at $76,000. Above its strike price, a put is not exercised andthe portfolio value is unconstrained. If the trader is wrong, and the marketgoes up, he loses the premium paid for the put. Depending on which strikeprice he chooses, he increases or decreases downside risk. He breaks evenwhen the Dow Future reaches a value of 7534 = 7600 – 66, the strike priceless the put premium. At this level, the unprotected and put-protected portfolio are equally profitable.The similarity to life insurance is striking. If you don’t die, the premiumis wasted. But if you do….
Improving Portfolio YieldsSituation 2All markets, as the reader is perhaps aware, are not trending. Days, weeks,months (sometimes years) can pass while the markets grind up and downin what are euphemistically known as trading range markets. When theastute technician identifies one of these market doldrums and judges that itwill continue so he can reap other returns on his portfolio by selling putsand calls on Dow Index futures.For example, when the Dow Index is 10000 and the trader calculates thatit will not break out for the next month above 10200, he sells calls at a strikeprice of 10200. The quoted premium of the 10200 call is, say, 10.10; selling a10200 call generates $1010 income.The trader pockets the entire premium as a profit if the index remainsbelow 10200 at the September expiration. The downside of this trade is thatthe trader gives up price appreciation above 10200. Above 10200, the combinedvalue of the portfolio and short call premium is $101,010. The break-evenpoint is 10301, where the Dow Future is equal to the sum of the strike priceand call premium. Above this point the covered call portfolio becomes lessprofitable than the original portfolio. Since the short call is covered by theportfolio, this strategy is not exposed to the risk represented by a naked call.The main risk is that the trader gives up the profit potential above the strikeprice of the call. As is obvious to the technician, this is a bad strategy intrending markets. Only in clearly range-bound markets would an enlightened trader want to write covered calls. The call premium collected is somecompensation for this risk, but cold comfort when the trader has misanalyzed the market. The best strike price of the call depends on the probabilitiesyou have assigned to future increases and behavior of the Dow.
Using Option Spreads in High- or Low-Volatility MarketsLong and short stock positions reflect definite market opinions or analyses.The market will go up or the market will go down and the moderatelycompetent technician should be right about this more often than theunwashed general public. In markets of coiling volatility (i.e., lower than
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average volatility and declining), it is sometimes possible to exploit uncertainty by putting on a long straddle. The long straddle combines a long putand a long call at the same strike price. This spread generates a return overtwo ranges of market values: values below the strike price of the put andvalues above the strike price of the call. It is a profitable strategy givensufficient volatility. The Editor’s company used such a strategy immediatelybefore the crash of 1987 for managed accounts and collected disproportionateprofits on a very low risk position. Experienced speculators and tradersgenerally sell high-volatility markets and try to backspread (go long) inchosen less volatile markets, expecting volatility to return to the mean.Sometimes they do this by writing a short straddle, a position with a shortput and a short call at the same strike price.
Situation 3In August, a technical analysis predicts that volatility will increase, and themarket is in a coiling process. The direction of prices is uncertain but potentially explosive. The trader buys a straddle of a long put at 7800 and a longcall at 7800. The quoted call premium is 18.90 and the quoted put premiumis 13.90. The total cost of the straddle is $3280 = $100 ⋅ 32.80. This is themaximum loss if the Dow Future stalls at 7800.The straddle makes a profit when the Dow Future moves enough torecover the cost of the straddle, either below 7472 = 7800 – 328 or above8128 = 7800 + 328. The potential upside profit is unlimited. The maximumprofit on the downside is $10 ⋅ (7800 – 328), or $74,720, if the Dow Futuregoes to zero (somewhat unlikely, but one never knows what Chicken Littlethe investor will do if he thinks the sky is falling).
Situation 4In August, the investor calculates that options are overvalued and that volatility will be lower than implied volatility. He expects a dormant market tocontinue through the end of the summer. He decides to sell the Septemberput and call at 7800, collecting $3280. The return on this short straddle willturn negative if the Dow Future in September goes below 7472 or above8128. The maximum loss on the downside is $10 ⋅ (7800 – 328), or $74,720,and the loss on the upside is unlimited. The investor, however, perceives therisk as limited, because he believes that the Dow Future will neither increasenor decrease to these levels within the next month when the options expire.Of course, in these cases, the trader must also consider catastrophic risk —as, for example, the Editor’s client who was short puts in the crash of 1987and lost $57MM.
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Perspective (EN9: Once again, do not practice the methods andtechniques described in this chapter without complete confidencein their use. A course in futures and options is recommended, orprofessional consultation.)I like to tell these stories so that prospective options traders and generalinvestors are made dramatically aware of the potential dangers, as well asthe potential profits. As I have said elsewhere in this book, the novice shouldwork to achieve competence and experience before attempting advancedtricks in futures and options. On the other hand, the investment use of theseinstruments for prudent hedging and insurance is recommended to theinvestor willing to do his homework, acquire competence, and grow ininvestment skills.Dow Index futures and futures options present new techniques of portfolio protection and profit-making for the general investor. Numerous strategies can be practiced by the moderately competent investor using theseinstruments. Keep in mind always that all the methods of analytical investingespoused in this book are the base discipline: that is, knowledge of theinstruments and their use; prudent trade management; and stop loss discipline; and close attention to the dynamics of the situation.Above all, the existence of these instruments allows the most conservative of investors insurance and hedging techniques not previously available.In sum, knowledge of the DJIA Futures and Options on Futures isabsolutely essential for the competent technical investor and trader.
Recommended Further StudyIn view of the importance of this chapter, I note here references to advancedmaterial, which will also be found in Resources (Appendix D). For moreinformation:Options as a Strategic Investment by Lawrence Macmillan.(www.optionstrategist.com)Chicago Board Options Exchange: www.cboe.comChicago Board of Trade, 312-435-3558 or 800-THE-CBOT.Fax: 312-341-3168; http://www.cbot.com
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part two
Trading TacticsMidwordAs a kind of foreword to the second part of this book, we might mention acommentary, “On Understanding Science: An Historical Approach,” byJames Bryant Conant, president emeritus of Harvard.Dr. Conant points out that, in school, we learn that science is a systematiccollection of facts, which are then classified in orderly array, broken down,analyzed, examined, synthesized, and pondered; and then lo! a Great Principle emerges, pat, perfect, and ready for use in industry, medicine, orwhat-have-you.He further points out that all of this is a mistaken point of view whichis held by most laymen. Discovery takes form little by little, shrouded inquestioning, and only gradually assumes the substance of a clear, precise,well-supported theory. The neat tabulation of basic data, forming a series ofproofs and checks, does not come at the start, but much later. In fact, it maybe the work of other men entirely, men who, being furnished with theconclusions, are then able to construct a complete, integrated body of evidence. Theories of market action are not conceived in a flash of inspiration;they are built, step by step, out of the experience of traders and students, toexplain the typical phenomena that appear over and over again through theyears.In market operations, the practical trader is not concerned with theoryas such. The neophyte’s question, “What is the method?” probably means,actually, “What can I buy to make a lot of money easily and quickly?” Ifsuch a trader reads this book, he may feel that there is “something in it.” Hemay feel “It’s worth a try” (a statement, incidentally, that reflects little crediton his own previous tries). And he may start out quite optimistically, withoutany understanding of theory, without any experience in these methods, andwithout any basis for real confidence in the method.
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In such cases, the chances are great that he will not immediately enjoythe easy success he hopes for. His very inexperience in a new approach willresult in mistakes and failures. But even with the most careful applicationof these methods, in correctly entered commitments, he may encounter aseries of difficult market moves which may give him a succession of losses.Whereupon, having no solid confidence in what he is doing, he may sigh,put the book back on the shelf, and say, “Just as I thought. It’s no damngood.”Now if you were about to go into farming for the first time, you mightbe told (and it would be true) that the shade tobacco business offers spectacular profits. But you would not expect to gain these profits without investing capital, without studying how shade tobacco is grown, in what kinds ofsoils, in what localities, nor without some experience with the crop.Furthermore, you would need confidence — faith in the opportunityand also in the methods you were using. If your first season’s crop wereblighted (and these things do happen), you would naturally be disappointed.If it should happen that your second year’s crop were destroyed by a hailstorm, you would be hurt and understandably despondent. And if your thirdseason’s crop were to be a total loss due to drought, you would probably bevery gloomy indeed (and who could blame you?). But you would not say,“There’s nothing to it. It’s no damn good.”You would know (if you had studied the industry and the approvedcultivation methods) that you were right, regardless of any combination ofunfavorable circumstances, and you would know that the ultimate rewardswould justify your continuation no matter how hard the road, rather thanturn to some easier but less potentially profitable crop.So it is with technical methods in the stock market. Anyone may encounter bad seasons. The Major Turns inevitably will produce a succession oflosses to Minor Trend operators using the methods suggested in this book.And there will be times when a man who has no understanding of basictheory will be tempted to give up the method entirely and look for a “system” that will fit into the pattern of recent market action nicely, so that hecan say, “If I had only averaged my trades…. If I had followed the DreamBook…. If I had taken Charlie’s tip on XYZ…. If I had done it this way orthat way, I would have come out with a neat profit.”It would be better, and safer, to understand at the start that no methodthat has ever been devised will unfailingly protect you against a loss, orsometimes even a painful succession of losses. You should realize that whatwe are looking for is the probability inherent in any situation. And just asyou would be justified in expecting to draw a white bean from a bag whichyou knew contained 700 white beans and 300 black beans (even though youhad just drawn out 10 black beans in succession!), so you are justified incontinuing to follow the methods which, over long periods, seem most surelyand most frequently to coincide with the mechanism of the market.So this book should not be given a quick “once-over” and adoptedstraightaway as a sure and easy road to riches. It should be read over and
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over, a number of times, and it should be consulted as a reference work.Furthermore, and most important, you will need the experience of your ownsuccesses and failures so that you will know that what you are doing is theonly logical thing you can do under a given set of circumstances. In such aframe of mind, you will have your portion of successes; and your failures,which you can take in stride as part of the business, will not ruin either yourpocketbook or your morale.In short, the problem stated and analyzed through this whole volumeis not so much a matter of “systems” as it is a matter of philosophy. The endresult of your work in technical analysis is a deep understanding of what isgoing on in the competitive free auction, what is the mechanism of thisauction, and what is the meaning of it all. And this philosophy does notgrow on trees. It does not spring full-bodied from the sea foam. It comesgradually from experience and from sincere, intelligent, hard work.The second section of this book, which follows, is concerned with tactics.Up to this point, we have been studying the technical formations and theirconsequences. We should have a good general understanding of what islikely to happen after certain manifestations on the charts. Knowing that,however, we will still need a more definite set of guides as to when and howit is best to execute this or that sale.This section is based on one man’s experience and his analysis of thousands of specific cases. It takes up questions of method, of detail, and ofapplication, and should provide you with a workable basis for your actualmarket operations. As time goes on, you will very likely adopt refinementsof your own, or modify some of the suggested methods according to yourown experience. But the authors feel that the suggestions made here willenable you to use technical analysis in an intelligent and orderly way thatshould help to protect you from losses and increase your profits.John Magee
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chapter eighteen
The Tactical ProblemEN: Magee in this chapter addresses the question of tactics for the “speculator” whofollows short- and medium-term trends. Chapter 18.1 addresses the question ofstrategy and tactics for the long-term investor. See Chapter 18.1 for a discussion ofthe term “speculator.”It is possible (as many traders have discovered) to lose money in a BullMarket — and, likewise, to lose money trading short in a Bear Market. Youmay be perfectly correct in judging the Major Trend; your long-term strategy,let us say, may be 100% right. But without tactics, without the ability to shapethe details of the campaign on the field, it is not possible to put your knowledge to work to your best advantage.There are several reasons why traders, especially inexperienced traders,so often do so poorly. At the time of buying a stock, if it should go up, theyhave no objectives and no idea of what policy to use in deciding when tosell and take a profit. If it should go down, they have no way of decidingwhen to sell and take a loss. Result: they often lose their profits; and theirlosses, instead of being nipped off quickly, run heavily against them. Also,there is this psychological handicap: the moment a stock is bought (or soldshort), commissions and costs are charged against the transaction. The traderknows that the moment he closes the trade, there will be another set ofcharges. Also, since he is not likely to catch the extreme top of a rally or theextreme bottom of a reaction, he is bound, in most cases, to see the stockrunning perhaps several points against him after he has made his commitment. Even on a perfectly sound, wise trade, he may see a 10% or morepaper loss, before the expected favorable move gets under way. Obviously,if he weakens and runs for cover without sufficient reason before the stockhas made the profitable move he looked for, he is taking an unnecessary lossand forfeiting entirely his chance to register a gain.The long-term investor who buys in near the bottom and remains in themarket to a point near the top, and then liquidates and remains in cash orbonds until (perhaps several years later) there is another opportunity to buyin at the bottom, does not face the continual problem of when to buy andwhen to sell. This assumes that one can tell precisely when such a bottomhas been reached, and that one can also tell when the trend has reached itsultimate top (and those are very broad assumptions indeed). The long-terminvestment problem for large gains over the Major Trends is by no means
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H76
S
S
1928
726864CUDAHY PACKING60Sales100’s
S
H
CUX
S
125100755025JULY7 14
AUGUST
21 28 4 11 18 25 1
SEPTEMBER
OCTOBER
NOVEMBER DECEMBER
8 15 22 29 6 13 20 27 3 10 17 24 1
8 15 22 29
FIGURE 200. It is possible to lose money owning stocks in a Bull Market. Noticethat this Major Top Formation did not occur in 1929, but in the summer of 1928. Formore than a year after this, a majority of stocks and the Averages continued the BullMarket Advance. But Cudahy declined steadily, reaching a price below 50 well beforethe 1929 Panic, and continued in its Bearish course for over 4 years, ultimately sellingat 20. Except for the somewhat unusual volume on the head on August 21, this is atypical Head-and-Shoulders Pattern with a perfect Pullback Rally in mid-November.It underscores what we have mentioned before; that a Head-and-Shoulders Top ina stock, even when other stocks look strong, cannot safely be disregarded.The Head-and-Shoulders Pattern, either in its simple form or with multiple headsor shoulders, is likely to occur at Major and Intermediate Tops, and in reverse positionat Major and Intermediate Bottoms. It has the same general characteristics as tovolume, duration, and breakout as the Rectangles, and the Ascending and Descending Triangles. In conservative stocks, it tends to resemble the Rounding Turns.
as simple as it sounds when you say, “Buy them when they’re low, and sellthem near the top.” However, such large gains have been made over thelong pull, and they are very impressive. EN: Note the record of the Dow Theoryin Chapters 5 and 5.1.This section of the book is concerned more particularly with the speculative purchase and sale of securities.There are some basic differences between the “investment” point of viewand the “speculative.” It is a good thing to know these differences and makesure that you know exactly where you stand. Either viewpoint is tenableand workable, but you can create serious problems for yourself, and sustainheavy losses, if you confuse them.One difference is that, as a speculator, you are dealing with stocks assuch. A stock, to be sure, represents ownership in a company. But the stockis not the same thing as the company. The securities of a strong companyare often weak; and sometimes the securities of a very weak concern are
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60565248444038
HUDSON MOTORS
HT
3634
1930
32302826Sales100’s5040302010JANUARY FEBRUARYAPRILJUNEMARCHMAY4 11 18 25 1 8 15 22 1 8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28
FIGURE 201. What would you have done with Hudson Motors? The great PanicMove of October–November 1929 carried the Dow–Jones Industrial Average downfrom its September all-time high of 386.10 to a November low of 198.69. A rally,bringing the Average back to 294.07 in April 1930, recovered 95 points or 51% of theground lost, a perfectly normal correction.Suppose you had bought HT after the decline from its 1929 high of 93½, say at 56,in the belief that the 37 point drop had brought it into a “bargain” range. On yourdaily chart, you would have seen the pattern shown above (which you will nowrecognize as a Descending Triangle) taking shape in the early months of 1930. Wouldyou have had a protective stop at 51? Would you have sold at the market the dayafter HT broke and closed below 54? Or would you have hoped for a rally, perhapseven bought more “bargains” at 50, at 48, at 40? Would you still have been holdingonto your “good long-term investment” when HT reached 25½ in June? Would youstill have been holding HT when it reached its ultimate 1932 bottom at less than 3?(See Figure 65.) EN: See Figure 201.1 for a recaptiulation of the lesson from the 2000s.
exceedingly strong. It is important to realize that the company and the stockare not precisely identical. The technical method is concerned only with thevalue of the stock as perceived by those who buy, sell, or own it.
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A second difference is in the matter of dividends. The “pure investor,”who, by the way, is a very rare person, is supposed to consider only the“income” or potential income from stocks — the return on his investmentin cash dividends. EN: This rara avis is largely extinct now. But there are manycases of stocks which have maintained a steady dividend while losing asmuch as 75% or more of their capital value. There are other cases wherestocks have made huge capital gains while paying only nominal dividendsor none at all. If the dividend rate were as important as some investorsconsider it, the only research tool one would need would be a calculator todetermine the percentage yields of the various issues, and hence their“value.” And, on this basis, stocks paying no dividends would have no valueat all.From the technical standpoint, “income,” as separate from capital gainsand losses, ceases to have any meaning. The amount realized in the sale ofa stock, less the price paid and plus total dividends received, is the totalgain. Whether the gain is made entirely in capital increase, or entirely individends, or in some combination of these, makes no difference. In the caseof short sales, the short seller must pay the dividends. But, here again, thisis simply one factor to be lumped with the capital gain or loss in determiningthe net result of the transaction.There is a third source of confusion. Very often, the “pure investor” willinsist that he has no loss in the stock he paid $30 for, which is now sellingat $22, because he has not sold it. Usually he will tell you that he hasconfidence in the company and that he will hold the stock until it recovers.Sometimes he will state emphatically that he never takes losses.How such an investor would justify his position if he had bought Studebaker at over $40 in 1953 and still held Studebaker Packard at around $5 in1956 (EN: Or Osborne at $25 and $0 in the 1980s or Visacalc at similar prices inthe same decade. EN9: Or Enron and WorldCom in the 2000s.) is hard to say. Butfor him, the loss does not exist until it becomes a “realized” loss.Actually, his faith that the stock will eventually be worth what he paidfor it may be no more than a speculative hope; and a forlorn one at that.Furthermore, one may question whether his reasoning is always consistent. For example, suppose another stock this investor had bought at $30was now selling at $45. Would he tell you that he did not consider a profitor loss until the stock was sold? Or would he be tempted to speak of the“profit” he had in this purchase?It is all right to consider gains or losses either on the basis of “realized”or completed transactions, or on the basis of the market values “accrued” ata particular time. But it is not being honest with yourself to use one methodto conceal your mistakes and the other method to accentuate your successes.The confusion of these concepts is responsible for many financial tragedies.EN: One might almost say, in the modern context, that such confusion amounts towillful or neurotic behavior. Given the easy availability of portfolio software which“marks to market” positions, avoidance of this knowledge can only be regarded asself-defeating.
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As a trader using technical methods, you will probably find the mostrealistic view is to consider your gains and losses “as accrued.” In otherwords, your gain or loss at a given time will be measured with reference tothe closing pricing of the stock on that day.Recapitulating, it is important: (1) to avoid regarding a stock and thecompany it represents as identical or equivalent; (2) to avoid the consciousor unconscious attribution of “value” to a stock on the basis of dividendyield, without regard to market prices; and (3) to avoid confusing “realized”and “accrued” gains or losses.*The technical trader is not committed to a “buy and hold” policy. Thereare times when it is clearly advantageous to retain a position for manymonths or for years. But there are also times when it will pay to get out ofa stock, either with a profit or with a loss. The successful technician willnever, for emotional causes, remain in a situation which, on the evidence athand, is no longer tenable.An experienced trader using technical methods can take advantage ofthe shorter Intermediate Trends, and it can be shown that the possible netgains are larger than the entire net gains on the Major Trend, even afterallowing for the greater costs in commissions and allowing for the greaterincome tax liability on short-term operations.But it should be understood that any such additional profits are noteasily won. They can be obtained only by continual alertness and adherenceto systematic tactical methods. For the market, regarded as a gamblingmachine, compares very poorly with stud poker or roulette, and it is notpossible to “beat the market” by the application of any simple mathematicalsystem. If you doubt this, it would be best to stop at this point and make acareful study of any such “system” that may appeal to you, checking itagainst a long record of actual market moves. Or ask yourself whether youhave ever known anyone who followed such a system alone, as a guide tomarket operations, and was successful. EN: After Magee wrote this, manysuccessful traders, aided by computer technology and advances in finance theory,have created objective systems which have been successful in the financial markets.However, the markets usually become aware of the success of these systems anddevelop counterstrategies to defeat them. So there is a tendency for the performanceof mechanical systems to degenerate or totally fail over time. In fine it is the happycombination of the system with markets hospitable to it which makes mechanicalsystems successful over defined periods of time.The practice of technical analysis, on the other hand, is not a mathematical process, although it does, of course, involve mathematics. It is intendedto search out the significance of market moves in the light of past experiencein similar cases, by means of charts, with a full recognition of the fact that* Some of the most serious and dangerous “traps and pitfalls” of the market are tied up withdifficulties of perception on the part of the investor, and consequent misevaluations and faultyidentifications. For a particular study of these psychological problems, see The General Semanticsof Wall Street by John Magee. EN: Now in its second edition as Winning the Mental Game on WallStreet, a title chosen by a computer, as edited by the present Editor.
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the market is a sensitive mechanism by which all of the opinions of allinterested persons are reduced by a competitive democratic auction to asingle figure, representing the price of the security at any particular moment.The various formations and patterns we have studied are not meaninglessor arbitrary. They signify changes in real values, the expectations, hopes,fears, developments in the industry, and all other factors that are known toanyone. It is not necessary that we know, in each case, what particular hopes,fears, or developments are represented by a certain pattern. It is importantthat we recognize the pattern and understand what results may be expectedto emerge from it.The shorter-term profits are, you might say, payment for service in the“smoothing out” of inequalities of trends, and for providing liquidity in themarket. As compared to the long-term investor, you will be quicker to makecommitments, and quicker to take either profits or (if necessary) losses. Youwill not concern yourself with maintaining “position” in a market on anyparticular stocks (although, as you will see, we will try to maintain a certain“total Composite Leverage” [or risk and profit exposure] according to thestate of the market, which accomplishes the same result). You will havesmaller gains on each transaction than the longer-term investor, but you willhave the advantage of being able to frequently step aside and review theentire situation before making a new commitment.Most particularly, you will be protected against Panic Markets. Thereare times (and 1929 was by no means the only time) (EN: 1987 and 1989 alsocome to mind. EN9: Add 2001-2, if you please: 5/21/01, Dow 11350; 9/17/01, 8062;and 3/18/02,