Haven (New York, New Haven, and Hartford Railroad) was a beacon of respectability (and lent luster to its investor) and paid “good dividends” are gone forever; as is the New Haven. In fact, after the turn of the century, corporations saw a change in investor sentiment about dividends. Investors wanted capital appreciation
Figure 18.3
If an investor only learned one thing from this book, it would be that one thing might be the salvation of his portfolio or his retirement plan (if all his assets in the investment plan were shares of Enron). Instead, the employees of Enron made a major mistake in not having a diversified retirement portfolio—they had all their eggs in one basket, their income and savings came from one source. But diversification is not even the crucial lesson here; the lesson is get out of the stock when it reverses. The corollary of that lesson is never buy a stock in a downtrend. However, the more important lesson is never buy a stock when it is in a swan dive. So obvious you say, but not so obvious at the time for portfolio managers for the University of Miami who continued to accumulate Enron stock even as it neared earth at 100 miles an hour. Of course, they had a sophisticated (?) company; the Motley Fools had a death grip on the stock all the way to the bottom.
and cared less for dividends. In fact, it has lately been considered the mark of a “growth stock” not to pay dividends. Evidently, the days of the New Haven are gone forever, when an “investor” was one who bought, held, and collected dividends, and “speculators” were slightly suspect men like Magee who played the medium-term trends and bought “unchic, speculative” stocks. It all has a sepia tone to it. Yesterday's Magee speculator might be called a medium-term investor today.
Although the term “speculator” could still be applied to anyone who “trades” the market, today that old-time speculator and his kind would more likely be called traders than speculators. Commodity traders who have no business interest in the contracts they exchange are always referred to as
speculators
, as opposed to
commercials
, who are hedgers and users of the commodities they trade. Now “day traders” might be considered the equivalent of the old-time speculators—except that day trading veers dangerously close to gambling. And only the passive, in the opinion of this editor, never trade at all and sit on their holdings during Bear Markets.
On the spectrum of investors, from investor to gambler, the old “New Haven Investor” who “wants his dividends” is pretty rare these days, and, again, may be one of those trust departments that does not want to get sued and so stays out of stocks that go up. After all, prudent men do not “trade in volatile stocks” but “invest in safe issues, like bonds,” which only lose about 1.5%-2.0% of their purchasing value per year but preserve the illusion of having “preserved principal.”
One definition of the long-term investor
Let us take as a long-term investor now one who expects to at least track market returns, for it has been demonstrated over a relatively long period of time that this can be done by passive indexing. At the turn of the century, as this is written, it would seem neither longterm, medium-term, nor short-term investors think about the risks involved in matching the market because, entering the third millennium, it has been so many years since we have had a really vicious Bear Market. Dow 36,000? This is a passing phase. As each Bull Market reaches higher and higher, the odds are lower and lower that it will continue— historic Bull Markets of the 1990s notwithstanding.
What then are the strategy and tactics for the long-term investor to achieve a goal of matching the market?
(EN9: Is it necessary to remind the reader of
Chapter 4
and the Dow Theory?)
Let us remark immediately that the tactics Magee described for the speculator—or trader if you will—are not at all in conflict with the short-term tactics used occasionally by the long-term investor. As buying or selling time approaches the stops of the long-term investor, that investor becomes a trader who can and should adopt the trader's tactics. Sooner or later, the focus even narrows to real time at the moment of trade execution. Interestingly, the charting techniques we have described here work on tick-by-tick data in real time also. Hence, if the trader wants to enter into the real-time environment, he can attempt to time his trade right down to the real-time chart formations. Only the really active and skilled long-term investor will be concerned with squeezing the last half point or points out of his position. This illustration of the time focus is addressed to any investor or trader or speculator to demonstrate the fractal nature of both price data and the applicability of Magee-type technical analysis to it.
The strategy of the long-term investor
The strategy of the long-term investor is to catch the long trends—to participate in trades that lasts month


any investor or trader or speculator to demonstrate the fractal nature of both price data and the applicability of Magee-type technical analysis to it.
The strategy of the long-term investor
The strategy of the long-term investor is to catch the long trends—to participate in trades that lasts months and years. However, this strategy does not intend to be sucked into long Bear Markets. Rather, portfolios are liquidated or hedged when Bear Market signals are received. As has been previously seen in examples of the performance of (more or less) mechanical Dow Theory (see
Chapter 4
), this kind of performance can be quite satisfactory—better indeed than buy-and-hold strategies that have come much into vogue because of the Clinton-Gore Bull Markets of the 1990s.
If the goal is to beat not only the markets but also the mutual funds (only 20% of which outperform the market over the long term anyway—and sometimes none of them make money), then passive indexing is the most likely strategy. This may be done in a number of ways—index funds, buying the basket, buying the futures, and so on. Nevertheless, the most attractive method might be the use of the Standard & Poor's Depositary Receipts (SPDRs; SPY) and DIAMONDS™ (DIA) and the like. The tactics may be calibrated to the risk tolerance and character of the investor. He might hedge or sell on Dow Theory signals, or on breaks of the 200-day moving average, or on breaks of the long-term or intermediate trendlines with a filter (Magee recommended 2%, and this might be calibrated to the character of the markets and increased to 3% or a factor relevant to actual market volatility). Basing Points (see
Chapter 28
) is also a powerful method. Instruments we have previously discussed— SPDRs, DIAMONDS, index futures, and options—can be used to execute these tactics.
Suffice it to say that every strategy must provide for the plan gone wrong, in other words, the dreaded Bear Market. Bear Markets would not be so fearsome if the average investor did not insist on seeing only the long side of the market. Long-term strategies go out the window quickly when blood runs on the floor of the New York Stock Exchange. The well-prepared technical investor has a plan that provides for the liquidation of positions gone bad and presumably the discipline to execute it.
This involves the regular recomputation of stops as markets go in the planned direction, and ruthless liquidation of losers that do not perform. One may think of a portfolio as a fruit tree. Weak branches must be pruned to improve the yield. Stop computation is treated in a number of places in this book (see
Chapters 27
and
28
). For the investor trading long term, this may be, as an example only and not as a recommendation, the breaking of the 200-day moving average or the breaking of a long-term trendline. The 200-day moving average is widely believed to be the long-term trend indicator, for which believing will sometimes make it come true.
(EN9: Let me emphasize here that “200” is a parameter and an example. Personal research may fit a better parameter to the actual market.)
In reality, more than just the 200-day moving average or a manually drawn trendline should be looked at. The chart patterns comprising the portfolio should be considered also, as well as charts of major indexes and averages. Also, consider the condition of the averages and their components—their technical state—whether they are topping, consolidating, or trending as indicated by their charts.
Moreover, it would be impossible not to mention Magee's Basing Points Procedure (see
Chapter 28
). Possibly the most powerful trailing stop method in existence.
Rhythmic investing
In addition, if
Chapter 31
on “Not All in One Basket” is weighed seriously, one might be rolling a portfolio from long to short gradually in natural rhythm with the markets and in harmony with the Magee Evaluative Index described there. That is the preferred strategy of the authors and editor of this book.
These things all depend on the goals, temperament, and character of the investor. If he is going to spend full time on the markets, he is probably not a long-term investor. Such men eat well and sleep soundly at night. The trader is lean and hungry—not necessarily for money, but for activity. It behooves one to know his type as a trader or investor. Knowing one's type or character is best established before finding it out in the markets, as the markets can be an expensive place to search for self-knowledge.
There is no inherent conflict in holding long-term positions and also attempting to profit from intermediate trends, depending on the amount of capital in hand and how much time, energy, and capital the investor wants to put into trading. A long-term strategy can be implemented with a modicum of time and energy, as follows: pay attention to the major indexes and averages and buy on breakouts, at the bottoms of consolidations and on pullbacks; sell or hedge on the breaking of trendlines

eBooks\Technical Analysis of Stock Trends 11thed\Converted\Technical Analysis of Stock Trends, Eleventh Edition.epub#section:main-24.xhtml


capital the investor wants to put into trading. A long-term strategy can be implemented with a modicum of time and energy, as follows: pay attention to the major indexes and averages and buy on breakouts, at the bottoms of consolidations and on pullbacks; sell or hedge on the breaking of trendlines, calculated on Basing Points (see
Chapter 28
) and the penetration of support zones.
The long-term investor will accept greater swings against his position than the intermediate-term trader or speculator. As an example with the method of using Basing Points in
Chapter 28
, the speculator is using a three-days-away rule, whereas a long-term investor might be using a three-week Basing Point or some such analogy. Plus, if interested, when he suspects or analyzes a long Bull Market is approaching a climax, he might adopt the three-days rule also, or even begin following his stock with a daily stop just under the market. Beware though, as professionals look for stops just under the close of the previous day in situations such as these.
It would be wise not to confuse long-term investing with “buy and hold,” or as it was expressed in one investment fad in the 1970s, “one-decision investing.” As an example of this misguided thinking, in 1972, the “best and brightest” investment analysts (fundamental) on the Street picked a portfolio of stocks for the generation, or 20 years. The companies would be difficult to argue with as the
creme de la creme
of American business. After all, who could kvetch at Avon, Eastman Kodak, IBM, Polaroid (unless he happened to look at
Figure
37.27
), Sears Roebuck, and Xerox? Even today, if you did not have a close eye on the market, you would immediately respond, “blue chips.” Consider the following table showing the stocks and the results achieved over the long term.
Price
Price
Percent
Stock
4/14/72
12/31/92
Change
Avon Products
61.00
27.69
(54.6)%
Eastman Kodak
42.47
32.26
(24.0)%
IBM
39.50
25.19
(36.2)%
Polaroid
65.75
31.13
(52.7)%
Sears Roebuck
21.67
17.13
(21.0)%
Xerox
47.37
26.42
(44.2)%
In 2017, the vagaries of unsupervised portfolios is again seen: Avon 2.50; Kodak 7.75; IBM 141; Polaroid unlisted; Sears 7.21; Xerox 32.64. Beware of pundits and mindless investing.
Charts (
Figures 18.4
and
18.5
) showing activity for IBM and Xerox appear on the following pages.
Figure 18.4
The questionable—even bizarre—results of “one-decision investing” (i.e., buy and hold) are amply illustrated by this chart. First of all, the “best and brightest” recommended IBM at a decade high to see it decline by more than 50%. It subsequently recovered to double from their original recommendation. Ah, sweet justification! Only, unfortunately, at the end of 20 years to see it rest approximately 40% beneath the recommendation. The analytical lines give some hint of how a technician might have traded the issue. I like to say that there are bulls, bears, and ostriches, and anyone who followed this one-decision investment proves my case.
Figure 18.5
Like IBM in the previous figure, Xerox was recommended at a place at which it should have been sold instead of bought. The comments there might apply to the chart here. The foolishness of “buy and hold” or “one-decision investing” is amply illustrated by observing the long-term swings of the stock and thus of the investor's equity. Technical analysis is intended to be an antidote to such foolishness.
Summary
The long-term investor attempts to catch major market moves—those lasting hundreds, if not thousands, of Dow points and stay in trades for many months if not years.
Within this time frame, he expects to take secondary trends against his position. Depending on his temperament and inclination, he may attempt to hedge his portfolio upon recognizing secondary market moves against his primary direction.
His preference for stocks and portfolio will be for market leaders, for baskets that reproduce the major indexes (or Index Shares) as the ballast for his portfolio, and he may choose some speculative stocks to add spice to his portfolio.
In spite of his penchant for long-lasting trades he will not tolerate weak, losing, or underperforming stocks. They are the shortest of his trades. He will cut losses and let profits run, the truest of the market maxims and the least understood by unsuccessful investors. The other maxim least understood by investors is “buy strength, sell weakness.”
Truly sophisticated investors attempt to participate in Bear Market trends also. This is the greatest difference between professional and general investors—professionals have no bias against the short side.
For the convenience of day traders, the URL of Gamblers Anonymous is noted:
http://
www.gamblersanonymous.org
.
chapter nineteen


The all-important details
In this chapter and the one following, we take up a number of elementary suggestions intended largely for the benefit of those who have never kept charts before. Much of this will seem obvious and repetitive to the advanced student, although even he may find some thoughts that will simplify his work. The beginner should read these chapters carefully and use them for later reference.
The details of how and when you keep the charts will not guarantee you profits, but if you fail to work out these details in such a way as to make your work easy, as part of a regular systematic routine, you cannot expect to keep up your charts properly or make any profits.
Charting and analyzing your charts is not a difficult process, nor will it take too much of your time if you have determined a reasonable number of charts and have arranged for doing the work regularly, meaning every day without fail.
You will need a source of data—the day's market prices and volume. If you live in a big city, your evening paper will carry the complete list, and you can plan to set aside a certain period before dinner, or after dinner, or during the evening. If you cannot allot such a period and keep it sacred against all other social or business obligations, then plan to do the charting in the morning. The key is to set a definite time and let nothing interfere, ever, or you are lost.
(EN: This process is radically simplified by automated computer downloading procedures and access to data sources and internet sites, but the principle is the same.)
You should have a suitable place to work and keep your charts. If it is at home, in the dining room or living room, other members of the family should understand that what you are doing is important. You should be able to shut the door and work without interruption. The light should be bright and as free from shadows as possible. (It makes a big difference, especially if you are keeping a large number of charts.) The ordinary desk lamp throws a reflected glare directly across the paper and into the eyes. It can be a strain if you are doing much of this close work. Better to have an overhead light, placed just a few inches in front of your head and a convenient distance above; and if this light can be a fluorescent fixture using two 40-watt lamps, you will get almost perfect shadowless lighting. These suggestions apply in case you are not working by daylight.
Additionally, have plenty of room. A big desk top or a dining room table with a large clear space for chart books, extra sheets, pencils, scratch paper, ruler, calculator, computer equipment, and anything else you need. If your working surface is fairly low, say 28 or 29 inches from the floor, it will be less tiring than the usual 30-inch desk height.
Whether you are working in ink or in pencil, pick out the writing tool that is easiest for you to use. If you are using pencils, try several different makes and degrees of hardness. Find one that is hard enough not to smudge too easily, and yet is not so hard you have to bear down to make a clean black mark. The wrong kind of pencil can tire you and irritate you more than you realize. Also, have plenty of pencils, a dozen at least, well-sharpened, so as soon as one becomes a trifle dull and you are not getting a clean, fine line, you can simply lay it aside and continue at once with another freshly-sharpened pencil.
Keep your charts in loose leaf books with big enough rings to make turning the pages easy. Do not overcrowd the books; get new books if a volume is too crowded. Finished charts may be kept in file folders. The only ones that need to be in the books are the current sheets and the sheets for the immediately preceding period. If possible, use a seven-ring binder. Pages are easily torn loose from two- and three-ring binders, but seven rings will hold the pages safely and you will seldom have one tear out.
The charts you keep will become increasingly valuable to you as the chart history builds up. The old chart sheets will be very helpful to you for reference. Provide a file or space where they can be indexed and kept in chronological order, and also have file folders for brokers' slips, dividend notices, corporate reports, clippings and articles, notes on your own methods, and analyses and special studies of the work you are doing.
In this connection you will, of course, keep a simple but complete record of each purchase, sale, dividend, and so on, on stocks you have bought or sold. This record will make your work much easier when the time comes to figure out income taxes. It will also give you all the statistical information you need to judge the results of your trading operations.
(EN: At the beginning of my investment career, and often in the middle of it, I thought the above was cracker-barrel wisdom. The longer I last the more I think that homespun wisdom might be the best kind to have in investing—somewhat like Mark Twain, who was astounded at how much his f

eBooks\Technical Analysis of Stock Trends 11thed\Converted\Technical Analysis of Stock Trends, Eleventh Edition.epub#section:main-25.xhtml


g operations.
(EN: At the beginning of my investment career, and often in the middle of it, I thought the above was cracker-barrel wisdom. The longer I last the more I think that homespun wisdom might be the best kind to have in investing—somewhat like Mark Twain, who was astounded at how much his father increased in wisdom the older Twain himself got.
We may restate the modest homilies above: Be serious. Be methodical. Be disciplined. Be businesslike. Anyone who succeeds in investing without these qualities is the recipient of blind luck and will be fortunate not to fall into a hole before his career is over.
These thoughts occur when one is wondering how Magee would have viewed the advent of the microcomputer and its impact on technical analysis and investing. Might he have said, “What hath this tool wrought?! Wonders and abominations!!”
Given the possibilities for complicating analysis and operations when confronted with all the bells and whistles of the average computer software package, the investor must maintain perspective. What, then, are the all-important details in practicing technical analysis with the aid of a computer?)
The simplest and most direct way to use
a computer for charting analysis
In reality, the computer can be used as a simple tool to do a simple job. There is nothing inherently complicated about keeping a chart on a computer. All computer software packages enable bar charting and many, if not most, enable many other kinds of charting, from candlesticks to oscillator charting. The process, in almost all commercially available packages, is so simple that explaining it here would be superfluous (see Appendix B, Resources, for demonstrations), except to generally say it consists of retrieving data, updating the program's price database, and clicking an icon to run a chart. The software packages themselves explain their features better than can be done here. What is important here is to give perspective. Even simpler when the whole process takes place on the internet, as at
http://www.stockcharts.com
or
http://www.bigcharts.com
, or
http://www.
tradestation.com
.
In this respect, charting can be done with quite expensive programs and also on publicly available free programs or freeware. Charting can also be done with interactive charting programs on many internet sites. The basic bar chart can be enhanced with an unending number of technical studies— moving averages, oscillators, and so on. Therein lies the danger. Chart analysis in itself is a qualitative process. Decorating graphic charts with number-driven information and studies can lead the general investor astray—and into confusion and indecision.
Thus, the first preference of this analyst is to keep the process as simple as possible. Get the data, draw a chart, analyze the patterns, consider the volume, and draw the appropriate analytical lines—this can usually be done by the program on the screen. Often a better graphic picture may be obtained by printing the chart and hand-drawing the analytical lines. This brings to the fore one of the main problems of almost all the software packages—screen graphics are poor and, at least to old chartists, disorienting. They are especially befuddling to analysts who are accustomed to working on TEKNIPLAT™ chart paper. With passing editions of Resources, this problem will be dealt with.
(EN9: In the intervening years since the eighth edition, two things have occurred: the editor adjusted to modern technology and the technology achieved a level of excellence acceptable to a carping analyst. Internet technical analysis sites such as
http://www.stockcharts.com
and
http://www.thinkorswim.com
improved to be surprisingly valuable resources at unbelievably low prices—even free.)
The question of graphic representation of the facts is worth noting as a persistent one. To a certain extent, the individual analyst will solve this conundrum by adapting his eye and mind to a graphic environment, using one graphic method consistently and seeing how it relates to the facts in the market. John Magee-oriented solutions to this problem will be available on the website
http://
www.edwards-magee.com
.
In Appendix B, Resources, the reader may see some examples of simple and inexpensive software packages and internet sites that are quite adequate to the required tasks of charting technical analysis, as well as more complex number-driven analysis.
Summary
The computer is an invaluable tool for analysis. Use of it will enable the following:
•
Data may be acquired automatically via internet or dial-up sites at little or no cost. Some of these even offer real-time data, which is a way for the unsophisticated trader to go broke in real time, but which the general investor may desire on the day of executing a trade. Many of these sites offer every kind of analysis from respectable technical analysis (usually too complicated) to extraterrestrial channeling.
•
A computer package and internet portfolio sites will give the a


ke in real time, but which the general investor may desire on the day of executing a trade. Many of these sites offer every kind of analysis from respectable technical analysis (usually too complicated) to extraterrestrial channeling.
•
A computer package and internet portfolio sites will give the analyst virtually effortless portfolio accounting and mark-to-market prices—a valuable device to have to keep the investor from mixing his cash and accrual accounting, as Magee says.
•
The computer will enable processing of a hitherto unimaginable degree. An unlimited number of stocks may be analyzed. Choosing those to trade with a computer will be dealt with in
Chapters 20
and
21
.
•
Appendix B, Resources, contains information on software packages that the reader may try and purchase at quite reasonable prices. In all likelihood, the least expensive of these will be adequate to the needs of most general investors. In addition, I present a brief discussion of internet sites and resources.
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter twenty
The kind of stocks we want:
the speculator's viewpoint
The specifications of the kind of stock we want to chart are fairly simple and few. We want a stock that will enable us to make a profit through trading operations, meaning a stock whose price will move over a wide enough range to make trading worthwhile. There are those who are concerned mainly with safety of principal and the assurance of income from a stock. For them, there are
(EN9: or were)
stocks that afford a considerable degree of stability. You may (and probably will) want to keep a substantial part of your total capital in stocks of this type. They move in a narrow price range; are extremely resistant to downside breaks in the market; are also (and necessarily) unresponsive to fast upside moves in the market as a whole, and are highly desirable for the conservative investor. They are not, however, the most suitable issues for trading operations, because their swings are small, and commissions would tend to diminish the narrow trading profits that could be taken. Also, they do not make the sharp, clear chart patterns of the more speculative issues, but move in rounding, sluggish undulations.
(EN9: These remarks reflect a bygone time. The described stocks by and large went the way of the Dodo. When T can disappear from the market as a factor, there is no place to hide, except in bonds, which, when stagnant, only lose real value at the rate of inflation and loss of purchasing power of the dollar. Even bonds should be subject to frequent reevaluation using the tools described in this book.)
(For illustrations in this chapter, see
Figures 20.1
through
20.4
.)
To amplify this comment and explain a bit about what underlies what we are doing, let us assume a certain company has two issues of stock, a preferred and a common. We will assume the concern has a certain steady minimum profit it has earned for years, sufficient to pay the preferred dividend, the continuance of these dividends seems practically assured. The dividends on the preferred are fixed at, let us say, 6%. Now the common stock gets all that is left. In one year, there may be $0.50 a share for the common stockholders. The next year, there may be $2.00 a share or four times as much. In a case like this, if there are no other factors, you would expect the preferred stock to sell at a fairly steady price without much change, whereas the common stock is subject to a “leverage” and might shoot up to four times its former value. The more speculative issues represent either a business that is, by its nature, uncertain as to net profit from year to year, where the volume of business or the profit margin fluctuates widely, or one in which the majority of the “sure” net profit has been sheared off for the benefit of senior obligations. There are also other factors that affect the speculative swing of a stock, and, as a result, one issue may be very sensitive and another extremely conservative, and between them there would be all shades and degrees of sensitivity or risk. It is enough here to note briefly the nature of the business itself does not always account for the habits of the stock because the other factors may be very important. Most stocks have a fairly well-defined “swing” power, which can usually be determined by past performance of
76
72
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60
56
52
48
44
40
36
32
28
--------------------------------1--------------------------------
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COMMON
RE
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Figure 20.1
Opportunity vs. Security. Here (at left) is Goodyear Common, representing the residual interest in all profits after senior obligations have been met, compared (at right) with the Goodyear $5.00 Prefer


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Figure 20.1
Opportunity vs. Security. Here (at left) is Goodyear Common, representing the residual interest in all profits after senior obligations have been met, compared (at right) with the Goodyear $5.00 Preferred, which carries a high degree of assurance that the $5.00 dividend will be met, but no promise of further participation in profits. Monthly range of each stock for the same 54-month period is shown on a ratio scale. As the Common makes an advance of more than 300%, the Preferred advances about 25%, leveling off at a point that represents the maximum price investors are willing to pay for the sure $5.00 dividend.
88
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99
00
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400
300
1500
1400
1300
1200
1100
1000
900
800
700
600
SPX LAST-Monthly-—
94
Figure 20.2
S&P. Here the benefits of relaxed long-term investing may be seen, buttressed, of course, by the longest and handsomest Bull Market in American history in the Clinton-Gore years. At the end of this record, the effects of public enthusiasm (or as Chairman Greenspan of the Fed said, “irrational exuberance”
vide tulipomania
) can be seen in the wide undisciplined swings (best seen in
Figure 20.3
). The dotted line represents 150-day (approximately) Moving Average. Just using the Moving Average as a signal (or the Basing Points Procedure) would have beaten the market and 99% (the 99%) of other investors.
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Figure 20.3
SPY. For illustration, here is a chart of the AMEX Index Share, the SPY, or ETF based on the S&P 500. After the crash of 1998 (the Asian Economic Flu crash), the fan lines tell a story, as does the last phase of the chart where the market whips in what appears a Broadening Top.
(EN9: Note this Broadening Top was identified in 1999-2000 before the crash as documented in the
http://www.
edwards-magee.com
archives. See
Figure 20.4
.)
Figure 20.4
The S&P 500 in all its glory and tragedy. An especially good portrait by Holbein, the younger. The Broadening Top pointed out in
Figure 20.3
in 2000 foretold the decline of the S&P to below 790—not quite 50% but close enough to catch the eye. Particularly fine lessons here, besides the Broadening Top lesson. All of them
screaming
for action. The broken trendline at A, the broken trendline at B, the broken “neckline” or horizontal line at C. Notice the close correspondence of the break at B and C. The next lesson is not to buy downtrends until a clear bottom is made in a major bear market. Clearly no bottom is made until the Kilroy Bottom at 1-2-3. Even then, the least risky trade for the long-term investor is when the Kilroy Fenceline (Neckline) is broken at D. All of this was knowable at the time.
how a stock will behave in the future as to the extent of its swing.
(EN9: Or we might say, short-term volatility and long-term range.)
Incidentally, for short-term trading
(EN9: amusing in the modern context; by short-term trading Magee means trading of trends of shorter length than Dow Waves)
, we are thinking about the habits of the stock that are only partly determined by the business it represents. Purchase of stock in one company that has a somewhat uncertain or fluctuating profit record may be more conservative than purchase of a highly leveraged stock of another company whose basic business is steadier and more conservative. We will take up the matter of determining these risk constants a little later.
One should also understand the short sale of a stock does not imply any feeling that the country is going to the dogs or even that the concern represented is going to the dogs. Such a sale merely indicates your belief the stock may be temporarily overpriced; that earnings or dividends may have been abnormal in recent years and are likely to be reduced; or that for one reason or another, the stock of the company may be worth a bit less than it has been worth.
For technical trading, we want a fairly speculative stock, one that will make sizable swings up in a Bullish Trend and down in a Bearish Trend. The very factors that tend to make a stock safe and desirable to the investor may make it entirely unsuitable for trading. Also, with certain reservations that will be taken up later on, the more speculative the stock the better it is for our purposes.
(EN: Entering the third millennium (since we Anglo-Saxons started counting—the fourth or fifth by other measures), the distinctions between “speculative” stocks and every other kind of stock has grown increasingly blurry. Rather than apply a perhaps pejorative (in the minds of some readers) term like “speculative” to otherwise-innocent stocks, we would do better to descr


g—the fourth or fifth by other measures), the distinctions between “speculative” stocks and every other kind of stock has grown increasingly blurry. Rather than apply a perhaps pejorative (in the minds of some readers) term like “speculative” to otherwise-innocent stocks, we would do better to describe stocks as wide ranging or narrow ranging, as volatile or nonvolatile. Stocks may then be evaluated one against another by their betas and historical volatilities, statistical data easy to obtain. “Betas” and “volatilities” are dealt with in
Chapters 24
and
42
.)
In line with this more current thinking, there is another question for readers of this book—the choice of trading (or investment) instruments for the long-term investor.
The kind of stocks we want: the long-term investor's viewpoint
Changing opinions about conservative investing
Virtually no one invests like the conservative investor described above in
Chapter 20
— except perhaps trust departments of antediluvian banks. There may be some investors still out there who are so risk averse they still follow the method described. Bank trust departments may be still doing it; they used to do it so the trust beneficiaries could not sue them. This is the reason trust departments exist, to give legal cover (the so-called prudent man rule) to trustees in case of suit by beneficiaries. Most enlightened trust departments and trustees now probably follow indexing or other more productive strategies to cater to new understandings of the prudent man rule.
“Indexing” refers to the practice of constructing a portfolio to replicate or closely reproduce the behavior of a widely followed index such as the Standard & Poor's (S&P) 500 or the Dow-Jones Industrials. These portfolios never track the Indexes exactly because the advisors and funds who manage them take management fees and expenses. These fees are generally less than fees and expenses on actively managed funds, but in fact are not necessary for the private investor to pay because even the tyro investor can now use “Index Shares” (e.g., DIAMONDS™ [DIA], S&P Depositary Receipts [SPDR; SPY, QQQ,] and so on) or other proxy instruments to do what the funds and professionals do. Essentially what indexing does is track the Averages, a strategy that was impossible or difficult (expensive) when Magee examined it, as in
Chapter 15
.
(EN9: In the opinion of this editor, hiring a management company to run an indexing strategy is a waste of capital. Much better for the investor to invest directly in ETFs
and
to exit the market when uptrends end and reverse. This is a much better strategy than “passive indexing,” which cleverly manages to capture both losses and profits in the Averages.)
The kinds of stocks long-term investors want:
the long-term investor's viewpoint
Perhaps one of the most important actualizations of recent editions is to bring current this book's treatment of the Averages, noting that it is now possible to trade the Averages in stock-like instruments. This fact deserves to be marked as a vitally important development in modern markets. This chapter will confine itself to describing facilities for trading and investing in the Averages and Indexes.
In 1993, the American Stock Exchange (AMEX) introduced trading in SPDRs™, an Exchange-traded unit investment trust based on the S&P 500 Composite Stock Price Index. The AMEX calls these securities Index Shares™, a name they also use for other similar instruments. As noted above, large investors and funds have long traded “baskets” of stocks representing the S&P 500, obviously an activity requiring large capital. In fact, a certain class of investment managers and funds have practiced “passive investing” meaning indexing, primarily for large clients. The purchase and liquidation of these and other “baskets” is one form of “program trading.”
Recognizing the utility of this investment practice, the AMEX created the SPDR as a proxy instrument to allow the smaller investor to practice the same strategy. The effectiveness of this product introduction may be measured by public participation in the trading of the SPDR (SPY). By 2000, almost $15 billion was invested in SPDRs with more than 100,000,000 shares outstanding. These units allow the investor to buy or sell the entire portfolio or basket of the S&P 500 stocks just as he would an individual stock, but the capital required to do so is radically reduced.
In 1998, the AMEX introduced DIA, Index Shares on the Dow-Jones Industrial Average™ (DJIA), which is analogous in every way to the SPDRs. Thus, an investor may “buy the DJIA.” So in current financial markets, it is possible to “buy the market,” unlike those conditions under which Edwards and Magee operated.
Construction of the Index Shares and similar instruments
The AMEX unit investment trusts are constructed to replicate the composition of their base instrument. The SPDR, for example, is an instrument that represents one-tenth of the full value of a basket of the S&P


which Edwards and Magee operated.
Construction of the Index Shares and similar instruments
The AMEX unit investment trusts are constructed to replicate the composition of their base instrument. The SPDR, for example, is an instrument that represents one-tenth of the full value of a basket of the S&P stocks and trades on the AMEX, just like a stock (SPY). Other characteristics of stocks are also reproduced such as long life (the SPDR Trust lasts into the twenty-second century) and quarterly dividends (cash paid on the SPDRs reproducing dividends accumulated on the stocks of the S&P 500). Even dividend reinvestment is possible, and the units may be traded on the AMEX during regular trading hours. Under normal conditions, there should be little variance in the price of the SPY relative to the S&P 500. (In 2008, the AMEX merged with the New York Stock Exchange. Trading and instruments remain as described.)
These elements, as discussed for SPDRs, are common to all the Index Shares— DIAMONDS, World Equity Benchmarks (WEBs), and others. There are, of course, some expenses and costs to using the Index Shares—a small price to pay for the use of the instrument and generally less than the costs of a fund. Index Shares are also much more flexible for the independent investor. Among other advantages, the private investor can control the tax consequences of his investment, which is not possible in funds.
Other Exchanges have created similar security instruments or derivatives or futures to replicate or track the well-known averages and indexes. Among these are tracking shares or index shares or futures (let us call them “instruments”) on other indexes (Russell, Nikkei, and so on) or options on the futures or indexes until there is a bewildering array of instruments available for trading, investing, and hedging. Among the more important exchanges and instruments traded are the Chicago Board of Trade (futures and options on futures on the Dow); the Chicago Mercantile Exchange (futures on the S&P, Nikkei 225, Mini S&P 500, S&P Midcap 400, Russell 2000, and NASDAQ 100); and the Chicago Board Options Exchange (S&P 100 and 500 options). This, by no means, is an exhaustive list. All the futures and options that matter will be found listed in the
Wall Street Journal
under Futures Prices or Futures Options Prices.
This book does not deal in comprehensive detail with futures and options, but it is worth mentioning these exchanges and their futures and options products because of the facility they offer the investor and trader for hedging portfolios in Index Shares and Average trading, not to mention opportunities for speculating.
Briefly, hedging is the practice of being neutral in the market. That is, one might be long the DIAMONDS and buy a put option on the DJIA at the Chicago Board of Trade, meaning that advances in the DJIA would result in profits in the DIAMONDS, and a loss of premium in the put. Conversely, a decline in the Dow would result in profits in the put and losses in the DIAMONDS. As this area is not the province of this book, this is a highly simplified description of a hedge. Nevertheless, the reader should see and understand that hedging can be an important strategy. Hedging can take the place of liquidation of a portfolio when the analyst recognizes a change of trend or unstable conditions but does not wish to incur taxes or wishes to defer them.
An outline of instruments available for trading and investing
It would be herculean to attempt to list the entire panoply of averages, indexes, futures, and options available for trading—herculean due to the fact new trading instruments are constantly in creation and due to the fact, now operating at internet speed, we may expect the rate of change to accelerate. In addition to those listed above, there are WEBS (meaning that exposure to world markets may be arranged).
In all, approximately 30 or more Index Share units or instruments were available for trading on the AMEX at the turn of the century, in addition to DIAMONDS and SPDRs. Similar instruments exist on the Philadelphia and in Chicago, and others are being created daily. To reduce the confusion, the general investor will probably find the major indices of the most importance. The more instruments one deals with the more complicated the strategy and tactics become. Therefore, the Dow, the S&P 500, and the NASDAQ composite (DIA, SPY, QQQ) are probably sufficient for the purposes of the gentleman (or lady) investor. The Mid-Caps, the Nikkei, and others begin to come into play when the trader begins to try to catch sector rotation, fads, short-term cycles, and so on.
The importance of these instruments: diversification,
dampened risks, tax, and technical regularity
It would be difficult to underestimate the importance of these new trading instruments. First of all, they afford the private investor what was previously reserved for the large capital trader—the ultimate in market diversification. The S&P 500 represen


dampened risks, tax, and technical regularity
It would be difficult to underestimate the importance of these new trading instruments. First of all, they afford the private investor what was previously reserved for the large capital trader—the ultimate in market diversification. The S&P 500 represents stocks comprising 69% of the value of stocks on the New York Stock Exchange. Buying it is buying the American economy. The 30 Dow Industrial stocks represent the most important symbol in the American economy—and perhaps in the world. Investors are well advised to pay attention to both Averages if they would fare well in the markets (Note the plural:
markets
). These two Averages now have the influence or clout that once the Dow alone had to express the state of the markets and stocks in general.
Buying the SPY or DIA then represents the immediate acquisition of a diversified portfolio. And buying the NASDAQ or QQQ gives one immediate exposure to the more speculative and volatile sector of the American economy. Given the long-term bullish bias of the averages and the American economy, it is difficult to argue with this as both strategy and tactics for the long-term investor. This does not mean positions should be taken blindly without thought or not monitored. On the contrary, recall if you will the record of the Dow Theory; even for the long-term investor, bear markets should not be allowed to destroy liquidity and equity value. These questions are discussed at greater length in
Chapter 18
.
Although we believe these instruments are good vehicles, it is wise to remember Magee's frequent admonition (less important now than when spoken) that it is a market of stocks, not a stock market. Meaning when the tide is flowing down with the Dow and S&P, prudence and care must be used in taking long positions in stocks that are in doubt as to direction. Additionally, it is worth noting investments in these instruments will be less profitable than an astutely chosen individual stock. For example, Qualcomm appreciated approximately 240% (temporarily) in 1999-2000 compared with about 24% in the S&P over the same period. Those who bought Qualcomm at its top and sold it at the bottom of its reaction lost about 75% or about $148 a share. Traders in Qualcomm tended to obsess and pay hyper attention to the stock, whereas investors in the SPY reviewed it once a week or less or told their computers or their brokers to give them a call if it broke the trendline or entered stops. Then they slept at night and had eupeptic digestion.
Other advantages accrue to the trading of the SPDRs. Ownership of a fund can result in tax liabilities as managers adjust portfolios to reflect changing membership in the fund or withdrawals in capital by irate stockholders. Since Index Shares last into the twenty-second century, the long-term investor has no need to realize gains and pay taxes. Bear markets may be dealt with by hedging with other instruments—futures, options, or proxy baskets of stock, or individual stocks, and accepting the tax consequences of these trades.
John Magee aptly observed before the direct trading of the Averages was possible that the Dow-Jones Industrials were very regular and dependable from the technical point of view. This observation is annotated at some length in comments on Dow Theory in
Chapter
36
. Therefore, the investor in the Index Shares may have a smoother time technically than a trader of an individual stock.
Summary
The long-term investor and mid-term speculator attempt to capture long secular (as well as cyclical) trends in the markets. They shun frequent trading and capital-eroding transactions. They recognize that risk fluctuates with time and trend, and they know that frequent turnover benefits mainly the broker.
The strategy of the long-term investor may be to match the market by using funds or SPDRs or baskets, but he does not like to participate in Bear trends. He hedges or liquidates his positions on major trend shifts. In fact, he may even short the indexes if his analysis indicates major bear markets.
If he desires to outperform the market (which will happen automatically if he follows the methods of this work), he finds some individual speculative stocks to trade in addition to his foundation portfolio. Depending on his risk tolerance, he may always be somewhat hedged. When long the indexes, he finds some stocks in downtrends to short. When he is short the indexes, he finds some strong stocks to hold long. There is no excuse for a moderately skilled and reasonably capitalized investor to lose money over the long term in the market.
As a reminder,
Chapters 5
and
28
describe powerful methods for the long-term investor using Magee's Basing Points Procedure.
chapter twenty-one


271Chapter seventeen: A summary an d concluding comments
 3. Enable processing of a hitherto unimaginable degree. An unlimited number of stocks
may be analyzed. Choosing those to trade with a computer will be dealt with in
Chapter 21, Selection of Stocks to Chart.
 4. Allow the investor to trade on ECNs or in electronic marketplaces where there are no
pit traders or locals to fiddle with prices.
Advancements in investment technology, part 1:
developments in finance theory and practice
Numerous pernicious and useless inventions, services, and products litter the internet
and the financial industry marketplace; but modern finance theory and technology are
important and must be taken into consideration by the general investor. This chapter will
explore the minimum the moderately advanced investor needs to know about advances
in theory and practice. And it will point the reader to further resources if he desires to
continue more advanced study.
Instruments of limited (or non) availability during the time of Edwards and Magee
included exchange traded options on stocks, futures on averages and indexes, options
on futures and indexes, and securitized indexes and averages, as a partial list of only the
most important instruments. Undoubtedly, one of the most important developments of
the modern era is the creation of trading instruments that allow the investor to trade and
hedge the major indexes. Of these, the instruments created by the Chicago Board of Trade
(CBOT
®) are of singular importance. These are the CBOT® DJIASM Futures and the CBOT®
DJIASM Futures Options, which are discussed in greater detail at the end of this chapter.
(EN9: Not so singular, perhaps. Probably of greater importance to readers of this book are the AMEX
iShares, particularly DIA, SPY, and QQQ, which are instruments (ETFs) that offer the investor
direct participation in the major indexes as though they were stocks.)
General developments of great importance in finance theory and practice are found in
the following sections.
Options
From the pivotal moment in 1973 when Fischer Black (friend and college classmate) and his
partner, Myron Scholes, published their—excuse the usage—paradigm-setting Model, the
options and derivatives markets have grown from negligible to trillions of dollars a year.
The investor who is not informed about options is playing with half a deck. The subject,
however, is beyond the scope of this book, which hopes only to offer some perspective on
the subject and guides to the further study necessary for most traders and many investors.
Something in the neighborhood of 30% or more of options expire worthless. This is
probably the most important fact to know about options. (There is a rule of thumb about
options called the 60–30–10 rule: 60% are closed out before expiration, 30% are “long at
expiration,” meaning they are worthless, and 10% are exercised.) Another fact to know
about options occurred in the Reagan Crash of 1987; the money puts bought at $0.625 on
October 16 were worth hundreds of dollars on October 19—if you could get the broker to
pick up the telephone and trade them. (The editor had a client at Options Research, Inc.
during that time who lost $57 million in three days and almost brought down a major
Chicago bank; he had sold too many naked puts.)
The most sophisticated and skilled traders in the world make their livings (quite
sumptuous livings, thank you) trading options. Educated estimates have been made that
as many as 90% of retail options traders lose money. That combined with the fact that by far

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272 Technical Analysis of Stock Trends
it is the general public that buys (rather than sells) options should suggest some syllogistic
reasoning to the reader.
With these facts firmly fixed in mind, let us put options in their proper perspective
for the general investor. Options have a number of useful functions, such as offering the
trader powerful leverage. With an option, he can control much more stock than by the direct
purchase of stock—his capital stretches much further. So options are an ideal speculative
instrument (Exaggerated leverage is almost always a characteristic of speculative
instruments.), but they can also be used in a most conservative way—as an insurance
policy. For example, a position on the long security side may be hedged by the purchase of
a put on the option side. (This is not a specific recommendation to do this. Every specific
situation should be evaluated by the prudent investor with professional assistance as to its
monetary consequences.)
The experienced investor may also use options to increase yield on his portfolio of
securities. He may write covered calls or naked puts on a stock to acquire it at a lower cost
(e.g., he sells out of the money put options. This is a way of being long the stock; if the stock
comes back to the exercise price, he acquires the stock. If not, he pockets the premium.)
There are numerous tactics of this sort that may be played with options. Played because,
for the general investor, the options game can be disastrous, as professionals are not
playing. They are seriously practicing skills the amateur can never hope to master. Many
floor traders, indeed, would qualify as idiot savants—they can compute the “fair value”
of options in their heads and make money on price anomalies of 1/16, or, as they call
it, a “teenie.” For perspective, the reader may contemplate a conversation the editor had
with one of the most important options traders in the world who remarked casually that
his fortune was built on teenies. The reader may imagine at some length what would be
necessary for the general investor to make a profit on anomalies of 1/16. (EN10: The advent
of digital pricing has given market makers and specialists even more flexibility to beat the investor
by shaving spreads, theoretically, to $0.01.)
This does not mean the general investor should never touch options; it just means he
should be thoroughly prepared before he goes down to play that game. In options trading,
traders speak of bull spreads, bear spreads, and alligator spreads. The alligator spread is
an options strategy that eats the customer’s capital in toto.
Among these strategies is covered call writing. This strategy is touted as being an
income producer on a stock portfolio. There is no purpose in writing a call on a stock in
which the investor is long—unless that stock is stuck in a clear congestion phase that is not
due to expire before the option expires. Besides, if the stock is in a downtrend, it should
be liquidated, but to write a call on a stock in a clear uptrend is to make oneself beloved of
the broker, whose good humor improves markedly with account activity and commission
income. The outcome of a covered call on an ascending stock is that the writer (you, dear
reader) has the stock called at the exercise price, losing his position and future appreciation,
not to mention costs. The income is actually small consolation, a sort of booby prize—a
way of cutting your profits while increasing your costs. Nevertheless, covered writes are
justified and profitable in some cases.
Quantitative analysis
The investor should be aware of another area of computer and investment technology
that has yielded much more dramatic and profitable results, but that is in a model-driven
market—namely, the options markets. Quantitative analysts, those who investigate and
trade the options markets, are a breed apart from technical analysts. In an interesting

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273Chapter seventeen: A summary a nd concluding comments
irony, behavioral markets, the stock markets, are used as the basis for derivatives, or
options whose price is determined largely by the operation of algorithms called “models.”
The original model that created the modern world of options trading was the Black–
Scholes options analysis model, which assumed the “fair value” of an option could be
determined by entering five parameters into the formula: the strike price of the option,
the price of the stock, the “risk-free” interest rate, the time to expiration, and the volatility
of the stock.
The eventual universal acceptance of this model resulted in the derivatives industry we
have today. To list all the forms of derivatives available for trading today would be to expand
this book by many pages, and it is not the purpose of this book anyway. The purpose of this
paragraph is to sternly warn general investors who are thinking of “beating the derivatives
markets” to undergo rigorous training first. The alternative could be extremely expensive.
At first, the traders who saw the importance of this model and used it to price options
virtually skinned older options traders and the public, who traded pretty much by the seat
of the pants or the strength of their convictions, meaning human emotion. But professional
losers learn fast and now all competent options traders use some sort of model or anti-model,
or anti-antimodel to trade. True to form, options sellers, who are largely professionals, take
most of the public’s (the buyers) money. This is the way of the world.
Options pricing models and their importance
After the introduction of the Black–Scholes model, numerous other models followed, among
them the Cox–Ross–Rubinstein, the Black Futures, and others. For the general investor, the
message is this: he must be acquainted with these models and what their functions are if
he intends to use options. Recall, the model computes the “fair value” of the option. One
way professionals make money off amateurs is by selling overpriced options and buying
underpriced options to create a relatively lower risk spread (for themselves). Not knowing
what these values are for the private investor is like not knowing where the present price is
for a stock; it is a piece of ignorance for which the professional will charge him a premium
to be educated about. Unfortunately, many private options traders never get educated, in
spite of paying tuition over and over again. But ignorance is not bliss—it is expensive.
Technology and knowledge works its way from innovators and creative geniuses
through the ranks of professionals and sooner or later is disseminated to the general public.
By that time, the innovators have developed new technology. Nonetheless, even assuming
that professionals have superior tools and technology, the general investor must thoroughly
educate himself before using options. As it is not the province of this book to dissect options
trading, though the reader may find references in Appendix B, Resources.
Here it would not be untoward to mention one of the better books on options as a
starting point for the moderately advanced and motivated trader. Lawrence McMillan’s
Options as a Strategic Investment is necessary reading. In addition, the newcomer may contact
the Chicago Board Options Exchange (the CBOE) at http:/ /www.cboe.com , which has
tutorial software.
Futures on indexes
Futures, like options, offer the speculator intense leverage—the ability to control a
comparatively large position with much less capital than the purchase of the underlying
commodity or index. Futures salesmen are fond of pointing out the fact that, if you are
margined at 5% or 10% of the contract value, a similar move in the price of the index will

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282 Technical Analysis of Stock Trends
Having correctly analyzed market trends, your action results in an increase in portfolio
value from $418,000 to $429,375. You could have accomplished the same result by buying and
selling bonds and stocks, but not without tax consequences and the attendant transaction
headaches. The use of futures to accomplish your goals allowed you to implement your
trading plan without disturbing your existing portfolio.
Perspective
Although there can be no argument about the importance of CBOT® DJIASM Index futures—
they are markets of enormous usefulness and importance—there can also be no doubt the
futures novice should thoroughly prepare himself before venturing into these pits. In such
a highly leveraged environment, mistakes will be punished much more severely than an
error in the stock market. By the same token, ignorance of this vital tool is the mark of an
investor who is not serious about his portfolio, or who is less intense in his investment
goals. “They” (the infamous “they”) use all the weapons at their disposal; so should “we.”
Options on Dow Index futures
The buyer of this instrument has the choice, or the right, to assume a position. It is his option
to do so—unlike a futures contract in which he has an obligation once entered. There are
two kinds of options: calls (the right to buy the underlying instrument) and puts (the right
to sell). Also, options can be bought (long) or sold (short) like futures contracts.
A long call option on Dow Index futures gives the buyer the right to buy one futures
contract at a specified price which is called the “exercise” or “strike” price. A long put option
12000
11800
11600
11400
11200
11000
10800
10600
10400
10200
1600
1200
800
400
11/1999 12/1999 00 2/2000
/DI200006 LAST-Daily 02/24/2000
Created with TradeStation www.TradeStation.com
Figure 17.4 Dow–Jones Futures and Options. A put purchased at the arrow on the break would have
protected patiently won gains over the previous 11 months. The increase in the value of the put can
be seen as futures track declining Dow cash. A theoretical drill, but theoretical drills precede actual
tactics in the market.

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283Chapter seventeen: A summary a nd concluding comments
on Dow Index futures gives the buyer the right to sell one futures contract at the strike
price. For example, a call at a strike price of 10,000 entitles the buyer to be long one futures
contract at a price of 10,000 when he exercises the option. A put at the same strike price
entitles the buyer to be short one futures contract at 10,000. The strike prices of Dow Index
futures options are listed in increments of 100 index points, giving the trader the flexibility
to express his opinions about upward or downward movement of the market.
The seller, or writer, of a call or put is short the option. Effectively selling a call makes
the writer short the market, just as selling a put makes the writer long the market. As in a
futures contract, the seller is obligated to fulfill the terms of the option if the buyer exercises.
If you are short a call, and the long exercises, you become short one futures contract at
10,000. If you are short one put and the long exercises, you become long one futures contract
at 10,000.
Buyers of options enjoy fixed risk. They can lose no more than the premium they pay
to go long an option. On the other hand, sellers of options have potentially unlimited risk.
Catastrophic moves in the markets often bankrupt imprudent option sellers.
Option premiums
The purchase price of the option is called the option premium. The option premium is
quoted in points, each point being worth $100. The premium for a Dow Index option is paid
by the buyer at initiation of the transaction.
The underlying instrument for one CBOT
® futures option is one CBOT® DJIASM futures
contract; so the option contract and the futures contract are essentially different expressions
of the same instrument, and both are based on the Dow–Jones Index.
Options premiums consist of two elements: intrinsic value and time value. The
difference between the futures price and strike price is the intrinsic value of the option. If
the futures price is greater than the strike price of a call, the call is said to be “in-the-money.”
In fact, you can be long the futures contract at less than its current price. For example, if the
futures price is 10,020 and the strike price is 10,000, the call is in-the-money and immediate
exercise of the call pays $10.00 times the difference between the futures and strike price,
or $10 × 20 = $200. If the futures price is less than the strike price, the call is “out-of-the-
money.” If the two are equal, the call is “at-the-money.” A put is in-the-money if the futures
price is less than the strike price and out-of-the-money if the futures price is greater than
the strike price. It is at-the-money when these two prices are equal.
Since a Dow Index futures option can be exercised at any date until expiration, and
exercise results in a cash payment equal to the intrinsic value, the value of the option must
be at least as great as its intrinsic value. The difference between the option price and the
intrinsic value represents the time value of the option. The time value reflects the possibility
that exercise will become more profitable if the futures price moves farther away from the
strike price. Generally, the more time until expiration, the greater the time value of the
option because the likelihood of the option becoming profitable to exercise is greater. At
expiration, the time value is zero and the option price equals the intrinsic value.
Volatility
The degree of fluctuation in the price of the underlying futures contract is known as
“volatility” (see Appendix B, Resources, for the formula). The greater the volatility of the
futures, the higher the option premium. The price of a futures option is a function of the
futures price, the strike price, the time left to expiration, the money market rate, and the volatility

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284 Technical Analysis of Stock Trends
of the futures price. Of these variables, volatility is the only one that cannot be observed
directly. Considering all the other variables are known, however, it is possible to infer from
option prices an estimate of how the market is gauging volatility. This estimate is called the
“implied volatility” of the option. It measures the market’s average expectation of what the
volatility of the underlying futures return will be until the expiration of the option. Implied
volatility is usually expressed in annualized terms. The significance and use of implied
volatility is potentially complex and confusing for the general investor, professionals having
a decided edge in this area. Their edge can be removed by serious study.
Exercising the option
At expiration, the rules of optimal exercise are clear. The call owner should exercise the
option if the strike price is less than the underlying futures price. The value of the exercised
call is the difference between the futures price and the strike price. Conversely, the put
owner should exercise the option if the strike price is greater than the futures price. The
value of the exercised put is the difference between the strike price and the futures price.
To illustrate, if the price of the expiring futures contract is 7 ,600, a call struck at 7 ,500
should be exercised, but a put at the same or lower strike price should not. The value of the
exercised call is $1,000. The value of the unexercised put is $0.00. If the price of the expiring
futures contract is 7 ,500, a 7 ,600 put should be exercised but not a call at 7 ,600 or a higher
strike. The value of the exercised put is $1,000 and that of the unexercised call is $0.00.
The profit on long options is the difference between the expiration value and the option
premium. The profit on short options is the expiration value plus the option premium.
The expiration values and profits on call and put options can often be an important tool
in an investment strategy. Their payoff patterns and risk parameters make options quite
different from futures. Their versatility makes them good instruments to adjust a portfolio
to changing expectations about stock market conditions. Moreover, these expectations
can range from general to specific predictions about the future direction and volatility of
stock prices. Effectively, there is an option strategy suited to virtually every set of market
conditions.
Using futures options to participate in market movements
Traders must often react to rapid and surprising events in the market. The transaction
costs and price impact of buying or selling a portfolio’s stocks on short notice inhibit many
investors from reacting to short-term market developments. Shorting stocks is an even
less palatable option for average investors because of the margin and risks involved and
semantical prejudices.
The flexibility that options provide can allow one to take advantage of the profits from
market cycles quickly and conveniently. A long call option on Dow Index futures profits
at all levels above its strike price. A long put option similarly profits at all levels below its
strike price. Let us examine both strategies.
Profits in rising markets
In August, the Dow Index is 10,000 and the Dow Index September future is 10,050. You
expect the current Bull Market to continue, and you would like to take advantage of the
trend without tying up too much capital and also undertake only limited risk.

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occurred in the Reagan Crash of 1987; the money puts bought at $0.625 on
October 16 were worth hundreds of dollars on October 19—if you could get
the broker to pick up the telephone and trade them. (The editor had a client
at Options Research, Inc. during that time who lost $57 million in three
days and almost brought down a major Chicago bank; he had sold too many
naked puts.)
The most sophisticated and skilled traders in the world make their livings
(quite sumptuous livings, thank you) trading options. Educated estimates
have been made that as many as 90% of retail options traders lose money.
That combined with the fact that by far it is the general public that buys
(rather than sells) options should suggest some syllogistic reasoning to the
reader.
With these facts firmly fixed in mind, let us put options in their proper
perspective for the general investor. Options have a number of useful
functions, such as offering the trader powerful leverage. With an option, he
can control much more stock than by the direct purchase of stock—his
capital stretches much further. So options are an ideal speculative
instrument (Exaggerated leverage is almost always a characteristic of
speculative instruments.), but they can also be used in a most conservative
way—as an insurance policy. For example, a position on the long security
side may be hedged by the purchase of a put on the option side. (This is not
a specific recommendation to do this. Every specific situation should be
evaluated by the prudent investor with professional assistance as to its
monetary consequences.)
The experienced investor may also use options to increase yield on his
portfolio of securities. He may write covered calls or naked puts on a stock
to acquire it at a lower cost (e.g., he sells out of the money put options. This
is a way of being long the stock; if the stock comes back to the exercise
price, he acquires the stock. If not, he pockets the premium.)
There are numerous tactics of this sort that may be played with options.
Played because, for the general investor, the options game can be
disastrous, as professionals are not playing. They are seriously practicing
skills the amateur can never hope to master. Many floor traders, indeed,
would qualify as idiot savants—they can compute the “fair value” of

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options in their heads and make money on price anomalies of 1/16, or, as
they call it, a “teenie.” For perspective, the reader may contemplate a
conversation the editor had with one of the most important options traders
in the world who remarked casually that his fortune was built on teenies.
The reader may imagine at some length what would be necessary for the
general investor to make a profit on anomalies of 1/16. (EN10: The advent
of digital pricing has given market makers and specialists even more
flexibility to beat the investor by shaving spreads, theoretically, to $0.01.)
This does not mean the general investor should never touch options; it just
means he should be thoroughly prepared before he goes down to play that
game. In options trading, traders speak of bull spreads, bear spreads, and
alligator spreads. The alligator spread is an options strategy that eats the
customer's capital in toto.
Among these strategies is covered call writing. This strategy is touted as
being an income producer on a stock portfolio. There is no purpose in
writing a call on a stock in which the investor is long—unless that stock is
stuck in a clear congestion phase that is not due to expire before the option
expires. Besides, if the stock is in a downtrend, it should be liquidated, but
to write a call on a stock in a clear uptrend is to make oneself beloved of the
broker, whose good humor improves markedly with account activity and
commission income. The outcome of a covered call on an ascending stock
is that the writer (you, dear reader) has the stock called at the exercise price,
losing his position and future appreciation, not to mention costs. The
income is actually small consolation, a sort of booby prize—a way of
cutting your profits while increasing your costs. Nevertheless, covered
writes are justified and profitable in some cases.
Quantitative analysis
The investor should be aware of another area of computer and investment
technology that has yielded much more dramatic and profitable results, but
that is in a model-driven market—namely, the options markets. Quantitative
analysts, those who investigate and trade the options markets, are a breed
apart from technical analysts. In an interesting irony, behavioral markets,
the stock markets, are used as the basis for derivatives, or options whose

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price is determined largely by the operation of algorithms called “models.”
The original model that created the modern world of options trading was
the Black-Scholes options analysis model, which assumed the “fair value”
of an option could be determined by entering five parameters into the
formula: the strike price of the option, the price of the stock, the “risk-free”
interest rate, the time to expiration, and the volatility of the stock.
The eventual universal acceptance of this model resulted in the derivatives
industry we have today. To list all the forms of derivatives available for
trading today would be to expand this book by many pages, and it is not the
purpose of this book anyway. The purpose of this paragraph is to sternly
warn general investors who are thinking of “beating the derivatives
markets” to undergo rigorous training first. The alternative could be
extremely expensive.
At first, the traders who saw the importance of this model and used it to
price options virtually skinned older options traders and the public, who
traded pretty much by the seat of the pants or the strength of their
convictions, meaning human emotion. But professional losers learn fast and
now all competent options traders use some sort of model or anti-model, or
anti-antimodel to trade. True to form, options sellers, who are largely
professionals, take most of the public's (the buyers) money. This is the way
of the world.
Options pricing models and their importance
After the introduction of the Black-Scholes model, numerous other models
followed, among them the Cox-Ross-Rubinstein, the Black Futures, and
others. For the general investor, the message is this: he must be acquainted
with these models and what their functions are if he intends to use options.
Recall, the model computes the “fair value” of the option. One way
professionals make money off amateurs is by selling overpriced options and
buying underpriced options to create a relatively lower risk spread (for
themselves). Not knowing what these values are for the private investor is
like not knowing where the present price is for a stock; it is a piece of
ignorance for which the professional will charge him a premium to be
educated about. Unfortunately, many private options traders never get

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long exercises, you become short one futures contract at 10,000. If you are
short one put and the long exercises, you become long one futures contract
at 10,000.
Buyers of options enjoy fixed risk. They can lose no more than the premium
they pay to go long an option. On the other hand, sellers of options have
potentially unlimited risk. Catastrophic moves in the markets often
bankrupt imprudent option sellers.
Option premiums
The purchase price of the option is called the option premium. The option
premium is quoted in points, each point being worth $100. The premium for
a Dow Index option is paid by the buyer at initiation of the transaction.
The underlying instrument for one CBOT® futures option is one CBOT®
DJIASM futures contract; so the option contract and the futures contract are
essentially different expressions of the same instrument, and both are based
on the Dow-Jones Index.
Options premiums consist of two elements: intrinsic value and time value.
The difference between the futures price and strike price is the intrinsic
value of the option. If the futures price is greater than the strike price of a
call, the call is said to be “in-the-money.” In fact, you can be long the
futures contract at less than its current price. For example, if the futures
price is 10,020 and the strike price is 10,000, the call is in-the-money and
immediate exercise of the call pays $10.00 times the difference between the
futures and strike price, or $10 x 20 = $200. If the futures price is less than
the strike price, the call is “out-of-the-money.” If the two are equal, the call
is “at-the-money.” A put is in-the-money if the futures price is less than the
strike price and out-of-the-money if the futures price is greater than the
strike price. It is at-the-money when these two prices are equal.
Since a Dow Index futures option can be exercised at any date until
expiration, and exercise results in a cash payment equal to the intrinsic
value, the value of the option must be at least as great as its intrinsic value.
The difference between the option price and the intrinsic value represents

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the time value of the option. The time value reflects the possibility that
exercise will become more profitable if the futures price moves farther
away from the strike price. Generally, the more time until expiration, the
greater the time value of the option because the likelihood of the option
becoming profitable to exercise is greater. At expiration, the time value is
zero and the option price equals the intrinsic value.
Volatility
The degree of fluctuation in the price of the underlying futures contract is
known as “volatility” (see Appendix B, Resources, for the formula). The
greater the volatility of the futures, the higher the option premium. The
price of a futures option is a function of the futures price, the strike price,
the time left to expiration, the money market rate, and the volatility of the
futures price. Of these variables, volatility is the only one that cannot be
observed directly. Considering all the other variables are known, however, it
is possible to infer from option prices an estimate of how the market is
gauging volatility. This estimate is called the “implied volatility” of the
option. It measures the market's average expectation of what the volatility
of the underlying futures return will be until the expiration of the option.
Implied volatility is usually expressed in annualized terms. The significance
and use of implied volatility is potentially complex and confusing for the
general investor, professionals having a decided edge in this area. Their
edge can be removed by serious study.
Exercising the option
At expiration, the rules of optimal exercise are clear. The call owner should
exercise the option if the strike price is less than the underlying futures
price. The value of the exercised call is the difference between the futures
price and the strike price. Conversely, the put owner should exercise the
option if the strike price is greater than the futures price. The value of the
exercised put is the difference between the strike price and the futures price.
To illustrate, if the price of the expiring futures contract is 7,600, a call
struck at 7,500 should be exercised, but a put at the same or lower strike
price should not. The value of the exercised call is $1,000. The value of the

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unexercised put is $0.00. If the price of the expiring futures contract is
7,500, a 7,600 put should be exercised but not a call at 7,600 or a higher
strike. The value of the exercised put is $1,000 and that of the unexercised
call is $0.00.
The profit on long options is the difference between the expiration value
and the option premium. The profit on short options is the expiration value
plus the option premium. The expiration values and profits on call and put
options can often be an important tool in an investment strategy. Their
payoff patterns and risk parameters make options quite different from
futures. Their versatility makes them good instruments to adjust a portfolio
to changing expectations about stock market conditions. Moreover, these
expectations can range from general to specific predictions about the future
direction and volatility of stock prices. Effectively, there is an option
strategy suited to virtually every set of market conditions.
Using futures options to participate in market movements
Traders must often react to rapid and surprising events in the market. The
transaction costs and price impact of buying or selling a portfolio's stocks
on short notice inhibit many investors from reacting to short-term market
developments. Shorting stocks is an even less palatable option for average
investors because of the margin and risks involved and semantical
prejudices.
The flexibility that options provide can allow one to take advantage of the
profits from market cycles quickly and conveniently. A long call option on
Dow Index futures profits at all levels above its strike price. A long put
option similarly profits at all levels below its strike price. Let us examine
both strategies.
Profits in rising markets
In August, the Dow Index is 10,000 and the Dow Index September future is
10,050. You expect the current Bull Market to continue, and you would like
to take advantage of the trend without tying up too much capital and also
undertake only limited risk.

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Introduction: Why Trade Options?
The house always wins
. This cautionary quote is certainly true, but it does not tell the entire story. From table limits to payout odds, every game in a casino is designed to give the house a statistical edge. The casino may take large, infrequent losses at the slot machines or small, frequent losses at the blackjack table, but as long as patrons play long enough, the house will inevitably turn a profit. Casinos have long relied on this principle as the foundation of their business model: People can either bet
against
the house and hope that luck lands in their favor or
be
the house and have probability on their side.
Unlike casinos, where the odds are fixed against the players, liquid financial markets offer a dynamic, level playing field with more room to strategize. However, similar to casinos, a successful trader does not rely on luck. Rather, traders' long‐term success depends on their ability to obtain a consistent, statistical edge from the tools, strategies, and information available to them. Today's markets are becoming increasingly accessible to the average person, as online and commission‐free trading have basically become industry standards. Investors have access to an
almost unlimited selection of strategies, and options play an interesting role in this development. An option is a type of financial contract that gives the holder the right to buy or sell an asset on or before some future date, a concept that will be explained more in the following chapter. Options have tunable risk‐reward profiles, allowing traders to reliably select the probability of profit, max loss, and max profit of a position and potentially profit in any type of market (bullish, bearish, or neutral). These highly versatile instruments can be used to hedge risk and diversify a portfolio,
or
options can be structured to give more risk‐tolerant traders a probabilistic edge.
In addition to being customizable according to specific risk‐reward preferences, options are also tradable with accounts of nearly any size because they are
leveraged
instruments. In the world of options, leverage refers to the ability to gain or lose more than the initial investment of a trade. An investor may pay $100 for an option and make $200 by the end of the trade, or an investor may make $100 by selling an option and lose $200 by the end of the trade. Leverage may seem unappealing because of its association with risk, but it is not inherently dangerous. When
misused
, leverage can easily wreak financial havoc. However, when used responsibly, the capital efficiency of leverage is a powerful tool that enables traders to achieve the same risk‐return exposure as a stock position with significantly less capital.
There is no free lunch in the market. A leveraged instrument that has a 70% chance of profiting must come with some trade‐off of risk, risk which may even be undefined in some cases. This is why the core principle of sustainable options trading is risk management. Just as casinos control the size of jackpot payouts by limiting the maximum amount a player can bet, options traders must control their exposure to potential losses from leveraged positions by limiting position size. And just as casinos diversify risk across different games with different odds, strategy diversification is essential to the long‐term success of an options portfolio.
Beyond the potential downside risk of options, other factors can make them unattractive to investors. Unlike equities, which are passive instruments, options require a more active trading approach due to their volatile nature and time sensitivity. Depending on the choice of strategies, options portfolios should be monitored anywhere from
daily to once every two weeks. Options trading also has a fairly steep learning curve and requires a larger base of math knowledge compared to equities. Although the mathematics of options can easily become complicated and burdensome, for the type of options trading covered in this book, trading decisions can often be made with a selection of indicators and intuitive, back‐of‐the‐envelope calculations.
The goal of this book is to educate traders to make personalized and informed decisions that best align with their unique profit goals and risk tolerances. Using statistics and historical backtests, this book contextualizes the downside risk of options, explores the strategic capacity of these contracts, and emphasizes the key risk management techniques in building a resilient options portfolio. To introduce these concepts in a straightforward way, this book begins with discussion of the math and finance basics of quantitative options trading (
Chapter 1
), followed by an intuitive explanation of implied volatility (
Chapter 2
) and trading short premium (
Chapter 3
). With these foundational concepts covered, the book then moves onto trading in practice, beginning with buying power reduction and option leverage (
Chapter 4
), followed by trad

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Chapter 1
Math and Finance Preliminaries
The purpose of this book is to provide a
qualitative
framework for options investing based on a
quantitative
analysis of financial data and theory. Mathematics plays a crucial role when developing this framework, but it is predominantly a means to an end. This chapter therefore includes a brief overview of the prerequisite math and financial concepts required to understand this book. Because this isn't in‐depth coverage of the following topics, we encourage you to explore the supplemental texts listed in the references section for those mathematically inclined. Formulae and their descriptions are included in several sections for reference, but they are not necessary to follow the remainder of the book.
Stocks, Exchange‐Traded Funds, and Options
From swaptions to non‐fungible tokens (NFTs), new instruments and opportunities frequently emerge as markets evolve. By the time this book
reaches the shelf, the financial landscape and the instruments occupying it may be very different from when it was written. Rather than focus on a wide range of instruments, this book discusses fundamental trading concepts using a small selection of asset classes (stocks, exchange‐traded funds, and options) to formulate examples.
A share of
stock
is a security that represents a fraction of ownership of a corporation. Stock shares are normally issued by the corporation as a source of funding, and these instruments are usually publicly traded on stock exchanges, such as the New York Stock Exchange (NYSE) and the Nasdaq. Shareholders are entitled to a fraction of the company's assets and profits based on the proportion of shares they own relative to the number of outstanding shares.
An
exchange‐traded fund (ETF)
is a basket of securities, such as stocks, bonds, or commodities. Like stocks, shares of ETFs are traded publicly on stock exchanges. Similar to mutual funds, these instruments represent a fraction of ownership of a diversified portfolio that is usually managed professionally. These assets track aspects of the market such as an index, sector, industry, or commodity. For example, SPDR S&P 500 (SPY) is a market index ETF tracking the S&P 500, Energy Select Sector SPDR Fund (XLE) is a sector ETF tracking the energy sector, and SPDR Gold Trust (GLD) is a commodity ETF tracking gold. ETFs are typically much cheaper to trade than the individual assets in an ETF portfolio and are inherently diversified. For instance, a share of stock for an energy company is subject to company‐specific risk factors, while a share of an energy ETF is diversified over several energy companies.
When assessing the price dynamics of a stock or ETF and comparing the dynamics of different assets, it is common to convert price information into returns. The return of a stock is the amount the stock price increased or decreased as a proportion of its value rather than a dollar amount. Returns can be scaled over any time frame (daily, monthly, annual), with calculations typically calling for daily returns. The two most common types of returns are simple returns, represented as a percentage and calculated using
Equation (1.1)
, and log returns, calculated using
Equation (1.2)
. The logarithm's mathematical definition and properties are covered in the appendix for those interested, but that information is not necessary to know to follow the remainder of the book.
(1.1)
(1.2)
where
is the price of the asset on day
and
is the price of the asset the prior day. For example, an asset priced at $100 on day 1 and $101 on day 2 has a simple daily return of 0.01 (1%) and a log return of 0.00995. Simple and log returns have different mathematical characteristics (e.g., log returns are time‐additive), which impact more advanced quantitative analysis. However, these factors are not relevant for the purposes of this book because the difference between log returns and simple returns is fairly negligible when working on daily timescales. Simple daily returns are used for all returns calculations shown.
An
option
is a type of financial derivative, meaning its price is based on the value of an underlying asset. Options contracts are either traded on public exchanges (exchange‐traded options) or traded privately with little regulatory oversight (over‐the‐counter [OTC] options). As OTC options are nonstandardized and usually inaccessible for retail investors, only exchange‐traded options will be discussed in this book.
An option gives the holder the right (but not the obligation) to buy or sell some amount of an underlying asset, such as a stock or ETF, at a predetermined price on or before a future date. The two most common styles of options are American and European options. American options can be exercised at any point prior to expiration, and European options can only be exercised on the expiration date.
1
Because American options are generally more popular than European options and offer more flexibility, this book focuses on American

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