reaches an important trendline or pattern borderor Resistance Area. This heavy volume means one of two things. Usually itmeans that the Minor Move has come to an end, that this is the top of therise for the moment. Occasionally, however, the volume may signal the startof a breakaway move that may run up several (and perhaps many) points,almost vertically. (The reverse situation, of course, may develop on downsidemoves.)If, noticing the heavy volume following a good rise, and assuming thatthis day marks the end of the move, you sell the stock at the market or at alimit, you are going to be dreadfully disappointed if this should be one ofthose rare cases where the stock opens next day on an upside gap andcontinues 3, 5, or 20 points up in the following days. On the other hand,experience will have shown you that it will not pay to expect that sort ofmove very often. You will know that, nine times out of ten, you will be betteroff out of the stock.Very well. After such a day when volume is exceptionally high (providedthis is not the first day of breakout into new high ground beyond the lastprevious Minor Top), cancel your protective stop and set a stop order forthe day only, just ⅛ point under the closing price. For example, you havebought a stock at 21. It goes up on moderate volume, smashes through theold Minor Top one day at 23 on very heavy volume, the next day continuesto 23¾ on moderate volume, the third day advances on moderate volume
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to 24¼, and, finally, the fourth day makes a rise to 25 on much heavier volumethan it has shown on any day of the rise except the day it broke through 23.The morning after this close at 25, you will notice the volume signal. Youwill cancel your protective stop, which may be at 18, and you will place astop order, for the day only, to sell on stop at 24⅞. In most cases, this willmean that your stock will be stopped out on the first sale of the day. Andyou may get a slightly lower price than you would get with a straight marketorder. On the other hand, after a day of high volume activity, you are notlikely to be left in a thin market; there should be bids enough, near the top,to get you out at or near your stop price.Meanwhile, you are protected against losing the stock if there should bea continued move in the right direction. Suppose the opening the morningafter you set your stop at 24⅞ should be a gap at 25¼, and that prices thenmove up further, closing at 26. (On “runaway” moves of this sort, the closingfor the day during the move is likely to be at the top.) You will then set yourstop, again for a single day only, at 25⅞. If the stock then opens at 26⅜ andmoves up to 28, you will set another day stop at 27⅞, which, let us assume,is caught at the opening the following day at 27⅝. In this example, you riskedonly ⅛ point on the first day, and eventually netted an extra gain of 2⅝points. This, it should be pointed out, is all net gain, since your commissionsare approximately the same in either case.A progressive stop of this sort can be indicated on the chart by any markyou choose to use; for example, a band of short diagonal lines. When a stockmoves for several days in a runaway move, you may repeat this mark eachday, indicating a tight stop ⅛ point under the close for each successive day,until finally, one of these stops is caught. In the case of short sales, a buystop is used in precisely the same way as the selling stop we have discussed,to follow the stock down on a sharp runaway dive.*This use of stop orders is indicated wherever a stock has reached itsreasonable objective on high volume, or where it has exceeded its objectiveand is moving out of the Trend Channel in free air, so to speak, and in somecases, where the stock has failed to reach its objective.If your stock, for instance, is rising in a Trend Channel, and, abouthalfway between the lower and upper trendlines, suddenly develops greatvolume, then a progressive tight stop will protect you against the threatenedfailure of the move. Extreme volume in such a case, before there has been abreakout to a new high above the last Minor High, is definitely a warningand a threat. This would be especially true if there were also a gap or a OneDay Reversal at this point.* In the case of a stock which has presumably completed its profitable move and has given aMinor Top signal by volume, you may place a near (EN: or “Hair-trigger” Stop) (⅛ point) stopthe first day. If the stock moves up the next day, without abnormal volume, you may leave thestop at this same point each day until another “blowoff” or Top signal appears; that is, untilyou see another day of heavy volume, a gap, or a One-Day Reversal, and then move the stopup to ⅛ point below the close of that day. This method often works out somewhat better thanthe continuously progressive near stop.
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The one day on which a tight stop would not be applied after heavyvolume had appeared would be the day the stock made a new high, runningentirely through the previous Minor Top and closing above it. This actiongenerally means the move is not yet completed. However, should the movecontinue higher and again show heavy volume, even if it is the very nextday, we would then protect with a progressive stop.In this chapter, as throughout the book, the expression “heavy volume”means heavy only with respect to the recent volume of sale in the stock youare watching. A thousand shares may be significantly heavy volume in somethin issues, whereas 10,000 shares would be no more than a normal turnoverin more actively traded stocks. The volume chart itself will show, by a marketpeak, when a day of abnormally heavy volume occurs.It should be understood that the progressive stops we have been discussing are intended to take short-term gains, or to close out an exceptionallyprofitable runaway move terminating in an Intermediate Climax. While theextreme conditions that call for this type of operation are by no means rare,they are not the usual, everyday action of the market. In the case of ordinaryMinor Tops, even when they are fairly apparent on the basis of Trend Channels, volume peak, and other indications, many traders and investors willprefer to wait out the expected reaction rather than pay additional commissions and lose a position that is still presumably in a favorable Major Trend.In short, the progressive stop is a device which may be very useful onoccasion, but it is intended to cope with a special and somewhat unusual move.The protective stops, on the other hand, offer the average trader, theman who is not able to spend his entire time studying the market, or whohas not had long experience, a device by which he can limit his possible loss.He will be protected from his own unwillingness to close out the bad holding,and so, he will avoid the ruinous condition of becoming frozen into a hopeless situation. Since he will be taken out automatically, regardless of whetherhe has an ultimate gain or loss, he will have the capital to use in better-looking issues and will not have to worry about the prospects of recovery in hisstock after it has gone many points against him.However, if one has sufficient knowledge and sufficient determination toget out as soon as the trend has shown convincing evidence on a turn, there isless need for the stop orders. EN: This editor believes that only the proventrader-investor should trade without a stop in the market. The reader may determineif he meets this criterion by examining his portfolio to see if he has ever let a loss run,or allowed a significant profit to slip away. If so he, or she, or they, or it, is not proven.It is possible for such a person to operate successfully without them; and thereare some advantages in doing this, since a stop order will occasionally be caughtby a false move or an extended dull reaction. There are also advantages in notusing stop orders for the experienced technician who is looking toward apossible long-term gain and who is willing to wait out a Secondary reaction.But it is a thousand times better for the person who is not sure of his methodsto be stopped out early, then to be left holding a stock bought at, say 60, whenit has declined to 29 — or to 5!
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What Is a Bottom — WhatIs a Top?EN9: In this extremely important chapter I have left intact Magee’s usage of “Topsand Bottoms.” It will be less potentially confusing for the reader to think of “highsand lows” as that terminology is commonly used in the business in the modern era.Also, thinking in terms of highs and lows is an important concept in itself. Thus,for a bull trend, higher highs, higher lows. And when this pattern is broken in animportant way the trader should be alert for a trend change. And, as the use ofeighths is of the essence in Figure 210, I have left the discussion in eighths whilethe reader knows that decimals are now used in the markets.In this chapter, we are not talking about what makes a Major Top or Bottom,nor what makes an Intermediate Top or Bottom. We are speaking of the MinorTops and Bottoms that give us important hooks on which to hang ourtechnical operations. Stop-order levels, trendlines, objectives, Supports andResistances are determined by these Minor Tops and Bottoms. They are ofprime importance to us as traders.Usually, these Minor Tops and Bottoms are well marked and perfectlyclear. Often they are not. Sometimes, it is not possible to say definitely thatthis or that place is or is not a Top or Bottom. But it is possible to set certainstandards, practical working rules, that will help us in making these points;and these rules will not fail us too often.A good rule for setting stop levels is to consider that a Bottom has beenmade when the stock has moved “three days away” from the day markingthe suspected low of the Bottom. If a stock reacts for some days and finallymakes a low at 24, with a high for that day at 25, then we will not have anestablished Bottom until we have had 3 days in which the stock sells at nolower than 25⅛. The entire price range for 3 full days must be entirely abovethe top price for the day making the low. This is the “three days away” rule,and it would apply in reverse in declining markets, where the range for3 days must be entirely below the entire range of the day making the high.This gives a rule for setting an original stop order. It also gives a rulefor changing the stop order. As soon as the stock has moved 3 days awayfrom a new Bottom, we move the stop order to a position below that Bottom.(We have already explained in Chapter 27 how we determine the distancethis stop level should be below the Bottom.)441
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1716AMERICAN CABLE & RADIO
ACR
15141945–194613121110Sales100’s
25020015010050JULYAUGUSTSEPTEMBER OCTOBERNOVEMBER DECEMBER7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1 8 15 22 29 5
FIGURE 210. Advance of a protective stop order in a long commitment. The dailychart of American Cable and Radio in the summer of 1945 made a Rounded Bottom,part of a long period of Consolidation following the advance which ended in July1944. A breakout on heavy volume occurred September 12, and purchases were thenpossible on any Minor Reactions.The first protective stop would immediately be placed 6% below the previousMinor Bottom of August 21, using the table given in Chapter 27. This would put thestop level at 9⅞. On September 19 and 20, we would have 2 days of market actionentirely “away” from the September 17 Minor Bottom, and, on September 28, a thirdday. We would then move the stop up to 6% under the September 17 Bottom, or to10⅝. The next move would come after the new high closing of October 11, which ismore than 3% higher than the October 1 Minor Peak. The stop would now be placedat 11⅞. On November 2, a new high close was registered more than 3% over theOctober 15 Minor Peak; the stop would be raised to 12¾. On November 15, anotherhigh closing topped by over 3% the Minor Peak made on November 7. The stopwould be moved up again, this time to 13½. November 29 made the third day theentire range was “three days away” from the November 26 Bottom, and the stopwas upped to 13¾. The closing on December 5 gave us a 3% advance over theNovember 17 high, and again we moved the stop, raising it to 14⅞. Finally, on January3, 1946, this stop was caught as shown on the chart. In a Bear Market, protectivestops would be moved down in exactly the same manner to protect a short sale. EN9:A number of inconsistencies exist in this figure and caption which are clarified later in the text.
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Protective stops for long stocks can move only up. A stop level, onceestablished, is never to be moved down except when the stock goes ex-dividend or ex-rights; then the stop may be dropped the amount of the dividendor rights. Similarly, protective stops for short sales are to be moved onlydown, and may not be raised. (In the case of ex-dividends and ex-rights, theshort-sale stop would be dropped the amount of the dividend or rights.)There are certain situations where it is difficult to determine Bottomsand Tops; where, indeed, it seems as though a Consolidation or Correctionhad been made without any significant move in the Secondary Direction. Insuch cases (as contrasted to the obvious situation where the stock moves upor down in series of well-marked steps and reactions, like a staircase), youwill need all your judgment and experience to determine where the MinorBasing Points actually occur.
Basing PointsLet us call the levels which determine where stops should be placed BasingPoints. In a Bull Market Move, we will consider the Bottom of each MinorReaction as a Basing Point, from which we will figure our stop-order levelas soon as the stock has moved up to “three days away.” We will also useeach Minor Top as a Basing Point in a Bull Move. In a Bear Market, we willconsider the Tops of each rally and also each Minor Bottom as Basing Pointsfor the protective stops, in the same way.Where a stock makes a substantial move in the Primary Direction, saya move of 15% or more, and then moves back at least 40% of the distancecovered from the previous Basing Point to the end of the Primary Move, thatsurely gives us a Basing Point as soon as the stock again starts off in thePrimary Direction. However, if the stock reacts less than 40%, perhaps evenmarks time at the same level for a week or more, that should also be considered a Basing Point as soon as the move in the Primary Direction iscontinued (provided the volume indications are right).The daily volume, as we have seen, is like the trained nurse’s clinicalthermometer; it tells a great deal about what is happening in a stock, morethan the superficial symptoms of price alone. There are three times at whichyou may look for exceptionally heavy volume: (1) on the day of breakoutfrom a pattern or a period of inaction, especially if the breakout is on theupside; (2) on the day on which the stock goes into new ground in thePrimary or Intermediate Direction, that is, goes above the last Minor Top ina Bull Market, or below the last Minor Bottom in a Bear Market; and (3) theday on which the Minor Move is completed or nearly completed, that is, thenew Minor Top in a Bull Market and the Minor Bottom in a Bear Market.To this we might add that extra heavy volume on any other day during amove in the Primary Direction is likely to indicate that the move is at anend and will not complete the hoped-for advance or decline.
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Now, after a Minor Top has occurred, the stock now being in new highground, and the Top having been made on very heavy volume, we may lookfor the corrective move. Ordinarily, that would be a decline of several days,a week, sometimes longer. Occasionally, the correction, as we said a fewparagraphs back, will take the form of a horizontal hesitation lasting a weekor more without any particular corrective move in the downward direction.Where there is a downward correction, it is likely to come down to or nearthe Top of the last previous Minor High (support). Also, and often at thesame time, the corrective move will carry down to the Basic Trendline drawnthrough two or more previous Minor Bottoms; or to the “parallel”; or to atrendline drawn through the last two or more previous Minor Tops. If thecorrective move is horizontal, it is likely to run out until it meets one of theselines.In any case, the thing to watch for is the decline of volume. If the tradingshrinks, perhaps irregularly, but on the whole, steadily, for some days aftera new Top has been made, during which time the stock either reacts or, atany rate, makes no progress in the Primary Direction, then you are justifiedin considering this as a Minor Correction. If the stock now continues thePrimary Move and gets to a point that is “three days away,” you can considerthe Bottom (that is, the point you draw your trendline through, not necessarily the extreme low point in the case of horizontal moves) as a new BasingPoint.Where a stock is starting what appears to be a new move, a breakoutfrom a period of vacillating moves, it is sometimes hard to say preciselywhat point should be considered the Bottom. There may be several smalland indecisive moves on low volume preceding the real breakout. In sucha case, we would consider the appearance of high volume as the breakoutsignal, and set our Basing Point at the low point immediately preceding thissignal. There will usually be such a point on one of the low-volume days inthe 3 or 4 days just before the breakout.All that has been said about Basing Points in a Bull Market would alsobe true, in reverse, in a Bear Market, except that heavy volume does notalways accompany a downside breakout.Now there comes the difficult and distressing situation where the stock,having made a long runaway move (let us assume it is an upward move),starts out, apparently, to make a Flag, and is bought after a sufficient correction of 40% with a decline of volume, and then continues to go downsteadily, without any rallies and without any clear volume indications. Thisis an unusual situation, but it does happen on both the upside and thedownside, from time to time. In the case we have just mentioned, we wouldlook for Support Levels (Consolidation Patterns, Multiple Tops, etc.) formedon the way down in the previous trend, and lying below the level at whichwe purchased the stock. We would use these supports as Basing Points ratherthan hold a stop under the extreme Bottom of the vertical move.In many cases of this type, you will not be able to find adequate BasingPoints. Therefore, it seems unwise to try to get in on corrections after long
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runaway moves except: (1) where the stock has risen well above good Support that can serve as a Basing Point, or (2) where the stock is completelyabove all prices for several years and is moving “in the clear.” (The reverse,of course: in Bear Markets, the stock should have fallen below a strongResistance Area, or must be in new low ground for the past several monthsbefore you consider a short sale.) And in any case of this sort where you arethinking of a trade in a stock that appears to be making a Consolidationafter a fast, long, vertical move, you must have pronounced and conspicuousdrying up of volume throughout the formation of the Flag or Pennant Correction.There is one more word of caution needed here regarding trading in anIntermediate Trend. A series of moves in a trend will often take place in veryregular form. There may be a good trendline, and the reactions may be about40% to 50% and may come back to the previous Minor Tops. The volumeon the Corrections may shrink, with increasing volume on the new Tops. Itis easy to start trading on such a “staircase” in the expectation that the moveswill continue to be regular and consistent. But trends do not go on forever.Any Minor Top may be the last. The importance of finding your BasingPoints is to enable you to get out, at best, on any closing violation of one ofthese points, and at worst, on your protective stop order. The volume mayagain come to your aid in this question of when to stop trading on a trend.Although you look for high volume on the Tops, you will be exceedinglysuspicious of volume that is much higher than that on any of the precedingMinor Tops (or Bottoms in a Bear Market). The final, or the next-to-final,“blow-off” of a trend will usually show more volume than any of the Minorblow-offs along the way; and when you see such climactic volume, youshould prepare to retire into your shell and wait for a full Correction of theentire series of moves making up your Intermediate Trend. Later, weeks later,or perhaps months later, you may find the stock has corrected 40% or moreof the whole Intermediate Move and is resting quietly with very little activity.Then is the time to watch it for new opportunities and a new trend in thePrimary Direction.EN9: In a book composed of nothing but important chapters this Chapter 28 mightnot get the emphasis it deserves from the unwary reader. In fact the procedureoutlined here is of absolutely basic importance in analyzing and trading trends. InChapter 28.1 I have added to it material which has been of great importance to mytrading and to the trading of my students.
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Basing Points – A Case AnalyzedThe longer one thinks about the chart so casually tossed off in Figure 210the more he realizes that it embodies a profound and natural understandingof trends and the market. Consider — wave up, wave recedes; wave up,wave recedes, and so on. As long as the trader or investor is not chased fromhis position by the corrective wave he will under normal circumstances ridethe trend to its natural end. But locals and hedge funds and those who profitfrom volatility know that the previous low is where investors and tradersset their stops. So in the ordinary flow of trading if they see an opportunityto take out an important low they will do it. If possible. And it is sometimespossible. And the low sometimes falls from the natural flow of trading.Bruce Kovner, on being interviewed by Jack Schwager (Market Wizards),was asked where he set his stops. “Where they’re hard to get to,” he said.A stop set on a basing point with a prudently calculated filter is hard to getto, unless the market has truly reversed direction. In fact, what is a long-termmoving average but a lagging stop with a filter built in?And what are Basing Points but the marking of highs and lows in fullrealization that a pattern of higher highs and higher lows is a bull trend,and when that pattern changes to one of lower highs and lower lows thetrend is changing, or has changed. This is the principle behind Dow Theory,and it is the principle behind trading trends of lesser duration than Dowtrends. And, as is quickly realized, a pattern of lower highs and lower lowsmeans inevitably that the trendline has been broken.As for Figure 210, Mark Twain had some cogent comments on it. Hesaid that anyone trying to make sense of it would go crazy, and anyonetrying to justify the prices with the chart would be shot. Figure 210 preservesunexplainable conundrums and conflicts carefully preserved since the earliest editions. The reader is urged to take it as a concept rather than usingit as a lesson. And see Figure 210.1. Therefore let me codify the rules implicitly presented in the Figure:1. A high is made, being recognized by no higher prices occurring forthe moment.2. Prices recede and a low is made. This low is found by watching eachday after the previous high until no lower prices are made. As pricesbegin to rise again we note each day on which prices are completelyoutside the range of our low day candidate.
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3. When three such days are observed before a new low is made wemark the candidate day as a Basing Point and raise our stop to 6%(or x%) under the low of the basing point day. (See Chapter 27).4. If a new high is 3% greater than the previous high a new Basing Pointis found at the low of the new high day.
The Basing Points ParadigmBy no means will every issue be amenable to this kind of analysis. But themethod is so paradigmatic that it is worth examining at greater length. Andlike virtually every other method of classical chart analysis it must be usedwith caution and good and thoughtful judgement. Sometimes on somestocks it will seem to work as smooth as silicon lubricant and on other issuesit will appear to be useless. However, even on recalcitrant issues the principles underlying the method will be of use, if not the actual method itself.With this in mind Figure 210.1 is presented. The careful reader will see thatthe chart in this example uses only bottoms or lows in stop setting and doesnot advance stops on the making of new highs as in Figure 210. This is donefor instructional purposes and to keep the example simple for the generalinvestor. More advanced traders will want to study and perhaps utilize thetechniques in Figure 210.Figure 210.1 actually serves more than one instructional purpose. Itillustrates a picture perfect case of the use of Basing Points, and it alsoillustrates a complete analysis of a bull market from entry to exit with keysmarking events in the life of the market. Thus, the observation of BasingPoints, the setting of the stops, the tracking of potentially false turns are allnoted. The chart is accompanied by the keys. Originally the marked andkeyed chart was used in graduate seminars at Golden Gate University forinstructional purposes. Shortly it became obvious that marking the chart inthis manner was extremely useful in trading. So it is suggested to the readeras a way of making his charts more communicative and more useful.
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FIGURE 210.1 Apple Computer, bull market of 1987. A near perfect example of the use of Basing Points fortrading of a reasonably regular and smooth bull market. Only low wave Basing Points are illustrated.
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KEY TO FIGURE 210.1 ANALYSIS1. A rounding bottom, or perhaps a scallop.2. Resistance or breakout line.3. Wake up call on volume.4. Run Day, big volume. Breakout through line 2. Sure entry signal.5. First Basing Point (BP) Notice prior volume fall off in consolidation, and surgeon run-day. A stop was entered before this BP using the low of the formationbefore the entry.6. BP7. A weak BP (because of shallowness of retracement)8. BP9. Test of BP at 8.10. A trendline drawn after point 9.11. BP12. BP candidate which fails 3 day rule.13. BP14. A potential BP but not a very good one because new high has not been madefrom 13.15. A support/resistance line.16. BP.17. BP18. A resistance/support line.19. Flag which becomes BP.20. TL, but too steep to last.21. Trendline.22. BP23. Trendline.24. BP25. BP26. Horizontal trendline.27. BP at 26.75 (stop 25.41). Stopped out at 25.41.A Narrative of the events in the Chart1,2,3. Had we been asleep the event at number 3 should have awakened us. A volumeday like this should catch the attention, and we begin paying attention to the stockand note the pattern that has been developing—the rounding bottom, or scallop.4. And at number 4 we see a ‘run day’ on heavy volume. A good signal for entrywith the breaking of the horizontal line at 2. When we enter we set our stop 5%under the recent low. After entering on strength there is every possibility that someprofit taking will occur as well as probing by locals to chase out arrivistes.5. We watch with interest for the first reaction. Each day we observe as a candidatefor a possible ‘Basing Point.’ This occurs at 5 and we now begin to count ‘days away’from the Basing Point, that is, days whose range is entirely outside the range of thecandidate day, and which occur before a lower low is made. When the Basing Pointat 5 is confirmed we raise our stop to 5% under the low of 5.6. A higher high is made after 5 with a subsequent reaction to 6, which proves tobe another Basing Point. So we raise our stop to 5% under 6.7. Prices continue to climb and another Basing Point is made at 7. The procedure isbecoming clear: Find a Basing Point and establish a stop a prudent distance underit. If a new Basing Point is made raise the stop. Watch with interest the reactionsagainst the trend. Either they allow you to establish a new higher Basing Point, orthey end your trade.
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8,9. We find a new Basing Point at 9, raise our stop and draw the trendline at 10.At 9 we have a lower low than 8, but our ‘filter,’ our 5% padding keeps our positionintact. We do not lower our stops using 9 as a new Basing Point. One of the inviolablerules is that stops are never lowered. The filter is important, since traders try to takeout nearby lows and exacerbate volatility. It is called the running of the sheep.11. At 11 we find a new, if tenuous Basing Point. An advance with a thin higher high.12. At 12 we have a candidate for a Basing Point which fails the 3 day rule.13. At 1