on & Schuster) bonds are a kind of deteriorating asset due to the unarrestabledepreciation 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 (EN: i.e., Portfolio Risk Strategy) andadhere to it in your trading commitments, changing it as necessary to meetchanged conditions, you will be forced to restrain your enthusiasm withinsafe 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 trader who
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is greatly overextended is intensifying this problem (which exists in any case,but which does not need to cause him too much worry if he has plannedhis 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 successeshe 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 and discussion.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 condition. There was one period of 10 monthsbetween the actual turn of the market and the Dow Signal for a Reversal ofthe Primary Trend. True, the resulting new trend, once established, ran farand long, and would have made up all losses and produced fine profits. Butduring the 10 hard months, allowing the fair average time of 30 days pertransaction, it is possible that 10 successive wrong-way trades might havebeen stopped out for losses, reducing the original $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, whereas
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if 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(EN: Portfolio Risk Exposure) and letting the law of averages work for youand with you, you will be on solid mathematical ground. Your technicalstudies will have every opportunity to make you a profit. Otherwise youcan, simply by unwise overextension of your trading, prevent even the besttechnical analysis from producing a net profit.EN: John Magee could easily be called the father of modern investment theorybut modern investment theory is so unenlightened as to technical analysis thatacademics largely have not recognized his contributions — and many probably havenot read his work. If they had, he would be recognized as having identified whattheorists now call systematic risk, or what is now called the beta (Greek letter β)with his concept of the Sensitivity Index. Similarly, his work on Composite Leverageprecedes (and may be more practical than) modern portfolio risk analysis, if cumbersome in the modern context.In his original exposition of Composite Leverage in this chapter Magee madeuse of some cumbersome manual procedures which I have relegated to Appendix A.There is nothing invalid about them, but there might be more simple and convenientways for the present-day trader to assess his leverage, his risk, and profit exposure.One of these is certainly utilizing VAR technology. But — or, and — there mightbe simpler more pragmatic (and even more effective) ways of extracting this information from our trading portfolios.Volatility, for example, tells us something about the risk of a stock. Portfoliovolatility gives us a way of measuring the riskiness of a group of stocks. In researching our systems and methods we should be able to get some handle on “drawdown,”or the largest negative swing against our equity in an account. Simple conclusionsfollow: if we are willing to accept larger risks, we pick a portfolio of volatile stocks —a portfolio of Internet (or whatever the current frenzy is) stocks rather than a portfolioof utility stocks.It is indispensable to maintain a regular periodic review of portfolio statisticsto assure oneself that excessive risks are not being undertaken heedlessly. Theseimportant numbers include:• Original risk per trade• Actual realized loss• Average loss and profit per trade and their relationship (average profitdivided by average loss)• Number of winning and losing trades and their ratio• Time in winning and losing trades (long-time trades combined with oversizelosses is an ominous sign)• Equity swings: average drawdown, maximum drawdown• Costs and expenses, summation, and per trade• Daily risk, yearly risk, and catastrophic risk, as computed by PragmaticPortfolio Theory (as discussed below)
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Risk of a Single StockThe beginning of conventional, or academic, analysis of risk is the examination ofvolatility.The formula for calculating the volatility of a stock (or downloading it) wasdiscussed in Chapter 24. As a theoretical exercise, the formula and the theory makecertain assumptions which are not necessarily of interest to the pragmatic practitioner. One of the assumptions is that the holder chooses to accept the inherentvolatility of the stock at hand. But the point of technical analysis is to limit the riskaccepted while attempting to realize profit opportunities. Thus the volatility of astock, its risk, is 0.30 or 30%, but when we trade it, we put a stop loss on it andonly risk a move of (say arbitrarily) 5–8% against our position. (Where the 5-8%sums to 2-3%, or x of total capital.) So our method of risk control is basically moredynamic than the theory. Nonetheless, volatility will give us a measure of the stockswhich make interesting trading vehicles.It is perfectly possible to take our own experience with a stock, or our system’sexperience with a stock and calculate its volatility to ourselves, using the methoddescribed in Chapter 24. If the dispersion of its returns was greater than our appetite,we could then eliminate it from our watch list. To my knowledge the literature doesnot mention this method for customizing our analysis of risk. Use of a customizingprocedure like this would give us an idea of the reliability of our methods in aparticular case. Stocks which didn’t behave would be banished to the portfolios ofmutual fund managers.
Risk of a PortfolioIf you have sufficient experience with a portfolio, you can calculate its volatility thesame way you calculate the volatility of a stock. And the method in Chapter 24 canbe used. You may also dramatize the volatility of your portfolio by preparing afrequency distribution. The dispersion of the returns would certainly highlightcharacteristics of your trading system or style.Academicians and investment managers use a measure called the Sharpe Ratioto compare the performance of two systems or competing money managers. It isdiscussed in Resources (Appendix D), and has severe deficiencies in analyzingportfolio risk. I will address this question later in this chapter after looking at someof the ways professionals treat risk.The reader may judge for himself in the use of Composite Leverage as presentedin Appendix A by Magee, or he may consider the following brief presentation ofmodern portfolio management and risk analysis. The purpose of Composite Leverageis to measure and control risk and profit exposure in a more or less quantitativemanner. Present-day portfolio managers might use VAR technology, or do this asfollows. The Editor offers this exposition only for perspective. His own preferredmethod, Pragmatic Portfolio Theory, follows thereafter.
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EN9: Risk and TrendRisk of a Portfolio and risk of a stock are affected by being the right way inthe trend. It seems intuitive and it is observable that losses (thus risk) expandin an Enron case where the trader remains long while the stock dies. Theconverse is also true. Risk is diminished to a portfolio and a stock when itis with the trend. In a paper submitted to the Market Technicians Association(mta.org), Dissecting Dow Theory, Bassetti and Brooker argue (with somesuccess in the opinion of this editor) that risk can be proved to diminish inthe Industrials when the portfolio (of Industrials) is with the trend as identified by Dow Theory. Charts 9.1 and 9.2 present other material from thispaper which is available at the Magee website, www.edwards-magee.com.
VAR ProcedureReturns of the individual securities are determined and, from these, returns of theportfolio are calculated. This is done based upon some time period for which theportfolio is held. Thus, from day to day the returns, or changes in value, of theportfolio will vary — some positive and some negative. Taking a totality of returns,an average return will be determined. A frequency distribution of returns may beconstructed. The width of this frequency distribution measures the riskiness of theportfolio. Thus, a portfolio which has a minimum return of 1% and a maximumreturn of 8% is inherently less risky (according to investment theory) than one withreturns varying from –1% to 20%. And while a frequency distribution is illustrative,it does not give us a common measure for two different portfolios. That is done bydetermining the volatility of the portfolio.Volatility measures the deviation of returns from the mean. This is known asthe standard deviation and is indicated by the Greek letter sigma (σ). The higherthe volatility of a portfolio the greater its risk, according to the academic theory.This would seem to be intuitive, in that a commodity portfolio might range from–30% to 100% returns because of leverage, whereas a bond portfolio would varyonly by the market price of the bonds and would return face value at maturity. Ofcourse in calculating bond risks, managers ignore the deterioration of money — butthat is a little secret among us pragmatic analysts and we needn’t bother academicians and bond traders with that information, as they wouldn’t want to know itanyway.As pointed out above, portfolio volatility can be easily obtained if we havesufficient experience with the portfolio. If we have to calculate the volatility, theprocedure gets quite complicated and the entire procedure for determining our VARrequires some statistical sophistication as well as a gamut of data. We must weightthe components of our portfolio, determine their correlations, compute correlationcoefficients, and on and on. And, as Mandelbrot notes in Scientific American, atthe end of all this, we would still be wondering what to do in the Perfect Storm.A crystal-clear procedure for computing VAR is presented in Philippe Jorion’s ValueAt Risk.
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Pragmatic Portfolio Theory (and Practice)Perhaps, rather than giving ourselves headaches trying to remember college statistics, we should look for something simpler and more pragmatic — something justas serviceable for the general investor: Pragmatic Portfolio Theory. The academicworld, and the world of rarefied Wall Street, strives madly to quantify everythingin the world except the risks and liabilities that they themselves create for theircustomers.Let us seek simpler methods to quantify the risks of individual stocks and theportfolios they reside in, knowing all the time that absolute precision is impossible.(Viz., Professional portfolio managers’ performance in The Great Panics — 1929,1957, 1987, 1989. Viz., Long-Term Capital Management which almost broughtdown the world financial system in 1998, and Leland O’Brien Rubinstein PortfolioInsurance which contributed mightily to the Reagan Crash in 1987.)
Pragmatic Portfolio Risk MeasurementDetermining the Risk of One StockThe theoretical risk of a stock is commonly agreed to be its volatility, which isdetermined as detailed in Chapter 24. So we might say that the theoretical risk ofour stock, Microsoft, for example, equals on 100 shares, our position, at the marketprice of 120 and annualized volatility of .44:Theoretical Risk = Volatility × Position × PriceV × Po × Pr = T$Risk.44 × 100 × 120 = $5200whereT$Risk = Theoretical $RiskV= VolatilityPo= Position (number of shares)Pr= PriceTheoretically speaking then, the annual risk for Microsoft should be volatility ×Price or (in 2000) 0.44 × 120 or $52. In fact, those non-chart analysts who boughtMicrosoft at 120 (there were some) and who did not have the technician’s ability toset a stop and discipline to stick to it saw a risk of 50% from its top of 120 inFebruary 2000 to its (presumed) bottom of 60 in June 2000.There is another measurement which might be more meaningful to us, Operational Risk. Operational Risk refers to the specific instance of the particular trade.For example, we have taken an initial position in Microsoft of 100 shares. Ouranalysis has identified a stop point where we put our stop, which is 5% away fromthe market price. Our Operational Risk is:
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( MP − S) × Po = O$Risk(120 − 114) × 100 = 600whereO$Risk = Operational RiskMP= Market PricePo= PositionS= Stop Price
Determining the Risk for a PortfolioComputing the theoretical risk for a portfolio is quite a complex process. Itinvolves, in essence, finding the volatility for the portfolio as a whole, andmultiplying the portfolio market value by the portfolio volatility. This doesnot sound so complex, but volatility is not determined by simply addingtogether volatilities of individual securities. Rather, correlations betweeninstrument returns must be computed, and variance and covariance of securities must be determined as steps along the way. This by no means presumesto be a complete description of the process, further study of which may beguided by entries in Resources (Appendix D).The theoretical risk for a portfolio is, for a simple case:Volatility × Market ValueTP$Risk = MV × VwhereTP$Risk = Portfolio Theoretical RiskMV= Market ValueV= VolatilityUnder normal market conditions, the Operational Risk of a simple Portfolio,PO$Risk, may be calculated by first taking the sum of the Operational Risk figures,O$Risk, for each stock held long. Then the sum of O$Risk for short positions issubtracted from the first figure.PO$Risk = ( sum of O$Risk longs) − ( sum of O$Risk shorts)In the situation of perfect negative correlation, the two factors would besummed.
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Measuring Maximum Drawdown,or Maximum RetracementIn the designing and testing of a system, or in actual trading experience, we carelittle about standard deviations and cold statistics. What bothers us is the flow ofblood, that is to say, the worst run of “luck” or experience we have. What is thegreatest sustained loss we suffer before our system or trading method rights itself,stanches the flow of blood, and begins to accumulate profits again? Constructing awave chart is one way to look at this experience. (A wave chart is illustrated inFigure 2.)Measuring from the top of the wave to the bottom gives us our maximumdrawdown, and an idea of what amount of capital we need and how much reservesto maintain. It also gives us a vivid depiction of our results. A chart with manytsunamis (in the wrong direction) probably means that we need to modify ourmethods — unless we genuinely enjoy riding roller coasters (with the full understanding that dreadful accidents do sometimes happen on thrill rides). If constructinga system without actual market experience, one should multiply maximum drawdown by 3 or 4 to get a reasonable amount of capital to back the system with.
Pragmatic Portfolio Analysis: Measuring the RiskIn analyzing a portfolio, we must first know what is important to measure. In orderto be able to control risk, we must be able to measure it. Theoreticians identify riskwith volatility. There are some real-life problems with this concept but we will useit for the moment anyway. In a portfolio, we want to be able to separate our varioustypes and weights of risk. In terms of volatility, bonds are obviously less volatilethan stocks, and unleveraged commitments are less volatile than, say, futures.Similarly, if the portfolio is not risk balanced, that is, if one issue represents a largeproportion of the whole, then it represents a larger portion of the risk. But, if aportfolio consisted of only the S&P 500, that would obviously be a different case,since a commitment like this would be by definition diversified. So we must knowwhat is important to measure. (Cf. Philippe Jorion’s Value At Risk. In additionthere is a piece of tutorial software called Risk Management 101, which is excellentin presenting these concepts.)In operational or pragmatic terms, a trader wants to know what his operationalrisk is, rather than his theoretical risk. And he doesn’t consider upside equityvolatility a negative. A trader may choose to measure risk by the pragmatic methodoutlined here. In doing so, he will want to know for his Portfolio Ordinary orNormal Risk, POR, his Risk Over Time, PRT, and his Extraordinary or Catastrophic Risk, PCR.
Portfolio Ordinary, or Operational, RiskFirst consider that we want to measure our risk today. Our Ordinary Risk today iseasily computed by taking the stop price from the market price on each position and
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summing the differences, as above. Dividing this figure by the allocated capital (TotalCapital, TC) will give us a Portfolio Risk Factor, PRF. And that is the risk factorthe trader is willing to assume for one day.POR = sum of DifferencesPRF = PO$Risk TC
Portfolio Risk Over TimeThe number can be annualized to give us a number for risk over time — or it canbe computed for a week or a month, etc. Or, this factor may be collected fromoperations. It may be collected by taking each day’s Ordinary Risk, summing anddividing for the desired time period (and plotted). It may also be computed by takingthe average return and the variances therefrom and calculating the standard deviation. This is Risk Over Time. Annualized risk, for example: DR × 365 whereDR = Daily Risk.
Portfolio Extraordinary or Catastrophic RiskExtraordinary Risk is the risk of market collapse or panic on any given day. Theway to look at this risk is, first of all, to assume normal behavior of the markets, oryour everyday panic. In this case, if all of one’s positions cratered, one would takehis worst-case, one-day loss and be out of the market. To extend this analysis, assumethat the market makes a two, then four, then six standard deviation move. Whatwill be the effect on your position in this event, when stops will not be honored byspecialists and market makers and the market will be stampeding like spooked cattlefor the exits? That is, meltdown. This is Extraordinary or Catastrophic Risk.
Controlling the RiskThe most danger in these meltdown events is in the greatest leverage — so thegreatest risk is in short options — and usually short puts. You will remember mystory of my customer who lost $57MM during the Reagan Crash of 1987. He wasshort puts. Some market makers have been destroyed by shorting calls, but the caseis rare and specifically results in the case of takeovers and unwise concentration ofcommitments in one issue only.The least risk lies in being hedged. To oversimplify, long the stock, long the put.The profit of one makes up for the loss on the other. Also, if one were long somestocks and short others, that also is a kind of hedge. Or long the Dow and shortfutures on the Dow, or some of its components.Now let us be pragmatic. If we have during the management of our portfoliosconsistently measured the market with the Magee Evaluative Index and balancedour portfolio accordingly, we will be at less risk, both from the Ordinary and theExtraordinary viewpoint. In fact, we may profit from an event which disemploysmany professional money managers.
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If you have been religiously raising your stops, following the market withprogressive stops, and in fact raising them based on new highs as described inChapter 28 (3-days-away procedure), it is quite possible that while the market isstorming you will be sailing to Byzantium in your customer yacht.
Summary of Risk and Money Management ProceduresThe procedures described above are easily reducible to simple formulas, even for themathophobic.Trade size is the basic unit for controlling risk. Regardless of volatility, 500shares of anything is riskier than 100 shares.To determine trade size, take the difference between the entry price and the stopprice, giving Dollar Risk 1 ($R1). Take the Risk Control Factor, the percentage oftotal capital to be ventured on the trade, and multiply times Total Capital — e.g.,3% times TC of $100,000, giving Risk-per-Trade. Divide Dollar Risk 1 by Risk-pertrade to determine Trade Size.EP − SP = $R1RCF × TC = RpT$R1 RpT = TSwhereTS = Trade SizeEP = Entry PriceSP = Stop Price$R1 = Dollar Risk 1RCF = Risk Control FactorTC = Total CapitalRpT = Risk-per TradeDaily, measure Operational Risk as described above. Divide Operational Riskby Total Capital to determine Portfolio Operational Risk Factor. If this factor is toohigh, look for hedges or positions to eliminate, starting, of course, with those whichare underwater.Recompute stops frequently (daily for a trader) raising them according to theBasing Points Procedure. Or Support and Resistance, or Trendlines. Or a moneymanagement stop may be employed, where the trader says, for instance, that nomore than 8% from the market price will be risked. And this 8% must represent nomore than x% of total capital. Money management stops, it should be noted, areinherently less dynamic than technically placed stops.As the markets proceed inevitably through their phases, track their internalcomposition with the Magee Evaluative Index, and as positions are naturally terminated, put on new positions in accord with the general long/short strengthreadings of the MEI. Remember that exceptionally high MEI readings coincide with
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broad market tops, and exceptionally low MEI readings coincide with broad marketbottoms.Professional risk managers compute daily the Extraordinary Risk potential inthe markets using the procedure described above to constrain traders under theirauthority from overexposure. In fact, panics and crashes rarely occur out of the blue.There is almost always a prepanic phase which the truly alert trader can identify,especially with the aid of a computer. These are marked by insider and professionalselling which creates increasing volume with Reversal Days occurring in manystocks and Gaps and Runaway down days. Almost always these conditions will bepreceded by many top formations among key stocks — double and triple tops andheads and shoulders and v-tops.Eternal vigilance is the cost of freedom. It is also the cost of investing success.
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chapter forty-three
Stick to Your GunsIt has often been pointed out that any of several different plans of operation,if followed consistently over a period of years, would have produced consistently a net gain on market operations. The methods we have discussedin this book (representing the technical approach) are a case in point.The fact is, however, that many traders, not having set up a basic strategyand having no sound philosophy of what the market is doing and why, areat the mercy of every Panic, boom, rumor, tip, in fact, of every wind thatblows. And since the market, by its very nature, is a meeting place of conflicting and competing forces, they are constantly torn by worry, uncertainty,and doubt. As a result, they often drop their good holdings for a loss on asudden dip or shakeout; they can be scared out of their short commitmentsby a wave of optimistic news; they spend their days picking up gossip,passing on rumors, trying to confirm their beliefs or alleviate their fears; andthey spend their nights weighing and balancing, checking and questioning,in a welter of bright hopes and dark fears.Furthermore, a trader of this type is in continual danger of getting caughtin a situation that might be truly ruinous. Since he has no fixed guides ordanger points to tell him when a commitment has gone bad and it is timeto get out with a small loss, he is prone to let stocks run entirely past thered light, hoping that the adverse move will soon be over, and that therewill be a “chance to get out even,” a chance that often never comes. And,even should stocks be moving in the right direction and showing him aprofit, he is not in a much happier position, since he has no guide as to thepoint at which to take these profits. The result is he is likely to get out toosoon and lose most of his possible gain, or overstay the market and lose partor all of the expected profits.If you have followed the preceding chapters carefully, you will haverealized that none of the technical formations and signals is certain andunfailing. The chart action of a stock discounts and records all presently knowninformation about that stock (which includes all matters of dividendsdeclared or expected, split-ups, and mergers that are known to be planned,political angles as they affect the market, world affairs, management, earningrecords, etc.). The chart does not and cannot forecast unforeseeable events,matters that are completely unknown to anybody. In a majority of cases, thecharts are dependable. If you are not satisfied that this is true, you shouldstudy further, or else plan not to use charts at all.609
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On the other hand, if you have satisfied yourself that the charts are, foryou, the most dependable indication of the probable future course of stockprices, then you should follow explicitly the signals given on your charts,either according to the rules we suggest here, or according to such otherrules and modifications as your experience dictates. But while you are following any set of rules and policies, follow them to the letter. It is the onlyway they can help you.If you do this, you will have certain large advantages, right at the start:(1) you will never be caught in a situation where a single stock commitmentcan wipe out your entire capital and ruin you; (2) you will not find yourselffrozen in a market that has turned against you badly, with a large accumulated loss and your capital tied up, so that you cannot use it in the reversedtrend to make new and potentially profitable commitments; and (3) you canmake your decisions calmly, knowing exactly what you will be looking foras a signal to take profits, and knowing also that your losses, at the veryworst, will be limited to a certain definite amount.All of this means that you will have peace of mind. You will take lossesand you will make gains. In neither case will you have to take your notebookshome and lie awake worrying. You will have made certain decisions. Ifdevelopments prove you were right, you will, at the proper point, take yourprofit. And if it turns out that you were wrong, then you can take yourcomparatively small loss, and start looking for a better situation, with yourcapital still largely intact, liquid, and available.Your job, as a speculator, is to provide liquidity in the market, and tocounteract the irrational excesses of market-in-motion. Part of that