etration into the oversold quadrant this year. Not since June of 1984 has this
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Balanced and Diversified
583
DOW–JONES INDUSTRIAL AVERAGE150013721297
13751250
‘GOLDEN AGE’
‘TURBULENT PERIOD’
1125
10671001
1000
1026
995958
1031
1079
918
875750
688
741
625564
500375
416
250
SOURCE
125
627525
M.C. HORSEY & CO
824
784
736
737
730
770
570
‘RENEWED UPSWING’
MAGEE EVALUATIVE INDEX LESS THAN 5% STRONG56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85
DIAGRAM 10.1. From Collected Market Letters, September 28, 1985. Magee Evaluative Index computed on the Dow–Jones Industrials illustrating the use of the Indexto identify tops and bottoms in the market. A sort of “oversold/overbought” indicator.
index been lower (see Figure 14; EN: Now Diagram 10.1.). Shortly after itsJune low of 8% Strong, the MEI headed steadily higher, giving an AggressiveBuy signal throughout late June and July.The June 1984 MEI low of 8% Strong, together with the 8% level reachedon February 25, 1984, constituted a Double Bottom oversold reading for thisindex. It corresponded to the 1079 Bottom recorded by the Dow–Jones Industrial Average on June 18, 1984, after which that index advanced steadily toits recent July peak of 1372.For over 20 years, all major stock market Bottoms have correspondedwith extremely low MEI readings. During the “turbulent period” when thestock market oscillated violently but showed no gain at all, MEI readings of5% Strong or less corresponded with all Major DJIA Bottoms until the June1982 low of 9% Strong, which immediately preceded the stock market’supward explosion.That slightly higher than “5% Strong or less” Bottom was an importantclue that a reinvigorated stock market was at hand; the straight-line DJIAadvance from 770 to nearly 1300 ended a 17-year “do-nothing” period forstock prices and ushered in the “renewed upswing” period shown on thechart.In this context, the “8% Strong Bottom” of June 1984, and the currentMEI reading of 9% Strong, take on added meaning. If, in fact, we are in aperiod of Renewed (or major secular) Upswing, stock market Bottoms willtend to be less severe and Tops more extremely overbought than would
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Technical Analysis of Stock Trends
otherwise be the case. Both the June 1982 DJIA low and that of June 1984 fitthis model. Because secular stock market waves tend to last for many years,even decades, the likelihood is that the current MEI reading of 9% Strongwill also define a Major DJIA low.
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chapter thirty-nine
Trial and ErrorYou will not expect to turn in a perfect record from the start. You may indeeddo poorly. That is one of the reasons we have suggested using only a safeamount of your capital, allowing enough leeway so that if you should misread and misdirect your campaigns, or if you should encounter an Intermediate Setback in the trend of a Major Turn, you will be able to get back oncourse, undismayed, and richer in experience.Your records of actual transactions (and notes on theoretical transactions)will help you. As time goes on, you will discover new trading refinements.Try these methods against your previous chart records. See whether yourimprovements work out consistently to your advantage. In that way, youcan test new details of method without risking actual capital until you havechecked the operation thoroughly.In one actual case, a trader who had shown a rather poor record ofperformance through a fast-moving Bear Phase of the market, rechecked 30of his actual trades made during that period in the light of new methods hehad subsequently developed. Where the original record showed a loss at therate of about 40% per year on the capital for the time it was tied up, thechanges he introduced, applied to the same situations, would have resultedin a profit at the annual rate of 156%. Such a result, while not conclusive,would strongly suggest trying out the new method in all similar situationsin the future, and if the performance continued to show this advantage, toadopt it as a permanent policy. It is only by continual checking and testingthat you can learn to pick up more of the profitable opportunities and protectyourself better against the unexpected Reversals.If you follow the suggestions of this book, those already given, and thosein the following chapters, you will proceed slowly and cautiously, not riskingall your capital on a single move in a single stock. Errors and plain bad luck,when they hurt you, will not hurt you too seriously. You will be preparedfor false moves, wrong interpretations, and complete Reversals of expecteddevelopments.If you have worked thoughtfully and serenely, without permitting youremotions to rule your judgment, the law of averages will bring you continually greater success. You are not gambling blindly in this work; you areintelligently using past experience as a guide — and it is a dependable guide.Your operations are part of the competitive workings of a free market; yourpurchases and sales are part of the process of interpreting the trend, checking585
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runaway inflation and crashes, and determining the value of the Americanindustrial plant.The market will continue to go up and down in the future as it has inthe past. Your technical knowledge will save you from “buying at the top”in the final Climactic Blow-off, and it will save you from selling everythingin a fit of depression and disgust when the Bottom is being established. Inyour studies of past market action, you have a strong shield against thesudden thrusts that surprise and often defeat the novice trader.EN9: I have often told my students that if their knowledge of this material doesnothing more than keep them from making stupid mistakes like buying a topor buying a downtrend or buying before a bottom has completed forming, then theirtime will have been well spent. The elimination of amateur blunders such as thesecan immeasurably improve investment performance.
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chapter forty
How Much Capitalto Use in TradingUp to this point, we have been talking mostly in terms of points and percentages. Little has been said about dollars. From here on we are going toturn the spotlight on the questions revolving around money, capital, thedollars you will actually be using in your operations. For, just as an understanding of the technical signals and patterns alone will not guarantee yourprofits without a tactical method of applications, so your tactics alone willnot insure you profits until you have tailored your method to fit your pocketbook, and until you have a systematic control of your trading in terms ofdollars and cents.At the start of your charting operations, you will be using no capital.You will be making no trades either actual or theoretical. Any commitmentyou might make during the first 4 or 5 weeks on a new chart would be nomore than gambling on a hunch. It will take about 2 months of thanklesscharting before you have any clear picture of how any of your stocks areacting technically. From then on, your chart history will become more valuable each week. Your first trades probably will be theoretical ones. You willwant to get the feel of the charts and learn to apply the methods you havestudied. Eventually, you will want to make an actual transaction.EN: The prudence of this approach can hardly be disputed. And, just as marketshave changed, stock market mentality and awareness have changed. The mere existence of this book and of the general atmosphere enable the modern investor to progressmore rapidly than the old pencil and paper and slide rule chap. The availability ofcomputers and databases and tutorial tools, not to mention online and offline coursesin the subject, are unparalleled resources.Then the question will come up, “How much of my capital shall I usefor trading purposes?” EN: In a certain sense, this question begs the question. Itpresupposes that the reader has capital. If the reader does not have capital, but isgambling with the milk money or the mortgage payment, his failure is virtuallyassured. Do not speculate with money whose loss will occasion you more thanpassing discomfort.That will depend on your circumstances and how much of your timeand effort you plan to put into stock trading, and also on your experiencein the market. If you have been buying and selling stocks for a number of
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years, you will naturally continue along the same lines, simply applying thenew techniques to your operations.On the other hand, if stock trading is entirely a new field for you, or ifit is only a minor hobby or sideline, it would pay to make haste slowly. Somewriters have pointed out that it usually takes about 2 years to gain enoughpractical experience to operate safely in the market, that during the 2-yearapprenticeship period, many traders come in, gradually lose their capital,and retire permanently from the field, leaving their money behind them.Therefore, no matter how confident you may be or how anxious to get inand start pitching, it would be safest to do most of your experimenting onthe theoretical basis, and to use only a small amount of your actual capital,so that after, say, 2 years, if you have shown some actual profits, consistentlyand regularly, even though small, you will be much better prepared to usemore of your capital wisely and safely. And conversely, if during that timeyou have made repeated mistakes and have registered many unnecessarylosses, you will be able to correct your methods and continue on a sounderbasis, without having lost your main capital reserve.In no case do you want to risk everything you can scrape together onthe theory that here is the quick way to make easy money. That simply isnot true, and the chances are overwhelmingly against you if you go aheadunder any such plan.Better to figure out how much you can spare, how much you couldafford to spend for experience, considering that the amount you start withis in the same category as money you might use for taking a special courseof instruction, or for improving property you hope to sell. Or, to take anotherexample, it would be similar to the salary you might lose in accepting alower-paid position in a new kind of work that eventually should be worthmore than your present job.In other words, you will not depend, from the start, on any returns fromthe capital you use in trading. You will plan your own budget outside ofthese funds, even if that calls for trimming your budget to make that possible.Then you can go ahead and follow your trading method free from anypressure to take unnecessary risks, free from the need to sell stock prematurely to meet obligations, and free from heckling fears and worries.You can start operations with as little as $500. EN: This is especially truein the Internet Age. Free commissions in many sites and the availability of low costdiversified trading instruments like indexes and AMEX trusts offer the small investor more opportunity than ever before in financial market history. Better to have$1000 or several thousand. It makes little difference, so long as you haveworked out what you can afford to use during the apprenticeship period,and as long as you are sure you will have capital to continue your operationas you develop ability. The important thing at the start is not how manydollars you can make, but what percentage of increase per year you canaverage with the capital you are using.
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How Much Capital to Use in Trading
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If you approach the serious business of trading in this frame of mind,you will not be afraid to take losses when it is necessary (and there are timeswhen that is the only wise course to adopt). You will not be straining tomake an unreasonable or impossible profit (with the usual disastrousresults). And you will be able calmly to build your trading policy in the sureconviction that the market will still be there next year, that opportunitieswill still be waiting for you, and that the basic procedures you are developingare more valuable than any “lucky break” you might pull out of thin air ora boardroom rumor.
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chapter forty-one
Application of Capitalin PracticeEN: Today we would refer to this question as “asset allocation,” about which manylearned books and articles have been written (see Resources, Appendix D). Themodest suggestions in this chapter are, like Magee, very pragmatic and simple —and quite possibly more effective for the general investor than those complicatedprocedures spun out by super computers for complicated Street portfolios.Let us now restate a number of ideas we have already investigated andon which (let’s hope) we are thoroughly agreed. EN: If the reader is not inagreement, he should reread the book up to this point carefully.1. Major Trends ordinarily run for long periods of time, covering atremendous number of points in total advance or decline.2. Almost unbelievable profits could be made by one who could buystocks at the extreme Bottom of a Bear Market and sell at the extremeTop of the following Bull Market; or sell short at the extreme peakof a Bull Market and cover at the extreme Bottom of the followingBear Market.3. It is not possible to accomplish either of these desirable results.4. It is possible to avoid becoming trapped in purchases made at ornear the extreme Bull Market Top so that losses become dangerousor ruinous in a Major Reversal. It is also possible, of course, to avoidsuch losses through ill-advised short sales near the extreme Bottomof a Bear Market.5. It is possible to make profits by trading in line with the Major Trend,and in some cases, by trading on the Intermediate Corrections to theMajor Trend, or, occasionally on the individual behavior of a stockwhich is moving contrary to the Major Trend.6. The greatest and most dependable profits may be made along theMajor Trend during the principal period of advance (or decline, inthe case of short sales), but not during the earliest phases when themovement first gets under way, nor during the rounding off or Reversal phenomena near the end of the movement.
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Therefore, in order to get the greatest benefits from following the MajorTrends, one would want to have a relatively small equity in the market atthe very start of the move and very little at or near the termination of themove, but a very substantial interest during the mid-portion when theadvance or decline was making the greatest headway.The writers have felt it should be possible to express this relationbetween the amount of capital tied up and the state of the Major Trend in aneat and definite equation. But inasmuch as the idea of a Major Trend is,itself, a matter of definition, and since, as we have already pointed out, thetrend is an abstraction from the individual movements of many stocks, itdoes not seem possible to arrive at any such easy solution to the problemof how much capital to use at a given time.Nor is it necessary to have a definite and exact answer. As we havealready seen, it is possible to set up an Evaluative Index which will give anapproximate answer good enough for all practical purposes so far as weighing the “strength” of the trend at a particular time. EN: To clarify and makemore explicit the concept here, I would point out the Asset Allocation implicationsof the Magee Evaluative Index. If the analyst’s analysis of the market indicated that30% of stocks were bullish, 30% bearish, and 40% neutral he might so commit hiscapital — 30% long, 30% short, and 40% cash. This would also assume that hisassessment of risk also indicated that the risks of the long and short positions werebalanced, or approximately equal — approximately equal, since infinite precision isonly achievable by the writers of academic treatises working with excellent hindsight.There are, however, some other questions. Most importantly, there is thequestion of how much total “risk” you are assuming. Since some stocks arevery conservative and others are very speculative, it is not enough to determine what part of your capital should be applied in a market trend. Theproportion of your total capital used is not necessarily the whole measureof your participation. The price level of a stock will affect its habits(low-priced stocks make bigger percentage moves than high-priced stocks).The amount of margin you are using will have an effect on the degree of risk.There is some substance to this plan (otherwise we would not be takingthe time to discuss it here at all), but there is a serious question whether thedecision as to the amount of capital to be used at any specified time can everbe reduced to a simple mathematical operation. EN: Still true although thereare those who attempt it.Let us suppose you are convinced that this is a Bull Market, in a phaseof such potency that you would be justified in using 80% of your capital.But you will immediately realize, from what has been said in earlier chapters,that if this money is put into a high-priced (EN: and low-beta) stock it willnot give you as much likelihood of either profit (if you are right) or loss (ifyou are wrong), as it would if put into a lower-priced (EN: and high-beta)stock. In the same way, your money put into a stock having a low SensitivityIndex, that is, a conservative stock like a Utility stock, will not give you asmuch likelihood for either profit or loss as a stock of high Sensitivity Index(EN: volatility), that is, a speculative stock such as an Internet issue. These
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factors, quite as much as the amount of actual dollars, affect your status,and are factors in answering the question, “Am I out on a limb and, if so,how far out?”To make this perfectly clear, we could take 80% of our capital, say $8000out of $10,000, and put this amount into the market by purchasing a conservative preferred stock, outright. A great rise in the general market mightbring us an increase in value of a few points, perhaps 4% or 5%. Andconversely, a great decline might depress the issue by about the sameamount. An example of going to the other extreme might be to purchase$8000 worth of options on a low-priced, extremely speculative stock, inwhich the probable result within 90 days would be either a profit of severalhundred percent, or a total loss of $8000.Obviously, we could vary our status during the progress of the marketeither by increasing or decreasing the amount of the total commitment, orby changing the nature of the account, switching part of the total into moreor less speculative stocks, higher- or lower-priced stocks, and also by varyingthe amount of margin used.In Appendix A we will show how the principal factors affecting a givensum of capital used (namely: sensitivity, price, and margin) can be combinedinto one figure, which we are going to call the Composite Leverage Index.EN: Once again Magee demonstrates a practical vision and intuitive understandingboth of the markets and of the basic character of investing far ahead of investmenttheory and understanding of his time. What we have in this concept is nothing lessthan the original glimmerings of VAR, or Value at Risk. The concepts and practicesof VAR are succinctly summarized in Chapter 42.It is perfectly true that you must vary your Composite Leverage (EN: riskexposure) so as to take advantage of the fast-moving central portions ofimportant moves, using a lower Composite Leverage at the beginning ofsuch moves, and during the tapering-off or turning periods near the end.However, it is one thing to express the Composite Leverage accurately,and another thing to write a formula for applying specific degrees of leverageat particular times. The method suggested at the very beginning of thischapter has some value, but owing to the Secondary Reactions and thedifficulty of determining Major Trends in individual stocks, it is not possibleto make this into the neat, pat rule we are looking for.It must be a matter of experience, or intuition based on experience. Youwill not permit your Composite Leverage factor to run out to a dangerouspoint on the limb. Neither will you allow it to become so low during timesof good market opportunity that you are not getting full benefits from themove.We can keep the general shape of a Major Swing in our minds as weconsider this. Bull Markets normally rise through a series of irregularadvances and declines, starting with a moderate upward trend, and gradually accelerating as the market approaches its ultimate top. Bear Markets arelikely to move fastest at the start, and taper off gradually toward the end.Bear Markets are steeper than Bull Markets. These considerations will help
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us to judge the times when the market will offer the best opportunities, thetimes when our Composite Leverage should be increased.There are other factors, even harder to pin down in simple figures. Wewould, at times, make switches of our holdings for reasons that had no directrelation to the factors making up the Composite Leverage Index of the stocks.We know, for example, that high-grade issues, the active market leaders, andperhaps some stocks of a more conservative nature will tend to start theirmoves in a Bull Market fairly early, and to continue their advance at a fairlysteady pace. Eventually, they will reach their tops and make a ReversalPattern. They will decline from this point, probably at a steeper averageangle than the ascent. Low-priced and low-grade issues, on the other hand,tend to be slow in getting started, will remain dormant during the earlyphases of a Bull Market, and will then suddenly and spectacularly skyrocketin a series of moves that brings them to their ultimate Top. However, thisTop is likely to be reached at a later point (perhaps months later) than thepoint at which many of the more conservative stocks topped out. The speculative group will then drop very fast and will return to the dead levels ofinaction before the conservative group has finished its more leisurely MajorDecline.This means that you will do well to concentrate your Bull Market tradingin the early stages, in the higher-grade stocks, and in the later stages, in thelower-grade stocks. In a Bear Market, you would perhaps be able to makeshort sales unsuccessfully in high-grade stocks even while some of the “catsand dogs” were still completing their final run-up; but you would be watching for the opportunity to cover those shorts and go short the low-gradestocks as soon as their Reversal was signaled.Appendix A will go into the Composite Leverage Index. It should be auseful gauge for you in your market operations, and a protection againstovertrading. But do not expect that you can use it mechanically as an indexagainst the market to answer all your questions involving the nature andsize of your commitments. For in gauging the condition of the Major Trendat any time, your own experience and judgment must be the final arbiters.
Put and Call OptionsOptions of various sorts have a long history in commercial markets. Nearly2000 years ago, the merchants who operated in the Mediterranean regionused “to arrive” agreements which amounted to option contracts, as insurance to reduce the risks of storm and piracy. Modern commodity futurescontracts resemble stock options in their dual nature of serving either astrading media or as insurance devices. Options are also widely used in realestate transactions and in various other applications.For many years, stock options were traded only on the basis of individualagreement between a buyer or a writer, and an opposite number, directly orthrough a broker or dealer. The customer and the writer were free to decide
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what stock (any stock) would be optioned, at what exercise or striking price,for what period of time, and at what premium.In 1973, a new method of handling option contracts was inaugurated bythe Chicago Board Options Exchange and later the American StockExchange, and then to other Exchanges around the country in which calloptions on a selected list of actively traded stocks are offered with standardexpiration dates (like commodity contracts) and at definite exercise prices,the premium depending on the bids and offers of buyers and writers. Anexcellent guide to this rapidly expanding market is (EN) Options as a StrategicInvestment by Lawrence G. McMillan.EN: In the Internet Age options and derivatives markets have attained anastounding economic importance. One amusing way of measuring this importanceis by listing some of the great debacles which have occurred to major traders ofderivatives. Bank Negara, Malaysia’s central bank, lost $5B (billion) in 1992–93through bad bets on exchange rates. Showa Shell Seikiyu, Japan, lost $1.58B in1993. Metallgesellschaft, Germany, lost $1.34B in the same period. Barings Banklost $1.33B on stock index futures. From 1987–1995 known losses like this totaled$16.7B. And, as Magee would say, etc., etc. Of course, compared to the estimatedtotal market in 1995 of $25T (trillion), this is a mere bagatelle. Perhaps this issufficient to warn the general investor that the field is strewn with financial minesfor even the sophisticated.EN9: If the investor considers stocks a complex or difficult area (though it ishoped this book will make it less so for him) options are exponentially more difficult.Professionals beat amateurs at that game so thoroughly and so often as to considerit easy money. So the general investor should be sternly warned that much trainingand study should be undertaken before becoming fodder for the pros.EN9: Tradestation, the superlatively fine trading system and brokerage operation, distributed with Tradestation 2000i, its standalone software package, an intelligent little book by Charlie Wright, Trading for a Living which among its otherfine points offered a plan for the ongoing allocation of capital to trading.
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chapter forty-two
Portfolio Risk Management*As we suggested in the preceding chapter, there is some relation betweenthe state or stage of a Major Market and its potentialities for profit. Thereare many mechanical plans and systems for coping with the problem, butwe do not believe it can be fully solved by mechanical means alone. Wementioned one plan by which the commitments were governed accordingto the consensus of trends in an entire portfolio of charts. EN: The MageeEvaluative Index, or MEI. There are other plans which depend on pyramidingthe commitment as the trend proceeds; and still others which are based onaveraging costs by increasing the commitment working against the trend,that is, by buying on a scale-down at progressively lower levels in a BearMarket, and selling on a scale-up in Bull Markets. (EN9: Invitations to disaster,both techniques. Avoid such methods.)None of the plans, taken by themselves, are adequate to answer thequestions of when to buy and when to sell. The primary purpose of thisbook is to study the technical phenomena of individual stocks. If we canlearn from the charts at what points to buy and under what conditions tosell, we have acquired the basic machinery for successful trading. On theother hand, obviously, if your buying and selling are at points which moreoften than not result in net losses, then it makes no difference how you divideup your capital or apply it in the market, for it will be bound to shrink until,eventually, it has all disappeared. EN: An investor who finds himself in thissituation should set a benchmark. He should decide that if he loses 50% of his capitalhe will quit trading and put his money in mutual funds or in the hands of an advisor.Generally speaking, an advisor is preferable to a mutual fund. And both are preferableto an investor with two left feet. They can certainly do no worse than a consistentlylosing performer.The first problem, then, is to learn to use the technical tools, patterns,trends, Supports, Resistances, etc. Then we can consider how much moneywe will risk and in what way.We have already seen that it makes a difference, sometimes a greatdifference, how we apply our capital. The various factors of price level,sensitivity, and margin enter into the concept we are going to call the Composite Leverage Index. In Appendix A, we will give a definition of this.
* “A Discussion of Composite Leverage” in the seventh edition has been moved to Appendix A.
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Meanwhile, we have said enough so you will understand what we aredriving at if we use the term in connection with your market commitments.You realize, of course, that you do not want to be so conservative thatyou will rule out practically all opportunities for making gains. If you decidenever to oppose the Primary Trend, you will have to be inactive during longSecondary Trends, and may be left waiting, sometimes for weeks on end,for a continuation of the Primary Move. Naturally, you will pass up all weaksignals and convergent trends, and shun new commitments after very activeblow-offs or Panic Climaxes. You could, no doubt, carry your refinement ofcaution so far that your percentage of success, instead of being a mere 60,70, or 80%, might approach 90%; you might actually be right 95% of the timein your decisions. But this extreme conservatism would also mean that youwould trade only in the very finest possible situations, when every factorwas clean-cut and favorable. You would not have such opportunities veryoften. The result might be a profit, but too small a profit to justify all thework and study you would be putting into your charts, for you can obtainnominally respectable returns on your capital without very much study andwithout much risk, and you must expect a much higher rate of return if yourefforts are to be worthwhile.EN: These “nominally respectable returns” are obtained by investing in T Bondsand similar instruments. Bond traders and investors traditionally consider theseinvestments “risk free,” which is, of course, another form of the denial of reality. Inreality as David Dreman has demonstrated (Contrarian Investment Strategy,Sim