, in broad categories, the Internet and all itsfacilities, developments in electronic markets, and advances in finance andinvestment theory and practice. This last is treated in Chapter 17.2.
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Due to the enormous body of material on these subjects, no attempt willbe made to explore these subjects exhaustively, but the general investor willbe given the information he needs to know to put these subjects in theirproper perspective. Resources will point the analyst to avenues for furtherinvestigation if the need is felt.But first of all, are there any technological developments of whateversort which have made charting obsolete? No. Are there any developmentswhich have made trading a guaranteed success? No. The only sure thing isthat some huckster will claim to have a sure thing. Those who believe suchclaims are the victims of their own naivete.
The Internet — the Eighth Wonder of the Modern World(EN9: Resources Appendix for the 9th Edition has beenenormously expanded and is of paramount importance tomodern investors.)The Internet has been called the most complex project ever built by man.And that is probably true. Complex, sprawling, idiosyncratic, it has something for everyone, especially the investor. Every form of investment creatureknown to man has set up a site on the Internet, and waits like the hungryarachnid for the casual surfer. Brokers. Advisors — technical and fundamental. Newspapers. News magazines. Newsgroups. Touts. Mutual funds.Mutual fund advisories. Critics and evaluators of all the above. Databasevendors. Chat rooms. Electronic marketplaces and exchanges. ECNs. Theonly unfilled niche that seems to exist is investment pornography. Perhapsnaked 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 cyberinvestor may be furtherexpanded to indicate the services and facilities available: quotes and data;portfolio management and accounting; online interactive charting; automaticalerts to PBDAs (personal body digital assistants or gizmos carried on thebody, e.g., cell phone and handheld computer, etc.); analysis and advice;electronic boardrooms; electronic exchanges where trading takes place without intermediaries. Resources (Appendix D) supplies specifics on these categories. This chapter supplies perspective. It is one thing to contemplate thiscornucopia of facilities and another thing to appreciate the importance andpriority of its elements. What good are real time quotes if you are onlyinterested in reviewing your portfolio once a week, except for special occasions? What good are satellite alerts and virtual reality glasses to a long-terminvestor? It is easy for the investor with no philosophy or method to bedrawn into the maelstrom of electronic wonders and stagger out of it littlewiser and much poorer.Observe then the goods and services of all this which are of importanceto the level-headed investor with his feet on the ground and his head out of
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the clouds. This hopefully not abstract investor, object of our attention here,needs what? He needs data, charts, and a connection to a trading place. Dataare available at the click of a mouse. A chart occupies the screen in anotherclick. Another click and a trade is placed. In the Internet Age it would betautological 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 doesit without thinking) may be seen at locations linked in Resources (Appendix D).The trade will be made, of necessity, through a broker of some sort. Perhapsan electronic broker, or even a nonvirtual broker who communicates viatelephone. And shortly, if not already, an electronic pit where one matcheswits 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 inthe new century. (The broker who earns his keep will always be with us,and welcome, too.) Electronic marketplaces where investors meet withoutthe necessity of a broker or specialist are already proliferating (see 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-floortraders. Suffice it to say that their initial phases will undoubtedly be periodsof dislocation, of risk and opportunity as their glitches are ironed out.Placing electronic orders, whether to an electronic exchange or to theNYSE, has certain inherent advantages over oral orders. No one can quarrelabout a trade registered electronically as opposed to orally where the potential for disagreement exists. In addition, the trader has only handled the dataonce — rather than making an analysis, calling a broker, recording the trade,passing it to the portfolio. If he just hits the trade button and the transactionis routed through his software package, no one will have any doubt as towhere an error might lie. The manual method presents an opportunity forerror at each step. And rest assured, errors occur and can be disastrous totrading.The efficiency and ease of the process with a computer has much torecommend it — automation of trade processing, elimination of confusionand ambiguities, audit tracks, automation of portfolio maintenance, and,perhaps most important of all, automatic mark-to-market of the portfolio.(Marking-to-market is the practice of valuing a portfolio at its present marketvalue whether trades are open or closed.)
Marking-to-MarketThis book might have been entitled Zen and the Art of Technical Analysis ifthat title were not so hackneyed and threadbare. It conveys, nonetheless, themessage of Zen in the art of archery, that of direct attachment to reality andthe importance of the present moment. In his seminal book The GeneralSemantics of Wall Street (now Winning the Mental Game on Wall Street) JohnMagee inveighed at some length against the very human tendency to keep
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two sets of books in the head — one recording profits, open and closed, andanother recording losses, but only closed losses. Open losses were not lossesuntil booked. Having an electronic portfolio accountant which refuses toparticipate in such self-deception has much to recommend it. If the portfoliois always marked to the market when the computer communicates with thedata vendor, or the trade broker, it is difficult not to see red ink, and to seethat the equity of the account reflects all trades, open and closed.
Separating the Wheat from the ChaffIt requires a gimlet-eyed investor to pick his way through the minefield oftemptations 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.
ChaffChat rooms. Touts. News. Predictions. Punditry. Brokerage House buy, sell,hold, strong hold, weak buy, strong buy, and any other species of BrokerageHouse recommendation taken at face value. Remember brokerage firmssurvive by selling securities and make their money in general on activity.Actually, much of their money is made servicing their institutional clientsand distributing their clients’ shares to their retail cleintele – a blatant conflictof interest which blew up in their faces in the early 2000s resulting in manyfines and some jail terms (plus ça change...). In the surging Clinton–Gore BullMarkets of the 1990s, all of these worked. In a serious Bear Market none ofthem will work. (EN9: A serious bear market started in earnest in 2000 and wascorrectly identified with Magee chart analysis as may be seen from the John MageeLetters at the edwards-magee.com web site.
Summary 2Never in the history of the markets have so many facilities for privateinvestors been available. The computer is necessary to take advantage ofthose facilities.Data may be acquired automatically via Internet or dial-up sites at littleor no cost.A (as they say) plethora of web sites offer cyberinvestors everythingfrom portfolio accounting to alerts sent to their personal body-carrieddevices (pagers, handheld PDAs, etc.).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.
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Internet chat rooms will provide real-time touting and numerous rumorsto send the lemmings and impressionable scurrying hither and yon. But, oneexpects, not the readers of this book.Of more importance, the info-revolution and the computer will:1. Relieve the analyst of manual drudgery, accelerate all the steps ofanalysis: data gathering, chart preparation, portfolio accounting, andanalysis and tax preparation.2. Give the analyst virtually effortless portfolio accounting and markto-market prices — a valuable device to have to keep the investorfrom mixing his cash and accrual accounting, as Magee says.3. Enable processing of a hitherto unimaginable degree. An unlimitednumber of stocks may be analyzed. Choosing those to trade with acomputer will be dealt with in Chapter 21, Selection of Stocks to Chart.4. Allow the investor to trade on ECNs or in electronic marketplaceswhere there are no pit traders or locals to fiddle with prices.
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chapter 17.2
Advancements inInvestment TechnologyPart 1. Developments in Finance Theory and PracticeNumerous pernicious and useless inventions, services, and products litterthe Internet and the financial industry marketplace; but modern financetheory and technology is important and must be taken into considerationby 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 continuemore advanced study.Instruments of limited (or non-) availability during the time of Edwardsand Magee included exchange traded options on stocks, futures on averagesand indices, options on futures and indices, securitized indices and averages,as the most important and as a partial list only. Undoubtedly one of the mostimportant developments of the modern era is the creation of trading instruments which allow the investor to trade and hedge the major indexes. Ofthese, the instruments created by the Chicago Board of Trade are of singularimportance. These are the CBOT® DJIASM Futures and the CBOT® DJIASMFutures Options, which are discussed in greater detail in Part 2 of thischapter. (EN9: Not so singular, perhaps. Probably of greater importance to readersof this book are the AMEX ishares, particularly DIA, SPY and QQQQ, instrumentswhich offer the investor direct participation in the major indices as though they werestocks.)General developments of great importance in finance theory and practiceare found in the following sections.
OptionsFrom the pivotal moment in 1973 when Fischer Black and his partner, MyronScholes, published their — excuse the usage — paradigm-setting Model tothe third millennium, the options/derivatives markets have grown fromnegligible to trillions of dollars a year. The investor who is not informedabout options is playing with half a deck. The subject, however, is beyondthe scope of this book, which hopes only to offer some perspective on thesubject and guides to the further study necessary for most traders and manyinvestors.333
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Something in the neighborhood of 30% or more of options expire worthless. This is probably the most important fact to know about options. (Thereis a rule of thumb about options called the 60–30–10 rule: 60% are closed outbefore expiration, 10% are exercised, and 30% are “long at expiration,” meaning they are worthless.) Another fact to know about options is: in the ReaganCrash of 1987, out of the money puts bought at $.625 on October 16 wereworth hundreds of dollars on October 19 — if you could get the broker topick up the telephone and trade them. (The editor had a client at OptionsResearch, Inc. during that time who lost $57MM in 3 days and almostbrought 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 havebeen made that as many as 90% of retail options traders lose money. Thatcombined with the fact that by far it is the general public which buys (ratherthan sells) options should suggest some syllogistic reasoning to the reader.With these facts firmly fixed in mind, let us put options in their properperspective for the general investor. Options have a number of useful functions. They offer the trader powerful leverage. With an option he can controlmuch more stock than by the direct purchase of stock — his capital stretchesmuch further. So options are an ideal speculative instrument. (Exaggeratedleverage is almost always a characteristic of speculative instruments.) Butthey can also be used in a most conservative way — that is, as an insurancepolicy. For example, a position on the long security side may be hedged bythe 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 prudentinvestor as to its monetary consequences.)The experienced investor may also use options to increase yield on hisportfolio of securities. He may write covered calls, or write naked puts ona stock in order to acquire it at a lower cost (e.g., he sells out of the moneyoptions. This is a way of being long with the stock. If the stock comes backto the exercise price, he acquires the stock. If not, he pockets the premium.)There are numerous tactics of this sort which may be played withoptions. Note, played. Played because, for the general investor, the optionsgame can be disastrous, as professionals are not playing. They are seriouslypracticing 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 $.625, or,as they call it, a “teenie.” For perspective, the reader may contemplate aconversation the editor had with one of the most important options tradersin the world. This market maker remarked casually that his fortune wasbuilt on teenies. The reader may imagine at some length what would benecessary for the general investor to make a profit on $.625.This does not mean the general investor should never touch options. Itjust means he should be thoroughly prepared before he goes down to playthat game. In options trading traders speak of bull spreads, bear spreads,
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and alligator spreads. The alligator spread is an options strategy which eatsthe customer’s capital in toto.Among these strategies is covered call writing. This is a strategy whichis touted as being an income producer on a stock portfolio. There is nopurpose in writing a call on a stock in which the investor is long — unlessthat stock is stuck in a clear congestion phase which is not due to expirebefore the option expires. And if the stock is in a downtrend it should beliquidated. But to write a call on a stock in a clear uptrend is to make oneselfbeloved of the broker, whose good humor improves markedly with accountactivity and commission income. The outcome of a covered call on an ascendingstock, of course, is that the writer (you, dear reader) has the stock called at theexercise price, losing his position and future appreciation, not to mention costs.The income is actually small consolation, a sort of booby prize — a way ofcutting your profits while increasing your costs.
Quantitative AnalysisThe investor should be aware of another area of computer and investmenttechnology that has yielded much more dramatic and profitable results, butthat is in a model-driven market — namely the options markets. Quantitativeanalysts, those who investigate and trade the options markets, are a breedapart from technical analysts. In an interesting irony, behavioral markets,the stock markets, are used as the basis for derivatives, or options whoseprice is determined largely by the operation of algorithms called models.The original model which for all intents and purposes created the modernworld of options trading was the Black–Scholes options analysis model,which assumed that the “fair value” of an option could be determined byentering five parameters into the formula: the strike price of the option; theprice of the stock; the “risk free” interest rate; the time to expiration; and thevolatility 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 availablefor trading today would be to expand this book by many pages, and it isnot the purpose of this book anyway. The purpose of this paragraph of thebook is to sternly warn general investors who are thinking of “beating thederivatives markets” that they should undergo rigorous training first. Thealternative could be extremely expensive.At first the traders who saw the importance of this model and used itto price options virtually skinned older options traders and the public, whotraded pretty much by the seat of the pants or the strength of their convictions, meaning human emotion. But professional losers learn fast, and nowall competent options traders use some sort of model or antimodel, or antiantimodel to trade. And true to form, options sellers, who are largely professionals, take most of the public’s (who are buyers) money. This is the wayof the world.
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Options Pricing Models and Their ImportanceAfter the introduction of the Black–Scholes Model numerous other modelsfollowed, among them the Cox–Ross–Rubinstein, the Black Futures, etc. Forthe general investor, the message is this: he must be acquainted with thesemodels and what their functions are if he intends to use options. Rememberthat the model computes the “fair value” of the option. One way professionals make money off amateurs is by selling overpriced options and buyingunderpriced options to create a relatively lower risk spread (for themselves).Not knowing what these values are for the private investor is like notknowing where the present price is for a stock. It is a piece of ignorance forwhich the professional will charge him a premium to be educated about.Unfortunately, many private options traders never get educated in spite ofpaying tuition over and over again. But ignorance is not bliss. It is expensive.Technology and knowledge works its way from innovators and creativegeniuses through the ranks of professionals and sooner or later is disseminated to the general public. Of course by that time the innovators have developed new technology. Nonetheless, even assuming that professionals havesuperior tools and technology, the general investor must thoroughly educatehimself before using options. As it is not the province of this book to dissectoptions trading, the reader may find references in Resources (Appendix D).Here it would not be untoward to mention one of the better books onoptions as a starting point for the moderately advanced and motivatedtrader. Lawrence McMillan’s Options as a Strategic Investment is necessaryreading. In addition the newcomer may contact the Chicago Board OptionsExchange, the CBOE, at www.cboe.com, which has tutorial software.
Futures on IndexesFutures, like options, offer the speculator intense leverage — the ability tocontrol a comparatively large position with much less capital than the purchase of the underlying commodity or index. Futures salesmen are fond ofpointing out the fact that, if you are margined at 5% or 10% of the contractvalue, a similar move in the price of the index will double your money. Theyare often not so conscientious about pointing out that a similar move againstyour position will wipe out your margin (actually earnest money). Unlike(long) options, a mishap in the market can result in more than the loss ofmargin. It can result in a deficit account and debts to the broker — in otherwords, losses of more than 100%. For this among other reasons, it is wisenot to plunge into futures without considerable preparation.This preparation might well begin, for the adroit investor, with thereading of Schwager’s Technical Analysis, Schwager on Futures, currently oneof the better books on the subject.But let us say that instead of using futures to speculate that we wantto use them as a hedge for our portfolio of Dow–Jones DIAMONDS orportfolio of Dow–Jones stocks. Now we are purchasing insurance, rather
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than speculating. As an oversimplified example, the investor might see thefailure of the DJIA to break through a top as the beginning of a congestionzone (a consolidation or reversal pattern). He could then hedge his positionby shorting the Dow–Jones futures. Now he is both long and short — longthe cash, short the futures. He would place a stop on the futures above hispurchase price to close the trade if the market continued rising. If the marketfell, he would maintain the futures position until he calculated that thereaction had passed its worst point, or until it were definitely analyzed tohave reversed. He would then take his profits on the futures position (taxable) but his cash position would be intact, and presumably the greatercapital gains on those positions would be safe from taxation, and also safefrom the costs and slippage and difficulties of reestablishing the stock position.
Options on Futures and IndexesConservative as well as speculative use may be made of options. For example, the investor might, after a vigorous spike upwards, feel that the S&P500, or the SPDRs which he is long, were overbought. He might then buyan 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 isundisturbed. If the Index continues to climb he loses the option premium —an insurance policy he took out to protect his stock portfolio.Note well: The tactics described here are for the reader’s conceptualeducation. Before executing tactics of this kind, or any other unfamiliarprocedure, the investor should thoroughly inform himself and rehearse theprocedure, testing outcomes through paper trading before committing realcapital. He must, in short, figure out how you lose. A number of web sites offerfacilities of this kind, and the investor may also build on his own computera 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 usedas the above examples for speculating or hedging, except in this case thesuccessful option buyer might wind up owning a futures contract insteadof the cash position. This could be disconcerting to one not accustomed tothe futures market, especially if large price anomalies between futures andcash occurred, as happened in 1987 and 1989 when futures prices went tohuge discounts to cash. A primary reason for employing the futures wouldbe for leverage. And the reason for using the options on futures would bethe analysis that uncertainty was in store and the wish to only risk theamount of the options premium.Obviously, a speculator can choose to forget the stock or futures part ofthe portfolio and trade only options. Before taking such a step the tradershould pass a postgraduate course. The proportion of successful amateuroption traders to successful professional traders is extremely skewed. In factone might say that all successful options traders are professionals.
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Modern Portfolio Theory (MPT)MPT is a procedure and process whereby a portfolio manager may classify andanalyze the components of his portfolio in such a way as to, hopefully, be awareof and control risk and return. It attempts to quantify the relationship betweenrisk and return. Rather than analyzing only the individual instruments withina portfolio, MPT attempts to determine the statistical relationships among themembers of the portfolio and their relationships to the market.The processes involved in MPT analysis are (1) portfolio valuation, ordescribing the portfolio in terms of expected risk and expected return;(2) asset allocation, determining how capital is to be allocated among theclasses of instruments (bonds, stocks, etc.); (3) optimization, or finding thetrade-offs between risk and return in selecting the components of the portfolio; and (4) performance measurement, or the division of each stock’s riskinto systematic and security-related classes.How important is this for the general investor? Not very. And there isa large question among pragmatic analysts, such as the editor, as to itspragmatic usefulness for professionals, although they cling to it as to a lifering in a shipwreck. Mandelbrot observed in articles (“A Multifractal WalkDown Wall Street”) and letters in the Scientific American (February 1999 andJune 1999) that MPT discards about 5% of statistical experience as if it didn’texist. (Although it [the experience] does.) And he observed that the ignoredexperience includes “10 sigma” market storms which are blamed for portfoliofailures as though it is the fault of the data instead of the fault of the process.
The Wonders and Joys of Investment TechnologyAre there any other innovations in finance and investment theory of whichthe general investor should be aware? (See Chapter 42 for discussion ofVAR.) Well, it never hurts to know everything, and the very best professionals not only are aware of everything, but are in the constant process of findingnew wrinkles and glitches and anomalies. But, as Magee would say, whatis necessary and sufficient to know (see Winning the Mental Game on WallStreet)? Absolute certainty is the hallmark of religious extremists and thenaive, who do not know what they do not know. So I will remark that probablythis book contains either what is necessary and sufficient for the investor toknow about these matters, and/or guides the reader to further study.And, nota bene, any number of little old ladies with a chart, a pencil, andprevious editions of this book have beaten the pants off professional stockpickers with supercomputers and MPT and Nobel Laureates and who knowswhat other resources. I personally know investment groups which have thrownenormous resources into the development of real-time systems which were inresearch 100% successful in beating the market. The only reality glitch was thatthe systems required so much computer power they could not be run quicklyenough in real time to actually trade in the markets. Philosopher’s stone redux.
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Part 2. Futures and Options on Futures on the Dow–JonesIndustrial Index at the Chicago Board of Trade(EN9: The general investor MUST be aware that themethods and techniques described in this chapter arefor advanced practitioners. Careless use of the describedinstruments can be extremely damaging to a portfolio.)Investment and Hedging Strategies Using the Chicago Boardof Trade DJIASM Futures ContractA futures contract is the obligation to buy or sell a specific commodity onor by some specified date in the future. For example, if one went long cornfutures he would be obligated to accept delivery of corn on the deliverydate, unless he sold the contract prior to the settlement date. Shorting thecontract would obligate the seller to deliver corn unless he offset (by repurchase) the contract. The “commodity” in our present case is the basket ofstocks represented by the DJIA Futures index. All futures contracts specifythe date by which the transaction must conclude, known as the “settlementdate,” and how the transaction will be implemented, known as “delivery.”The DJIA futures contract price closely tracks the price of the Dow JonesIndustrials as computed from stock market values.The value of the future is found by multiplying the index price of thefutures contract by $10. For example, if the futures index price is 10000, thevalue of the contract is 10000 ⋅ $10 = $100,000. So the buyer or seller of thefutures contract is trading approximately $100,000 worth of stocks at thatDow Futures level. The value may be higher or lower owing to severalfactors, for example, cost of carry, which I will discuss below.
Settlement of Futures ContractsAll futures contracts must be “settled.” Some futures are settled by delivery.This is the famous nightmare of finding 5000 bushels of soybeans deliveredon your front lawn. Dow Index futures “settle” (are delivered) in cash. Theshort does not dump a basket of Dow stocks on the yard of the long. Thuson the settlement date of the contract the settlement price is $10 times afigure called the “Special Opening Quotation,” a value calculated from theopening prices of the member stocks of the Dow Future following the lastday of trading in the futures contract. This value is compared to the pricepaid for the contract when the trade initiated. For example, if the Dow Futureis 10000 at expiration, a long who bought the contract at 9000 receives $10,000($10 ⋅ 1000) from the short.
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Marking to MarketThis $10,000, however, is paid daily over the life of the contract, rather thanin 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. And the practice of squaring upaccounts at the end of every day’s trading is called “marking to market.”These daily payments are determined based on the difference between theprevious day’s settlement price and the contract settlement price at the closeof trading each day.As a practical example, if the settlement price of June Dow Index futuresincreases from 9800 to 9840 from May 17 to May 18, the short pays $400($10 ⋅ 40) and the long’s account is credited $400. If the futures settlementprice decreases 10 points the following day, the long pays $100 to the short’saccount — and so on each day until expiration of the contract, when thefutures 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 settlementprice.
FungibilityOne of the great contributions of the great established exchanges like theChicago Board of Trade and the Chicago Mercantile Exchange is their institutionalization of contract terms and relationships. This, of