job is tokeep yourself free to become liquid whenever it is necessary, in order toreverse your position. And to keep yourself free from irrational and excessiveemotional actions. If you do this intelligently and consistently, you will beperforming a useful and necessary service to the general economic welfare,and you will find that the market offers as good or better returns for yourefforts as any other line of endeavor.EN9: With the 9th Edition I expect the reader will have some powerful new guns tostick to: the Turtle trading manual (which has applications to stocks, as Robert Colbyhas shown); new lessons in Basing Points which show what a powerful procedureit can be; new analyses of Dow Theory which refresh and reinforce the validity andpersuasiveness not just of the Theory but of long-term investing as such. Goodtrading and stick to all your guns!
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appendix AChapter A(Magee’s Original Chapter 24 from the Seventh Edition)The Probable Moves of 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, Chapter B you will find in a discussion of Composite Leverage that there are stocks which ordinarily move many, many times as fastas others. We do not know, for example, whether a year from now GlennMartin (EN: Read, Microsoft) will be moving up or down, but we do know,and it is one of the most dependable things we know, that whichever wayit is going, it will be covering ground much faster than American Telephoneand Telegraph. These differences of habit, of course, are due to the size ofissue, floating supply, nature of business, and leverage in the capital structure, matters we have touched on briefly before. As a matter of fact, we arenot especially concerned with why the differences exist. We are interestedmainly in what the differences are, 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?
611
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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, Chapter D, Sensitivity Indexes.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.(EN9: The general investor who in the 21st century operates with a computerand the Internet will not find the following necessary reading.) In order to computethe Sensitivity Indexes, the range of each stock from high closing to lowclosing, each sheet of the chart is marked with a dotted blue (top) and red(bottom) line in the left-hand margin of the next chart sheet for that particularstock. At the end of each series of chart sheets, this price range for each stockin the period covered by the chart sheet just finished is measured from top(blue) line to red (bottom) line, and these ranges, expressed in eighths of aninch, are added together and divided by the total number of stocks charted.This gives you an average range for the period, representing the compositeor average movement of the entire group of stocks. An arbitrary “normal”average range is permanently selected (on the basis of the average range fora number of series of charts for several years),* and as each series of newcharts is completed, this “normal” average range is divided by the averagerange for the new series, to arrive at a decimal fraction which represents thereciprocal of that market movement for the period. (Thus, a period of widemarket activity would show a small decimal less than 1, such as 0.65, whereasa period of dull and inactive markets would result in a larger figure, suchas 1.49.) We will call this (just to give it a handy name for future reference)the Market Reciprocal for this period or series of charts.
* Theoretically, the “normal” average range should be adjusted continuously at the close ofeach period. Practically, there is no need for such refinement.
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613
Now the price range, expressed in eighths of an inch, for each stock inturn, is divided by the range corresponding to the “normal” or average rangefor a stock at that price (see Range-for-Price table, Appendix A, Chapter C),and this fraction is multiplied by the Market Reciprocal. The resulting figureis the fractional Sensitivity Index covering the action of this particular stockfor this particular market period. In order to obtain the overall or long-termSensitivity Index for a stock, we simply add the fractional indexes for eachperiod together and divide by the number of periods. As new chart sheetsare completed, we add the new fractions and compute the new index. Asingle fractional index is, as you might expect, unreliable and rather meaningless as regards the future. The second, third, and fourth series fractionswill revise and “smooth” the Index. As time goes on and new series areadded, these Sensitivity Indexes will settle down to fairly constant figures;corrections, if any, will be slight as new series are added. And these Indexesare very reliable in forecasting the probable future sensitivity of each stock.The measuring of price ranges in eighths of an inch, in order to getfigures representing percentage moves, implies of course that you are usinga ratio chart paper. With other types of paper, you would have to computethe percentage price range for each period from the high and low closingprices on your charts.We have outlined this method in some detail so that you can, if youwish, compute your own Sensitivity Indexes. EN: As previously mentioned, themodern reader will probably wish to obtain betas, if interested, from sources documented in Resources (Appendix D). It is not necessary that your stocks all befrom the New York Stock Exchange. Using this method, you can includeothers from other exchanges, averaging them all together and treating yourentire portfolio as a group in determining your Market Reciprocals.You will find that sensitivity runs from over 2.00 (which we would speakof as 200%) in the case of highly speculative issues, down to 0.20 (20%, thatis) or less on ultraconservative investment stocks. Roughly, you may considerthat stocks with a Sensitivity Index of 50% or less are extremely conservative,50% to 100% moderately conservative, 100% to 150% speculative, and anything over 150% highly speculative.
Chapter B(Magee’s original Chapter 42 in the Seventh Edition)A Discussion of Composite LeverageEN: The general reader may expect more than a little difficulty in comprehendingthis chapter. The editor has kindly supplied some comments as an endnote, whichwill aid those interested in Magee’s thinking. As the chapter predates much workin risk analysis and portfolio management theory, I have left it “as is.” In concept,it certainly has more than historical value and can in fact be used by the manualchart-keeping investor. The concern of the chapter, namely measuring portfolio risk,is addressed for the computerized investor in Chapter 42.
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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.) There are other plans which depend on pyramiding thecommitment 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.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 capital,he will quit trading and put his money in mutual funds. They can certainly do noworse than that.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 the latter part of this chapter, we will give adefinition of this. Meanwhile, we have said enough so you will understandwhat we are driving at if we use the term in connection with your marketcommitments.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 factor
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Appendix A
615
was 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, bonds are a wasting asset due to theunarrestable deterioration in the commodity denominated value of currency.In order to put your charts to work, you have to avail yourself of thehigher-leveraged stocks, stocks which carry more opportunity for gain and,hence, more risk of loss. You have to accept, deliberately, a greater risk thanthe man who is content to buy a “safe” security, put it in the box, and forget it.By maintaining your Composite Leverage (EN: Portfolio Risk) at or nearsome constant level which your experience and judgment tells you is safefor the particular state of the market, you will be protected against overcaution. More important, if you maintain this Composite Leverage in youroperations, you will be protected against unconsciously overtrading. This isa fault more common than extreme caution, and can be a dangerous enemyeven when your percentage of theoretical trading gains is high. When youselect a definite Composite Leverage and adhere to it in your trading commitments, changing it as necessary to meet changed conditions, you will beforced to restrain your enthusiasm within safe limits, and you will be continually aware of the risks you are taking.
Overtrading — and a ParadoxThis leads to another point. A series of identical percentage gains and losseson your capital does not give you a series of equal gains and losses in dollarsand cents. This is a serious problem, worth understanding — for a traderwho is greatly overextended is intensifying this problem (which exists inany case, but which does not need to cause him too much worry if he hasplanned his program).You can understand the paradoxical statement that percentage gains andlosses are not equal if you take the extreme case, first, of a man, who, inevery business venture he enters, risks his entire capital with the expectationof either a 100% gain or a 100% loss. If this first venture is a loss, he loses100%. He is finished, because he cannot gain by making 100% on nothing.However, if the first venture is successful and he then uses his entire capital,including the new profits, again on the same terms, and the second ventureis a failure, he will be wiped out completely. No matter how many successes
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he may have, he stands to lose everything on his first failure. EN: This is, ofcourse, the problem of “gambler’s ruin,” which has been admirably analyzed by anumber of writers, including Niederhoffer with the most delightful illustration. SeeResources (Appendix D) for the formula.In a lesser degree, this is the situation we are speaking of. You wouldnot risk all of your capital on a basis of doubling your money or losing all.But suppose you were extended, continually, to a point where you weretaking the risk of a 40% net loss on each transaction, with the hope of a 40%net gain. Should you start with $1000 and have a succession of 10 losses,you would wind up with about $6. Now suppose the very next 10 transactions were all successful. You would finally come out, after 10 losses and10 gains, each of 40%, with capital of less than $100. It would not be necessaryeither that these 10 losses and 10 gains come in the order given. You mighthave the 10 gains first, or three gains, four losses, seven gains, and then sixlosses. The result would be the same. After 10 gains and losses, in any order,you would have lost more than 90% of your capital.On the other hand, if you risked your entire capital each time on20 ventures, in 10 of which you took an 8% net gain and in 10 an 8% netloss, your $1000 after the 10 gains and losses would be reduced only to $937.You would still have about 94% of your original capital. Therefore, in thiscase (and 8% is a fair average figure for short-term transactions resulting ina loss, in fact, a rather liberal figure according to extensive tabulations ofactual transactions), you would have a handicap due to this paradox of onlyabout ⅓ of 1% on each trade.Now it is conceivable that 10 successive trades might go wrong, thoughthat would be an unusual (EN: but perfectly predictable) condition. There wasone period of 10 months between the actual turn of the market and the DowSignal for a Reversal of the Primary Trend. True, the resulting new trend,once established, ran far and long, and would have made up all losses andproduced fine profits. But during the 10 hard months, allowing the fairaverage time of 30 days per transaction, it is possible that 10 successivewrong-way trades might have been stopped out for losses, reducing theoriginal $1000 to $434.The important thing here is that the next 10 successful trades wouldhave brought this $434 back to $937; in other words, you could have rightedthe boat and sailed right on if you were working on the 8% basis, whereasif you had been following the 40% basis we gave previously as an example,you would have been sunk without a trace, a victim of overtrading.Therefore, by maintaining a sane Composite Leverage Index and lettingthe law of averages work for you and with you, you will be on solid mathematical ground. Your technical studies will have every opportunity to makeyou a profit. Otherwise you can, simply by unwise overextension of yourtrading, prevent even the best technical analysis from producing a net profit.
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617
Composite Leverage Index of a Single StockIf you keep a record of sensitivity as outlined in (EN: original Chapter 24,Chapter A of this Appendix) and have computed the Sensitivity Indexes foryour stocks, then you can set down the Composite Leverage of any purchaseor short sale as follows:• Let S represent the Sensitivity Index of the stock.• Let N represent the Normal Range-for-Price, based on the price atthe time of the original commitment.• Let T represent the Total Net Paid or received on the original transaction.• Let C represent the Capital reserved to finance this commitment. Inthe case of outright cash purchases or 100% margin short transactions, this figure cancels out against T in the numerator.ThenComposite Leverage =
SNT15.5 × C
(15.5 is the Normal Range for a stock selling at a price of 25, and is simplyan arbitrary selection to serve as a fixed point of reference in determiningratios.)
Composite Leverage on an Entire PortfolioThe Composite Leverage on the entire account is a summation of the risksof the component stocks, and can be figured in this way:Total Composite Leverage =
Sum of SNT**15.5 × Total Capital or Net Worth
Let us add one more striking example of the importance of CompositeLeverage. At a time when stocks could be bought on a 30% margin, it wouldhave been possible to buy, with $1000, $3300 worth of a highly speculativestock, Standard Gas and Electric $4 Preferred, then listed on the New YorkStock Exchange. Let us assume that the price at that time was $25 a share.The Composite Leverage, then, on your $1000 capital would be 693% using* Sum of SNT means that you figure S × N × T for each stock in the portfolio separately, andadd all these figures together.
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the methods we have just outlined in determining this Composite Leverage.At this same time, using the same methods of figuring, an outright purchaseof $1000 worth of Celanese 4¾% 1st Preferred at 106 would give a CompositeLeverage of only 11.8%. Comparing these two transactions, your purchaseof “SG Pr” provided a leverage of 693 to 11.8 as compared to the purchaseof “CZ 1st Pr” or approximately 60 to 1 (58.7 to 1). Presumably, and basedon the past history of the stocks, your chances of capital gain or loss wereabout 60 times as great in the “SG Pr” as in the “CZ 1st Pr.”The method proposed here gives you a means of knowing at leastapproximately how much risk you are assuming in a stock or in a group ofstocks. It can help you to avoid exposing yourself unwittingly to an inordinate degree of risk or, on the other hand, restricting unduly your opportunities for gain.
Investment Account PolicyOrdinarily, investment account management is based largely on considerations of the “fundamentals,” and not to any great extent on technical indications. Furthermore, such accounts would normally be set up on a moreconservative basis, and would not try to use Bear Markets for short sales.EN: Magee refers here to what he considered “the long-term investor” or, one whomoved only when major fault lines shook — i.e., major changes in the Dow or somesuch. As strikingly illustrated by the long-term record of the Dow in Chapter 5 and5.1, this can be a successful strategy but this editor feels strongly that short salesand Bear strategies fit well with even the most conservative of investment portfolios.MPT (implicitly) encourages it and any investor who had some shorts in his portfolioon October 19, 1987 (or September 11, 2001), felt a lot better on following mornings.Nevertheless, the matter of Composite Leverage figured on the entireaccount is a help in determining the overall nature of the investment. Itwould be a help in determining whether the account should be placed in amore conservative position, or whether it could stand a change in the direction of somewhat more speculative holdings. These decisions would, naturally, depend on the size of the account, the condition and requirements ofthe owner, and on the general condition of business and the market itself.However the Composite Leverage Index will provide a useful gauge forappraising the character of the account as a whole at any particular time.(EN9: Cf. Portfolio Operating Risk computations in Chapter 42.)
Negative Composite LeverageFrom what we have said about the “insurance” function of short sales in aBull Market (and purchases in a Bear Market), where these “contrary” transactions are used to achieve balance by means of the Evaluative Index, it mustbe clear that such short sales or protective purchases must tend to reduce
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Appendix A
619
the Composite Leverage or total risk of the account, which is exactly whythey would be used.It might seem that by considering the contrary transactions as negative,and those in line with the presumed Major Trend as positive, this sum couldbe reduced to zero, or at least to a point where there was no substantial totalrisk at all. This is not quite possible, since we are dealing, at best, with roughapproximations, and also because we are dealing with more or less independent variables which may, and will, at times, make erratic moves.EN: In fact, after the development of the Black–Scholes formula for calculatingoptions values, some very astute traders developed the “Delta Neutral” method ofarbitraging options. Among the most sophisticated of these was Blair Hull, theeditor’s boss at Options Research, Inc. Delta Neutral means that over very shorttime periods market price movement, up or down, should not, theoretically, affectthe value of options arbitrage portfolios. Large fortunes have been made by marketmakers practicing this method. See Schwager’s books on the Market Wizards.However, it is true that we can greatly reduce the total risk and that thecontrary moves do, in a real sense, “subtract” risk from the total account.This “subtraction” of risk appears in commodity accounts, where it iscustomary for brokers to reduce the margin required on total commitmentsif some of these commitments are “contrary,” that is, if there are some shortsalong with a majority of long positions, or vice versa.EN: Modern Portfolio Theorists have sagaciously adopted some of these concepts, probably like the Russians, discovering them for themselves or at least notcrediting Magee if they learned of the concepts from his work. Chapter 42 exploresthe idea which Magee is concerned with here — that of measuring portfolio riskand profit opportunity. He is concerned not just with risk but also with opportunity,and maintaining a balance between them. He also wants to maintain a consistentstance to the market, exposing his capital to most risk and opportunity when heanalyzes the market to present most promise, and keeping a lower profile at timesof uncertainty and at turning points.The procedures presented here are still workable by the dedicated manual technician and, if I am not mistaken, are still effective, if cumbersome in the age ofcomputers. All of the data, tables, and Indexes necessary are included in this Appendix. Computer-oriented analysts will probably find the procedures outlined in themain sections of the book to be somewhat more convenient and also sufficient.
Chapter CNormal Range-for-Price IndexesThe figures in this table represent that particular component of the CompositeLeverage of a stock which is a function of its price level. They are based onactual tabulations from 3800 stock charts. They state the relative proportion orpercentage range of movement of a stock in each price range through anaverage 6-month period.
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Price1¼1½1¾22¼2½33½45678910111213141516171819202122232425262728293031
Technical Analysis of Stock Trends
Normal Range
Price
Normal Range
Price
Normal Range
38.035.033.031.530.029.227.626.525.324.022.822.021.220.419.819.218.718.418.017.617.317.016.816.616.516.316.115.915.715.515.315.215.114.914.714.6
323334353637383940414243444546474849505152535455565758596061626364656667
14.514.414.314.214.114.013.913.813.713.613.513.413.313.213.113.012.912.812.712.712.612.612.512.512.412.412.312.212.112.012.011.911.911.811.811.7
6869707172737475767778798081828384858687888990919293949596979899100150200250
11.711.611.611.511.511.411.411.311.311.211.211.111.111.111.011.011.010.910.910.910.810.810.810.710.710.710.610.610.610.510.510.510.49.08.07.0
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Appendix A
621
Chapter DSensitivity Indexes of Stocks*Although it is not possible to predict the advance or decline of a stock overthe years in the future, it is possible to make a reasonable estimate of themost likely “degree” of advance or decline, based on its long-term markethistory. Barring major changes in corporate structure or in the nature of thecompany’s product, we can assume that the relatively conservative stockwill usually continue to move conservatively, and that the relatively speculative stock will continue to be subject to wide swings of advance or decline.This new table of Sensitivity Indexes shows the approximate relativesensitivity of stocks, based on the percentage price range of each stock foreach year over the period from 1964 to 1973 inclusive, and the median priceof each stock in each year. The values are adjusted for major split-ups andprice level, and also for the overall range of the market in each year. For thiscorrection, we have used a Market Reciprocal which is inversely proportionalto the total price range of all the stocks considered, and this makes it possibleto set up the annual Sensitivity Indexes from which the 10-year figures usedin the table are obtained.Since some students may want to work out their own relative sensitivityfigures or use this data in other ways, we are giving here the Market Reciprocals used for each of the years in these computations:
19641965196619671968
Abbott LaboratoriesACF Industries, Inc.Adams Express Co.Addressograph-MultigraphAetna Life & Casualty Co.Air Producers & ChemicalsAirco, Inc.Akzona, Inc.Alcan Aluminum Ltd.Allegheny Corp.
1.5441.3201.0891.0271.122
.9481.095.5351.593.967.844.8421.031.8891.084
19691970197119721973
0.9530.8611.0751.2380.786
Allegheny Ludlum IndustriesAllied Chemical Corp.Allied Stores Corp.Allis-Chalmers Corp.Alpha Portland IndustriesAluminum Co. of AmericaAMAX Inc.AMBAC IndustriesAmerada Hess Corp.American Air Filter
1.192.9161.0451.195.9221.069.8301.