sucked into the black hole ofunderwriters and 21-year-old huckster CEO wallets. Better than the SouthSeas Bubble. And, as definite proof that man is directly descended from geeseand sees no farther ahead than the next feeding bowl the ghost of the maniaoozes from the closet in 2005, reborn as Google mania. Man (or goose if youwill) never learns. That’s why he’s so much fun to watch. Honk.
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PLMO(D) - Weekly NASDAQ L = 21.40 –0.40 –1.03%
O = 21.36
407
C = 21.431610.001010.00633.00397.00249.00156.0098.0061.0039.0024.0021.43
18.23
15.0010.00
2001
2002
2003
2004
2005Created with TradeStation
FIGURE 205.2.1. Dealers palmed all the missing capital in PALM? Somebody madethe money disappear up a shirt sleeve. What makes you think the deck was stacked?Or that the IPO was laddered? Maybe it was just fools chasing tulips. Those investors(gamblers) playing the shell game with PALM found themselves playing with 6 shellsinstead of three as like an insidious amoeba PALM divided into two tulips PLMOand PSRC. Keep you eye on the magician closely. For the analyst all the smoke andmirrors could not hide the fact that gravity took PALM in all its manifestations down.The downtrend lines are broken in 2003 and 2004 and a respectable Kilroy Bottomis made. But. The implications of the bottom may have already been carried out. Acontinuing story for speculators or astute (very astute) investors who know something fundamental and have very long-term vision.
Google. What a creature is man! What a game is the market! Google, awonderful company, and a great concept goes public in 2004 after worldclass (World class? Intergalactic class!) hype. Floated as a red herring at 135it eventually goes IPO at 85 in an innovative public offering. Then the funstarts. Future readers of this book may observe the mark up made as of thedate of writing (November 2004) and judge whether the method worked. Acompany on roller blades, impossible to dislike as a company. Remember,unless you are Warren Buffet you are buying the stock, not the company.
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PSRC(D) -Daily NASDAQ L = 8.89 +0.02 +0.23%
O = 8.85
C = 8.89
42.0035.0029.0024.0020.0017.0014.0012.0010.008.89O
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FIGURE 205.2.2. PSRC in its amoeba-like glory. The failure of what might havebeen a rounding bottom, especially with the breakdown gap in October and thefailure to rally back to the neckline left no doubt as to the fate of PALM by any othersymbol. Broken trendlines are also indicative. Remember that any large pattern canbe broken down into smaller patterns susceptible to short trend line analysis, as inthis case. Sooner or later a palm-size computer, PDA, widget device is going to bethe wave of the future. The canny investor will not mistake the company for thestock, and will also not venture capital until there is a better chart story.
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Choosing and Managing High-Risk Stocks
FIGURE 205.3. COMS. Underwriters cleverly only three 3% of 3Com-owned Palm stock onto the market at the IPO. Palm wound up“worth” more than 3Com for a short time. Here the lesson of tulipomania is vivid. The contrast in before and after volume. The necessityof analysis to deal with tulips in bloom. The fatal lesson of heeding (or not heeding) gaps across horizontal trendlines. Impossible tomanage for the buy and hold investor.
Apr Jul Oct 97 Apr Jul Oct 98 Apr Jul Oct 99 Apr Jul Oct 00 Apr Jul Oct 01 Apr Jul Oct
1998=2004 Prophet Financial Systems, Inc. I Terms of use apply.
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3com Corporation-(Nasdaq NM) 3.71 0.10 2.77%
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FIGURE 205.4. ORCL. True to the character of stocks during the tulipomania, Oracle was difficult to handle without careful analysis. Stocksplits preceded a number of the sell offs (note gaps post splits). Bullish gaps are also frequent here, and the tulip top is obvious, and wasat the time. An excellent trading vehicle. A wreck for the casual investor.
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Choosing and Managing High-Risk Stocks
FIGURE 205.5. INKT. The pleasures and delights (and disappointments) of Internet stocks. The last trendline, in conjunction with thesecond horizontal trendline, clearly marks the end of the party (AND WILL FOR ANY STOCK WHATSOEVER). The break of the longterm trendline is the last exit signal, as if the previous signals weren’t clear enough. Is it not obvious that this issue was (and is) manageablewith technical analysis?
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FIGURE 205.6. EMULEX. (ELX) The message of 2000, a severe drubbing, and precipitous at that, would have been lost on the nontechnician. Those who continued to ride the roller coaster relearned a lesson technicians know, that stocks often repeat the same behavior(or misbehavior). The lesson of monster breakaway gaps (or air gaps) may have needed relearning also. Oh well, after such a gap thedamage is done, the unenlightened investor says, only to see the damage continue down to 10 (from 110!). These are signals of suchmagnitude that disaster awaits him who denies its significance. The air gap here nicely complements those of Figure 130 and Figure 269.
412
0.696 Apr Jul Oct 97 Apr Jul Oct 98 Apr Jul Oct 99 Apr Jul Oct 00 Apr Jul Oct 01 Apr Jul© 1999–2004 Prophet Financial Systems, Inc. Terms of use apply.
Emulex Corp 19.74 0.01 0.05%
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Amazon.com Inc.-(Nasdaq NM) 47.15 –0.84 –1.75%12010080605040302010
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FIGURE 205.7. Amazon weekly. Amazing Amazon dances in the Internet follies.The breathtaking plunges are the direct result of the breathtaking speculative excess.See the daily chart (Figure 205.7.1) for a closer look at the details of the blow-off.
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AMZN (Amazon.com, Inc.)08/26/2006 5:51 PM EDT
© 2002-2006 Prophet Financial Systems, Inc. All Rights Reserved.
FIGURE 205.7.1. Amazon daily. In cases of speculative blow-off, trendlines are oflittle use. A dozing trader (presumably it was obvious that this was not an investmentissue) would have been mauled in the plunge. An alert trader, knowing that in blowoffs the procedure is to sell strength, might have avoided it. Other techniques includerecognition of the second exhaustion gap and exit. Also a trader using the techniquesdescribed in Chapter 28, setting progressively tight stops, might have avoided thefall.
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AMZN(D) - Weekly NASDAQ L = 32.31 –0.21 –0.65%
O = 32.85
415
C = 32.36
88.0062.0042.04
44.0032.36
22.0018.35
15.0011.008.005.004.003.002.00
1998
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FIGURE 205.7.2. The wild frontier of the Internet and of the gunslinger speculators(gamblers?). Amazon bucks on. Give us a slug of rotgut whiskey and get out theruler. A clear top for the rational analyst with clear broken trendlines and brokenhorizontal lines and then a clear bear market with a clear bottom resembling a KilroyBottom and then a clear breakout and another bull market and then another downtrend. Talk about your fearless bull riders down at the rodeo. But this bull/bear isridable with a little technical analysis. Without technical analysis it’s like being thetarget in a shooting gallery. A sitting duck.
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Cisco Systems Inc.-(Nasdaq NM) 17.29 0.08 0.46%1817161514131211109876
5
4
97 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 98 Feb Mar Apr May Jun Jul Aug Sep Oct Nov© 1999–2004 Prophet Financial Systems, Inc. Terms of use apply.
FIGURE 205.8 CISCO. (CSCO) While the first long term trendline beautifully intercepts the downtrend in progress at a gap (a coincidence of indicators which occurstoo often to be a coincidence), the trendlines drawn later are of such strength thateven the novice analyst should know how to exit. And, in fact, one of my students,an employee of Cisco, did just that, saving himself thousands of paper dollars in thisvery case.
4/2000 5/2000 6/2000 7/2000 8/2000 9/2000 10/2000 11/2000 12/2000 01
2/2001 3/2001 4/2001 5/2001 6/2001 7/2001Created with TradeStation 2000i by Omega Research
1999
FIGURE 205.8.1 Is there any way the trader (investors keep away) could avoid stepping off this cliff?Extreme paranoia is one way. Another way is by being acutely conscious of the pattern of behaviormanifested by Cisco in Figure 205.8.
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GOOG(D) - Daily NASDAQ L = 219.75 +0.30 +0 14%
O = 221.91
C = 220.00220.00216.00
204.79
204.00193.00182.00171.00
163.99
162.00153.00144.00136.00128.00121.00114.00108.00101.00
Aug Sep
Oct
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FIGURE 205.8.2. You thought all the tulips and bulls had been exhausted in thetulipomania in 2000? Silly you. There is an inexhaustible supply. All you need is acompany and a story and an underwriter to peddle it. Sometimes there are evenearnings. Sometimes the earnings are even real. Sometimes the earnings are skatinguphill on roller blades. And sometimes the characters are so appealing that you arealmost willing to buy the IPO at face value. But not if you are a cynic as all technicalanalysts are. Google was rumored at $200 or more on the IPO. The editor offered tosell all of it at that price and throw in the Brooklyn Bridge for free. This offer (well,there may have been other factors also) knocked the IPO down to $85 (still an arrantspeculation), but only insane, not unreasonable. The oversubscription in an innovative offering revealed that the tulip virus was not dead, but very much alive andinfecting not just the same old suspects, but many new ones. We love a horse raceand this is a great one. Notice the obvious defensive lines and support and resistance.How long Google can defy gravity (a galactic P/E ratio) remains to be seen. Prudentgamblers will have a stop identified. On this chart, for the long-term gambler it mightbe in the 182 area. For the more agile gambler it might be failure of the supportaround 204, or closing of the breakaway gap there. No opprobrium is attached tothe-term gambler. In fact bolder investors (competent readers of this book) shouldtake a flyer from time to time with about 5% of their capital. This, of course, is theflyer which should have been taken. The breakaway gaps in October and April,operating against disbelief, were signals of enormous technical strength. And Googlewent to 475!! The lesson here, which must be learned and relearned and…ad infinitum… is: Trust the chart. Ignore the story.
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chapter twenty-four
The Probable Movesof Your StocksAt first glance, all stocks appear to move helter-skelter without rhyme orreason, all over the lot. All stocks go up at times, and all go down at times —not always at the same time. But we already have seen that in these risesand falls stocks do follow trends, make various typical patterns, and behavein a not completely disorderly manner.It is also true that each stock has its own habits and characteristics, whichare more or less stable from year to year. Certain stocks normally respondto a Bullish Phase of the market with a very large upsurge, while others,perhaps in the same price class, will make only moderate moves. You willfind that the same stocks which make wide upward swings are also the oneswhich make large declines in Bear Markets, whereas the ones that make lessspectacular up-moves are more resistant to downside breaks in the market.In Appendix A you will find in a discussion of Composite Leverage thatthere are stocks which ordinarily move many, many times as fast as others.We do not know, for example, whether a year from now Glenn Martin(EN: Read, Microsoft, Ebay) will be moving up or down, but we do know, andit is one of the most dependable things we know, that whichever way it isgoing, it will be covering ground much faster than American Telephone andTelegraph. (EN9: Even T accelerated into hyperspace after its ill-advised divestmentof local Bells. And, unlike the leopard, completely changed its spots.) These differences of habit, of course, are due to the size of issue, floating supply, natureof business, and leverage in the capital structure, matters we have touchedon briefly before. As a matter of fact, we are not especially concerned withwhy the differences exist. We are interested mainly in what the differencesare, and how we can determine them.This is important: stocks which habitually move in a narrow range,although excellent for investment purposes where stability and income arethe chief desiderata, are not good trading stocks. A fairly high degree ofsensitivity (EN: volatility), with wide percentage moves, is necessary in orderto make possible profitable commitments that will cover costs and leave anet gain. In order to be in a position to make a profit, you should see theprobability of at least a 15% move in your stock.How then are you going to tell which stocks are most sensitive andpotentially most profitable?419
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CORN PRODUCTS REF.
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FIGURES 206 and 207. Some stocks move faster than others. We have alreadynoticed that low-priced stocks have much larger percentage moves than high-pricedissues. But even between two stocks, which may, at a particular time, be selling atthe same price, there are enormous differences in their habits. Furthermore, thesehabits change very little from year to year.Here we have a weekly chart of Corn Products Refining Company (left), coveringan 18-month period in the years 1945 and 1946. Also a chart of Schenley Distillers(right) for the same period. The average price between the high and low on thesecharts is about 64½,the same for both stocks.However, during this period, we see “CFG” moving between a low of 58½ and ahigh of 71, a range of 12½ points, while at the same time, “SH” has moved between28½ and 100, a range of 71½. A thousand dollars put into outright purchase of “CFG”at its extreme low would have grown to $1210 at its extreme high, whereas the sameamount used for outright purchase of “SH” at its low would have grown to $3510.Your gain of $2510 in “SH” would be more than 10 times the gain of $210 in “CFG,”and this without using margin.It is not likely, of course, that you would actually purchase either stock at theextreme low, nor sell at the extreme high. The point we are bringing out here is thatthere are enormous differences in the swing habits of stocks.Individual stocks have their characteristic habits, and so do some entire industries.In general, the food stocks, of which “CFG” is one, are stable and slow-moving. Onthe other hand, liquor stocks make wide moves on any general advance or declineof the market. At this time “CFG” had a Sensitivity Index (EN9: Or beta equivalent) of0.58, whereas Schenley’s was 2.05.
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The Probable Moves of Your Stocks
FIGURES 208 and 209. Another example of the difference in swings between stocks. In this case also, the stocks show the sameaverage price between the high and low of the period, and both stocks are plotted for the same 18 months in 1945 and 1946.Although in a lower price range and even though the disparity in their Sensitivity Indexes is less, there is a considerable differencein their actions. Cuban–American Sugar (left), a food stock, shows a range of 76% from its low of 16½ to its high of 29, whereasElectric Boat (right), a shipbuilding concern, advances more than 140%.
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By examining the record of a certain stock for a number of years back,and comparing the percentage moves it has made with the percentage movesof the market as a whole, you can obtain a fair picture of that stock’s habits.You will not be able to say, at any particular moment, “This stock is nowgoing to move up 25%,” but you can say, with a good deal of confidence,“If the market as a whole makes an advance of 10%, this stock will probablyadvance about 25%.” Or, conversely, of course, “If the market goes down10%, this stock will very likely go down at least 25%.”Many methods have been used for measuring and checking these percentage-move habits, differing only in detail. Indexes on several hundredimportant stocks listed on the New York Stock Exchange have been computed by the authors and are presented in Appendix A.EN: Current day betas may be compared with these and/or substituted for themin other computations suggested in this book, for example in Composite Leverageformulas. The reader may read in the following text “beta” for “Sensitivity Index”and avoid the annoyance of excessive notation by the editor.The Indexes are relative. They show that stocks with a high SensitivityIndex (EN: beta) will move much faster in either Bull Markets or Bear Marketsthan stocks with low Indexes, and about how much faster, relative to theother stocks.EN: As is obvious to the experienced reader, and new to the inexperienced,Magee’s method predates the compilation of betas. Beta measures the systematicrisk of a stock, or for those who are not into financial industry jargon, the sensitivityof a stock to the market. Thus, if the market moves one point, a stock with beta of1.5 will move 1.5 points. And a stock with a beta of .5 will move a half a point.Approximately. Or more or less. For readers who like to roll their own, I offer herethe formula for computing the beta of a stock, which is somewhat more sophisticatedthan Magee’s method:
(( N )(Sum of XY )) − ((Sum of X)(Sum of Y ))whereN = the number of observationsX = rate of return for the S&P 500 IndexY = Rate of return for stock or fund.The general investor may not be avidly interested in this calculation, especiallywhen the beta is readily available at Value Line and is published regularly by MerrillLynch.Of equal or greater importance is the individual risk of a stock which professionals like to determine by computing its volatility. Somewhat akin to Magee’s“normal range for price,” volatility measures the variability of a stock’s returns(price movement). The general investor should be informed that the study of volatility is an extremely sophisticated subject, and that professionals expend enormous
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resources dealing with the question. Numerous methods are used to derive volatilities, but these mainly come into play in options arbitrage and professional tradingon exchange floors.For the private investor it is sufficient to know of the dangers of this arcanearea. Before venturing into “volatility plays,” the newcomer should take a postgraduate course. For the general investor who wants to know enough to calculate hisown volatilities (not recommended or necessary), I note the formula here:To calculate the volatility of a portfolio, first find the difference between each returnand the average. Then square each difference and add them together. Divide the sumby the number of returns minus one. This result is known as the variance. Finally,take the square root of the variance to get the volatility. Combining these steps intoa formula:n
••••••
2Step 1: Calculate the average return.R i − μ)(Step 2: Calculate the deviation of each return.σ = i =1Step 3: Square each period’s deviation.n −1Step 4: Add them together.Step 5: Divide the sum by the number of periods – 1. This is the variance.Step 6: Take the square root.
∑
The less punctilious investor may find volatilities at optionstrategist.com,cboe.com, as well as other locations findable at google.com.
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chapter twenty-five
Two Touchy QuestionsThis chapter is directed largely to the new trader, to the investor who hasfollowed other analytical methods, and to the investor type who is now, forthe first time, taking up the technical trading of stocks for the shorter term.The first question here is the use of margin. There are many people who,knowing of the disastrous margin calls of 1929 and the staggering way lossescan be multiplied against one in a margined account during a sharp breakin the market, take the attitude that the use of margin is intrinsically bad,dangerous, foolish, and unsound. They will tell you that they are willing torisk their own money, but they never speculate on borrowed funds. Theywill tell you that by buying securities outright, they are safe against any kindof break in the market.There is something to this line of argument, although very often youwill find that the arguer has not really thought the case through all the way.If he had, he might realize that, in buying outright stocks which are sensitiveor highly leveraged, he is accomplishing almost exactly the same thing assomeone else who buys more conservative stocks on a margin basis. Veryoften, despite his feeling that outright purchase is more conservative thanmargin buying, he is a speculator at heart. He is not really interested individends and a stable investment. Rather, he is looking for “something withappreciation opportunity.” And because he is not facing the issue squarely,he may fall into expensive errors.To be thoroughly consistent here, a man who shuns the risks inherentin margin trading should shun the risks of leverage and volatility. He shouldavoid risk, forget “opportunity for appreciation,” and confine himself tosound, income-producing stocks of a sort that will not fluctuate widely.If we are looking for stability, we do not want excessive fluctuation. Andthere are securities that provide stability. In this work, however, we arelooking for “swing power.” We want the highest degree of fluctuation wecan handle safely. We can secure this by buying outright a stock that isnormally subject to fairly broad swings; that is, a stock with a high SensitivityIndex (EN: beta). We can get the same effect by trading in a stock of moreconservative habits, but increasing the Composite Leverage (EN: or simpleleverage) by using margin. (The method of computing and comparing Composite Leverages in various situations is covered in Appendix A.)Let us assume, for example, that we will buy 100 shares of a ratherspeculative stock, which we will call UVW, on an outright basis. It has a425
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