3 we find the Basing Point that is good and raise our stop.14. And at 14 we are confronted with a marginal situation. It is potential BasingPoint. But a marginal one because a higher high was not made after 13.15. At 15 we are able to draw a line defining resistance — a line which will becomea support line.16. At 16 a new Basing Point which would have tested a point at 14.17. At 17 we find a new Basing Point and at 18 we can identify a resistance line. Thespurt across this line is both gratifying and a warning. Because it becomes a flagpolefrom which the flag at 19 flies. Flags and flagpoles are messages that the market hasheated up and now wants close watching. A flag can serve as a Basing Point, so wemove our stop again, fully aware that the end may be approaching. The trendline at20 is further confirmation of this environment due to its steepness. But we see twogood anchor points in 16 and 17 and draw trendline 21 — a better line to defend.22. A good reaction finally occurs at 22 giving a strong Basing Point and goodrationale for raising the stop. Notice the interesting fact that points 22 and 24 havecome back to rest on the trendline we drew at 10.24. As the tempo has increased and the volatility 24 furnishes us another valid BasingPoint.25. Even 25 is a valid point and we can now see the clear support line at 26.27. When this line is pierced at 27 upon extraordinary volume, and in the processtakes out our Basing Point stop from 25, it is clearly time to exit the train.The Basing Point concept is even more thoroughly explored in the paper titled “StairStops” on the John Magee Technical Analysis website: www.edwards-magee.com
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chapter twenty-nine
Trendlines in ActionFrom what has already been said in Part One of this book, you will be familiarwith the characteristic single-line trends of stocks, and the numerous exceptions and deviations that come into the picture from time to time. We knowthat stocks often move in parallel trends, sometimes for months, occasionallyeven for years. We also know that they may, and do, break out of trend orchange the direction of their trends without notice.Most of the pattern formations we have studied can be considered asmanifestations of trend action, that is, as Continuations or Reversals of atrend.Thus, a Symmetrical Triangle is simply the meeting of two trends. Duringthe formation of the Triangle, the stock is following both trends in a narrowing pattern, until finally, the dominant trend asserts itself. An AscendingTriangle is following an upward trend, but has encountered a ResistanceLevel at the Top. A Head-and-Shoulders shows the end of an upward trendand the beginning of a downward trend. A Rectangle is a Parallel TrendChannel running in a horizontal direction. And so on.We can project a Parallel Trend, and, in the case of stocks which happento continue moving in that trend, we can buy and sell at almost the precisepoints of contact with the trendline. Unfortunately, long and perfect straightline trends of this sort are the exception rather than the rule. For actualtrading purposes we will project our trends more or less continuously onthe basis of the most recently established data.From the standpoint of tactics, let’s consider the trends as they areindicated by the successive Minor Tops and Minor Bottoms. For illustrationof this, and as a guide to what we are leading up to, we will considersimplified, ideal situations (see diagram examples on the next page).To avoid confusion, mark the top trendline in blue and the bottomtrendline in red. This can be done on daily charts easily by using coloredpencils. We will refer to the upper trendline as the Blue Trend, and the lowertrendline as the Red Trend. From time to time, we will also want to draw aline parallel to a Blue Trend across the Bottom of the trend so as to includea segment of the Trend Channel between two Tops within parallel lines. Thiswe will call the Blue Parallel, and we will mark it with a dotted or brokenblue line. Conversely, we may wish to draw a parallel to the Red Trend soas to include the segment of the Trend Channel between two Bottoms; andthis dotted red line we will call the Red Parallel.451
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DIAGRAM 3 (Left, above). Here is a rising trend showing the Basic Trendlineacross two Bottoms, which we call the Red Trendline, and its parallel (indicated bya broken line) through the Top of the intervening peak. The parallel suggests theapproximate objective of the next move if the stock continues in trend.DIAGRAM 4 (Right, above). The same rising trend with the Return Line, whichwe call the Blue Trendline, drawn through two Tops. Broken line represents itsparallel through the intervening Bottom. This Blue Parallel is useful in determininga buying point, especially in trends of rapidly changing form when the stock maynot react to its Basic Trendline.
DIAGRAM 5 (Left, above). This is a declining trend showing the Basic Trendlineacross two Tops, which we call the Blue Trendline, and its parallel (indicated by abroken line) through the Bottom of the intervening decline. The parallel suggests theapproximate objective of the next move if the stock continues in trend.DIAGRAM 6 (Right, above). The same declining trend with the Return Line, whichwe call the Red Trendline, drawn through two Bottoms. Broken line represents itsparallel through the intervening Top. This Red Parallel is useful in determining apoint at which to make short sales, especially in trends of rapidly changing formwhen the stock may not rally to its Basic Trendline.
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DIAGRAM 7. Simplified diagram of a stock chart showing trend action. BasicTrendlines are marked with heavy lines; Return Lines are marked lightly.At the start, the stock declines in a Parallel Trend Channel. Blue Trendline is basichere. A short sale on a rally to the Red Parallel at point A will find its objective onthe Blue Parallel at B. Another short sale on the Red Parallel at C would be followedby failure to reach the objective. Chances are good, however, that increased volumewould develop at the Double Bottom and give warning to get out of short commitments. The upside penetration of the basic Blue Trendline at E, alone, is not sufficientreason to reverse position and go long. Trendlines set up during formation of theRectangle would be marked in the regular way, but are indicated here by brokenlines to emphasize the pattern. Another short sale, if tried on the sixth point of contactwith the Rectangle at F, would be stopped out on the breakout.The trend is now rising, although we cannot yet draw a Basic (Red) Trendline. Thefirst buy would be made on a 40–50% correction of the breakout move from theRectangle, or on a return to the Top (Support) level at H.A trendline would be drawn to the first Bottom established in the Triangle. Thisis not shown, as it would ultimately be replaced by the line shown through theoutermost point in the Triangle. We have indicated by broken lines the trendlines setup during the formation of the pattern.The objective of the breakout move from the Triangle would be the Red Parallelto our now rising Basic Trendline. This objective is reached at J. A Return Line (Blue)would be drawn from the first Reversal Top of the Triangle at G through the Top ofthe breakout move at J, and the parallel to this through point I would indicate aboutwhere to make the next purchase. As a matter of fact, the stock does not actually getback to that point; in practice, the purchase would probably be made at K on thebasis of a 40–50% correction, or on a reaction to the Support Level G.The subsequent upward move would not carry through to the Red Parallel markedW. However, the alarm would probably be sounded clearly by a day of heavy volume,a One-Day Reversal, or a gap. Since the trend is now obviously convergent, no furtherpurchases would be considered. The next move fails to make such headway and fallsfar short of the objective set by the Red Parallel marked Y. Soon after, the Wedgebreaks out downside.
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Since, ordinarily, a Top will be formed after a Bottom and a Bottom aftera Top, we will expect to draw, alternately, a Blue Trendline and then a RedTrendline, these lines being drawn as soon as the new Top or Bottom isestablished. (In some cases, a light pencil line may be drawn to indicatesuspected Tops or Bottoms, until developments confirm their validity.)We have already taken up the important and rather difficult question ofdetermining the Minor Tops and Bottoms. Very often, these points will beclear and obvious. Sometimes they will be obscure, and you will be able todraw trendlines with confidence, in such cases, only after considerable experience covering many types of action. The most difficult times to determineMinor Trends are during Reversals, especially where these are of the roundedand irregular types. However, in these cases (of Reversal), we will notdepend so much on the trendlines to determine buying and selling points.So long as a stock persists in a Parallel Trend Channel, it is perfectlyclear that you should buy near the Bottom of the channel and sell near theTop. From the geometry of the situation (see examples), you will see at aglance that it is not likely to be profitable to sell short in an upward-movingtrend (since the reactions are necessarily smaller than the advances), nor tobuy stock in a downward-moving trend.Therefore, a trend must show that it is presumably an uptrend beforeyou are justified in buying stock. And you must have what is presumably adowntrend to justify a short sale.You will notice from the simplified examples shown here that patternformations indicate trends. The breaking of a Rectangle on the upside resultsin an upward slope of the Blue Trend. The move up out of an AscendingTriangle confirms the rising Red Trend and creates a rising Blue Trend. Thedownside breaking of a Head-and-Shoulders neckline confirms a descendingBlue Trend and sets up a descending Red Trend. And so on.From studies of these patterns and various trend actions, we arrive at acompact set of trading rules based on these Red and Blue trendlines. Theserules are summarized below.
Buying Stock, “Going Long”• Preparatory Buying Signals (indicating that a buying opportunitymay be in the making). Penetration of Blue Trend to a new highclosing (in most cases). (The simple breaking of a descending BlueTrendline, where no other pattern or indication is present, is notsufficiently conclusive evidence of Reversal to justify commitments.)– Contact with the ascending Blue Trend if Red Trend is also ascending, provided the trends do not converge (Parallel or Divergent Trend Channel).
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–
Contact with horizontal Blue Trend if Red Trend is also horizontalor ascending (Rectangle, Ascending Triangle).– Penetration of descending Blue Trend on volume if Red Trend isascending (Symmetrical Triangle).• Execution of Buys (after preparatory buying signal).– In case the previous Blue Trend has been ascending, draw theBlue Parallel and buy at or near this line.– In case the previous Blue Trend has been horizontal or descending(that is to say, emerging from Rectangles, Triangles, and variousReversal Patterns), buy on a reaction of 40 to 45% of the distancefrom the last previous Minor Bottom to the extreme Top of themost recent move.
Liquidating, or Selling a Long PositionImmediately on execution of the buy order, determine the stop level (seeChapter 27 on Stop Orders), and place your protective stop. Penetration ofthis stop level will automatically close out your transaction. The stop levelmay be moved up according to the “three days away” rule, but may neverbe moved down (except to adjust for ex-dividend or ex-rights). If the stockcloses below a previous Minor Bottom (thus setting up a descending RedTrend), sell on tight (EN: or hair-trigger) progressive stops.If the stock advances on moderate volume and then develops unusuallyhigh volume on any day during the advance before either the Blue Trend isbroken (with a close above that trendline) or before the stock has made anew high closing over the last Minor Top, close out the transaction on tightprogressive stops.If the stock develops high volume on the day on which it either topsand closes above the Blue Trend or makes a new high closing over theprevious Minor Top, hold it. If heavy volume again occurs on the followingday or any subsequent day, however, sell on tight progressive stops.You will find that, in many cases, the heavy volume signal will develop(sometimes with also a One-Day Reversal or an Exhaustion Gap) on or nearthe Red Parallel. You will watch especially for this volume indication as asign of a good profit-taking point. If the volume signal does not show up,your selling objective is this Red Parallel, at a limit or on tight progressivestops. In case there is no such volume signal at the top of the move and themove does not reach the Blue Trend nor make a new high, you are verylikely running into a Triangle situation. In that case, you will have to waitfor a breakout one way or the other. Meanwhile, maintain your stop protection underneath.
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A
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DIAGRAM 8. Preparatory buying signals shown by trend action.(A) Penetration of an ascending Blue Trendline.(B) Penetration of a horizontal Blue Trendline.(C) The penetration of a descending Blue Trendline without other technical indications is not conclusive evidence of a change in trend, and does not justify longcommitments.(D) Contact with the Blue Trendline of an Ascending Parallel Trend Pattern.(E) Contact with the Blue Trendline of an Ascending Divergent Trend Pattern.(F) In this case, contact with the Blue Trendline does not suggest a buy on the nextreaction, since the trend appears to be converging; a possible Wedge in the making,with Bearish implications.(G) Contact with the Blue Trendline of a Rectangle at its fifth point of Reversal.(H) Contact with the Blue Trendline of an Ascending Triangle.(I) Penetration on volume of descending Blue Trendline when Red Trendline is ascending (Symmetrical Triangle).In rising trends, the Blue Trendline is a Return Line, and purchases will be madeon reactions to a line parallel to the new Blue Trendline established at the Top of thesignal move, and drawn through the intervening Bottom. Note that in the case ofdecisive breakouts from patterns such as Rectangles and Triangles, a purchase mayalso be made on the basis of a computed 40–50% correction of the breakout move,or on a return to Support.
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DIAGRAM 9. Preparatory signals for short sales shown by trend action.(J) Penetration of a descending Red Trendline.(K) Penetration of a horizontal Red Trendline.(L) The penetration of an ascending Red Trendline without other technical indicationsis not conclusive evidence of a change in trend, and does not justify short commitments.(M) Line of a Descending Parallel Trend Channel.(N) Contact with the Red Trendline of a Descending Divergent Trend Pattern.(O) In this case, contact with the Red Trendline does not suggest a short sale on thenext rally, since the trend appears to be converging; a possible Wedge in the making,with Bullish implications.(P) Contact with the Red Trendline of a Rectangle at its fifth point of Reversal.(Q) Contact with the Red Trendline of a Descending Triangle.(R) Penetration of ascending Red Trendline (with or without volume) when BlueTrendline is descending (Symmetrical Triangle).In descending trends, the Red Trendline is a return Line, and short sales will bemade on rallies to a line parallel to the new Red Trendline established at the Bottomof the signal move and drawn through the intervening peak. Note that in the caseof decisive breakouts from patterns such as Rectangles and Triangles, a short salemight also be made on the basis of a computed 40–50% correction of the breakoutmove, or on a return to Resistance.
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Selling Stock Short• Preparatory Selling Signals (indicating that an opportunity for shortsales may be in the making).– Penetration of Red Trend to a new low closing (in most cases).(The simple breaking of an ascending Red Trendline where noother pattern or indication is present is not sufficiently conclusiveevidence of Reversal to justify commitments.)– Contact with descending Red Trend if Blue Trend is also descending, provided the trends do not converge (Parallel or Divergent Trend Channel).– Contact with horizontal Red Trend if Blue Trend is also horizontalor descending (Rectangle, Descending Triangle).– Penetration of ascending Red Trend (with or without volumeincrease) if Blue Trend is descending (Symmetrical Triangle).• Execution of Short Sales (after preparatory selling signal).– In case the previous Red Trend has been descending, draw theRed Parallel and sell at or near this line.– In case the previous Red Trend has been horizontal or ascending(that is to say, emerging from Rectangles, Triangles, and variousReversal Patterns), sell on a rally of 40 to 45% of the distance fromthe last previous Minor Top to the extreme Bottom of the mostrecent move.
Covering Short SalesImmediately on execution of the short sale, determine the stop level (seeChapter 27 on Stop Orders), and place your protective stop. Penetration ofthis stop level will automatically close out your transaction. The stop levelmay be moved down according to the “three days away” rule, but may neverbe moved up.If the stock closes above a previous Minor Top (thus setting up anascending Blue Trend), buy to cover on tight progressive stops.If the stock declines on moderate volume and then develops unusuallyhigh volume on any day during the decline before either the Red Trend isbroken (with a close below that trendline), or before the stock has made anew low closing under the last Minor Bottom, close out the transaction ontight progressive stops.If the stock develops high volume on the day on which it either breaksand closes below the Red Trend or makes a new low closing under theprevious Minor Bottom, hold it short. If heavy volume again occurs on thefollowing day or any subsequent day, however, buy to cover on tight progressive stops.You will find that in many cases the heavy volume signal will develop(sometimes with also a One-Day Reversal or an Exhaustion Gap) on or nearthe Blue Parallel. You will watch especially for this volume indication as a
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sign of a good profit-taking point. If the volume signal does not show up,your buying objective is the Blue Parallel, at a limit or on tight progressivestops. In case there is no such volume signal at the bottom of the move andthe move does not reach the Red Trend nor make a new low, you are verylikely running into a Triangle situation. In that case, you will have to waitfor a breakout one way or the other, meanwhile maintaining your stopprotection overhead.
Additional SuggestionsWhen a level is reached which appears to be either a Minor Bottom on areaction or a Minor Top on a rally, and when the stock continues to stall andremain at this point, moving in a very narrow range for 3 weeks or morewithout giving any signal either by way of price change or volume actionas to its next move, it is wise to assume that this congestion is definitely akey area, should be considered a Minor Top or Bottom, and protective stopsadjusted to it as a Basing Point, instead of the previously established Top orBottom, as against the possibility that the move out of this area, when itcomes, may be in the wrong direction.After a series of moves in a trend, with each move in the PrimaryDirection marked by heavier volume than the retreats or Corrective Movesagainst the trend, you are likely to have a move in the Primary Direction,which is marked by extraordinary volume; that is to say, by much largervolume than the normal increase for a Primary Move. On such a move, aftertaking your profits on previous commitments, you would ordinarily beginto plan the next commitment on the Correction. But in this particular case,noting the extreme volume, you would cancel any immediate plans forfurther commitments in the Primary Direction.The reason for this is that such climactic volume normally indicates thefinal “blow-off” of the Intermediate Trend, to be followed either by a Reversal, or at least by a period of stagnation, or formation of ConsolidationPatterns, or Intermediate Correction. In such a case, it is not safe to makeany further commitments on this trend pending further developments andthe positive reassertion of the trend.If you examine daily charts of various stocks, covering long and important trends, you will find that the series of Minor Moves making up theIntermediate Trend is likely to culminate in a Minor Move marked by tremendous volume. This is more true of Tops than Bottoms, although at theend of the Panic Phase of a Bear Market, we very often see climactic volume.The climax indicates, on the other hand, the sale of large amounts of stockby strong investors to weak traders, near the top; on the other hand, theliquidation of holdings by weak traders occurs near the bottom, into thehands of strong investors who will hold them for the next Major Move.One of the most common errors, and one of the easiest to fall into, is tomistake a Climactic Top or Bottom for a normal confirmation or preparatorysignal for a new commitment in line with the preceding trend.
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It is similar in nature to the error often made by novices in the marketof buying on the Minor Tops (becoming dazzled with the rapid price advanceand the great volume of activity). However, in the case of these final “blowoff” moves, the volume is greater and the adverse portent far more serious.
General Outline of Policy for Trading in the Major TrendA. Always trade in the direction of the Major or Primary Dow Trend(EN: See the editor’s comments in Chapter 3) as it is indicated at the time.B. If the two component Averages of the Dow Theory (Industrials andRails EN9: Transportations) are not in agreement, trade in the directionof the last established Primary Trend but only in the componentwhich is still following that trend.C. Examine charts of group Averages covering groups of businesses inthe same or related lines; trade in the Primary Direction when thetrend of the group corresponds.D. Trade in any particular stock when its own individual chart indicatesa trend in the same direction as the Primary Trend, and when thetechnical picture has indicated a probable move in that direction.Make all new commitments on the reactions or rallies following thesignaling move in the Primary direction, except in the case of Primary Reversals from Bull Market to Bear Market, when short sales may be made at themarket immediately following the Reversal.Exception: after an extended move or a series of moves in the PrimaryDirection, when signs of exhaustion and Reversal appear in individualcharts, commitments in the opposite direction may be made with objectiveslimited to a correction of the preceding Intermediate Move in the PrimaryDirection.EN9: Now the reader’s head is spinning and the color blind are completelyconfused. As this book is unfortunately printed in black and white the reader withoutcolored pencils will be at sea. But the principles articulated here by Magee are ofgreat value to a Trader and are worth study. Technology rides to the rescue. A colorPDF of this chapter will be found in the distant future on the John Magee TechicalAnalysis website at www.edwards-magee.com.
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chapter thirty
Use of Support andResistanceWe know that after many breakouts from well-defined Reversal and Consolidation Patterns, we get a short countermove back to the edge of thepattern, and that the checking of this move at that point is an example ofSupport or Resistance, as the case may be. Also, we should be familiar bynow with the tendency of stocks to move up or down in a series of zigzagsteps. If the move is upward, the reaction after each advance tends to stopat the level of the preceding peak. If the move is downward, the rally aftereach decline tends to stop at the level of the preceding bottom. This is againa matter of Support and Resistance, and provides the basis for buying onreactions or selling on rallies.It has also been pointed out that Intermediate Secondary Moves willfrequently stop at or close to the previous Intermediate Top or Bottom.It is necessary to evaluate the importance of these phenomena of Supportand Resistance, and apply them in market practice, for they are among themost important tools we have. Unfortunately it is not easy to reduce thisparticular subject to a neat formula or body of rules. (EN9: And the effort willbe made. See endnote of this chapter for an interesting effort to do just that.) Hereyou will depend very largely on experience and observation. You will haveto be alert in spotting the levels where Resistance or Support is likely to beencountered, and some judgment is needed in balancing the various factorsthat will affect the situation.For example, there is a stock which has broken up out of a well-definedRectangle of considerable duration. Should the heavy volume of the breakoutmove give way to a dull reaction, you will look for an opportunity to buythis stock at a point a little above the top level of the Rectangle. It willprobably not penetrate very far below that level and, indeed, will often failto react all the way to the Support. If the stock should then advance to anew high, and once more decline on low volume, you may look for anotherbuying point at about the level of the peak reached on the original breakout.Another advance may be followed by reaction to the second peak, and thisprocess may be repeated a number of times, each reaction carrying back tothe level of the preceding high.
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Now we all know that this sort of thing does not continue indefinitely.When the stock first breaks out, moving from, say, 15 to 19, we may buyrather confidently on the reaction to 17, if that is the Support Level. If wedid not buy on this move, we may buy with considerable assurance on thereaction to Support after the next advance. This advance might have carriedthe price to 21 and our buying point would, of course, be at the previouspeak of 19. However, as the stock moves up to 25, 30, 40, it must be clearthat we are approaching a real Top; that although we cannot say where thatTop will be reached, we can be sure that it is becoming increasingly temptingto long-time holders of this stock to sell and take their substantial gains. Theseries of steps is bound to come to an end. To be sure, the Major course ofthe stock and of the market may continue up for months or years, but aftera series of sharp rises, we may reasonably expect a Reversal and a rathersubstantial Intermediate Decline before the upward move is continued.Therefore, we must regard each successive step of advance with increasing suspicion, and it is a fair rule that after a stock has made three suchmoves in the Primary Direction, it is time to look for an Intermediate Correction, or at least an important period of Consolidation.Thus, we have the rough shape of a rule. Buy on the reaction to Supportafter the first breakout. Buy on the reaction to the first Minor Peak after thenext move. But do not buy on the reaction to the second Minor Peak.Let us say, then, that we have been successful in two short-term moves,buying on the reaction to Support and selling on the climax after a new Tophas been made. But we have decided not to attempt a third such trade. What,then, may we expect next? We may see a period of Consolidation, we maysee the beginning of an Intermediate Decline, or we may see the stockactually go right on moving up. No matter. We will wait for the IntermediateReaction. We will wait until the stock makes a very substantial decline, andthis may take many weeks. Then, if the Major Trend has not reversed itself,we will again look for a buying opportunity at (or somewhat above) theIntermediate Support, which will usually be the top level of the advancepreceding the one just completed, for this is the level from which the nextPrimary Advance is likely to proceed and is a good buying point.Of course, we find the same situation in Bear Markets. A breakout islikely to be followed by one, two, three, or more steps of decline, withintervening rallies to Minor Resistance. Sooner or later (and we would counton no more than three such steps in a series), we will get a turn and anIntermediate Recovery. We will then wait for this rally, which may itself bemade up of several Minor steps, to reach or approach closely the precedingIntermediate Bottom, at which point we may look for substantial Resistance.Here is the place again to put out shorts.Questions will come to your mind. One of them, and one of the mostimportant is: how do we decide when an expected Support or Resistancehas failed us, and at what point do we then abandon our position?It will be clear that this question can be a very painful one. Let us supposeyou have seen a stock rise to 25 and have placed an order to buy it at 23½
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on the basis of expected Support at 23, the level of a previous Minor Peak.The order is executed during a dull reaction. The next day, the stock slipsdown to 22½, on perhaps only two or three sales. The next day, it continuesdown to 21½, still on low volume. And during the next week, it goes downsteadily, without much volume, nearly every sale being at a lower price, asthough no new bids were being received, and as though no substantialnumber of bids were standing on the book at any point. A decline of thissort can eventually assume the magnitude of an Intermediate Reaction. Themove may carry down to 15 before it turns. Obviously this was not whatyou expected, and you should be out of the stock.The painful part of these drifting moves is that you do not want to sellyour stock (which you bought at 23½) on just a slight move down, say to22¾, since the probability is strong that it will shoot up at any moment tonew high levels. And yet, at some point during a continued decline, youmust decide, “This has gone through the Support; I should sell and take asmall loss now, rather than risk a more serious loss.” And the most painfulpart of all is that sometimes, the moment you have sold and taken your loss,the stock