effectsof regulation — has resulted in a few more “false moves,” more spells ofuninteresting (and unprofitable) inactivity. But, in the main, the market goesright on repeating the same old movements in much the same old routine.The importance of a knowledge of these phenomena to the trader and investor has been in no whit diminished.Part Two, which has to do with the practical application of these marketpatterns and phenomena, with the tactics of trading, is all new. For morethan 15 years (his total market experience extends back nearly 30 years),John Magee has invested and traded exclusively via the technical theory,kept thousands of charts, made hundreds of actual trades, tested all sorts ofapplications, audited and analyzed methods, tactics, and results from everyconceivable angle, depended on his profits for his living. His contributionis that of one who has tried and knows.
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It may well be added here — and will be often repeated in the followingpages — that the technical guides to trading in stocks are by no meansinfallible. The more experience one gains in their use, the more alive onebecomes to their pitfalls and their failures. There is no such thing as a surefire method of “beating the market”; the authors have no hesitancy in sayingthat there never will be. Nevertheless, a knowledge and judicious applicationof the principles of technical analysis does pay dividends — is more profitable (and far safer) for the average investor than any other of the presentlyrecognized and established approaches to the problems of buying and sellingsecurities.Robert D. EdwardsJuly 1948
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ContentsPreface to the Ninth Edition ...............................................................................vPreface to the Eighth Edition .............................................................................ixIn Memoriam .................................................................................................... xxiiiPrefaces to Previous Editions..........................................................................xxv
Part 1: Technical TheoryChapter 1
The Technical Approach to Trading and Investing .............3Technical vs. Fundamental Theory — Philosophy ofTechnical Approach — Drawbacks of FundamentalApproach
Chapter 2
Charts .............................................................................................9Different Types of Charts — Data Required —Arithmetic and Logarithmic Scales
Chapter 3
The Dow Theory .......................................................................13The Forerunner of All Technical Theories — Use ofMarket Averages — Basic Tenets of Dow Theory —Characteristic Phases of Bull and Bear Trends
Chapter 4
The Dow Theory in Practice ...................................................25Applying Dow Theory to the Averages through 1941 —The 1942 Action — The Bull Market Signal — TheSecondary Correction of 1943 — Bull MarketReaffirmed — The Spring of 1946 — Third PhaseSymptoms — The Bear Market Signal
Chapter 5
The Dow Theory’s Defects......................................................41Second Guessing — The “Too Late” Criticism — TheFifty-Year Record of Results — Little Help inIntermediate Term Trading
Chapter 5.1
The Dow Theory in the 20th and 21st Centuries ...............45Updating the Record of the Dow — Results to 2005 —Reconsidering Dow Theory
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Chapter 6
Important Reversal Patterns....................................................55Divergence between Individual Stocks and Averages —Definition of Reversal and Reversal Formation — TimeRequired to Build — How Insiders Distribute — TheH e a d - a n d - S h o u l d e r s To p P a t t e r n — Vo l u m eCharacteristics — Breaking the Neckline — Symmetryand Variations — Measuring Formula
Chapter 7
Important Reversal Patterns — Continued ..........................75Head-and-Shoulders Bottoms — Volume and BreakoutDifferences — Multiple Head-and-Shoulders Patterns —Rounding Tops and Bottoms — Trading Activity onRounding Turns — Dormant Bottoms — Patterns onWeekly and Monthly Charts
Chapter 8
Important Reversal Patterns — The Triangles ....................99Triangles — The Symmetrical Form — Volume — HowPrices Break Out — A Theoretical Example — Reversalor Consolidation — Right Angle Triangles, Ascendingand Descending — Measuring Implications — OnWeekly and Monthly Charts
Chapter 9
Important Reversal Patterns — Continued ........................129Rectangles — Pool Tactics — Relation to Dow Line —Double and Triple Tops and Bottoms — ImportantRecognition Criteria — Completion and Breakout —Triple Tops and Bottoms
Chapter 10
Other Reversal Phenomena...................................................151Broadening Formations — The Broadening Top —Right-Angles Broadening Patterns — Diamonds —Wedge Formations — The Falling Wedge — RisingWedges in Bear Market Rallies — The One-DayReversal — Selling Climax
Chapter 10.1 Short-Term Phenomena of Potential Importance.............181Key Reversal Days — Spikes — RunawaysChapter 11
Consolidation Formations .....................................................189Flags and Pennants — Pennant vs. Wedge — MeasuringFormula — Reliability Tests for Flags and Pennants —On Weekly and Monthly Charts — Head-andShoulders Consolidations — Scallops and Saucers —Modern vs. Old-Style Markets
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Chapter 12
Gaps............................................................................................ 211Which Gaps Are Significant? — Common or AreaGaps — Breakaway Gaps Continuation or RunawayGaps — Measuring Implications — Exhaustion Gaps —Island Reversals — Gaps in the Averages
Chapter 13
Support and Resistance..........................................................231Definition of Support and Resistance Levels — HowThey Reverse Their Roles — Reasons forS u p p o r t / R e s i s t a n c e P h e n o m e n a — Te s t s f o rDetermining Potential — Importance of Volume —Rules for Locating — Implications of a Breakthrough —Round Figures — Historical Levels — Panic Moves andRecoveries — Pattern Resistance — Support-Resistancein the Averages
Chapter 14
Trendlines and Channels.......................................................253Basic Trendlines — How They Form — Arithmetic vs.Logarithmic Scale — Intermediate Uptrends — Tests forTrendline Authority — Validity of Penetration —Throwback Moves — Amendment of Trendlines —Double Trendlines — Trend Channels — Practices toAvoid — Consequences of Penetration — IntermediateDowntrends — Corrective Trends — The Fan Principle
Chapter 15
Major Trendlines .....................................................................281Different Forms of Major Uptrends — Arithmetic andLogarithmic Scaling — Tests for Significance — MajorDowntrends — Major Trend Channels — Trendlines inthe Averages
Chapter 15.1 Trading the Averages in the 21st Century .........................295Power of Trendlines in Trading the Averages —Redrawing the Trendlines as Markets AccelerateChapter 16
Technical Analysis of Commodity Charts .........................301Theoretical Application — Commodity Markets of the20th (and 21st) Century Suitable for Technical Trading— I n t r i n s i c D i ff e re n c e s B e t w e e n S t o c k s a n dCommodities as Trading Mediums
Chapter 16.1 Technical Analysis of Commodity Charts, Part 2 ............307A 21st Century Perspective
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Chapter 17
A Summary and Some Concluding Comments................319Philosophy of Technical Approach — Review ofTechnical Methods — Need for Perspective — Patience
Chapter 17.1 Technical Analysis and Technology in the 21stCentury: The Computer and the Internet, Toolsof the Investment/ Information Revolution ......................325The Computer and the Internet — Tools of theInvestment/Information Revolution — Separating theWheat from the ChaffChapter 17.2 Advancements in Investment Technology.........................333Options and Derivatives — Quantitative Analysis —Futures on Indexes — Options on Futures andIndexes — Modern Portfolio Theory — Importance tothe Private Investor
Part 2: Trading TacticsMidword ..............................................................................................................355Chapter 18
The Tactical Problem ..............................................................359Characteristics of Desirable Speculative Stocks
Chapter 18.1 Strategy and Tactics for the Long-Term Investor .............367What’s a Speculator, What’s an Investor? — Strategy ofthe Long-term Investor (Hypothetical) — RhythmicInvestingChapter 19
The All-Important Details.....................................................375Source of Data — Suggestions on Chart Keeping —Using Computer Technology
Chapter 20
The Kind of Stocks We Want — The Speculator’sViewpoint..................................................................................379Leverage — Swing Habit — Volatility
Chapter 20.1 The Kind of Stocks We Want — The Long-TermInvestor’s Viewpoint...............................................................383Changing Opinions about Conservative Investing —Index Shares and Similar Instruments — Importance ofModern Trading Instruments
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Chapter 21
Selection of Stocks to Chart..................................................391Character and Habits — Number — Advantages ofListed Issues
Chapter 22
Selection of Stocks to Chart — Continued ........................395Diversification — Price Range — Swing Power withinGroups — Slow-Moving Groups
Chapter 23
Choosing and Managing High-Risk Stocks: TulipStocks, Internet Sector, and Speculative Frenzies............401Managing Speculative Frenzies and Runaways
Chapter 24
The Probable Moves of Your Stocks...................................419Choosing Stocks which Have the Potential to Move —Volatility
Chapter 25
Two Touchy Questions...........................................................425Use of Margin — Short Selling
Chapter 26
Round Lots or Odd Lots? ......................................................433Extra Cost of Odd Lots — Occasional Advantages —Determining Trade Size and Risk
Chapter 27
Stop Orders...............................................................................435Protective Stops — Computing Stop Levels — Table ofStop Distances — Progressive Stops
Chapter 28
What Is a Bottom — What Is a Top?...................................441The Three Days Away Rule — Basing Points — VolumeSignals
Chapter 28.1 Basing Point Case Analyzed, Illustrated............................446Chapter 29
Trendlines in Action ...............................................................451Buying Stock — Selling Long Stock — Selling StockShort — Covering Short Sales — Additional Suggestions
Chapter 30
Use of Support and Resistance ............................................461Formulating a Rule for Buying — When a Support Fails— Placing Stop Orders — Software for DeterminingSupport-Resistance
Chapter 31
Not All in One Basket............................................................467Diversification — Its Cost and Benefits — Trading IndexShares
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Chapter 32
Measuring Implications in Technical Chart Patterns......469Reactions vs. Primary Moves
Chapter 33
Tactical Review of Chart Action ..........................................473Dow Theory — Head-and-Shoulders — Multiple Headand-Shoulders — Rounding Tops and Bottoms —Triangles — Broadening Tops — Rectangles — DoubleTops and Bottoms — Diamonds — Wedges — One-DayReversals — Flags and Pennants — Gaps — Supportand Resistance — Trendlines
Chapter 34
A Quick Summation of Tactical Methods .........................501When to Get Out — When to Get In
Chapter 35
Effect of Technical Trading on Market Action .................505Many Types of Investors — Technicians a MinorityGroup — Persistence of Ingrained Evaluative Habits
Chapter 36
Automated Trendline: The Moving Average ....................507Sensitizing Moving Averages — Crossovers andPenetrations
Chapter 37
“The Same Old Patterns” ......................................................513Repetitive Character of Market Behavior Over theYears — Additional Chart Examples Covering MarketAction up through 2005
Chapter 38
Balanced and Diversified.......................................................577The “Not All” Principle — The Evaluative Index —Reducing Risk and Anxiety — Identifying Bull and BearMarket Tops and Bottoms with the Magee EvaluativeIndex
Chapter 39
Trial and Error ..........................................................................585Putting Experience to Work
Chapter 40
How Much Capital to Use in Trading ................................587
Chapter 41
Application of Capital in Practice .......................................591Using Composite Leverage According to the Market’sCondition — Overall Strategy
Chapter 42
Portfolio Risk Management ..................................................597Finding the Sensible Risk Posture — Overtrading andUndertrading — Controlling Risk per Trade — Risk ofa Single Stock — Risk of a Portfolio — Pragmatic
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Portfolio Theory — Pragmatic Portfolio RiskMeasurement — Pragmatic Portfolio Analysis — TheMagee Method of Controlling the RiskChapter 43
Stick to Your Guns..................................................................609
APPENDIX A Chapters A–DChapter A
The Probable Moves of Your Stocks(Chapter 24 from the Seventh Edition) .............................. 611Relative Sensitivity — The Market Reciprocal — NormalRange-for-Price-Volatility
Chapter B
A Discussion of Composite Leverage(Chapter 42 from the Seventh Edition) ..............................613Overtrading and a Paradox — The Composite LeverageIndex of a Single Stock — Composite Leverage of aPortfolio — Investment Account Policy — NegativeComposite Leverage
Chapter C
Normal Range-for-Price Indexes(Appendix B, Fifth Edition) ..................................................619
Chapter D
Sensitivity Indexes of Stocks(Appendix C, Fifth Edition) ..................................................621
Appendix B .........................................................................................................629Section 1: The Mechanics of Building a Chart(Chapter 23 from the Fifth and Seventh Editions)Section 2: TEKNIPLAT Chart PaperAppendix C
Technical Analysis of Futures Charts(Chapter 16 from the Seventh Editionby Richard McDermott) .........................................................639Applications for the Use of Chart Patterns and OtherIndicators in the Trading of Futures/Derivatives —Moving Averages, Bollinger Bands, Stochastics, andOthers
Appendix D Resources...................................................................................669Important Internet Sites — References for Further Study— Investment Oriented Sites — The Sharpe Ratio —Calculating Volatility — Gambler’s Ruin — Essence ofFundamental Analysis — Useful Software and SpecificInternet Technical Analysis Sites
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Appendix E
Example of Trading Manual: Original TurtleTrading Systems and Procedures .........................................681
List of Illustrations and Text Diagrams ........................................................703Index of Charts by Stock Name .....................................................................722Glossary ...............................................................................................................743Bibliography .......................................................................................................769Index .....................................................................................................................773
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part one
Technical Theory
1
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chapter one
The Technical Approachto Trading and InvestingFew human activities have been so exhaustively studied during the pastcentury, from so many angles and by so many different sorts of people, ashas the buying and selling of corporate securities. The rewards which thestock market holds out to those who read it right are enormous; the penaltiesit exacts from careless, dozing, or “unlucky” investors are calamitous. Nowonder it has attracted some of the world’s most astute accountants, analysts, and researchers, along with a motley crew of eccentrics, mystics, and“hunch players,” and a multitude of just ordinary hopeful citizens.Able brains have sought, and continue constantly to seek, for safe andsure methods of appraising the state and trend of the market, of discoveringthe right stock to buy and the right time to buy it. This intensive researchhas not been fruitless — far from it. There are a great many successfulinvestors and speculators (using the word in its true sense, which is withoutopprobrium) who, by one road or another, have acquired the necessaryinsight into the forces with which they deal and the judgment, the forethought, and the all important self-discipline to deal with them profitably.In the course of years of stock market study, two quite distinct schoolsof thought have arisen, two radically different methods of arriving at theanswers to the trader’s problem of what and when. In the parlance of “theStreet,” one of these is commonly referred to as the fundamental or statistical,and the other as the technical. (In recent years a third approach, the cyclical,has made rapid progress and, although still beset by a “lunatic fringe,” itpromises to contribute a great deal to our understanding of economic trends.)The stock market fundamentalist depends on statistics. He examines theauditors’ reports, the profit-and-loss statements, the quarterly balance sheets,the dividend records, and policies of the companies whose shares he hasunder observation. He analyzes sales data, managerial ability, plant capacity,the competition. He turns to bank and treasury reports, production indexes,price statistics, and crop forecasts to gauge the state of business in general,and reads the daily news carefully to arrive at an estimate of future businessconditions. Taking all these into account, he evaluates his stock; if it is sellingcurrently below his appraisal, he regards it as a buy. (EN9: And, no surprise,the buyer’s name is Warren Buffet, and he buys the company, not the stock, forwhile this is an excellent way to buy companies it is not a very good way to buystocks.) EN: Read Robert Prechter’s summation of the fundamental methodology asan amusing endnote at the end of this chapter.3
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Technical Analysis of Stock Trends
As a matter of fact, aside from the greenest of newcomers when theyfirst tackle the investment problem, and to whom, in their inexperience, anyother point of view is not only irrational but incomprehensible, your purefundamentalist is a very rare bird. Even those market authorities who pretend to scorn charts and “chartists” utterly are not oblivious to the “action”chronicled by the ticker tape, nor do they conceal their respect for the DowTheory which, whether they realize it or not, is, in its very essence, purelytechnical.
Definition of Technical AnalysisThe term “technical,” in its application to the stock market, has come to havea very special meaning, quite different from its ordinary dictionary definition. It refers to the study of the action of the market itself as opposed to thestudy of the goods in which the market deals. Technical Analysis is the scienceof recording, usually in graphic form, the actual history of trading (pricechanges, volume of transactions, etc.) in a certain stock or in “the Averages”and then deducing from that pictured history the probable future trend.EN: With the advent of the computer, many schools of technical analysis have arisen.Number-driven technical analysis, e.g., moving average studies oscillators, etc.,attempts to completely objectify the analysis of the markets. The work of Edwardsand Magee is the embodiment and definition of “classical technical analysis.” SeeAppendix C.The technical student argues thus: it is futile to assign an intrinsic valueto a stock certificate. One share of United States Steel, for example, was worth$261 in the early fall of 1929, but you could buy it for only $22 in June of1932! By March 1937, it was selling for $126 and just 1 year later for $38. InMay of 1946, it had climbed back up to $97, and 10 months later, in 1947,had dropped below $70, although the company’s earnings on this last datewere reputed to be nearing an all-time high and interest rates in generalwere still near an all-time low. The book value of this share of U.S. Steel,according to the corporation’s balance sheet, was about $204 in 1929 (end ofthe year); $187 in 1932; $151 in 1937; $117 in 1938, and $142 in 1946. Thissort of thing, this wide divergence between presumed value and actual price,is not the exception; it is the rule. It is going on all the time. The fact is thatthe real value of a share of U.S. Steel common is determined at any giventime solely, definitely, and inexorably by supply and demand, which areaccurately reflected in the transactions consummated on the floor of the NewYork Stock Exchange.Of course, the statistics which the fundamentalists study play a part inthe supply–demand equation — that is freely admitted. But there are manyother factors affecting it. The market price reflects not only the differingvalue opinions of many orthodox security appraisers, but also all the hopesand fears and guesses and moods, rational and irrational, of hundreds ofpotential buyers and sellers, as well as their needs and their resources — intotal, factors which defy analysis and for which no statistics are obtainable,
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The Technical Approach to Trading and Investing
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240U. S. STEEL
X
220
200
180160
140
120
100
80
60
40
20
1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 1942 1943 1944 1945 1946
FIGURE 1. Monthly price ranges of U.S. Steel common from January 1929 toDecember 1946. Compare the great swings in the market price for this stock — from1929 (extreme high, 261¾) to 1932 (extreme low, 21¼), from 1932 to 1937, from 1937to 1938, from 1942 to 1946 — with its book values for those years as cited on theprevious page.
but which are nevertheless all synthesized, weighed, and finally expressedin the one precise figure at which a buyer and a seller get together and makea deal (through their agents, their respective stock brokers). This is the onlyfigure that counts.Moreover, the technician claims, with complete justification, that thebulk of the statistics which the fundamentalists study are past history,already out of date and sterile, because the market is not interested in the
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Technical Analysis of Stock Trends
past or even in the present! It is constantly looking ahead, attempting todiscount future developments, weighing and balancing all the estimates andguesses of hundreds of investors who look into the future from differentpoints of view and through glasses of many different hues. In brief, the goingprice, as established by the market itself, comprehends all the fundamentalinformation which the statistical analyst can hope to learn (plus some thatis perhaps secret from him, known only to a few insiders) and much elsebesides of equal or even greater importance.All of which, admitting its truth, would be of little significance were itnot for the fact, which no one of experience doubts, that prices move intrends and trends tend to continue until something happens to change thesupply–demand balance. Such changes are usually detectable in the actionof the market itself. Certain patterns or formations, levels or areas, appearon the charts which have a meaning, and can be interpreted in terms ofprobable future trend development. They are not infallible, it must be noted,but the odds are definitely in their favor. Time after time, as experience hasamply proved, they are far more prescient than the best-informed and mostshrewd of statisticians.The technical analyst may go even further in his claims. He may offerto interpret the chart of a stock whose name he does not know, so long asthe record of trading is accurate and covers a long enough term to enablehim to study its market background and habits. He may suggest that hecould trade with profit in a stock knowing only its ticker symbol, completelyignorant of the company, the industry, what it manufactures or sells, or howit is capitalized. Needless to say, such practice is not recommended, but ifyour market technician is really experienced at his business, he could, intheory, do exactly what he claims.Should the reader, at this point, find the technical approach to tradingor investing, as explained in the foregoing, completely abhorrent, perhapshe had better close the book now. For it is primarily the technical approach,the science of technical analysis, with which the remainder of the book deals.
EN: The Elliott Wave Theory: Perspective and Comments*This week we had the pleasure of attending the December meeting of the MarketTechnicians Association of New York.Long-term subscribers will remember the MTANY as the organization whichhonored John Magee with its “Man of the Year” award in 1978. The speaker wasRobert Prechter, publisher of “The Elliott Wave Theorist,” an investment advisorywhich bases its forecasts on interpretations of R.N. Elliott’s work on the stockmarket.…Of primary interest to SAS subscribers are Prechter’s comments on technicalanalysis itself. The Elliott Wave Theory, it must be remembered, is really no morethan a “catalog” of stock market price movements, laid one on top of the other, so* From the John Magee Market Letters, December 15, 1984.
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Chapter one:
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to speak, until a grand, underlying, and enduring pattern is observed; in short, puretechnical analysis. Among Prechter’s definitions and observations regarding fundamental analysis are the following:1. “First let’s define ‘technical’ versus ‘fundamental’ data…technical data isthat which is generated by the action of the market under study.”2. “The main problem with fundamental analysis is that its indicators areremoved from the market itself. The analyst assumes causality betweenexternal events and market movements, a concept which is almost certainlyfalse. But, just as important, and less recognized, is that fundamentalanalysis almost always requires a forecast of the fundamental data itselfbefore conclusions about the market are drawn. The analyst is then forcedto take a second step in coming to a conclusion about how those forecastedevents will affect the markets! Technicians only have one step to take, whichgives them an edge right off the bat. Their main advantage is that they don’thave to forecast their indicators.”3. “What’s worse, even the fundamentalists’ second step is probably a processbuilt on quicksand.… The most common application of fundamental analysis is estimating companies’ earnings for both the current year and nextyear, and recommending stocks on that basis.… And the record on that basisalone is very poor, as Barron’s pointed out in a June 4 article, which showedthat earnings estimates averaged 18% error in the 30 DJIA stocks for anyyear already completed and 54% error for the year ahead. The weakest link,however, is the assumption that correct earnings estimates are a basis forchoosing stock market winners. According to a table in the same Barron’sarticle, a purchase of the 10 DJIA stocks with the best earnings estimateswould have produced a 10-year cumulative gain of 40.5%, while choosingthe 10 DJIA with the worst earnings estimates would have produced awhopping 142.5% gain.”We enjoyed Prechter’s polished exposition of a technical approach different fromour own. As for his observations about fundamental analysis, we simply couldn’tagree more.
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chapter two
ChartsCharts are the working tools of the technical analyst. They have been developed in a multitude of forms and styles to represent graphically almostanything and everything that takes place in the market, or to plot an “index”derived therefrom. They may be monthly charts on which an entire month’strading record is condensed into a single entry, or weekly, daily, hourly,transaction, “point-and-figure,” candlestick, etc. They may be constructedon arithmetic, logarithmic, or square-root scale, or projected as “oscillators.”They may delineate moving averages, proportion of trading volume to pricemovement, average price of “most active” issues, odd-lot transactions, theshort interest, and an infinitude of other relations, ratios, and indexes — alltechnical in the sense that they are derived, directly or indirectly, from whathas actually been transacted on the exchanges.With most of these, fortunately, we shall not need to concern ourselvesat all; they are of interest only to the full-time economic analyst. Many ofthem have derived from a completely futile (so far, at least) endeavor todiscover some one “mechanical” index or combination of indexes which willalways, automatically, without ever failing or going wrong, give warning ofa change in trend; such, in our experience, are often confusing and sometimesdownright deceptive at a most critical juncture. This book, however