ful with it while its adopters lose their assets.)
It is also possible the excess of technical information created by these indicators may be like the excess of fundamental information—another shell to hide the pea under, another magician's trick to keep the investor from seeing what is truly important, and what is necessary and sufficient to know to trade well. Perhaps the investor would be better off with a behavioral model because the markets are behavioral. Number-driven technical analysis can do many things, some like Dr. Johnson's dog, which walked on its hind legs, but they cannot put the market in perspective—only the human mind can do that. Number-driven models after all do not consider skirt lengths, moon cycles, sun spots, the length of the economic cycle, or the Bullish or Bearish state of the market (if Bear Markets still exist) (
EN9: A wry ironical comment written before the market crash of the 2000s
.) In the end, the human brain is still the only organ capable of synthesizing all this quantitative and qualitative information and assessing those elements that cannot be reduced to ones and zeros. The educated mind is still the best discriminator of patterns and their contexts.
Summary 1
The computer is a tool, a powerful tool, but a tool nonetheless. It is not an intelligent problem solver or decision maker. We use a mechanical ditch digger to dig a ditch, but not to figure out where the ditch should be.
The multitude of indicators and systems should be viewed with a skeptical eye and evaluated within the context of informed chart analysis. Sometimes an indicator or technique will work for one user or its inventor but strangely mislead the chart analyst who tries to use it—or buys it, even based on a verified track record.
Therefore, the experienced investor keeps his methods and analysis simple until he has definitive knowledge of any technique, method, or indicator he would like to add to his repertoire. Most of all, he depends on his own observations and experience to evaluate his and others' trading techniques.
Other technological developments of importance to
the technical Magee analyst and all investors
The computer is not the only technological development of interest to the technical investor. A number of information revolution technologies need to be put in perspective. These are, in broad categories, the internet and all its facilities, developments in electronic markets, and advances in finance and investment theory and practice. This last is treated in the final section of this chapter.
Owing to the enormous body of material on these subjects, no attempt will be made to explore these subjects exhaustively, but the general investor will be given the information he needs to know to put these subjects in their proper perspective. Resources will point the analyst to avenues for further investigation if the need is felt.
First of all, are there any technological developments of whatever sort that have made charting obsolete? No. Are there any developments that have made trading a guaranteed success? No. The only sure thing is some huckster will claim to have a sure thing. Those who believe such claims are the victims of their own naivete.
The Internet: the eighth wonder of the modern world (EN9: Appendix
B, Resources, for the ninth edition has been enormously expanded
and is of paramount importance to modern investors.)
The internet has been called the most complex project ever built by man, which is probably true. Complex, sprawling, and idiosyncratic, it has something for everyone, especially the investor. Every form of investment creature known to man has set up a site on the internet and waits like the hungry arachnid for the casual surfer: brokers and advisors—technical and fundamental; newspapers, news magazines, newsgroups, and touts; mutual funds, mutual fund advisories, critics and evaluators of all the above; database vendors, chat rooms, electronic marketplaces and exchanges, and Exchange Traded Notes (ECNs)—the only unfilled niche that seems to exist is investment pornography. Perhaps naked options will be able to satisfy this need.
This is a bewildering array of resources. How does one sort them out? The implications of all this for the electronic or cyber investor may be further expanded to indicate the services and facilities available: quotes and data; portfolio management and accounting; online interactive charting; automatic alerts to PBDAs (personal body digital assistants or gizmos carried on the body, for example, cell phones and handheld computers, and so on); analysis and advice; electronic boardrooms; and electronic exchanges where trading takes place without intermediaries.
Appendix B, Resources
, supplies the specifics on these categories while this chapter supplies perspective. It is one thing to contemplate this cornucopia of facilities and another thing to appreciate the importance and priority of its elements. What good are real-time quotes if you are only


iaries.
Appendix B, Resources
, supplies the specifics on these categories while this chapter supplies perspective. It is one thing to contemplate this cornucopia of facilities and another thing to appreciate the importance and priority of its elements. What good are real-time quotes if you are only interested in reviewing your portfolio once a week, except for special occasions? What good are satellite alerts and virtual reality glasses to a long-term investor? It is easy for the investor with no philosophy or method to be drawn into the maelstrom of electronic wonders and stagger out of it a little wiser and much poorer.
Observe then the goods and services of all of this are of importance to the levelheaded investor with his feet on the ground and his head out of the clouds (or
Cloud
). This, hopefully not, abstract investor, the object of our attention here, needs what? He needs
data
,
charts
, and
a connection to a trading place
. Data are available at the click of a mouse. A chart occupies the screen in another click. Another click and a trade is placed. In the Internet Age, it would be tautological to attempt to describe this process in prose when live demonstrations are as close as the desktop computer and an internet connection. A demonstration of this rather simple process (easy to say when one does it without thinking) may be seen at locations linked in
Appendix B, Resources
. The trade will be made, of necessity, through a broker of some sort, perhaps an electronic broker or even a non-virtual broker who communicates via telephone. This will occur shortly, if not already, an electronic pit where one matches wits with a computer instead of a market maker or specialist.
How long brokers will be necessary is a question that is up in the air in the new century. (The broker who earns his keep will always be with us, and welcome, too.) Electronic marketplaces where investors meet without the necessity of a broker or specialist are already proliferating (see
Appendix B, Resources
) and will continue to gain the advantage for the investor over the trading pit, which is one of the last remaining edges the professionals hold over off-floor traders. Suffice it to say, their initial phases will undoubtedly be periods of dislocation, risk, and opportunity as their glitches are ironed out.
Placing electronic orders, whether to an electronic exchange or to the New York Stock Exchange, has certain inherent advantages over oral orders. No one can quarrel about a trade registered electronically as opposed to orally where the potential for disagreement exists. In addition, the trader has only handled the data once—rather than making an analysis, calling a broker, recording the trade, and passing it to the portfolio. If he just hits the trade button and the transaction is routed through his software package, no one will have any doubt as to where an error might lie. The manual method presents an opportunity for error at each step. Rest assured, errors occur and can be disastrous to trading.
The efficiency and ease of the process with a computer have much to recommend it— automation of trade processing, elimination of confusion and ambiguities, audit tracks, automation of portfolio maintenance, and, perhaps most important of all, automatic mark-to-market of the portfolio (the practice of valuing a portfolio at its present market value whether trades are open or closed).
Marking-to-market
This book might have been entitled
Zen and the Art of Technical Analysis
if that title were not so hackneyed and threadbare. It conveys, nonetheless, the message of Zen in the art of archery, that of direct attachment to reality and the importance of the present moment. In his seminal book
The General Semantics of Wall Street
(now
Winning the Mental Game on Wall Street
), John Magee inveighed at some length against the very human tendency to keep two sets of books in the head—one recording profits, open and closed, and another recording losses, but only closed losses. Open losses were not losses until booked. Having an electronic portfolio accountant that refuses to participate in such self-deception has much to recommend it. If the portfolio is always marked to the market when the computer communicates with the data vendor, or the trade broker, it is difficult not to see red ink, and to see the equity of the account reflects all trades, open and closed.
Separating the wheat from the chaff
It requires a gimlet-eyed investor to pick his way through the minefield of temptations in electronic investing and number-driven technical analysis. Playing with the toys, seeing what the pundits have to say, and fiddling with “research” can subtly replace profitable trading as the activity. Actually, almost all the research the Magee analyst
must
do is addressed in this book.
Chaff
Chat rooms, touts, news, predictions, punditry, brokerage house buy, sell, hold, strong hold, weak buy, strong buy, and any other species of brokerage house recommenda

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


ace profitable trading as the activity. Actually, almost all the research the Magee analyst
must
do is addressed in this book.
Chaff
Chat rooms, touts, news, predictions, punditry, brokerage house buy, sell, hold, strong hold, weak buy, strong buy, and any other species of brokerage house recommendation should be taken at face value. Remember, brokerage firms survive by selling securities and make their money in general on activity. Actually, much of their money is made servicing their institutional clients and distributing their clients' shares to their retail clientele—a blatant conflict of interest that blew up in their faces in the early 2000s, resulting in many fines and some jail terms
(plus ga change ... ).
In the surging Clinton-Gore Bull Markets of the 1990s, all of these worked. In a serious Bear Market, none of them will work.
(EN9: A serious Bear Market started in earnest in 2000 and was correctly identified with Magee chart analysis as may be seen from the John Magee Letters at the
http://www.edwards-magee.com
.)
Summary 2
Never in the history of the markets have so many facilities for private investors been available. The computer is necessary to take advantage of those facilities.
Data may be acquired automatically via internet or dial-up sites at little or no cost. A (as they say) plethora of websites offer cyber investors everything from portfolio accounting to alerts sent to their personal body-carried devices (cell phones, pagers, handheld PDAs, and so on). Some of these even offer real-time data, which is a way for the unsophisticated trader to go broke in real time. Many of these sites offer every kind of analysis from respectable technical analysis (usually too complicated) to extraterrestrial channeling.
Internet chat rooms will provide real-time touting and numerous rumors to send the lemmings and impressionable scurrying hither and yon. But, one expects, not the readers of this book.
Of more importance, the information revolution and the computer will:
1. Relieve the analyst of manual drudgery, accelerate all the steps of analysis: data gathering, chart preparation, portfolio accounting, and analysis and tax preparation.
2. Give the analyst virtually effortless portfolio accounting and mark-to-market prices—a valuable device to have to keep the investor from mixing his cash and accrual accounting, as Magee says.
3. Enable processing of a hitherto unimaginable degree. An unlimited number of stocks may be analyzed. Choosing those to trade with a computer will be dealt with in
Chapter 21
,
Selection of Stocks to Chart
.
4. Allow the investor to trade on ECNs or in electronic marketplaces where there are no pit traders or locals to fiddle with prices.
Advancements in investment technology, part 1:
developments in finance theory and practice
Numerous pernicious and useless inventions, services, and products litter the internet and the financial industry marketplace; but modern finance theory and technology are important and must be taken into consideration by the general investor. This chapter will explore the minimum the moderately advanced investor needs to know about advances in theory and practice. And it will point the reader to further resources if he desires to continue more advanced study.
Instruments of limited (or non) availability during the time of Edwards and Magee included exchange traded options on stocks, futures on averages and indexes, options on futures and indexes, and securitized indexes and averages, as a partial list of only the most important instruments. Undoubtedly, one of the most important developments of the modern era is the creation of trading instruments that allow the investor to trade and hedge the major indexes. Of these, the instruments created by the Chicago Board of Trade (CBOT
®
) are of singular importance. These are the CBOT
®
DJIA
SM
Futures and the CBOT
®
DJIA
SM
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 imp


ck. 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 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 a


fitable in some cases.
Quantitative analysis
The investor should be aware of another area of computer and investment technology that has yielded much more dramatic and profitable results, but that is in a model-driven market—namely, the options markets. Quantitative analysts, those who investigate and trade the options markets, are a breed apart from technical analysts. In an interesting irony, behavioral markets, the stock markets, are used as the basis for derivatives, or options whose price is determined largely by the operation of algorithms called “models.” The original model that created the modern world of options trading was the Black-Scholes options analysis model, which assumed the “fair value” of an option could be determined by entering five parameters into the formula: the strike price of the option, the price of the stock, the “risk-free” interest rate, the time to expiration, and the volatility of the stock.
The eventual universal acceptance of this model resulted in the derivatives industry we have today. To list all the forms of derivatives available for trading today would be to expand this book by many pages, and it is not the purpose of this book anyway. The purpose of this paragraph is to sternly warn general investors who are thinking of “beating the derivatives markets” to undergo rigorous training first. The alternative could be extremely expensive.
At first, the traders who saw the importance of this model and used it to price options virtually skinned older options traders and the public, who traded pretty much by the seat of the pants or the strength of their convictions, meaning human emotion. But professional losers learn fast and now all competent options traders use some sort of model or anti-model, or anti-antimodel to trade. True to form, options sellers, who are largely professionals, take most of the public's (the buyers) money. This is the way of the world.
Options pricing models and their importance
After the introduction of the Black-Scholes model, numerous other models followed, among them the Cox-Ross-Rubinstein, the Black Futures, and others. For the general investor, the message is this: he must be acquainted with these models and what their functions are if he intends to use options. Recall, the model computes the “fair value” of the option. One way professionals make money off amateurs is by selling overpriced options and buying underpriced options to create a relatively lower risk spread (for themselves). Not knowing what these values are for the private investor is like not knowing where the present price is for a stock; it is a piece of ignorance for which the professional will charge him a premium to be educated about. Unfortunately, many private options traders never get educated, in spite of paying tuition over and over again. But ignorance is not bliss—it is expensive.
Technology and knowledge works its way from innovators and creative geniuses through the ranks of professionals and sooner or later is disseminated to the general public. By that time, the innovators have developed new technology. Nonetheless, even assuming that professionals have superior tools and technology, the general investor must thoroughly educate himself before using options. As it is not the province of this book to dissect options trading, though the reader may find references in
Appendix B, Resources
.
Here it would not be untoward to mention one of the better books on options as a starting point for the moderately advanced and motivated trader. Lawrence McMillan's
Options as a Strategic Investment
is necessary reading. In addition, the newcomer may contact the Chicago Board Options Exchange (the CBOE) at
http://www.cboe.com
, which has tutorial software.
Futures on indexes
Futures, like options, offer the speculator intense leverage—the ability to control a comparatively large position with much less capital than the purchase of the underlying commodity or index. Futures salesmen are fond of pointing out the fact that, if you are margined at 5% or 10% of the contract value, a similar move in the price of the index will double your money. They are often not so conscientious about pointing out a similar move against your position will wipe out your margin (actually earnest money). Unlike (long) options, a mishap in the market can result in more than the loss of margin; it can become a deficit account and debts to the broker—in other words, losses of more than 100%. For this, among other reasons, it is wise not to plunge into futures without considerable preparation. This preparation might well begin, for the adroit investor, with the reading of Schwager's
Technical Analysis, Schwager on Futures
, currently one of the better books on the subject.
Let us say that, instead of using futures to speculate, we want to use them as a hedge for our portfolio of Dow-Jones DIAMONDS (DIA) or portfolio of Dow-Jones stocks. Now we are purchasing insurance, rather than speculating. As an oversimpl


Futures
, currently one of the better books on the subject.
Let us say that, instead of using futures to speculate, we want to use them as a hedge for our portfolio of Dow-Jones DIAMONDS (DIA) or portfolio of Dow-Jones stocks. Now we are purchasing insurance, rather than speculating. As an oversimplified example, the investor might see the failure of the DJIA to break through a top as the beginning of a congestion zone (a consolidation or reversal pattern). He could then hedge his position by shorting the Dow-Jones futures. Now he is both long and short—long the cash, short the futures. He would place a stop on the futures above his purchase price to close the trade if the market continued rising. If the market fell, he would maintain the futures position until he calculated that the reaction had passed its worst point, or until it were definitely analyzed to have reversed. He would then take his profits on the futures position (taxable), but his cash position would be intact, and presumably, the greater capital gains on those positions would be safe from taxation, and also safe from the costs, slippage, and difficulties of reestablishing the stock position.
Options on futures and indexes
Conservative as well as speculative use may be made of options. For example, the investor might, after a vigorous spike upwards, feel the Standard & Poor's (S&P) 500, or the SPYs which he is long, were overbought. He might then buy an index put on the S&P as a hedge against the expected decline. If it occurs, he collects his profit on the option and his cash position in the S&P is undisturbed. If the index continues to climb, he loses the option premium—an insurance policy he took out to protect his stock portfolio.
Note:
The tactics described here are for the reader's conceptual education. Before executing tactics of this kind, or any other unfamiliar procedure, the investor should thoroughly inform himself and rehearse the procedure, testing outcomes through paper trading before committing real capital.
He must, in short, figure out how you lose
. A number of websites offer facilities of this kind, and the investor may also build on his own computer a research or paper-trading portfolio segregated from his actual transactions.
The trader might also choose to buy an option on a future. At the CBOT
®
, the trader can trade both options and futures on the DJIA. These can be used as the above examples for speculating or hedging, except in this case, the successful option buyer might wind up owning a futures contract instead of the cash position. This could be disconcerting to one not accustomed to the futures market, especially if large price anomalies between futures and cash occurred, as happened in 1987 and 1989 when futures prices went to huge discounts to cash. A primary reason for employing the futures would be for leverage and the reason for using the options on futures would be the analysis that uncertainty was in store and the wish to only risk the amount of the options premium.
Obviously, a speculator can choose to forget the stock or futures part of the portfolio and trade only options. Before taking such a step, the trader should pass a postgraduate course. The proportion of successful amateur option traders to successful professional traders is extremely skewed. In fact, one might say all successful options traders are professionals.
Modern Portfolio Theory
Modern Portfolio Theory (MPT) is a procedure and process whereby a portfolio manager may classify and analyze the components of his portfolio in such a way as to, hopefully, be aware of and control risk and return. It attempts to quantify the relationship between risk and return. Rather than analyzing only the individual instruments within a portfolio, MPT attempts to determine the statistical relationships among the members of the portfolio and their relationships to the market.
The processes involved in MPT analysis are as follows (1)
portfolio valuation
, or describing the portfolio in terms of expected risk and expected return; (2)
asset allocation
, determining how capital is to be allocated among the classes of instruments (bonds, stocks, and so on); (3)
optimization
, or finding the trade-offs between risk and return in selecting the components of the portfolio; and (4)
performance measurement
, or the division of each stock's risk into systemic and security-related classes.
How important is this for the general investor? Not very and there is a large question among pragmatic analysts, such as the editor, as to its pragmatic usefulness for professionals, although they cling to it as to a life ring in a shipwreck. Mandelbrot observed in articles (“A Multifractal Walk Down Wall Street”) and letters in the
Scientific American
(February 1999 and June 1999) that MPT discards about 5% of statistical experience as if it did not exist (although it [the experience] does). He also observed the ignored experience includes 10-sigma market storms that are blamed fo


tal Walk Down Wall Street”) and letters in the
Scientific American
(February 1999 and June 1999) that MPT discards about 5% of statistical experience as if it did not exist (although it [the experience] does). He also observed the ignored experience includes 10-sigma market storms that are blamed for portfolio failures as though it were the fault of the data instead of the fault of the process.
The wonders and joys of investment technology
Are there any other innovations in finance and investment theory of which the general investor should be aware? (See
Chapter 42
for discussion of Value at Risk and Pragmatic Portfolio Theory.) Well, it never hurts to know everything, and the very best professionals not only are aware of everything, but also are in the constant process of finding new wrinkles and glitches and anomalies. Though, as Magee would ask, what is necessary and sufficient to know (see
Winning the Mental Game on Wall Street
)? Absolute certainty is the hallmark of religious extremists and the naive, who do not know what they do not know. So I will remark that
probably
this book contains either what is necessary and sufficient for the investor to know about these matters or guides the reader to further study.
Not to mention,
nota bene
, any number of little old ladies with a chart, a pencil, a ruler, and previous editions of this book have beaten the pants off professional stock pickers with supercomputers and MPT and Nobel Laureates and who knows what other resources. I personally know investment groups that have thrown enormous resources into the development of real-time systems that, in research, were 100% successful in beating the market. The only real glitch was the systems required so much computer power they could not be run quickly enough in real time to actually trade in the markets. Philosopher's stone
redux.
Advancements in investment technology, part 2:
futures and options on futures on the Dow-Jones
Industrial Index at the CBOT
(EN9: The general investor
must
be aware that the methods and techniques described in this chapter are for advanced practitioners. Careless use of the described instruments can be extremely damaging to a portfolio.)
Investment and hedging strategies using the CBOT
®
DJIA
SM
futures contract
A futures contract is the obligation to buy or sell a specific commodity on or by some specified date in the future. For example, if one went long corn futures, he would be obligated to accept delivery of corn on the delivery date, unless he sold the contract before the settlement date. Shorting the contract would obligate the seller to deliver corn unless he offset (by repurchase) the contract. The “commodity” in our present case is the basket of stocks represented by the DJIA futures index. All futures contracts specify the date by which the transaction must conclude, known as the “settlement date,” and how the transaction will be implemented, known as “delivery.” The DJIA futures contract price closely tracks the price of the Dow-Jones Industrials as computed from stock market values.
The value of the future is found by multiplying the index price of the futures contract by $10.00. For example, if the futures index price is 10,000, the value of the contract is 10,000 x $10.00 = $100,000. So the buyer or seller of the futures contract is trading approximately $100,000 worth of stocks at that Dow futures level. The value may be higher or lower owing to several factors, for example, cost of carry, which will be discussed below.
Settlement of futures contracts
All futures contracts must be “settled.” Some futures are settled by delivery, the famous nightmare of finding 5,000 bushels of soybeans delivered on your front lawn. Dow Index futures “settle” (are delivered) in cash. The short does not dump a basket of Dow stocks on the yard of the long. Thus, on the settlement date of the contract, the settlement price is $10.00 times a figure called the “Special Opening Quotation,” a value calculated from the opening prices of the member stocks of the Dow Future following the last day of trading in the futures contract. This value is compared with the price paid for the contract when the trade initiated. For example, if the Dow Future is 10,000 at expiration, a long who bought the contract at 9,000 receives $10,000 ($10.00 x 1000) from the short.
Marking-to-market
This $10,000, however, is paid daily over the life of the contract, rather than in one payment upon expiration of the contract. It is paid as successive daily “margin” payments. These payments are not really margin but are in effect “earnest money” or a performance bond. The practice of squaring up accounts at the end of every day's trading is called “marking-to-market.” These daily payments are determined based on the difference between the previous day's settlement price and the contract settlement price at the close of trading each day.
As a practical example, if the settlement price of June Dow Index futures increases fro


s trading is called “marking-to-market.” These daily payments are determined based on the difference between the previous day's settlement price and the contract settlement price at the close of trading each day.
As a practical example, if the settlement price of June Dow Index futures increases from 9,800 to 9,840 from May 17 to May 18, the short pays $400 ($10.00 x 40) and the long's account is credited $400. If the futures settlement price decreases 10 points the following day, the long pays $100 to the short's account—and so on each day until expiration of the contract, when the futures price and the index price achieve parity.
At any time, the trader can close his position by offsetting the contract, that is, by selling to close an open long, or buying to close an open short. At the expiration date, open contracts are settled in cash at the final settlement price.
Fungibility
One of the great contributions of the great established exchanges like the CBOT
®
and the Chicago Mercantile Exchange is their institutionalization of contract terms and relationships is known as “fungibility.” Any one futures contract for corn, or an index, or any other commodity is substitutable for another of the same commodity. Similarly, the Exchange has negated counterparty risk by placing a Clearing Corporation between all parties to trades. Thus, even if the other party to a trade went broke, the Clearing Corporation would assume his liability and, using the mechanism of daily settlement, whereby losers pay winners daily, the danger of major default is avoided.
Futures “margins” (or “earnest money”) are deposited with the broker on opening a trade. The leverage obtainable is quite extreme for a stock trader. The initial margin is usually 3%-5% of the total value of the contract. Each day thereafter, margins vary according to the process described above of marking-to-market.
As the reader can see, the purchase or sale of a Dow Future is the equivalent of a fairly large portfolio transaction, with the understanding it is a transaction that will be closed in the future, unlike a stock purchase, which may be held indefinitely.
Differences between cash and futures
The main two differences between the cash and the futures transactions are as follows:
1. In cash, the value of the portfolio must be paid up front or financed in a stock margin account.
2. The owner of the cash portfolio receives cash dividends.
These are not the only differences. The leverage employed in the futures transaction is a two-edged sword. If the trader has no reserves, a minor move in the index wipes him out. Such a minor move would be barely noticed by the owner of a cash portfolio.
Dow Index futures
The price of the future and the price of the index are closely linked. Any price anomaly is quickly corrected by arbitragers. On any significant price difference, arbitragers will buy the underpriced and sell the overpriced, bringing the relationship back in line. Their prices are not exactly the same because the futures contract value must reflect the costs of short-term financing of stocks and the dividends paid by index stocks until futures expiration, known as the “cost of carry.” The “theoretical value” of the future should equal the price of the index plus the carrying cost, what is called the “fair” or “theoretical” value.
Using stock index futures to control exposure to the market
The owner of a cash portfolio in the Dow, or of DIAMONDS, can control his exposure, his risk, by using futures to hedge. If, for example, he is pessimistic about the market, or more to the point, a lot of uptrend lines have been broken and the technical situation seems to be deteriorating, he can sell a futures contract equivalent to his portfolio and be flat the market.
Readers will immediately recognize the advantages of this strategy. Tax consequences on the cash portfolio are avoided, as are the other negative consequences of trading— slippage, errors, and so on. Long-term positions are better left alone. By flattening his position, the investor has now insured the future value of his portfolio,
and
the capital involved is now earning the money market rate of return.
What happens if the forecast market decline occurs? The portfolio is protected from loss and the capital earns the market rate of return; however, the investor should monitor his hedge closely, lifting it when he calculates the correction has run its course. Taxes will then be due on the profits on the hedge.
In monitoring the hedge, the possibility the market rises instead of falls must be considered. In planning the hedge in the first place, the investor must plan for this eventuality and determine at which point he will lift the hedge on the losing side. At worst, the investor has surrendered portfolio appreciation. Not considering cash flow implications.
It is worth emphasizing, in fact
strongly
emphasizing, that these techniques require knowledge, expertise, and study. Careless use of techniques of thi


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


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


).
Results: at the September futures expiration, the value of the Dow future is 11,000, a rate of return of 10%, and the market value of the bonds is 101-08, a rate of return of -1%.
Portfolio value with no market action taken:
Stocks
$200,000 x 1.10
$220,000
Money market
$200,000 x 0.99
$198,000
Total
$418,000
Value of futures positions:
Long Dow futures
$10 x 1 x (11,000 - 10,000)
$10,000
Short bond futures
+$1000 x 1 x (102-20 - 101-08)
$1375
Total
$11,375
Grand total
$429,375
Value of portfolio had transaction been done in cash market:
Stocks
$300,000 x 1.10
$330,000
Bonds
+$100,000 x 0.99
$99,000
Total
$429,000
By this simple maneuver, you have quickly and easily changed your market posture to add an additional $100,000 exposure to stocks and subtract $100,000 exposure to bonds.
Figure 17.4
Dow-Jones Futures and Options. A put purchased at the arrow on the break would have protected patiently won gains over the previous 11 months. The increase in the value of the put can be seen as futures track declining Dow cash. A theoretical drill, but theoretical drills precede actual tactics in the market.
Having correctly analyzed market trends, your action results in an increase in portfolio value from $418,000 to $429,375. You could have accomplished the same result by buying and selling bonds and stocks, but not without tax consequences and the attendant transaction headaches. The use of futures to accomplish your goals allowed you to implement your


Perspective
Although there can be no argument about the importance of CBOT
®
DJIA
SM
Index futures— they are markets of enormous usefulness and importance—there can also be no doubt the futures novice should thoroughly prepare himself before venturing into these pits. In such a highly leveraged environment, mistakes will be punished much more severely than an error in the stock market. By the same token, ignorance of this vital tool is the mark of an investor who is not serious about his portfolio, or who is less intense in his investment goals. “They” (the infamous “they”) use all the weapons at their disposal; so should “we.”
Options on Dow Index futures
The buyer of this instrument has the choice, or the right, to assume a position. It is his
option
to do so—unlike a futures contract in which he has an
obligation
once entered. There are two kinds of options: calls (the right to buy the underlying instrument) and puts (the right to sell). Also, options can be bought (long) or sold (short) like futures contracts.
A long call option on Dow Index futures gives the buyer the right to buy one futures contract at a specified price which is called the “exercise” or “strike” price. A long put option on Dow Index futures gives the buyer the right to sell one futures contract at the strike price. For example, a call at a strike price of 10,000 entitles the buyer to be long one futures contract at a price of 10,000 when he exercises the option. A put at the same strike price entitles the buyer to be short one futures contract at 10,000. The strike prices of Dow Index futures options are listed in increments of 100 index points, giving the trader the flexibility to express his opinions about upward or downward movement of the market.
The seller, or writer, of a call or put is short the option. Effectively selling a call makes the writer short the market, just as selling a put makes the writer long the market. As in a futures contract, the seller is obligated to fulfill the terms of the option if the buyer exercises. If you are short a call, and the long exercises, you become short one futures contract at 10,000. If you are short one put and the long exercises, you become long one futures contract at 10,000.
Buyers of options enjoy fixed risk. They can lose no more than the premium they pay to go long an option. On the other hand, sellers of options have potentially unlimited risk. Catastrophic moves in the markets often bankrupt imprudent option sellers.
Option premiums
The purchase price of the option is called the option premium. The option premium is quoted in points, each point being worth $100. The premium for a Dow Index option is paid by the buyer at initiation of the transaction.
The underlying instrument for one CBOT
®
futures option is one CBOT
®
DJIA
SM
futures contract; so the option contract and the futures contract are essentially different expressions of the same instrument, and both are based on the Dow-Jones Index.
Options premiums consist of two elements: intrinsic value and time value. The difference between the futures price and strike price is the intrinsic value of the option. If the futures price is greater than the strike price of a call, the call is said to be “in-the-money.” In fact, you can be long the futures contract at less than its current price. For example, if the futures price is 10,020 and the strike price is 10,000, the call is in-the-money and immediate exercise of the call pays $10.00 times the difference between the futures and strike price, or $10 x 20 = $200. If the futures price is less than the strike price, the call is “out-of-the-money.” If the two are equal, the call is “at-the-money.” A put is in-the-money if the futures price is less than the strike price and out-of-the-money if the futures price is greater than the strike price. It is at-the-money when these two prices are equal.
Since a Dow Index futures option can be exercised at any date until expiration, and exercise results in a cash payment equal to the intrinsic value, the value of the option must be at least as great as its intrinsic value. The difference between the option price and the intrinsic value represents the time value of the option. The time value reflects the possibility that exercise will become more profitable if the futures price moves farther away from the strike price. Generally, the more time until expiration, the greater the time value of the option because the likelihood of the option becoming profitable to exercise is greater. At expiration, the time value is zero and the option price equals the intrinsic value.
Volatility
The degree of fluctuation in the price of the underlying futures contract is known as “volatility” (see Appendix B, Resources, for the formula). The greater the volatility of the futures, the higher the option premium. The price of a futures option is a function of the
futures price, the strike price, the time left to expiration, the money market rate, and the volatility

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


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 unexercised put is $0.00. If the price of the expiring futures contract is 7,500, a 7,600 put should be exercised but not a call at 7,600 or a higher strike. The value of the exercised put is $1,000 and that of the unexercised call is $0.00.
The profit on long options is the difference between the expiration value and the option premium. The profit on short options is the expiration value plus the option premium. The expiration values and profits on call and put options can often be an important tool in an investment strategy. Their payoff patterns and risk parameters make options quite different from futures. Their versatility makes them good instruments to adjust a portfolio to changing expectations about stock market conditions. Moreover, these expectations can range from general to specific predictions about the future direction and volatility of stock prices. Effectively, there is an option strategy suited to virtually every set of market conditions.
Using futures options to participate in market movements
Traders must often react to rapid and surprising events in the market. The transaction costs and price impact of buying or selling a portfolio's stocks on short notice inhibit many investors from reacting to short-term market developments. Shorting stocks is an even less palatable option for average investors because of the margin and risks involved and semantical prejudices.
The flexibility that options provide can allow one to take advantage of the profits from market cycles quickly and conveniently. A long call option on Dow Index futures profits at all levels above its strike price. A long put option similarly profits at all levels below its strike price. Let us examine both strategies.
Profits in rising markets
In August, the Dow Index is 10,000 and the Dow Index September future is 10,050. You expect the current Bull Market to continue, and you would like to take advantage of the trend without tying up too much capital and also undertake only limited risk.
You buy a September call option on Dow Index futures. These options will expire simultaneously with September futures, and the futures price will be the same as the cash index at expiration.
Your analysis is bullish, so the 10,500 call (out-of-the-money strike price) is a reasonable alternative at a quoted premium of 10.10. You pay $1,010 for the call ($100 x 10.10).
The payoff: at the September expiration, the value of the Dow Future is 10,610. Now, your call is in-the-money, and you exercise it and garner the exercise value less the premium, or $90.00 = $10.00 x (10,610 - 10,500) - $100 x (10.10) = $1,100 - $1,010. If the Dow future stays at or below 10,500, you let the call expire worthless and simply lose the premium. This is the maximum possible loss on the call. If the Dow future increases by 101 points above the strike price, you break even.
Instead of buying the call option, the trader could have invested $100,500 directly in the Dow stocks. Given a value of the Dow future of 10,110 in September, he would have had a gain of $3,030. If he had invested directly in the stocks, however, an unexpected market decline would have led to a loss.
Exploiting market reversals
The trader expects a reversal of the Bull Market now at 7,8


e Dow stocks. Given a value of the Dow future of 10,110 in September, he would have had a gain of $3,030. If he had invested directly in the stocks, however, an unexpected market decline would have led to a loss.
Exploiting market reversals
The trader expects a reversal of the Bull Market now at 7,800 and would like some downside protection.
He buys a put with a strike price of 7,700 (out-of-the-money). The put premium is 9.80, for a total cost of $980 = $100 x 9.80. If the Index decreases to 7,600, with a corresponding decrease in the futures contract in September, the put is worth $1,000. The maximum loss is the premium cost, which is lost if the Dow future is above 7,700 at expiration. The trader breaks even if the Dow future decreases by 98 points below the strike price.
Using puts to protect profits in an appreciated portfolio
During a sustained Bull Market, investors often search for ways to protect their paper profits from a possible market break. Even when fundamental economic factors tend to support a continued market upside, investors have to guard against unpredictable “technical market corrections” and market over-reactions to news.
Selling stocks to reduce downside risk is costly in fees and taxes and sacrifices potential price gains. What is desirable in a sideways market environment is an instrument that protects the value of a portfolio against a market drop but does not constrain upside participation. This is precisely what put options are designed to do.
Situation 1
The market is in an uptrend in August, which is when the market lives with the anxiety the Federal Reserve will tighten short-term interest rates further in the coming months. The trader has $78,000 invested in the Dow portfolio, and the Dow Future is at 7,800.
To hedge his portfolio, he purchases a put option on September futures against a possible market downturn. He buys a 7,600 put at a premium of 6.60, cost $100 x 6.60 = $660.
Buying the put places a floor on the value of the portfolio at the strike price. Buying a put with a strike price of 7600 effectively locks in the value of the portfolio at $76,000. Above its strike price, a put is not exercised and the portfolio value is unconstrained. If the trader is wrong, and the market goes up, he loses the premium paid for the put. Depending on which strike price he chooses, he increases or decreases downside risk. He breaks even when the Dow future reaches a value of 7,534 = 7,600 - 66, the strike price less the put premium. At this level, the unprotected and put-protected portfolios are equally profitable.
The similarity to life insurance is striking. If you do not die, the premium is wasted. But if you do...
Improving portfolio yields
Situation 2
All markets, as the reader is perhaps aware, are not trending. Days, weeks, months, sometimes years can pass while the markets grind up and down in what are euphemistically known as trading range markets. When the astute technician identifies one of these market doldrums and judges that it will continue, he can reap other returns on his portfolio by selling puts and calls on Dow Index futures.
For example, when the Dow Index is 10,000 and the trader calculates it will not break out for the next month above 10,200, he sells calls at a strike price of 10,200. The quoted premium of the 10,200 call is, say, 10.10; selling a 10,200 call generates $1010 income.
The trader pockets the entire premium as a profit if the index remains below 10,200 at the September expiration. The downside of this trade is that the trader gives up price appreciation above 10,200. Above 10,200, the combined value of the portfolio and short call premium is $101,010. The break-even point is 10,301, where the Dow Future is equal to the sum of the strike price and call premium. Above this point the covered call portfolio becomes less profitable than the original portfolio. Since the short call is covered by the portfolio, this strategy is not exposed to the risk represented by a naked call. The main risk is the trader giving up the profit potential above the strike price of the call. As is obvious to the technician, this is a bad strategy in trending markets. Only in clearly range-bound markets would an enlightened trader want to write covered calls. The call premium collected is some compensation for this risk, but cold comfort when the trader has misanalyzed the market. The best strike price of the call depends on the probabilities you have assigned to future increases and behavior of the Dow.
Using option spreads in high- or low-volatility markets
Long and short stock positions reflect definite market opinions or analyses. The market will go up or the market will go down and the moderately competent technician should be right about this more often than the unwashed general public. In markets of coiling volatility (i.e., lower than average volatility and declining), it is sometimes possible to exploit uncertainty by putting on a long straddle. The long straddle


down and the moderately competent technician should be right about this more often than the unwashed general public. In markets of coiling volatility (i.e., lower than average volatility and declining), it is sometimes possible to exploit uncertainty by putting on a long straddle. The long straddle combines a long put and a long call at the same strike price. This spread generates a return over two ranges of market values: values below the strike price of the put and values above the strike price of the call. It is a profitable strategy given sufficient volatility; the editor's company used such a strategy immediately before the crash of 1987 for managed accounts and collected disproportionate profits on a very low-risk position. Experienced speculators and traders generally sell high-volatility markets and try to backspread (go long) in chosen less-volatile markets, expecting volatility to return to the mean. Sometimes they do this by writing a short straddle, a position with a short put and a short call at the same strike price.
Situation 3
In August, a technical analysis predicts that volatility will increase, and the market is in a coiling process. The direction of prices is uncertain but potentially explosive. The trader buys a straddle of a long put at 7,800 and a long call at 7,800. The quoted call premium is 18.90 and the quoted put premium is 13.90. The total cost of the straddle is $3280 = $100 x 32.80. This is the maximum loss if the Dow Future stalls at 7,800.
The straddle makes a profit when the Dow Future moves enough to recover the cost of the straddle, either below 7,472 = 7,800 - 328 or above 8,128 = 7,800 + 328. The potential upside profit is unlimited. The maximum profit on the downside is $10.00 x (7,800 - 328), or $74,720, if the Dow future goes to zero (somewhat unlikely, but one never knows what Chicken Little the investor will do if he thinks the sky is falling).
Situation 4
In August, the investor calculates options are overvalued and volatility will be lower than implied volatility. He expects a dormant market to continue through the end of the summer. He decides to sell the September put and call at 7,800, collecting $3,280. The return on this short straddle will turn negative if the Dow future in September goes below 7,472 or above 8,128. The maximum loss on the downside is $10.00 x (7,800 - 328), or $74,720, and the loss on the upside is unlimited. The investor, however, perceives the risk as limited because he believes the Dow future will neither increase nor decrease to these levels within the next month when the options expire. In these cases, the trader must also consider catastrophic risk—as, for example, the editor's client who was short puts in the crash of 1987 and lost $57 million.
Perspective
(EN9: Once again, do not practice the methods and techniques described in this chapter without complete confidence in their use. A course in futures and options is recommended, or professional consultation.)
I like to tell these stories so prospective options traders and general investors are made dramatically aware of the potential dangers, as well as the potential profits. As stated elsewhere in this book, the novice should work to achieve competence and experience before attempting advanced tricks in futures and options. On the other hand, the investment use of these instruments for prudent hedging and insurance is recommended to the investor willing to do his homework, acquire competence, and grow in investment skills.
Dow Index futures and futures options present new techniques of portfolio protection and profit-making for the general investor. Numerous strategies can be practiced by the moderately competent investor using these instruments. Keep in mind always that all the methods of analytical investing espoused in this book are the base discipline—that is, knowledge of the instruments and their use, prudent trade management, stop-loss discipline, and close attention to the dynamics of the situation. Above all, the existence of these instruments allows the most conservative of investors insurance and hedging techniques not previously available.
In summation, knowledge of the DJIA futures and options on futures is absolutely essential for the competent technical investor and trader.
Recommended further study
In view of the importance of this chapter, noted here are references to advanced material, which are also found in
Appendix B, Resources
.
The CBOE has a website explaining the math behind hedging. To hedge a portfolio of $500,000 tracking the S&P 500, you need four puts. The address for the calculation of the hedging ratio is available at
http://www.cboe.com/portfoliohedge
.
For further study, see the following:
•
Options
as a Strategic Investment
by Lawrence Macmillan,
http://www.optionstrategist.
com
• Chicago Board Options Exchange,
http://www.cboe.com
• Chicago Board of Trade, 312-435-3558 or 800-THE-CBOT; 312-341-3168 (fax);
http://
www.cbot.com
part two
Trading ta


For further study, see the following:
•
Options
as a Strategic Investment
by Lawrence Macmillan,
http://www.optionstrategist.
com
• Chicago Board Options Exchange,
http://www.cboe.com
• Chicago Board of Trade, 312-435-3558 or 800-THE-CBOT; 312-341-3168 (fax);
http://
www.cbot.com
part two
Trading tactics
Midword
As a kind of foreword to Section II of this book, we might mention a commentary, “On Understanding Science: An Historical Approach,” by James Bryant Conant, president emeritus of Harvard.
Dr. Conant points out that, in school, we learn science is a systematic collection of facts that are classified in orderly array, broken down, analyzed, examined, synthesized, and pondered; and then lo! a Great Principle emerges—pat, perfect, and ready for use in industry, medicine, or what-have-you.
He further points out that all of this is a mistaken point of view held by most laymen. Discovery takes form little by little, shrouded in questioning, and only gradually assumes the substance of a clear, precise, well-supported theory. The neat tabulation of basic data, forming a series of proofs and checks, does not come at the start but much later. In fact, it may be the work of other men entirely, men who, being furnished with the conclusions, are then able to construct a complete, integrated body of evidence. Theories of market action are not conceived in a flash of inspiration; they are built, step by step, out of the experience of traders and students, to explain the typical phenomena that appear over and over again through the years.
In market operations, the practical trader is not concerned with theory as such. The neophyte's question, “What is the method?” probably means, actually, “What can I buy to make a lot of money easily and quickly?” If such a trader reads this book, he may feel there is “something in it.” He may feel “It's worth a try” (a statement, incidentally, that reflects little credit on his own previous tries). He may also start out quite optimistically, without any understanding of theory or any experience in these methods, and without any basis for real confidence in the method.
In such cases, the chances are great he will not immediately enjoy the easy success he hopes for. His very inexperience in a new approach will result in mistakes and failures. Yet, even with the most careful application of these methods, in correctly entered commitments, he may encounter a series of difficult market moves that may give him a succession of losses. Whereupon, having no solid confidence in what he is doing, he may sigh, put the book back on the shelf, and say, “Just as I thought. It's no damn good.”
Now, if you were about to go into farming for the first time, you might be told (and it would be true) the shade tobacco business offers spectacular profits. But you would not expect to gain these profits without investing capital, without studying how shade tobacco is grown and in what kinds of soils and what localities, nor without some experience with the crop. Furthermore, you would need confidence—faith in the opportunity and also in the methods you were using. If your first season's crop were blighted (and these things do happen), you would naturally be disappointed. If it should happen that your second year's crop were destroyed by a hailstorm, you would be hurt and understandably despondent. Moreover, if your third season's crop were to be a total loss because of drought, you would probably be very gloomy indeed (and who could blame you?). But you would not say, “There's nothing to it. It's no damn good.”
You would know (if you had studied the industry and the approved cultivation methods) that you were right, regardless of any combination of unfavorable circumstances, and you would know the ultimate rewards would justify your continuation, no matter how hard the road, rather than turn to some easier but less potentially profitable crop.
So it is with technical methods in the stock market; anyone may encounter bad seasons. The Major Turns inevitably will produce a succession of losses to Minor Trend operators using the methods suggested in this book. There will also be times when a man who has no understanding of basic theory will be tempted to give up the method entirely and look for a “system” that will fit into the pattern of recent market action nicely, so he can say, “If I had only averaged my trades ... . If I had followed the Dream Book ... . If I had taken Charlie's tip on XYZ ... . If I had done it this way or that way, I would have come out with a neat profit.”
It would be better, and safer, to understand at the start that no method ever devised will unfailingly protect you against a loss, or sometimes even a painful succession of losses. You should realize what we are looking for is the probability inherent in any situation. Likewise, just as you would be justified in expecting to draw a white bean from a bag which you knew contained 700 white beans and 300 black beans (even though you had


etimes even a painful succession of losses. You should realize what we are looking for is the probability inherent in any situation. Likewise, just as you would be justified in expecting to draw a white bean from a bag which you knew contained 700 white beans and 300 black beans (even though you had just drawn out 10 black beans in succession!), so too you are justified in continuing to follow the methods that, over long periods, seem most surely and most frequently to coincide with the mechanism of the market.
Thus, this book should not be given a quick “once-over” and adopted straightaway as a sure and easy road to riches. It should be read over and over, a number of times, and it should be consulted as a reference work. Furthermore, and most importantly, you will need the experience of your own successes and failures so you will know what you are doing is the only logical thing you can do under a given set of circumstances. In such a frame of mind, you will have your portion of successes and your failures, which you can take in stride, as part of the business, will not ruin either your pocketbook or your morale.
In short, the problem stated and analyzed through this whole volume is not so much a matter of “systems” as it is a matter of philosophy. The end result of your work in technical analysis is a deep understanding of what is going on in the competitive free auction, what is the mechanism of this auction, and what is the meaning of it all. Be mindful this philosophy does not grow on trees; it does not spring full-bodied from the sea foam either. It comes gradually from experience and from sincere, intelligent, hard work.
Section II of this book, which follows, is concerned with tactics. Up to this point, we have been studying the technical formations and their consequences. We should have a good general understanding of what is likely to happen after certain manifestations on the charts. Knowing that, however, we will still need a more definite set of guides as to when and how it is best to execute this or that sale.
These chapters are based on one man's experience and his analysis of thousands of specific cases. It takes up questions of method, of detail, and of application, and should provide you with a workable basis for your actual market operations. As time goes on, you will very likely adopt refinements of your own or modify some of the suggested methods according to your own experience. However, the authors feel the suggestions made here will enable you to use technical analysis in an intelligent and orderly way that should help to protect you from losses and increase your profits.
John Magee
Taylor & Francis
Taylor & Francis Group
http://taylorandfrancis.com
chapter eighteen
The tactical problem
(EN: In this chapter, Magee addresses the question of tactics for the “speculator” who follows short and medium-term trends. The later sections of the chapter address the question of strategy and tactics for the long-term investor and provide a discussion of the term “speculator.”)
It is possible (as many traders have discovered) to lose money in a Bull Market—and, likewise, to lose money trading short in a Bear Market. You may be perfectly correct in judging the Major Trend; your long-term strategy, let us say, may be 100% right. Except, without tactics, without the ability to shape the details of the campaign on the field, it is not possible to put your knowledge to work to your best advantage.
There are several reasons why traders, especially inexperienced traders, so often do so poorly. At the time of buying a stock, if it should go up, they have no objectives and no idea of what policy to use in deciding when to sell and take a profit. If it should go down, they have no way of deciding when to sell and take a loss. Result: they often lose their profits; and their losses, instead of being nipped off quickly, run heavily against them. Also, there is this psychological handicap: the moment a stock is bought (or sold short), commissions and costs are charged against the transaction. The trader knows the moment he closes the trade there will be another set of charges. Also, since he is not likely to catch the extreme top of a rally or the extreme bottom of a reaction, he is bound, in most cases, to see the stock running perhaps several points against him after he has made his commitment. Even on a perfectly sound, wise trade, he may see a 10% or more paper loss before the expected favorable move gets under way (see
Figure 18.1
). Obviously, if he weakens and runs for cover without sufficient reason before the stock has made the profitable move he looked for, he is taking an unnecessary loss and forfeiting entirely his chance to register a gain.
The long-term investor who buys in near the bottom and remains in the market to a point near the top, to later liquidate and remain in cash or bonds until (perhaps several years later) there is another opportunity to buy in at the bottom, does not face the con


entirely his chance to register a gain.
The long-term investor who buys in near the bottom and remains in the market to a point near the top, to later liquidate and remain in cash or bonds until (perhaps several years later) there is another opportunity to buy in at the bottom, does not face the continual problem of when to buy and when to sell. This assumes one can tell precisely when such a bottom has been reached and when the trend has reached its ultimate top (and those are very broad assumptions indeed). The long-term investment problem for large gains over the Major Trends is by no means as simple as it sounds when you say, “Buy them when they're low, and sell them near the top.” However, such large gains have been made over the long pull, and they are very impressive.
(EN: Note the record of the Dow Theory in
Chapters
4
and
5
.)
This section of the book is concerned more particularly with the speculative purchase and sale of securities.
There are some basic differences between the “investment” point of view and the “speculative.” It is a good thing to know these differences and make sure you know exactly where you stand (see
Figure 18.2
). Either viewpoint is tenable and workable, but you can create serious problems for yourself, and sustain heavy losses, if you confuse them.
One difference is a speculator deals with stocks as such. A stock, to be sure, represents ownership in a company, but the stock is not the same thing as the company. The securities
76
72
68
64
60 Sales 100's 125 100
75
50
25
CUX
CUDAHY PACKING
JULY    AUGUST   SEPTEMBER OCTOBER NOVEMBER DECEMBER
I 7 114 I 211 28> 4 i 111181 251 1
1
8 115122 ■ 29 I 6
1
13
1
20
1
27
1
3 110117 >241 1 * 8
1
1^ 22 • 29 •
Figure 18.1
It is possible to lose money owning stocks in a Bull Market. Notice this Major Top Formation did not occur in 1929, but in the summer of 1928. For more than a year after this, a majority of stocks and the Averages continued the Bull Market Advance. But Cudahy declined steadily, reaching a price below 50 well before the 1929 Panic, and continued in its Bearish course for more than four years, ultimately selling at 20. Except for the somewhat unusual volume on the head on August 21, this is a typical Head-and-Shoulders Pattern with a perfect Pullback Rally in mid-November. It underscores what we have mentioned before—a Head-and-Shoulders Top in a stock, even when other stocks look strong, cannot safely be disregarded.
The Head-and-Shoulders Pattern, either in its simple form or with multiple heads or shoulders, is likely to occur at Major and Intermediate Tops, and in reverse position at Major and Intermediate Bottoms. It has the same general characteristics as volume, duration, and breakout as the Rectangles and the Ascending and Descending Triangles. In conservative stocks, it tends to resemble the Rounding Turns.
of a strong company are often weak, and sometimes the securities of a very weak concern are exceedingly strong. It is important to realize the company and the stock are not precisely identical. The technical method is concerned only with the value of the stock as perceived by those who buy, sell, or own it.
A second difference is in the matter of dividends. The “pure investor,” who, by the way, is a very rare person, is supposed to consider only the “income” or potential income from stocks—the return on his investment in cash dividends.
(EN: This
rara avis
is largely extinct now.)
Nevertheless, there are many cases of stocks that have maintained a steady dividend while losing as much as 75% or more of their capital value. There are other cases in which stocks have made huge capital gains while paying only nominal dividends or none at all. If the dividend rate were as important as some investors consider it, the only research tool one would need would be a calculator to determine the percentage yields of the various issues; hence, their “value,” which, on this basis, stocks paying no dividends would have no value at all.
From the technical standpoint, “income,” as separate from capital gains and losses, ceases to have any meaning. The amount realized in the sale of a stock, less the price paid and plus total dividends received, is the total gain. Whether the gain is made entirely in capital increase, entirely in dividends, or in some combination of these, makes no difference. In the case of short sales, the short seller must pay the dividends. Although, here again, this is simply one factor to be lumped with the capital gain or loss in determining the net result of the transaction.
Figure 18.2
What would you have done with Hudson Motors? The great Panic Move of October-November 1929 carried the Dow-Jones Industrial Average down from its September all-time high of 386.10 to a November low of 198.69. A rally, bringing the Average back to 294.07 in April 1930, recovered 95 points, or 51% of the ground lost, a perfectly normal correction.
Suppose you had bought HT after the decline from its 1929 high of 93 1/2, say


erage down from its September all-time high of 386.10 to a November low of 198.69. A rally, bringing the Average back to 294.07 in April 1930, recovered 95 points, or 51% of the ground lost, a perfectly normal correction.
Suppose you had bought HT after the decline from its 1929 high of 93 1/2, say at 56, in the belief that the 37-point drop had brought it into a “bargain” range. On your daily chart, you would have seen the pattern shown above (which you will now recognize as a Descending Triangle) taking shape in the early months of 1930. Would you have had a protective stop at 51? Would you have sold at the market the day after HT broke and closed below 54? Or would you have hoped for a rally, perhaps even bought more “bargains” at 50, at 48, at 40? Would you still have been holding onto your “good long-term investment” when HT reached 25 1/2 in June? Would you still have been holding HT when it reached its ultimate 1932 bottom at less than 3 (see
Figure 8.22)
?
(EN: See
Figure 18.4
for a recapitulation of the lesson from the 2000s.)
There is a third source of confusion; very often, the “pure investor” will insist he has no loss in the stock he paid $30.00 for, which is now selling at $22.00, because he has not sold it. Usually he will tell you he has confidence in the company and he will hold the stock until it recovers. Sometimes he will state emphatically that he never takes losses.
How such an investor would justify his position if he had bought Studebaker at more than $40.00 in 1953 and still held Studebaker Packard at around $5.00 in 1956
(EN: Or Osborne at $25.00 and $0.00 in the 1980s or Visacalc at similar prices in the same decade. EN9: Or Enron and WorldCom in the 2000s. Or Bear Stearns, or Lehman, or ... )
is hard to say; however, for him, the loss does not exist until it becomes a “realized” loss.
Actually, his faith the stock will eventually be worth what he paid for it may be no more than a speculative hope—and a forlorn one at that.
Furthermore, one may question whether his reasoning is always consistent. For example, suppose another stock this investor had bought at $30.00 was now selling at $45.00. Would he tell you he did not consider a profit or loss until the stock was sold? Or would he be tempted to speak of the “profit” he had in this purchase?
It is all right to consider gains or losses either on the basis of “realized” or completed transactions, or on the basis of the market values “accrued” at a particular time? Yet, it is not being honest with yourself to use one method to conceal your mistakes and the other method to accentuate your successes. The confusion of these concepts is responsible for many financial tragedies.
(EN: One might almost say, in the modern context, such confusion amounts to willful or neurotic behavior. Given the easy availability of portfolio software that marks-to-market positions, avoidance of this knowledge can only be regarded as self-defeating.)
As a trader using technical methods, you will probably find the most realistic view is to consider your gains and losses “as accrued.” In other words, your gain or loss at a given time will be measured with reference to the closing pricing of the stock on that day.
Recapitulating, it is important (1) to avoid regarding a stock and the company it represents as identical or equivalent; (2) to avoid the conscious or unconscious attribution of “value” to a stock on the basis of dividend yield, without regard to market prices; and (3) to avoid confusing “realized” and “accrued” gains or losses.
The technical trader is not committed to a buy-and-hold policy. There are times when it is clearly advantageous to retain a position for many months or for years, but there are also times when it will pay to get out of a stock, either with a profit or with a loss. The successful technician will never, for emotional causes, remain in a situation that, on the evidence at hand, is no longer tenable.
An experienced trader using technical methods can take advantage of the shorter Intermediate Trends, and it can be shown that the possible net gains are larger than the entire net gains on the Major Trend, even after allowing for the greater costs in commissions and allowing for the greater income tax liability on short-term operations.
It should be understood that any such additional profits are not easily won. They can be obtained only by continual alertness and adherence to systematic tactical methods. For the market, regarded as a gambling machine, compares very poorly with stud poker or roulette, and it is not possible to “beat the market” by the application of any simple mathematical system. If you doubt this, it would be best to stop at this point and make a careful study of any such “system” that may appeal to you, checking it against a long record of actual market moves. Ask yourself whether you have ever known anyone who followed such a system alone, as a guide to market operations, and was successful.
(EN: After Magee wrot


p at this point and make a careful study of any such “system” that may appeal to you, checking it against a long record of actual market moves. Ask yourself whether you have ever known anyone who followed such a system alone, as a guide to market operations, and was successful.
(EN: After Magee wrote this, many successful traders, aided by computer technology and advances in finance theory, have created algorithmic systems that have been successful in the financial markets. However, the markets usually become aware of the success of these systems and develop counterstrategies to defeat them. So there is a tendency for the performance of mechanical systems to degenerate or totally fail over time. It is the happy combination of
the system with markets hospitable to it
that makes mechanical systems successful over defined periods of time.)
The practice of technical analysis, on the other hand, is not a mathematical process, although it does involve mathematics. It is intended to search out the significance of market moves in the light of past experience in similar cases, by means of charts, with a full recognition of the fact that the market is a sensitive mechanism by which all of the opinions of all interested persons are reduced by a competitive democratic auction to a single figure, representing the price of the security at any particular moment. The various formations and patterns we have studied are not meaningless or arbitrary. They signify changes in real values, the expectations, hopes, fears, developments in the industry, and all other factors that are known to anyone. It is not necessary to know, in each case, what particular hopes, fears, or developments are represented by a certain pattern. It is important to recognize the pattern and understand what results may be expected to emerge from it.
The short-term profits are, you might say, payment for service in the “smoothing out” of inequalities of trends, and for providing liquidity in the market. As compared with the long-term investor, you will be quicker to make commitments and quicker to take either profits or (if necessary) losses. You will not concern yourself with maintaining “position” in a market on any particular stocks (although, as you will see, we will try to maintain a certain “total Composite Leverage” [or risk and profit exposure] according to the state of the market, which accomplishes the same result). You will have smaller gains on each transaction than the long-term investor, but you will have the advantage of being able to frequently step aside and review the entire situation before making a new commitment.
Most particularly, you will be protected against Panic Markets. There are times (and 1929 was by no means the only time)
(EN: 1987 and 1989 also come to mind. EN9: Add 20012002, if you please: May 2, 2001, Dow 11,350; September 17, 2001, 8,062; March 18, 2002, 10,673; and July 22, 2002, 7,532)
, when the long-term investor stands to see a large part of his slowly accumulated gains wiped out in a few days. The short-term trader, in such catastrophes, will be taken out by his stop-loss orders, or his market orders, with only moderate losses, and will still have his capital largely intact to use in the new trend as it develops.
(EN: The best technical analysts' opinion in “modern times” is that even long-term investors should not grin and bear a Bear Market. This is a necessity only for bank trust departments and believers in Burton Malkiel.)
Finally, before we get on with the subject of tactics, the operations we are speaking of are those of the small and midsize trader. The methods suggested here, either for getting into a market or getting out of it, will apply to the purchase or sale of odd lots, 100 shares, 200 shares, and sometimes up to lots of thousands of shares or more of a stock, depending on the activity and the market for the particular issue. The same methods would not work for the trader who was dealing in 10,000-share blocks (except in the largest issues) because, in such cases, his own purchases or sales would seriously affect the price of the stock. Such large-scale operations are in a special field governed by the same basic trends and strategy, but that requires a different type of market tactics (see
Figure 18.3
).
(EN: Or, put another way, as Magee said to me one time, a mouse can go where an elephant cannot
.
)
Strategy and tactics for the long-term investor—
What's a speculator? What's an investor?
In the years since Magee wrote the original
Chapter 18
, some different connotations have attached themselves to the terms “speculator” and “investor.” A great cultural shift has also occurred. The days when the New 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 want