307 lines
56 KiB
Plaintext
307 lines
56 KiB
Plaintext
Perspective
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Although there can be no argument about the importance of CBOT
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®
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DJIA
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SM
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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.”
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Options on Dow Index futures
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The buyer of this instrument has the choice, or the right, to assume a position. It is his
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option
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to do so—unlike a futures contract in which he has an
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obligation
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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.
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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.
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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.
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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.
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Option premiums
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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.
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The underlying instrument for one CBOT
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®
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futures option is one CBOT
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®
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DJIA
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SM
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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.
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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.
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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.
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Volatility
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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
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futures price, the strike price, the time left to expiration, the money market rate, and the volatility of the futures price.
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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.
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Exercising the option
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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.
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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.
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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.
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Using futures options to participate in market movements
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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.
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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.
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Profits in rising markets
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In August, the Dow Index is 10,000 and the Dow Index September future is 10,050. You expect the current Bull Market to continue, and you would like to take advantage of the trend without tying up too much capital and also undertake only limited risk.
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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.
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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).
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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.
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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.
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Exploiting market reversals
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The trader expects a reversal of the Bull Market now at 7,800 and would like some downside protection.
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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.
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Using puts to protect profits in an appreciated portfolio
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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.
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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.
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Situation 1
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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.
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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.
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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.
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The similarity to life insurance is striking. If you do not die, the premium is wasted. But if you do...
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Improving portfolio yields
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Situation 2
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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.
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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.
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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.
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Using option spreads in high- or low-volatility markets
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Long and short stock positions reflect definite market opinions or analyses. The market will go up or the market will go down and the moderately competent technician should be right about this more often than the unwashed general public. In markets of coiling volatility (i.e., lower than average volatility and declining), it is sometimes possible to exploit uncertainty by putting on a long straddle. The long straddle combines a long put and a long call at the same strike price. This spread generates a return over two ranges of market values: values below the strike price of the put and values above the strike price of the call. It is a profitable strategy given sufficient volatility; the editor's company used such a strategy immediately before the crash of 1987 for managed accounts and collected disproportionate profits on a very low-risk position. Experienced speculators and traders generally sell high-volatility markets and try to backspread (go long) in chosen less-volatile markets, expecting volatility to return to the mean. Sometimes they do this by writing a short straddle, a position with a short put and a short call at the same strike price.
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Situation 3
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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.
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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).
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Situation 4
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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.
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Perspective
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(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.)
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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.
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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.
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In summation, knowledge of the DJIA futures and options on futures is absolutely essential for the competent technical investor and trader.
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Recommended further study
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In view of the importance of this chapter, noted here are references to advanced material, which are also found in
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Appendix B, Resources
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.
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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
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http://www.cboe.com/portfoliohedge
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.
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For further study, see the following:
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•
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Options
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as a Strategic Investment
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by Lawrence Macmillan,
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http://www.optionstrategist.
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com
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• Chicago Board Options Exchange,
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http://www.cboe.com
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• Chicago Board of Trade, 312-435-3558 or 800-THE-CBOT; 312-341-3168 (fax);
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http://
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www.cbot.com
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part two
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Trading tactics
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Midword
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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.
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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.
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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.
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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.
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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.”
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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.”
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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.
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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.”
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It would be better, and safer, to understand at the start that no method ever devised will unfailingly protect you against a loss, or sometimes even a painful succession of losses. You should realize what we are looking for is the probability inherent in any situation. Likewise, just as you would be justified in expecting to draw a white bean from a bag which you knew contained 700 white beans and 300 black beans (even though you had just drawn out 10 black beans in succession!), so too you are justified in continuing to follow the methods that, over long periods, seem most surely and most frequently to coincide with the mechanism of the market.
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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.
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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.
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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.
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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.
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John Magee
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Taylor & Francis
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Taylor & Francis Group
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http://taylorandfrancis.com
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chapter eighteen
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The tactical problem
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(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.”)
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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.
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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
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Figure 18.1
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). 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.
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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.
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(EN: Note the record of the Dow Theory in
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Chapters
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4
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and
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5
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.)
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This section of the book is concerned more particularly with the speculative purchase and sale of securities.
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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
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Figure 18.2
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). Either viewpoint is tenable and workable, but you can create serious problems for yourself, and sustain heavy losses, if you confuse them.
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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
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76
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72
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68
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60 Sales 100's 125 100
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75
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50
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25
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CUX
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CUDAHY PACKING
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JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER
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I 7 114 I 211 28> 4 i 111181 251 1
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1
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8 115122 ■ 29 I 6
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1
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13
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1
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20
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1
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27
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3 110117 >241 1 * 8
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1
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1^ 22 • 29 •
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Figure 18.1
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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.
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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.
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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.
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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.
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(EN: This
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rara avis
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is largely extinct now.)
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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.
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From the technical standpoint, “income,” as separate from capital gains and losses, ceases to have any meaning. The amount realized in the sale of a stock, less the price paid and plus total dividends received, is the total gain. Whether the gain is made entirely in capital increase, entirely in dividends, or in some combination of these, makes no difference. In the case of short sales, the short seller must pay the dividends. Although, here again, this is simply one factor to be lumped with the capital gain or loss in determining the net result of the transaction.
|
||
Figure 18.2
|
||
What would you have done with Hudson Motors? The great Panic Move of October-November 1929 carried the Dow-Jones Industrial Average down from its September all-time high of 386.10 to a November low of 198.69. A rally, bringing the Average back to 294.07 in April 1930, recovered 95 points, or 51% of the ground lost, a perfectly normal correction.
|
||
Suppose you had bought HT after the decline from its 1929 high of 93 1/2, say at 56, in the belief that the 37-point drop had brought it into a “bargain” range. On your daily chart, you would have seen the pattern shown above (which you will now recognize as a Descending Triangle) taking shape in the early months of 1930. Would you have had a protective stop at 51? Would you have sold at the market the day after HT broke and closed below 54? Or would you have hoped for a rally, perhaps even bought more “bargains” at 50, at 48, at 40? Would you still have been holding onto your “good long-term investment” when HT reached 25 1/2 in June? Would you still have been holding HT when it reached its ultimate 1932 bottom at less than 3 (see
|
||
Figure 8.22)
|
||
?
|
||
(EN: See
|
||
Figure 18.4
|
||
for a recapitulation of the lesson from the 2000s.)
|
||
There is a third source of confusion; very often, the “pure investor” will insist he has no loss in the stock he paid $30.00 for, which is now selling at $22.00, because he has not sold it. Usually he will tell you he has confidence in the company and he will hold the stock until it recovers. Sometimes he will state emphatically that he never takes losses.
|
||
How such an investor would justify his position if he had bought Studebaker at more than $40.00 in 1953 and still held Studebaker Packard at around $5.00 in 1956
|
||
(EN: Or Osborne at $25.00 and $0.00 in the 1980s or Visacalc at similar prices in the same decade. EN9: Or Enron and WorldCom in the 2000s. Or Bear Stearns, or Lehman, or ... )
|
||
is hard to say; however, for him, the loss does not exist until it becomes a “realized” loss.
|
||
Actually, his faith the stock will eventually be worth what he paid for it may be no more than a speculative hope—and a forlorn one at that.
|
||
Furthermore, one may question whether his reasoning is always consistent. For example, suppose another stock this investor had bought at $30.00 was now selling at $45.00. Would he tell you he did not consider a profit or loss until the stock was sold? Or would he be tempted to speak of the “profit” he had in this purchase?
|
||
It is all right to consider gains or losses either on the basis of “realized” or completed transactions, or on the basis of the market values “accrued” at a particular time? Yet, it is not being honest with yourself to use one method to conceal your mistakes and the other method to accentuate your successes. The confusion of these concepts is responsible for many financial tragedies.
|
||
(EN: One might almost say, in the modern context, such confusion amounts to willful or neurotic behavior. Given the easy availability of portfolio software that marks-to-market positions, avoidance of this knowledge can only be regarded as self-defeating.)
|
||
As a trader using technical methods, you will probably find the most realistic view is to consider your gains and losses “as accrued.” In other words, your gain or loss at a given time will be measured with reference to the closing pricing of the stock on that day.
|
||
Recapitulating, it is important (1) to avoid regarding a stock and the company it represents as identical or equivalent; (2) to avoid the conscious or unconscious attribution of “value” to a stock on the basis of dividend yield, without regard to market prices; and (3) to avoid confusing “realized” and “accrued” gains or losses.
|
||
The technical trader is not committed to a buy-and-hold policy. There are times when it is clearly advantageous to retain a position for many months or for years, but there are also times when it will pay to get out of a stock, either with a profit or with a loss. The successful technician will never, for emotional causes, remain in a situation that, on the evidence at hand, is no longer tenable.
|
||
An experienced trader using technical methods can take advantage of the shorter Intermediate Trends, and it can be shown that the possible net gains are larger than the entire net gains on the Major Trend, even after allowing for the greater costs in commissions and allowing for the greater income tax liability on short-term operations.
|
||
It should be understood that any such additional profits are not easily won. They can be obtained only by continual alertness and adherence to systematic tactical methods. For the market, regarded as a gambling machine, compares very poorly with stud poker or roulette, and it is not possible to “beat the market” by the application of any simple mathematical system. If you doubt this, it would be best to stop at this point and make a careful study of any such “system” that may appeal to you, checking it against a long record of actual market moves. Ask yourself whether you have ever known anyone who followed such a system alone, as a guide to market operations, and was successful.
|
||
(EN: After Magee wrote this, many successful traders, aided by computer technology and advances in finance theory, have created algorithmic systems that have been successful in the financial markets. However, the markets usually become aware of the success of these systems and develop counterstrategies to defeat them. So there is a tendency for the performance of mechanical systems to degenerate or totally fail over time. It is the happy combination of
|
||
the system with markets hospitable to it
|
||
that makes mechanical systems successful over defined periods of time.)
|
||
The practice of technical analysis, on the other hand, is not a mathematical process, although it does involve mathematics. It is intended to search out the significance of market moves in the light of past experience in similar cases, by means of charts, with a full recognition of the fact that the market is a sensitive mechanism by which all of the opinions of all interested persons are reduced by a competitive democratic auction to a single figure, representing the price of the security at any particular moment. The various formations and patterns we have studied are not meaningless or arbitrary. They signify changes in real values, the expectations, hopes, fears, developments in the industry, and all other factors 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 wanted capital appreciation
|
||
Figure 18.3
|
||
If an investor only learned one thing from this book, it would be that one thing might be the salvation of his portfolio or his retirement plan (if all his assets in the investment plan were shares of Enron). Instead, the employees of Enron made a major mistake in not having a diversified retirement portfolio—they had all their eggs in one basket, their income and savings came from one source. But diversification is not even the crucial lesson here; the lesson is get out of the stock when it reverses. The corollary of that lesson is never buy a stock in a downtrend. However, the more important lesson is never buy a stock when it is in a swan dive. So obvious you say, but not so obvious at the time for portfolio managers for the University of Miami who continued to accumulate Enron stock even as it neared earth at 100 miles an hour. Of course, they had a sophisticated (?) company; the Motley Fools had a death grip on the stock all the way to the bottom.
|
||
and cared less for dividends. In fact, it has lately been considered the mark of a “growth stock” not to pay dividends. Evidently, the days of the New Haven are gone forever, when an “investor” was one who bought, held, and collected dividends, and “speculators” were slightly suspect men like Magee who played the medium-term trends and bought “unchic, speculative” stocks. It all has a sepia tone to it. Yesterday's Magee speculator might be called a medium-term investor today.
|
||
Although the term “speculator” could still be applied to anyone who “trades” the market, today that old-time speculator and his kind would more likely be called traders than speculators. Commodity traders who have no business interest in the contracts they exchange are always referred to as
|
||
speculators
|
||
, as opposed to
|
||
commercials
|
||
, who are hedgers and users of the commodities they trade. Now “day traders” might be considered the equivalent of the old-time speculators—except that day trading veers dangerously close to gambling. And only the passive, in the opinion of this editor, never trade at all and sit on their holdings during Bear Markets.
|
||
On the spectrum of investors, from investor to gambler, the old “New Haven Investor” who “wants his dividends” is pretty rare these days, and, again, may be one of those trust departments that does not want to get sued and so stays out of stocks that go up. After all, prudent men do not “trade in volatile stocks” but “invest in safe issues, like bonds,” which only lose about 1.5%-2.0% of their purchasing value per year but preserve the illusion of having “preserved principal.”
|
||
One definition of the long-term investor
|
||
Let us take as a long-term investor now one who expects to at least track market returns, for it has been demonstrated over a relatively long period of time that this can be done by passive indexing. At the turn of the century, as this is written, it would seem neither longterm, medium-term, nor short-term investors think about the risks involved in matching the market because, entering the third millennium, it has been so many years since we have had a really vicious Bear Market. Dow 36,000? This is a passing phase. As each Bull Market reaches higher and higher, the odds are lower and lower that it will continue— historic Bull Markets of the 1990s notwithstanding.
|
||
What then are the strategy and tactics for the long-term investor to achieve a goal of matching the market?
|
||
(EN9: Is it necessary to remind the reader of
|
||
Chapter 4
|
||
and the Dow Theory?)
|
||
Let us remark immediately that the tactics Magee described for the speculator—or trader if you will—are not at all in conflict with the short-term tactics used occasionally by the long-term investor. As buying or selling time approaches the stops of the long-term investor, that investor becomes a trader who can and should adopt the trader's tactics. Sooner or later, the focus even narrows to real time at the moment of trade execution. Interestingly, the charting techniques we have described here work on tick-by-tick data in real time also. Hence, if the trader wants to enter into the real-time environment, he can attempt to time his trade right down to the real-time chart formations. Only the really active and skilled long-term investor will be concerned with squeezing the last half point or points out of his position. This illustration of the time focus is addressed to any investor or trader or speculator to demonstrate the fractal nature of both price data and the applicability of Magee-type technical analysis to it.
|
||
The strategy of the long-term investor
|
||
The strategy of the long-term investor is to catch the long trends—to participate in trades that lasts months and years. However, this strategy does not intend to be sucked into long Bear Markets. Rather, portfolios are liquidated or hedged when Bear Market signals are received. As has been previously seen in examples of the performance of (more or less) mechanical Dow Theory (see
|
||
Chapter 4
|
||
), this kind of performance can be quite satisfactory—better indeed than buy-and-hold strategies that have come much into vogue because of the Clinton-Gore Bull Markets of the 1990s.
|
||
If the goal is to beat not only the markets but also the mutual funds (only 20% of which outperform the market over the long term anyway—and sometimes none of them make money), then passive indexing is the most likely strategy. This may be done in a number of ways—index funds, buying the basket, buying the futures, and so on. Nevertheless, the most attractive method might be the use of the Standard & Poor's Depositary Receipts (SPDRs; SPY) and DIAMONDS™ (DIA) and the like. The tactics may be calibrated to the risk tolerance and character of the investor. He might hedge or sell on Dow Theory signals, or on breaks of the 200-day moving average, or on breaks of the long-term or intermediate trendlines with a filter (Magee recommended 2%, and this might be calibrated to the character of the markets and increased to 3% or a factor relevant to actual market volatility). Basing Points (see
|
||
Chapter 28
|
||
) is also a powerful method. Instruments we have previously discussed— SPDRs, DIAMONDS, index futures, and options—can be used to execute these tactics.
|
||
Suffice it to say that every strategy must provide for the plan gone wrong, in other words, the dreaded Bear Market. Bear Markets would not be so fearsome if the average investor did not insist on seeing only the long side of the market. Long-term strategies go out the window quickly when blood runs on the floor of the New York Stock Exchange. The well-prepared technical investor has a plan that provides for the liquidation of positions gone bad and presumably the discipline to execute it.
|
||
This involves the regular recomputation of stops as markets go in the planned direction, and ruthless liquidation of losers that do not perform. One may think of a portfolio as a fruit tree. Weak branches must be pruned to improve the yield. Stop computation is treated in a number of places in this book (see
|
||
Chapters 27
|
||
and
|
||
28
|
||
). For the investor trading long term, this may be, as an example only and not as a recommendation, the breaking of the 200-day moving average or the breaking of a long-term trendline. The 200-day moving average is widely believed to be the long-term trend indicator, for which believing will sometimes make it come true.
|
||
(EN9: Let me emphasize here that “200” is a parameter and an example. Personal research may fit a better parameter to the actual market.)
|
||
In reality, more than just the 200-day moving average or a manually drawn trendline should be looked at. The chart patterns comprising the portfolio should be considered also, as well as charts of major indexes and averages. Also, consider the condition of the averages and their components—their technical state—whether they are topping, consolidating, or trending as indicated by their charts.
|
||
Moreover, it would be impossible not to mention Magee's Basing Points Procedure (see
|
||
Chapter 28
|
||
). Possibly the most powerful trailing stop method in existence.
|
||
Rhythmic investing
|
||
In addition, if
|
||
Chapter 31
|
||
on “Not All in One Basket” is weighed seriously, one might be rolling a portfolio from long to short gradually in natural rhythm with the markets and in harmony with the Magee Evaluative Index described there. That is the preferred strategy of the authors and editor of this book.
|
||
These things all depend on the goals, temperament, and character of the investor. If he is going to spend full time on the markets, he is probably not a long-term investor. Such men eat well and sleep soundly at night. The trader is lean and hungry—not necessarily for money, but for activity. It behooves one to know his type as a trader or investor. Knowing one's type or character is best established before finding it out in the markets, as the markets can be an expensive place to search for self-knowledge.
|
||
There is no inherent conflict in holding long-term positions and also attempting to profit from intermediate trends, depending on the amount of capital in hand and how much time, energy, and capital the investor wants to put into trading. A long-term strategy can be implemented with a modicum of time and energy, as follows: pay attention to the major indexes and averages and buy on breakouts, at the bottoms of consolidations and on pullbacks; sell or hedge on the breaking of trendlines, calculated on Basing Points (see
|
||
Chapter 28
|
||
) and the penetration of support zones.
|
||
The long-term investor will accept greater swings against his position than the intermediate-term trader or speculator. As an example with the method of using Basing Points in
|
||
Chapter 28
|
||
, the speculator is using a three-days-away rule, whereas a long-term investor might be using a three-week Basing Point or some such analogy. Plus, if interested, when he suspects or analyzes a long Bull Market is approaching a climax, he might adopt the three-days rule also, or even begin following his stock with a daily stop just under the market. Beware though, as professionals look for stops just under the close of the previous day in situations such as these.
|
||
It would be wise not to confuse long-term investing with “buy and hold,” or as it was expressed in one investment fad in the 1970s, “one-decision investing.” As an example of this misguided thinking, in 1972, the “best and brightest” investment analysts (fundamental) on the Street picked a portfolio of stocks for the generation, or 20 years. The companies would be difficult to argue with as the
|
||
creme de la creme
|
||
of American business. After all, who could kvetch at Avon, Eastman Kodak, IBM, Polaroid (unless he happened to look at
|
||
Figure
|
||
37.27
|
||
), Sears Roebuck, and Xerox? Even today, if you did not have a close eye on the market, you would immediately respond, “blue chips.” Consider the following table showing the stocks and the results achieved over the long term.
|
||
Price
|
||
Price
|
||
Percent
|
||
Stock
|
||
4/14/72
|
||
12/31/92
|
||
Change
|
||
Avon Products
|
||
61.00
|
||
27.69
|
||
(54.6)%
|
||
Eastman Kodak
|
||
42.47
|
||
32.26
|
||
(24.0)%
|
||
IBM
|
||
39.50
|
||
25.19
|
||
(36.2)%
|
||
Polaroid
|
||
65.75
|
||
31.13
|
||
(52.7)%
|
||
Sears Roebuck
|
||
21.67
|
||
17.13
|
||
(21.0)%
|
||
Xerox
|
||
47.37
|
||
26.42
|
||
(44.2)%
|
||
In 2017, the vagaries of unsupervised portfolios is again seen: Avon 2.50; Kodak 7.75; IBM 141; Polaroid unlisted; Sears 7.21; Xerox 32.64. Beware of pundits and mindless investing.
|
||
Charts (
|
||
Figures 18.4
|
||
and
|
||
18.5
|
||
) showing activity for IBM and Xerox appear on the following pages.
|
||
Figure 18.4
|
||
The questionable—even bizarre—results of “one-decision investing” (i.e., buy and hold) are amply illustrated by this chart. First of all, the “best and brightest” recommended IBM at a decade high to see it decline by more than 50%. It subsequently recovered to double from their original recommendation. Ah, sweet justification! Only, unfortunately, at the end of 20 years to see it rest approximately 40% beneath the recommendation. The analytical lines give some hint of how a technician might have traded the issue. I like to say that there are bulls, bears, and ostriches, and anyone who followed this one-decision investment proves my case.
|
||
Figure 18.5
|
||
Like IBM in the previous figure, Xerox was recommended at a place at which it should have been sold instead of bought. The comments there might apply to the chart here. The foolishness of “buy and hold” or “one-decision investing” is amply illustrated by observing the long-term swings of the stock and thus of the investor's equity. Technical analysis is intended to be an antidote to such foolishness.
|
||
Summary
|
||
The long-term investor attempts to catch major market moves—those lasting hundreds, if not thousands, of Dow points and stay in trades for many months if not years.
|
||
Within this time frame, he expects to take secondary trends against his position. Depending on his temperament and inclination, he may attempt to hedge his portfolio upon recognizing secondary market moves against his primary direction.
|
||
His preference for stocks and portfolio will be for market leaders, for baskets that reproduce the major indexes (or Index Shares) as the ballast for his portfolio, and he may choose some speculative stocks to add spice to his portfolio.
|
||
In spite of his penchant for long-lasting trades he will not tolerate weak, losing, or underperforming stocks. They are the shortest of his trades. He will cut losses and let profits run, the truest of the market maxims and the least understood by unsuccessful investors. The other maxim least understood by investors is “buy strength, sell weakness.”
|
||
Truly sophisticated investors attempt to participate in Bear Market trends also. This is the greatest difference between professional and general investors—professionals have no bias against the short side.
|
||
For the convenience of day traders, the URL of Gamblers Anonymous is noted:
|
||
http://
|
||
www.gamblersanonymous.org
|
||
.
|
||
chapter nineteen |