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Sensitivity Index of 1.50, and now sells (let us say) at 20. At the same time,we buy a somewhat less speculative stock, XYZ, also selling at 20; but inthis case, we buy on 70% margin, putting up only three quarters of the valueof the stock. In a general advance affecting both of these stocks, the probabilities would favor a somewhat greater percentage move in UVW than inXYZ. If such a general rise should bring UVW to 30, we might expect XYZto rise to a lesser degree, say to 28. Now the advance of 10 points on the$2000 invested in outright purchase of LVW will represent a gain of $1000or 50%. The advance of XYZ to 28 on the $1400 invested at 70% margin willmean a gain of $800 or 57%. In other words, we have, by the use of margin,increased the effective leverage of XYZ; made it, in fact, slightly more speculative than UVW.The effect of margin use is simply to accentuate or increase the sensitivityof a situation. It is a mechanism for assuming more risks and, therefore, moreopportunities for faster gains. Assuming you are willing to assume risk (asyou must be if you intend to make speculative commitments), it is simplya matter of knowing approximately what risks you are taking and whetheryou can afford to take them. The danger in margin lies in cases where thecustomer grossly overextends himself, taking on a risk far beyond his abilityto protect himself. This will not happen if he sets a reasonable limit to histotal leverage (EN: put another way, his portfolio risk).The margin transaction is simply a matter of buying (or selling short)more stock than you have money to pay for in full. The purchase of a homeon a mortgage is essentially a margin transaction. The financing of businessoperations, using borrowed money for part of the capital, is the same. Thebuying of anything where the purchaser puts up part of the capital andborrows the rest, using the value of the purchased property as security forthe loan, is exactly similar to the trading of stocks on margin. In each case,any change in the value of the property will cause a larger net change in thevalue of the margin capital. Thus, if a man buys a home for $100,000, paying$50,000 cash, and later sells it for $150,000 (an increase of 50% in the valueof his property), he will benefit to the extent of $50,000 profit, or 100% onhis invested capital.The question of margin calls, being “wiped out” on margin transactions,will seldom, if ever, come up if you protect yourself properly by maintainingstops at all times or by closing out the transaction when it has violated certainpredetermined danger points. Needless to say, if you have allowed a tradeto go so bad that it has reached the minimum margin maintenance range,the best thing is to take your loss and forget it; not try to meet the margincall. But again — this need not ever happen.As we will see in discussions of sensitivity and leverage, stop levels, etc.,there are certain limits which can be fairly well defined, beyond which youcannot safely venture. If you could buy stock on a 10% margin, as you couldat one time, you might have visions of highballing a thousand dollars up toa million in one Bull Market. But that is not a reasonable hope, and it is not
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safe to risk your capital on a 10% margin, since, in many cases, your perfectlylogical purchase would sag enough to wipe you out entirely before goingahead to the normal advance you expected. EN: In a nutshell, the risk of tradingcommodities and futures. In judging how much margin you can or should use,within the limits of margin trading laid down by law, you must take intoaccount the method of trading you are using, the amount of adverse fluctuation you must expect in the normal operation of your method, the natureof the stock you are dealing with, that is, its Sensitivity Index and NormalRange-for-Price (EN: at the risk of being repetitive, beta and volatility) at the timeyou make the original commitment.
Short SellingThe other touchy question is that of short sales. A majority of traders avoidthe short side of the market. Six out of seven you meet, who have boughtor sold stocks, will tell you that they would never sell a stock short underany conditions, at any time. In fact, short selling is limited, very largely, toskilled professionals. EN: The private investor, because of his fears and prejudices,voluntarily grants this “edge” or advantage to professionals. Magee dealt with thissubject at length in Winning the Mental Game on Wall Street, which I wholeheartedly recommend to the reader. EN9: The widespread proliferation of hedge fundsin the new century attests to the frustration of professional managers with mutualfund rules requiring them to maintain only long positions. Even with this development short selling by the general investor remains a limited technique — to thedisadvantage of the nonprofessional.Now, if you have studied long-term charts (weekly and monthly), andthe daily charts in this book, you will recognize several facts about the actionof markets. Most stocks go up most of the time. There are almost alwaysmore advances than declines in the list of most active stocks published eachday. Stocks, in general, advance about two thirds of the time, and go downonly about one third of the time. (EN9: Probably a truth over the long term, butin the modern context ample short opportunities exist.)Furthermore, most of the news releases, rumors, and comments in thepress related to stocks and corporate affairs have to do with the brighter sideof industry. It is only natural that executives, public relations people, andthe reporters themselves should be interested in forward-looking developments, new processes, expansion of facilities, increased earnings, and thelike; and that such items should prove more newsworthy than less optimisticreports.These various factors may explain why “the public” is always Bullish.The public is always hoping and expecting stocks to go up all the time. Ifstocks are rising and in a Bullish Phase, the public expects them to go stillhigher. If stocks have declined sharply, the public will argue that they arenow better buys than before and must surely go up soon. But it is up, up UP,always up, in the mind of the public.
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And, yet, examination of the long-term charts, covering the action of theAverages over many years, will show you that through these long periods,the levels rise and fall about the same amount.*This being the case, it must follow that stocks come down as far as theygo up, and since they go up about two thirds of the time, they must comedown much faster than they go up. This you will find is true. The angles ofdecline in the Averages and also in individual stocks are usually steeper inBear Market Moves than the advances are in Bull Market Moves. A corollaryto that is that profits can be made faster on the downside of the market than onthe upside.Such profits are made by selling short. It is important if you are a traderthat you understand the meaning of a short sale. When you sell a stock short,you borrow that stock from someone who owns it, and then you turn aroundand sell it to someone else, agreeing with the original owner to replace hisshares at some unspecified time in the future. All of the detail of this transaction is, of course, handled by your broker. Shares of most stocks of largeoutstanding issue are available for loan at all times in the hands of brokers,and your own broker has access to them. The mechanics of this borrowingand sale are interesting; you may wish to get from your broker the wholestory of how these operations are carried out. For all practical purposes,however, all you need to do is tell your broker what you wish to sell andleave the rest to him.He will advise you if, by any chance, the stock you have selected forshort sale is not available for loan. Another practical point, although of minorconsequence, is that a slight additional tax is assessed against short sales.EN: In that gains on short sales are not eligible for long-term capital gains tax.It is important also, if you are a trader, that you accept opportunities tosell short as readily as you go long stock. Unfortunately, there are psychological barriers to short selling. There are, for example, the unintelligent andentirely irrelevant slogans about “selling America short.” There is the feelingon the part of many who are poorly informed that short selling is thesomewhat unethical trick of the manipulator. Others have the impressionthat, in selling short, one is hoping to profit by the misfortunes of others attimes of disaster and Panic. It is not the purpose of this book to persuadeanyone to sell stocks short, any more than it is our purpose to advise anyonewho shouldn’t to speculate on the long side of the market. But so manyquestions are constantly raised, even by fairly sophisticated investors, about* This principle probably still holds even after the extension of the Dow Industrial Average intonew all-time high ground since late in 1954. EN: And into the economic stratosphere at the turn ofthe millennium with predictions — we will not assess their credibility — being made that the Dow willin good time reach 36000. In spite of the long-term “secular trend” and the history of these recentyears (EN: 1950s and 1960s) in the Average, it seems safe to assume that there will continue tobe major general declines in the future as there have been in the past. As a matter of fact, anumber of important stocks have been in Major Downtrends throughout the past few years ofthe mid-20th century Bull Market: Celanese, for example, Kresge, Lorillard, Schenley, andStudebaker–Packard. EN: Compare the historic Bull Markets of the 1990s and Kodak, Avon, Xerox,General Motors, and IBM, all of which were under their 1990 benchmarks in 2000.
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the ethics, as well as the practical procedure of short selling, that we mayperhaps be pardoned for saying a few more words in its defense.All of the popular ideas about short selling mentioned in the precedingparagraph may be branded as so much nonsense. There is nothing morereprehensible about selling short than buying long. Each is a speculation inrelative values. The truth is that money is a commodity, just as much as ashare of stock. There is no moral or practical difference between borrowingmoney to buy stock because you believe that the latter will go up in valuein terms of the former, and borrowing stock in order to “buy” money becauseyou believe the latter is going to go up in value in terms of the former. Ineach case, you are obligated eventually to repay the loan whether it be moneyor stock. In each case, you are taking a risk on the basis of your consideredforecast as to the future trend of relative values.There are, in fact, many common business practices which are more orless analogous to selling stocks short. For example, every time the publisherof a magazine accepts cash in advance for a subscription he is makingsomething like a short sale. His ultimate profit or loss will depend on whatthe magazines he will eventually supply have cost him by the time thesubscription runs out.When you sell stocks short, you (or rather your broker) receives theproceeds of the sale at once but you are obligated to turn back an equalnumber of the same shares at some future date to the man from whom thestock certificates were borrowed. EN: One of the advantages or edges that professionals enjoy over private investors is the credit of short sales to their accountsand the payment of interest thereon. While the proceeds are credited to the privateinvestor, no interest is generally paid on it, unless the investor has influence withthe broker. A favorable situation is created, however, in that, if a short sale of$100,000 were made on, say, 50% margin, a credit of $150,000 would be made tohis account, and no interest would be charged. Any dividends the trader paid onthe transaction would be expensible. Consequently, sooner or later, you have togo into the market again and buy those shares. When you buy them, you(or rather your broker) returns the shares to the original lender, thus discharging your obligation. If the cost of your purchase was less than theproceeds of the earlier sale, the difference is your profit. If it costs you moreto buy in the shares — or as it is termed, cover your short — then thedifference represents a loss. Of course, you do not enter into a short-sidetransaction unless you expect the price of the stock to go down and, hence,show you a profit.One of the little-appreciated results of a large volume of short selling isactually to strengthen the market. Every short seller is a potential buyer.Most short sellers are glad to cover and take their profits on a relativelyMinor Decline. Consequently, if there is a big short interest at any given timein a particular issue, that means that there are many people waiting to buythat stock when it goes down. This situation tends to “cushion” bad breaks.Some astute operators will actually buy a stock when they learn that thereis a very large short interest in it (that is, that a great many shares of it have
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been sold short and not yet covered) because they realize that competitionamong the short sellers to buy the stock whenever it has a small decline mayresult in a very fast and profitable Short-Covering Rally. Any stock is stronger, technically, if there is a good-sized short interest in it.There is one further objection raised against short selling. It will bepointed out that when you buy stock, your loss, if worse comes to worst,can be no more than the total amount you paid for it. But in the case of ashort sale, the price of your stock could, theoretically, rise against you to $50,$100, $1000, $10,000 a share; in other words, could rise without limit. Thisargument sounds much more alarming than it really is. Certainly there is nooccasion to lose sleep over it. Stocks do not go up without limit all of asudden. It is just as easy to set a stop on the loss you are willing to take ona short-side transaction as it is on a long purchase. Such situations as thefamous 1901 corner in Northern Pacific are not likely ever to occur againunder present regulations. EN: The famous “short squeeze.” Short squeezes stilloccur but extremely rarely in big liquid issues. A famous short squeeze occurred inthe silver markets of the 1980s when the Hunt brothers trapped Exchange membersand almost bankrupted them. The Members, of course, being in control, retaliatedby quintupling margin requirements and bankrupted the Hunts. The authorsrealize that nothing they can say, and probably no amount of cold-bloodedanalysis on the part of the reader himself, will remove entirely the trepidationwhich most nonprofessional traders experience when they sell short. Themental hazards will always be slightly greater than in buying long. Nevertheless, from every practical angle, a short sale is exactly the same thing(although in a reverse direction) as a long purchase, with no greater risk,with actually somewhat greater chance of quick profit, and differing only indetails of execution.A commitment in commodity futures contracts, whether long or short,though quite different in theory, has some similarities to a short sale of stock.In making a contract, no actual sale takes place, and no loan of either cashor the commodity is involved. Such a contract is simply a binding legalagreement to accept delivery or to deliver a certain commodity at a certainprice at a certain time. In this respect, it is different from a short sale of stock.It is also different in that it must be closed out on or before a definite date.But the purchase or sale of a commodity contract is similar to a stock shortsale in that: (1) it is necessarily a margin transaction, and (2) it creates an“open” or incomplete transaction which must eventually be liquidated.A short sale of stock must always and necessarily be a margin transaction. Thus, if you buy 100 shares of stock outright at 20, it can sink to 15 andyou cannot be called for more margin. You have lost $500, but the stock isstill yours. If you sell, you get back $1500, disregarding commissions. Onthe other hand, if you sell a stock short at 20, putting up a margin of 100%,and the stock rises to 25, you will also have lost $500. The broker, undercertain conditions, such as the 100% margin requirements in effect at onetime, might call on you for $500 additional margin. Or, if the transactionwere to be closed out at that point, you would receive back $1500 less
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commissions, the same as in the long transaction. In the case of this shortsale, had the price dropped to 15, your profit would have been $500.On short-term moves, the effect of short selling is exactly the same asthe buying of long stock, but in the opposite direction. You simply apply thesame methods here in reverse, during a Bear Market, that you would use ina Bull Market. As we have already seen, the various technical indicationsthat point to upward moves in a Bullish Phase have their counterparts indownside signals during a Bearish Phase.Execution of short sales cannot be made at any time and at any priceyou wish. A short sale must be made in a rising market. You are not permittedto sell a stock short on the New York Stock Exchange during a market breakwhen each regular sale is at a lower price than the one before it (EN9: theuptick rule). However, this need not bother you much since, ordinarily, youwould make such a sale on the rally as it reached your price, and this wouldnaturally fill the requirement of a rising market. Your broker can give you,in detail, the special rules and regulations that apply to short sales. It willpay you to study these so that you can place your orders correctly when theproper time comes to make such sales. EN9: At the AMEX short sales on ETFsand some HOLDRS are exempt from the uptick rule as are futures contracts on thefutures exchanges.
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chapter twenty-six
Round Lots or Odd Lots?(EN: Or, Put Another Way, Size?)One of the minor tactical questions bound to plague you is whether to tradein round lots of 100 shares or odd lots (less than 100 shares in active stocks).EN: In Internet Age markets this question has virtually lost its relevancy. InMagee’s time, there was a distinct disadvantage to trading odd lots, and one onlytraded odd lots if hampered by limited capital. Now that an investor can achievefull diversification in an odd lot position by buying odd lots of SPDRs andDIAMONDs there seems little point in discussing it. There is, of course, alwaysthe question of broker commission — if the broker has a fixed commission rateregardless of the size of the trade, then the small investor gets nicked. It would seemthat this follows the old adage that the rich get richer. But now the small investorcan strike back by finding a broker who does not charge commissions. At first Ithought that commission-free brokers were making up their profit on volume. Butthere are in fact other ways to make a profit on trades than charging a commission —for example, directing the execution of the orders to a trader who needs “order flow.”In the Internet Age, the question of what size a trade or investment should beis different from the question which confronted traders of, as it were, ancient times.Now it is not so much a matter of cost disadvantage in trading odd lots as it is amuch deeper question — that of risk and portfolio management. So how does theaware investor determine the size of any individual trade?I am indebted to a longtime friend, colleague and broker, and fellow trader,William Scott, for articulating the common sense procedure here for calculatingtrade size and controlling risk.First, we determine the percentage of our capital we want to risk on any giventrade. Among many professional traders of our acquaintance, this figure is often2 or 3%. For the sake of illustration, using round numbers, if we have $100,000capital this means we will be risking $3000 on a trade. Let us say that we are goingto buy a $20 stock and defend our position with a stop-loss order $5 away. Ourformula for computing position size is3000 5 = n number of shares, or 600 shares
433
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If we were going to accept a $10 risk, our trade size would be 3000/10 =300 shares. Thus we adjust our trade size to fit our risk parameters.This is a simple, practical, elegant way to implement risk control at the individual trade level.
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chapter twenty-seven
Stop OrdersWe are going to take up two kinds of stop orders, or, rather, two entirelydifferent uses of the mechanism of stop orders.First, let us look at the protective stop order. At best, it is not a happysubject. Stop orders of this type are like fire extinguishers. The occasionswhen they are put into operation are not times of rejoicing. Stop orders areused for emergency rescue when things get so bad that there seems noreasonable hope for a situation.Wherever you set your protective stop, it is likely to be touched off atwhat seems to be the worst possible moment. You will set it at a safe distanceunder a certain bottom. The stock will break through, catch your stop, andthen proceed to build a new bottom at this level for the next rise, or to rallyat once and make new highs. No matter. You had your reasons for settingthe stop. The stock did not act the way it should have. The situation is notworking out according to Hoyle, and certainly not the way you hoped itwould. Better to be out of it, even at a loss, rather than face a period ofuncertainty and worry. If the stock has started to act badly, you cannot tellhow much worse it is going to behave. If you fail to set a stop, you may goon day after day hoping for a rally that never comes, while your stock sinkslower and lower, and eventually you may find (as millions have found) thatwhat started to be a small reaction, and an annoying but trivial loss, hasturned out to be a ruinous catastrophe. Stop orders cannot always be placed.In certain cases in active stocks, the exchanges may even restrict the use ofstop orders.The question is where and when to set the stop, realizing that there isno perfect and absolutely satisfactory rule. If the stop is too close, you will,of course, take unnecessary losses; you will lose your holdings of stocks thateventually forge ahead and complete the profitable rise you hoped for. Ifstops are too wide (too far away), you will take larger losses than necessaryin those cases where your stock definitely has broken out of pattern.Now it will be obvious that the setting of stop orders depends on theprice of the stock and its habits. You would not place your stop level at thesame percentage distance under a Bottom in a conservative, high-pricedstock when it is selling at 80 that you would to protect a speculative issueat a time when it is selling at 8.The higher-priced stocks, as we already have seen, make smaller percentage moves. Conversely, the lower-priced stocks make wider percentage435
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moves. Therefore, the lower-priced stocks should have more leeway for theirgyrations. We will need a wider stop for them than we will for the lessvolatile “blue chips.”Similarly, we can take our Sensitivity Indexes (EN: Betas in considering astock relative to the market, and Volatilities for absolute measure of one stock againstanother) to give us a picture of the individual habits of the stock. Althoughtwo stocks may be selling at the same price at a given moment, you wouldexpect a high-beta, high-volatility stock to make wider swings than alow-beta, low-volatility stock; therefore, you will set your stops wider onthe higher-volatility stock.We must take these factors into account and work out some sort of simplerule of thumb that we can follow. Let us arbitrarily assume an imaginarystock of “average” habits and a price of 25. Let us further assume that wewill be satisfied, in this particular case, with stop protection 5% below thelast established Minor Bottom.For a stock of the same sensitivity selling at 5, we would need abouthalf again as much stop leeway (on a percentage basis). That is, the stopwould be placed 7.5% below the last Bottom (EN9: Significant low). We arriveat this by taking the normal expected range of an average stock at price 25,which is represented by the Index Figure 15.5, and comparing it with thenormal range of a stock selling at 5, which is 24. These are merely relativeindexes and mean only that the stock selling at 5 will normally move about24%, while the stock selling at 25 is making a move of about 15.5%. Wemultiply the basic stop distance of 5% by the fraction 24/15.5, and we getapproximately 7.5%.In exactly the same way, we introduce the relative sensitivity of the stock,using the Sensitivity Index. If this Index should be 1.33, we multiply the stopdistance again by this figure and get 10%. In the case of a stock having asensitivity of 2.00 at this same price, our stop distance would be 15%. If thesensitivity of the stock were only 0.66, we would get 5%.In any case, the stop distance, expressed as a percentage, is obtained bydividing the Normal Range-for-Price by 15.5, then multiplying by the Sensitivity Index, and multiplying this result by 5%. (This operation can be donemost easily and quickly with a calculator or computer routine.)All of the foregoing may seem needlessly complicated to the averagereader. We realize that many will not care to take the time and trouble towork out an exact, scientific stop level for each of their occasional commitments. However, the method of determining where stops should be placedin a systematic and consistent way has been given in some detail here, sothat the principles involved will be perfectly clear, and so that you can changeor adapt the various factors if you feel your experience justifies changes.For most ordinary purposes, a simplified table of stop distances will besufficient. This table, which follows, gives you the approximate stop distanceyou would get by the method outlined above, for stocks in various priceclassifications and of various degrees of sensitivity.
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Table of Stop Distances(Expressed in Percent of the Price of the Stock)
PriceOver 10040 to 10020 to 4010 to 205 to 10Under 5a
ConservativeSensitivityunder 0.75
MedianSensitivity0.75 to 1.25
SpeculativeSensitivityover 1.25
ImpliedVolatilityunder 0.40
ImpliedVolatility0.41–0.79
ImpliedVolatilityover 0.79
5%5%5%5%5%a5%a
5%5%5%6%7%10%
5%6%8%10%12%15%
Note: Ordinarily, stocks in these price ranges would not be in theconservative group.
EN: The informed reader may consider an alternative to Magee’s SensitivityIndex which I have conjectured here — that is, basing the stop distance on impliedvolatility, which would present a dynamic method of adjustment. Implied volatilityis produced from, for instance, the Black–Scholes Model when the model is solvedfor volatility rather than price, taking the market price as the given.The stop level should be marked on your chart as a horizontal line assoon as an actual or theoretical transaction has been entered into, and itshould be maintained until the transaction is closed, or until progressivestops (which we will explain in a moment) have been started in order toclose it out. In the case of purchases, the stop level ordinarily will be at theindicated distance below the last previous Minor Bottom. In the case of shortsales, it ordinarily would be at the indicated distance above the last MinorTop.To determine the position of this stop level, simply figure what thepercentage distance would amount to at the price of the stock. If you aredealing with a stock selling at 30 and the stop distance comes out 10%, thenallow 3 points under your last Minor Bottom.To make this even easier, if you are using the TEKNIPLAT paper, youwill see that it is possible to divide each of the two cycles making up a chartsheet into five spaces. If the center of the paper were numbered 10, thenthese spaces would be from 10 to 12, 12 to 14, 14 to 16, 16 to 18, and 18 to20. Each of these “jumps” is made up of 16 of the smallest vertical spaces.In the lowest section, it will take about four of these small spaces to make5%. It will take five in the second position, six in the third position, sevenin the fourth, and eight in the top position. You will soon learn to count outan approximate stop interval of 15% or 8% or 12% at any price level, withouta moment’s hesitation.
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In no case would we ever set a protective stop level at less than a 5%interval, even for the most conservative, high-priced stocks.These questions remain: “What constitutes a Minor Bottom? What makesan established Minor Top? How do we know how to choose the basing point(EN9: cf. Chapter 28) from which to measure off our stop level interval?”What constitutes a Bottom or a Top will be taken up in the next chapter. Forthe present, let us accept the proposition that we will determine the correctbasing point and that we will always, always set our stop level at the momentwe make the commitment.It is understood, of course, that protective stops under long stock arenever moved down, nor are protective stops over shorts ever moved up. Assoon as the stock has moved in the right direction far enough to establish anew basing point, the stop level is moved up (on longs) or down (on shorts),using the same rules for determining the new stop level as were used infixing the original level.
The Progressive StopThere is another use of the stop which is properly considered here. This isthe progressive stop, used to close out a stock that has made a profitablemove, or in some cases where a stock has given a danger signal before eithercompleting a profitable move or violating a previous Minor Bottom.You will find that on many moves, the stock will progress in the primarydirection for several days, and then may develop exceptional volume. Often,this occurs just as the stock