analysts here, as they are of a different religious persuasion. Chart analysts, or Magee-type technical analysts, pretty much confine their analysis of the market to the interpretation of bar charts. (This does not mean their minds must be closed to other inputs. On the contrary—anything that works.) Another chart analyst school uses point and figure charts, and another candlestick charts. Another breed of technical analysts takes basic market data, price and volume, and uses them as the input to statistical routines that calculate everything from moving averages to mystically designated indicators like %R or Bollinger Bands (see Glossary); they are known as statistical or number-driven technical analysts. All these analysts attempt to invest or trade stocks and other financial instruments (not including options) using some form of what is called technical analysis—that is, they all take hard data that people cannot lie about, misrepresent, and manipulate, (unlike the data inputted to fundamental analysis like earnings, cash flow, sales, etc.) as input to their analysis.
Using number-driven or statistical technical analysis, these latter schools attempt, just as chart analysts do, to predict market trends and trading opportunities. This can be more than a little difficult because the stock and bond markets are behavioral markets driven by human emotion, perhaps the most important of many variables influencing price. Plus, human emotion and behavior dictates manic and depressive elements, which have not yet been quantified. Yet, some chart analysts believe they can recognize it when they see it on the charts.
In another area, the computer has yielded much more dramatic and profitable results, but that is in a model-driven market, namely the options markets. Quantitative analysts, those who investigate and trade the options markets, are a breed apart from technical analysts. In an interesting irony, emotion-driven markets, the stock markets, are used as the basis for derivatives, or options, whose price is determined largely by the operation of algorithms called “models;” for example, the Black Scholes model. Quantitative analysts believe, as does this editor, the options markets can be successfully gamed through quantitative analysis. Results of sk


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