ities, techs, Internets, biotechs, ad infinitum….The reason for this is simply that, very often, many stocks in a particularindustrial group will show the same or similar patterns, as the entire industryis affected by certain Major conditions. You will often find, for instance, thatwhen Allis-Chalmers (EN: or Dell) makes a Triangle or other Area Pattern,followed by a sharp upward move, Deere (EN: or Compaq), MinneapolisMoline, Harvester, and Case will make similar Triangles, or possibly Rectangles or some other Consolidation Pattern, followed by a similar upwardmove. When Schenley is moving in a long downtrend, you will very likelyfind that Distillers — Seagrams, National Distillers, Publicker, and AmericanDistilling — are also moving in a long downtrend. EN: Metaphorical names,like the names of Greek gods. Or Ulysses and Leopold Bloom. The present-day readermay read Intel, Fairchild, and National Semiconductor or 3COM. The idea is thesame.Therefore, unless you plan to keep enough charts to include severalstocks of each important group, it is best to pick your stocks to make up aswidely diversified a list as possible. In this way, during times when certaingroups are moving indecisively, or are inactive, you will have some representation in other groups which may be active. (Do not infer from this thatall stocks of a group move together at all times. Individual concerns willfrequently move according to special influences that bear on a single company. But where the Major influence is some industry-wide condition, thegroup will move more or less as a unit.)We, therefore, choose stocks representing a wide variety of groups orbasic industries. But, suppose we are limited as to the number of charts, andwe must choose one stock from a group; which stock to choose? Suppose,for instance, we must choose one stock from the transportation group. EN:Or Biotech, or Internets. As a matter of fact, you would probably want morethan one because this particular group is so important and so large. But for
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the moment, let us choose just one. EN9: Or, even better, why not one of theindexes for the desired group. An example of betting on all the horses rather thantrying to pick the winner, and there is no conflict between making both bets.Should it be a high-priced stock or a low-priced stock? Let us examinethat point first.If you examine the past records of stocks you will find that, in general,the lower-priced issues make much larger percentage moves than the higherpriced stocks. It is not unusual for a stock selling around 5 to make a rise of100%, moving up to 10 sometimes within a few weeks. On the other hand,you do not find 100% moves in days or weeks among the stocks selling at100 or 200. The same industry-wide move which carries your $5 stock from5 to 10 might carry your $100 stock from 100 to 140. Obviously, if you hadput $1000 into outright purchase of the stock at 5, the move would haveincreased the value of your stock 100% or $1000. In the other case, if youhad put the same amount into a stock at 100, the move to 140 (althoughmany more points) would have increased your capital to only $1400. Thegain in the lower-priced stock would be about two- and one-half times asgreat.The authors have worked out and tabulated the percentage moves oflarge groups of stocks over long periods of time (cf. Appendix A), and haveset up a table which shows the relative average sensitivity of stocks at different price levels. This table pertains only to the price level of stocks; thus,the same stock which today sells at 5 and makes wide percentage swingswill not swing so widely when it has moved up to a price level of 20 to 30.Several questions may come to your mind at this point. Do not the costsof trading low-priced stocks relative to higher-priced issues have to be takeninto account? EN: Yes, they do. Given the extreme changeability in these costs inthe Internet economy, calculation of those costs here would be tantamount to wastingtrees. This cost question may be researched quickly and easily given availability ofgoogle.com and the Internet.In selecting the price level of the stocks you prefer to trade in, you cannotset too arbitrary a limit, since there are other factors to consider, and youmay have to make some compromises on one score in order to get what youwant in some other direction. Stocks from 20 to 30 are in a good tradingprice range. Very often, you will find stocks in the 10 to 20 range which areso interesting you will want to chart them, and trade in them. You will findgood situations in stocks selling at 30 to 40. Furthermore, you will understand, of course, that the stocks which are now selling at 10 may be sellingnext year at 40, or vice versa. And since you cannot be changing yourportfolio of charts all the time, you must not be too “choosy” in picking theprice range of your stocks. However, you would not ordinarily pick out astock that was selling far above the price range of most stocks of its group,say at 150, when several others in the same industry were selling at 15, 28,or 37. For the high-priced stock, as we have said, is likely to be sluggish as
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FIGURES 204 and 205. Low-priced stocks move faster than high-priced stocks.Here are weekly charts of two rail stocks, charted on ratio scale over the same6-month period. Baltimore and Ohio during this time advanced from 12⅜ to 28⅞, again of 16½ points, while Union Pacific moved up from 109 to 137, a gain of 28 points.The advance in “UP,” however, compared to its price, is much less than the advancein “BO.” A thousand dollars used for outright purchase of “UP” would show you acapital increase of 25%. On the other hand, if you had put a thousand dollars intooutright purchase of “BO,” your increase would have been 133%, or more thanfive times as much.Bear in mind that low-priced stocks not only go up much faster, but also comedown much faster than high-priced stocks. When you own a low-priced stock, youcannot safely “put it away in the box and forget it.” For security and stability, youwould do better to buy a few shares of a high-priced, gilt-edge security. But, fortrading purposes, you will want to strike a compromise between the rather sluggish“blue chips” and the extremely erratic “cats and dogs” in the lowest price bracket.
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a trading medium. On the other hand, you would not take the very lowestpriced issues of the group, selling at, say, 4 or 2 when others were in the10 to 30 bracket. You would not only be faced with erratic and tricky chartaction, and much higher percentage costs for commissions; but you mightnot be able to operate on margin at all. There are, from time to time, limitations on the amount of margin on stocks at all levels. In the lower-pricedissues, these limits are often more stringent. And in the lowest-pricedstocks, you are sometimes not permitted to trade on margin. EN: Becausethese requirements are subject to the vagaries of the Federal Reserve Board, theinvestor must inform himself at his personal broker or ECN. For quite some yearsthe general margin requirement has been 50%. The Fed came in for some sharpcriticism for not dampening speculation in the fin de siècle bubble by raisingmargin rates to 100%, and its lack of action exacerbated the blow off of 2000. Achange in margin rates should get the immediate attention of the tecnical analyst.Something will be up.Ordinarily, you will get the greatest effective leverage at some point inthe 20s, considering all these factors. And your trading can run downthrough the teens and up through the 40s. Above 40 and below 10, you willhave to have strong reasons for trading, which might be, of course, amplecapital. It would therefore be best for the moderately financed investor tochoose a majority of his stocks from the middle price range (10 to 40), plusonly those special situations you are particularly interested in watchingamong the very low and very high brackets.However, if you will go back to the long-time past record of any groupof stocks, you will find that even among stocks moving at nearly the sameprice levels today, there are widely different behavior patterns. You will findthat some stocks respond to a severe market setback by reacting, let us say,20% — that is, if they were selling at 30, they would move down to around24. And you will find others that will respond to the same setback in thegeneral market by a reaction of 50% — that is, if they were selling at 30, theywould end up at around 15. And you will notice, if you examine the records,that the same stocks which make these relatively different reactions in onesetback will make about the same moves, relative to each other, in othersetbacks. Furthermore, the same ones which make only moderate correctionson declines will make only moderate advances on rises. And the ones thatgo down sharply on setbacks will also skyrocket in a Bullish Market. Thishas nothing to do with the phenomenon we discussed earlier, by which wesaw that cheap stocks move faster than expensive stocks. This is due to thehabits of particular stocks, and these habits seem to be quite stable overperiods of many years.We will find, for instance, volatile and speculative issues which makelarger percentage swings than most other stocks at their price level. And, onthe other hand, we will find a stock, selling for much less, that has smallerpercentage swings than most stocks at its price level. This fact may beobscured, as the comparatively low-priced stock may actually make largerswings than the higher priced. It is only when we have taken the price level
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into account that we can see what the individual habit of the stock really is.Knowing this, we can project that habit to other price levels.We are not too interested, as we have said before, in stocks which donot ordinarily make substantial moves. We are very much interested in thosewhich make the wider moves. We can compute the basic swing power of astock, which we call the Sensitivity Index, and will outline the method fordoing this in Appendix A. EN: The procedure Magee speaks of here, of computinga “Sensitivity Index,” may be regarded as the historical predecessor of what are nowcalled “betas.” The beta of a stock compares its relative volatility to that of the marketas a whole, so that if the beta of the market is 1.00 and the beta of the stock inquestion is 1.50 a move of $1 in the market will probably be matched by a move of$1.50 in the higher beta stock. The formula for beta will be found in Resources, andcalculated betas at finance.yahoo.com.So, you will have eliminated from your list stocks at the wrong pricelevel and stocks without enough swing power (for you want to chart onlythose stocks in which you can trade profitably). Of the ones that are left, youwill eliminate others. You will find that some stocks, which make wide pricemoves and apparently offer large opportunities for profit, may be very“thin.” The charts will be spotty, filled with gaps, days of “no sale,” andmoves of several points on only a few hundred shares of business. Thesestocks are thin because of a small issue, because of ownership of a largeblock of shares by some corporation or by insiders, or for other reasons.They are difficult to trade in because they are hard to buy and hard to sell;you stand to lose heavily on the “spread” between bid and offer. It mightbe hard to liquidate even 500 shares without driving the price down badly,to your loss, and sometimes you will see changes of 1 or 2 full points betweensales of single hundreds. These you will want to eliminate, and if you donot know the habits before you choose your portfolio, you will probablyfind it worthwhile to drop any stocks that prove too thin, substituting newand more dependable choices.After you have culled the list from all these angles you will find youhave left a choice of a number of stocks, all of them selling in a price rangethat is attractive, all of them sufficiently active and responsive to markettrends, and all of them available in sufficient supply to provide a goodtrading medium. The final choice of any one (or several) of these stocks isthen a matter of personal preference.After you pick out your stocks from one group, study the other groups —the motors group, the amusements, the computers (EN: the Internets) and soforth, until you have finally made up your selection of stocks to follow. Tryto get as complete and balanced a representation of groups as the numberof your charts will allow. EN: In this context, the process described here is madeinfinitely simpler by available software and by the proliferation of group indexesand indicators. In fact, if the investor desires, rather than trading an individualstock in an industry group, he may often choose to trade the average or index itselfand cushion his risks. This will almost never be as profitable as a well-chosenindividual issue, but will always be better than a badly chosen individual issue.
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In this connection, if you are not planning to represent all groups, thereare some groups that are more likely to provide good trading stocks thanothers. The foods and tobaccos, for example, are generally less responsiveto market swings than the rails, liquors, and airlines, which are very responsive. Do not worry too much, however, about exactly which stocks to choose.For even if you took the first 50 or 100 stocks in the listed issues, you wouldhave among them at least 25 good trading stocks. You can start with almostany list, and, as time goes on, you will drop some and add others, improvingyour portfolio and tailoring it to your own needs.EN: As additional commentary here it is worth noting that “techs,” “biotechs”(or whatever the mania of the moment is — probably space hotels and intergalactictravel in this millennium) will present areas of risk and reward sufficient to excitethe 17th century tulip trader. The centered investor and trader will consider voguesand manias as he chooses his active portfolio and choose to participate (or not)depending on his appetite for risk and excitement. Or as the popular maxim has it,one man’s champagne is another man’s poison. This question is pursued in greaterdetail in Chapter 23.By way of further simplification, the investor may choose to follow only one ortwo issues — the SPDRs (SPY) or DIAMONDS (DIA). If it were not only bought,but also sold, or hedged, the market would be outperformed. This would be a simpleinvestor’s life indeed.
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chapter twenty-three
Choosing and ManagingHigh-Risk Stocks: TulipStocks, Internet Sector,and Speculative FrenziesNothing could more vividly illustrate the timeless nature of chart patternsand situations than the Internet stocks which bloomed at the turn of thecentury. These stocks repeated that eternal pattern — the tulipomania, thegold rush, the can’t-fail-opportunity-to-get-rich-quick.It is almost impossible to resist comparing the speculative frenzy whichtook place in the Internets and technology issues to the famous 17th centurymania which Holland experienced in the famous tulipomania. In MacKay’sundying classic account (Extraordinary Popular Delusions and the Madness ofCrowds), the trading of tulip bulbs replaced sober commerce and businessas the occupation of the country, and enormous fortunes were made tradingthe tubers. Blocks of real estate, breweries, assets of real and large value weretraded for one tulip bulb. And MacKay produced my favorite paragraph inthe literature of finance: “A golden bait hung temptingly out before thepeople, and one after the other, they rushed to tulip-marts, like flies arounda honey pot. Every one imagined that the passion for tulips would lastforever, and that the wealthy from every part of the world would send toHolland, and pay whatever prices were asked for them.”That mania ended in ruin. A better long-term prospect may be in storefor the Internets as there is a basis of technology and economic substance tothe sector. You could not, after all, use your tulip to check the market forprices. And, in fact there were those, admittedly a small number, who struckit rich in the California gold rush of 1849. It’s an ill wind, etc….But as an exercise in rueful perspective, the seventh edition of this bookremarked, in the words of Richard McDermott, “Companies like Lotus orMicrosoft went public and grew into business giants in a short period oftime…. A significant theme stock for the 1990s has been Internet stocks.Names like America Online, CompuServe, and Netscape have providedimportant products and services that allow individuals to ‘surf the net’ forinformation around the world.” Young students of the market will search invain for Lotus, CompuServe, and Netscape in the lists of stock symbols. The401
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giant Lotus was swallowed by IBM, in part because Microsoft, a ruthlesscompetitor, disemboweled it. CompuServe and Netscape disappeared intothe belly of a larger fish, AOL, with some of the same factors involved. LaterMicrosoft got its comeuppance — halving in value as the U.S. Justice Department brought successful antitrust action against it.There are those who fault the great Wall Street investment banks for havingbrought half-baked potatoes (or unblooming tulips) to market. The Street firms,cashing in on the mania, were willing to sell the public every immature profitless idea and company named “dot.com inc” that venture capitalists floatedon a sea of seed money. Mining engineers will recognize the phenomenon of“salting the mine.” It was the finest moment for the great old firms of the Streetsince the investment trusts of the 1920s. The reader is most recommended tolook into The Great Crash 1929 by John Kenneth Galbraith to compare the Streetfirms’ behavior from one mania to the next. It will be found most edifying. Atthe pinnacle of great manias, no one can be trusted.
Managing Tulipomanias and Internet FrenziesIn a time of excess, the centered investor maintains his composure and focus.Probably easier said than done. Nonetheless, many investors and tradersprofited from the Internet boom or were not severely damaged. Many managers and traders watched with envy from the sidelines, and with schadenfreude when the bubble burst.For technical analysts speculating and trading according to the principlesof this book, important opportunities arise in speculative frenzies and buyingpanics — namely important profits may be made by remaining calm andmethodical while the uninformed and naive cause speculative blow-offs.And, speculative blow-offs have some things in common with the ends ofgreat bull trends in substantive issues.So the question becomes that of realizing some of the profits to be madein these exciting times. Of course, the first thing to do is not get excited.These manias come and go — sometimes they are called biotechs, sometimescomputers, sometimes Internets, and probably, at some point, humangenome miracle drugs or Martian real estate. It should be emphasized thatthese profits are to made on both sides, long and short. The crowd will onlythink of the riches to be made long. Professionals and skilled technicians,professional or not, will take the profits on the short side.Here is the most important concept in trading these runaway issues: allof the techniques and methods described in this book remain valid for dealing withthese kinds of stocks. In addition, here are some other points which should betaken into consideration. The sector in question, tech-tech, web-tech, biotech, Internet, space travel, whatever, will be a market unto itself, and specialtechnical factors will apply to it. The phases of market lives, accumulation,attraction, mark up, mania, blow-off will occur in compressed time spans —much shorter than the cyclical life of an issue with fundamental data toattach it to reality (cf. Figure 205.2 of Palm Computing).
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MSFT(D) - Daily NASDAQ L = 27.56 +0.35 +1 .29% B = 27.55 A = 27.56 O = 27.67 Hi = 27.73 Lo = 27.44 C = 27.56 V = 57145012
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FIGURE 205.1. Multitudinous lessons in Microsoft. But short-lived joy. The toprounds over, price makes another attempt, and then the momentum is clearly, ifpuzzlingly down. The cancellation of the runaway day in January definitely markedthis move as a bull trap, and the short-term trendline from October would also havetaken the trader out of the trap. Use of basing points technique (Chapter 28) wouldalso have allowed escape from the trap. Failed signals, as this one, often are excellentsignals for a trade in the other direction.
By the time the IPO occurs, the insiders are already prepared to begin thedistribution phase. For example, when Palm Computing was spun off from3Com in 2000, only 3% of the shares were sold — creating an artificial scarcityand propelling it to absurd heights — so that Palm attained an instant marketvalue greater than that of 3Com which owned most of its stock. EN9: We have,since The Fall, learned of “laddering.” In order to let their inside clients in on the IPOsome of the underwriters required the clients to buy more of the stock in the open marketafter the IPO at higher prices. A clever way to throw gasoline on a raging bonfire.Whether Palm was laddered or not is not known.These issues must be traded with the utmost care and attention. Forexample, it is the height of foolishness to enter a market order to buy on theissue of the IPO. An issue going public at 12 might trade on the opening at50 in these frenzies — a sign to the savvy technician that the sheep are headedfor the shearing shed.Certain factors must be kept in mind. Some IPOs collapse shortly aftergoing public. Others rocket off before distribution is complete. So stops mustbe carefully computed. Once it is clear that the rocket is taking off, asindicated by price and volume, some discreet pyramiding might be possiblefor the experienced and skilled speculator.
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Microsoft Corporation-(Nasdaq NM) 26.86 0.03 0.11%52443628242016128
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FIGURE 205.1.1. MSFT Monthly. It is easy to lose perspective when looking at adaily chart of a bull trap in which one has lost a leg. A monthly long-term look atMicrosoft can help restore perspective. Unfortunately, the Dow–Jones Company waslooking at this chart, not the nearby, when they added Microsoft to the Dow 30 in2000. Expert timing? At the time the John Magee Newsletter observed that it was anegative indicator of a major top in the Industrials.
Detailed Techniques for Managementof the Runaway IssuesThe technique described in Chapter 28 for progressive stops is certainly oneway of dealing with these stocks. There the method for finding basing pointsand raising stops based on the 3-days-away rule is detailed. Also, especiallyin the case of these rocket stocks, the practice of raising stops based on newpercentage highs should be implemented. Since these are “game” situations,and irrational, one may employ tactics that he might not ordinarily use withhis serious capital — some light pyramiding and some scaling out of theposition based on continuous new highs. Additionally in the blow-off phasewhen close monitoring is necessary, one might want to exit on a long reversalday, or on a key reversal pattern (see Chapter 10.1), and then go to the beach.Or, if from Texas, one might want to short the issue.
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FIGURE 205.1.2. The editor learns a lesson. Never leave a chart unanalyzed, evenif the implications are obvious. And never be afraid to belabor the obvious. ObviouslyFigure 205.1.1 should have had a long-term trendline drawn on it. No monumentalbull market should be ignored. Why give the market its money back? It should havebeen obvious from Figure 205.1 that the Microsoft party was over and not just thefat lady but the entire chorus was beating on anvils. And. The protective line mustbe drawn. Here the broken line at A is the most important and saves a bit of capitalrather than waiting for the plaintive signal at C. Given the robust bull market inMicrosoft the long-term investor might have been justified in waiting until the Ctrendline was broken. A matter of investing style and philosophy. There appears tobe some long-term support at 18. And the 5 year sideways market appears to beresolving itself into a macro triangle which might breakout one way or the other in2005. This is a case in which an investor might make a fundamental analysis to guidehis position (always confirming with the chart analysis). Microsoft is beset withhowling wolves on all sides. Linux, Unix, sales of only one copy of Windows inChina, hackers playing hob with security holes in its software. Can it rise again?Only the chart knows for sure, and it is silent at this recording.
Essentially, I view these stocks as interesting aberrations in the early partof their lives. So I would not look for long-term investment type trades. Takethe money and run. In all likelihood, these stocks will explode like fireworksand then expire. There will, of course, be the Microsoft and — it remains to beseen — the Yahoo. After the fireworks show, the patient technician may returnto the scene of the crime to see if there are any burning embers. Once they haveblown off, crashed, and made reasonable bottoms, then one begins to look forinvestment possibilities, which there will definitely be. The technology of the
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FIGURE 205.2. PALM. Fool’s gold. Fool’s gold with naivete writ large on it. Hereis a spike reversal day on the initial day of trading. The accumulation, markup, andmost of the distribution occurred behind closed doors before this trick was perpetrated. After the matanza, the continuation takes on the shape of a rounding bottom.Perhaps there is some real gold there — but only over the long term.
Internet — and biotech, and the human genome — there is too much potential in all of them for some phoenix not to rise from the ashes.And, in the beginning it behooves the trader to regard them as speculative instruments of exceptional risk and opportunity.Several caveats are in order.One, that the prudent speculator does not commit too much of his capitalto such enterprises. Probably no more than 5–10%.Two, when selling them short, one should not be early. A definite topshould be seen, because there might be a second stage of the rocket.Three, emotional involvement with tulips and Internet stocks — orstocks of any kind actually — can lead to a broken heart. In the charts,note the success in a number of cases of trading the key reversal day.EN9: Reviewing charts from the apocalypse is a sobering experience. So manyrash and mad adventures. So much capital