Professional Documents
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Mage System
Mage System
MAGEE
SYSTEM
OF TECHNICAL
A N A LY S I S
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THE INTRODUCTION TO THE
MAGEE
SYSTEM
OF TECHNICAL
A N A LY S I S
JOHN MAGEE
in a new edition by W.H.C. Bassetti
A MACOM
American Management Association
New York • Atlanta • Boston • Kansas City • San Francisco
Washington, D.C. • Brussels • Mexico City • Tokyo • Toronto
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This book contains information obtained from authentic and highly regarded sources. Reprinted material
is quoted with permission, and sources are indicated. A wide variety of references are listed. Reasonable
efforts have been made to publish reliable data and information, but the author and the publisher cannot
assume responsibility for the validity of all materials or for the consequences of their use.
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AUTHORS
W. H. C. Bassetti, editor and co-author of this book and the 8th edition
of Technical Analysis of Stock Trends, is an honors graduate of Harvard.
His experience spans the modern history of the markets, beginning as a
student and client of John Magee in the 1960s through the electronic
markets of the present. He was formerly a principal in California’s first
licensed commodity advisor, CEO of Blair Hull’s Options Research, Inc.,
managing partner of a market maker, and president of an options arbitrage
manager. He is presently Adjunct Professor of Finance and Economics at
Golden Gate University, where he teaches technical analysis of stock
trends.
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A SPECIAL
ACKNOWLEDGMENT
Anyone who has engaged in research on issues long dead knows what
a nightmare it is to pursue data on the New Haven, or astoundingly(!)
IBM before 1968. In fact, if IBM has digital data on its stock prices prior
to 1968, I was unable to find it within that corporation (or anywhere else).
On the other hand a veritable treasure trove of old data is kept at M.C.
Horsey and Company Inc., P.O. Box 2597, Salisbury, MD 21802. On hand-
kept ledger cards. M.C. Horsey publishes this data on very long-ter m
monthly charts in “The Stock Picture.” I am most indebted to them for
use of their IBM data and recommend them to seekers after wisdom and
truth who can’t find it in real time data.
Special appreciation goes to makers of software packages utilized in
preparation of this and previous editions:
TradeStation
Omega Research
14257 SW 119th Avenue
Miami, FL 33186
305-485-7599
www.tradestation.com
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ACKNOWLEDGMENTS
ix
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FOREWORD
xi
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Foreword xiii
on which to rest further studies. And the direction these studies should
take will be pointed out to them. Traders need to know the same thing
investors need to know. They also must know other things which the
investor will profit from knowing. Some of this is presented here.
To this end, this book includes appendices on Directed Further Study
as well as on Resources for all types of investors. Included also is material
on suggested trading plans for all different types of investors — plungers
to the somnolent.
ABOUT GENDER
Female readers will note that the usage of “her system,” “she will,” and
so on does not appear in this book and perhaps think Magee and me
chauvinist pigs. Quite the contrary. I quote here from my foreword to the
2nd edition of Magee’s General Semantics of Wall Street (charmingly
renamed according to the current fashions, Winning the Mental Game on
Wall Street):
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“Ich bin ein feminist. How could any modern man, son of a beloved
woman, husband of an adored woman and father of a joyful and
delightful daughter not be? I am also a traditionalist and purist in
matters of usage, grammar and style. So where does that leave me
and my cogenerationalists, enlightened literary (sigh) men (and
women) with regards to the use of the masculine pronoun when
used in the general sense to apply to the neuter situation?
“Politically correct fanatics may rail, but so are my teeth set on edge;
thus I have generally preserved the authors’ usage of the masculine
for the generic case. This grammatical scourge will pass and be
forgotten and weak willed myn (by which I intend to indicate men
and women) who pander to grammatical terrorists will in the future
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Foreword xv
W.H.C. Bassetti
San Francisco
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CONTENTS
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Contents xix
I
A BRIEF HISTORY
OF DOW THEORY AND
THE FOUNDATIONS OF
TECHNICAL ANALYSIS
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1
BASIC TENETS OF TECHNICAL
ANALYSIS AS EVOLVED
FROM DOW-JONES THEORY
AND THE BAR CHART, TOOL
OF TECHNICAL ANALYSIS
John Magee’s Inc.’s objective has always been to forecast individual stock
prices — not the “overall” stock market. Investors buy individual stocks,
not the “market” — their profits (or losses) reflect how well those stocks
do. (Magee, of course, wrote this statement and practiced before it was
possible for the general investor to “buy the market” by purchasing ishares
or DJIA futures, instruments which effectively allow the investor to “buy
the market.” These instruments are explored later. The purposes and meth-
ods Magee discusses remain valid not only for individual stocks but also
for the averages themselves.) Although it is often the case that the vast
majority of stocks move in the same direction as the market, it is not
always so. Certain groups may lead a market move whereas others may
lag or not participate at all. And, even within a group of stocks such as
airlines or steel, for example, certain stocks may move ahead of, with, or
actually lag behind their own group.
The basic tenets of technical analysis were first put forth by Charles
Dow, editor of the Wall Street Journal and creator of the Dow-Jones
averages. By analyzing the behavior of the industrial and rail averages,
Dow developed a theory — the famous Dow Theory — by which he
sought to forecast the major direction of the stock market from the price
behavior of these indices.
3
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STOCK IN UPTREND
An uptrend is considered to be in force as long as each successive rally
reaches a higher price than the one before it, and each successive reaction
stops at a higher level than the previous reaction. A similar (reversed or
mirror image) definition holds for a downtrend.
We divide a trend into three subcategories:
1. The major trend usually lasts a year or more and results in appre-
ciation or depreciation of 20% or more.
2. The intermediate trend operates in the opposite direction of the
major trend, usually retracing one half or less of the prior movement
in the direction of the major trend. It is often referred to as an
intermediate reaction.
3. Minor trends consist of day-to-day fluctuations which are unim-
portant except as they combine to form larger trends.
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Chart 2. The Dow Industrials Uptrend. Here is the greatest uptrend in the history
of the U.S. markets — the Great Clinton–Gore bull market. A complex of factors
combined to produce the most important market in U.S. history. The benefits of
computer technology, the rush to the Internet, the incredible prosperity of the
people as a whole, and not least the fiscal responsibility of the Clinton–Gore
administration, which for the first time since the 1950s balanced the budget and
began to pay down the enervating debt produced in the Reagan years. Technicians
generally turn a deaf ear to analyses of this kind. And usually for the immediate
moment and for the short-term purposes of investing and trading they should.
But secular factors of this kind are worth noting, if not trading on. Trading and
investing takes place for most investors in a much more limited time frame.
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Chart 3. Xerox, in a Downtrend. Bull trends require labor and time and blood
sweat and tears. Bear trends are effortless and fall to earth, in many cases, like a
punctured hot-air balloon. Often it was hot air which created the bull trend. But
virtually always an important trend line is broken before the bear trend begins.
This is a common downtrend — after all a downtrend must begin from up. And
almost always will be ragged rather than regular, especially in modern markets
where investors are so quick to flee the least sign of weakness.
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One other question remains which we feel has always been given
more weight than it deserves, especially by those who have not studied
too long or too deeply. The question is whether the movement may
represent merely the manipulative operations of dishonest traders, or
whether, through false rumors or merely through the fact that something
seems to be happening, the movement snowballs and accelerates on its
own momentum.
As far as dishonest manipulation is concerned, this has never been an
entirely safe or easy thing, even in the “bad old days” when no punches
were barred. Today, with the various regulatory laws and the rules of
procedure in the important Exchanges, plus the self-protective, self-regu-
lation of the reputable brokerage houses, it is more difficult. Still, as the
various insider trading trials prove, there will always be a dishonest
element in the market.
Nor do we believe that the important market moves are merely the
result of rumor, collective hysteria, and emotional confusion. There are
too many hardheaded men, both individuals and traders for institutions,
who are prepared to check and counterbalance an entirely capricious or
irrational move. We would question whether the recommendations of
brokers or investment advisory services, or the statements of newspaper
writers or radio and TV analysts, or the self-reflexive action of technical
factors are major elements in important market moves. In all this, in all
the changes shown in the charts (which are a picture of what is actually
happening in the market and which are indirectly a portrayal of what the
collective investing public is perceiving), we are dealing with speculation.
In this connection, we are using the word in the particular sense in which
Webster’s Ninth New International Dictionary defines it, in the first defi-
nition of the word as in current use: “The faculty, act, or process of
intellectual examination or investigation.” This is the proper and legitimate
function of a market and in no way implies any dishonorable or unfair
practice. The word, as Webster here defines it, is merely synonymous with
evaluation, and it is in this sense that we use it in this treatise.
II
THE CENTRAL
CONCEPTS AND
VOCABULARY OF
TECHNICAL ANALYSIS
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It is all very well to see one’s stocks go up. When do you sell?
The explanation of stops which is given in this section reveals
the best thinking of one of the most respected advisors in the
history of U.S. markets.
2
IMPORTANT PRACTICAL
CONCEPTS: SUPPORT
AND RESISTANCE
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The Introduction to the Magee System of Technical Analysis
Chart 5. American Express, Support and Resistance Illustration. This chart of American Express vividly illustrates the phenomenon
of support and resistance, as marked by the horizontal lines. For months price bounces off the resistance at 110 and when repulsed
finds support around 99. An almost perfect bull trap is executed in July — almost perfect because the shrinkage in volume on the
breakout and top is a sharp warning sign of something amiss. Rising volume as price falls from the top is another warning sign.
Then the huge increase in volume in early August is the third strike. The exaggerated volume from August to October as disappointed
bulls liquidate their holdings allows the breakout in mid October, and then the stock goes happily back to its support/resistance range.
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and resistance. When prices break down, for example, out of a descending
triangle, the horizontal lower boundary of the formation, which was
originally a demand line, promptly reverses its role and becomes a
resistance line. Any attempt to put prices back up through it after a decisive
breakout is stopped by supply at or near the line. By the same token,
the neckline of a head-and-shoulders top, which was a demand line,
becomes a resistance level after it has been broken. The top, or supply
line of the rectangle, becomes a support line after prices have pushed
above it on volume and by a decisive margin.
Major corrections or crashes, such as the ones in 1929, 1962, ( 1987,
1998, and 2001) can change supply and demand zones fast. Panics, once
they get under way, seem to sweep away all potential support in their
calamitous plunges until they exhaust themselves in a general market-
selling climax.
Another basic premise of technical analysis is that each stock has a
level of primary price support and resistance — in short, a price range
indicating an historical balance of buying and selling pressure. In stocks
with a record of volatile price activity, the range will be broader than that
of a stock whose price has not fluctuated dramatically. The primary support
and resistance levels are most obvious in stocks that have remained
inactive for lengthy periods. Technicians call this channeling. If a stock
price violates primary support or penetrates previous resistance, particu-
larly on an increase in trading volume, the technician assumes that a trend
is forming. In the case of inactive or channeling stocks, such a breakout
often indicates dramatic future price activity.
Technical analysis also reveals the existence of secondary price support
levels. Stock prices do not move in a straight line. Within an uptrend,
they advance, retreat, and then advance again. Conversely, during a
downtrend, the pattern is decline, partial rebound, and further decline.
Secondary price support levels are the price ranges to which stock prices
either rise or fall before resuming the dominant trend. They are not static
but, rather, move with the stock price. In the case of an uptrend, when
a stock price falls below the previous secondary support level, the tech-
nician is alerted to a potential change and, perhaps, reversal of the
dominant trend.
Overpage we illustrate the mechanics of support and resistance formation.
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Diagram 1. How Resistance Forms. Here we see prices grind back and forth in
a congestion zone. We could give the pattern a number of different names, but
for the moment we will call it just a zone of contest between buyers and sellers.
When the price breaks definitively below the lows of this zone the lower reaches
(indeed all of it) become a resistance level. When prices return to this level we
will expect to see a supply of stock become available and constitute resistance.
Diagram 3. Old Resistance Becomes New Support. A resistance zone once over-
come becomes a source of future support. Here we see how the resistance zone
has offered a line of support to higher prices once overcome.
Diagram 4. Valid Support Levels. The top of a congestion zone will often serve
as a support zone when prices have broken out, but other valid levels may develop,
identifiable by volume behavior and the containment of prices within rational
boundaries.
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Diagram 5. The Bull Trap. When prices break out of a congestion or trading
zone on the upside, even on good volume and conditions, bulls will rush to buy.
When further action nullifies the signal and the price drops through what previ-
ously looked like support, we say that a “bull trap” has been sprung. Quite often
the trade that develops after the trap is sprung turns out to be profitable (i.e.,
the trade on the short side). In fact, Schwager calls this subsequent signal one of
the most reliable of pattern trades.
Diagram 6. The Bear Trap. As in Diagram 5, the initial breakout, this time on
the downside, is a feint, trapping bears who jump too fast. The subsequent trade,
after the signal is canceled, can develop quite well.
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TOP
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SECONDARY RESISTANCE
8 PRICE BREAKOUT
SECONDARY
SUPPORT
7 PRIMARY RESISTANCE
PRIMARY SUPPORT
BOTTOM
6
VOLUME SPIKE
Diagram 7. Decoding a Bar Chart. Now we may look at the foregoing diagram
with some understanding and identify zones of resistance and support, of price
breakout, of tops and sell-offs. This chart is EveryMan’s EveryStock. Here we have
some support and resistance and some rectangles or battle zones and some tops
and bottoms. In fine, EveryStock. Primary support and resistance develop along
the horizontal trend lines of the rectangle. When price breaks out and encounters
secondary resistance, it returns to the top of the rectangle and finds there the
secondary support we expect to build up in normal times out of a zone such as
this. After the top, the secondary support line holds the price up until those
holders become discouraged after their second attempt at a breakout in July. And
then sellers drive the price lower to the bottom. These are discouraged bulls.
Notice the low volume on the downtrend. These fair-weather friends being out
of the way, true believers can take control of the stock in August, driving it back
up and causing acid indigestion in those who (probably rightly) sold out. Our
cunning technical analysts bailed out in July (perhaps even going short) and bailed
back in when the downtrend line was broken on eye-catching volume. See
Diagram 1, How Resistance Forms.
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3
THE CENTRAL CONCEPT: THE
IMPORTANCE OF TRENDS
AND TREND CHANNELS
TRENDS
It almost always surprises novices to discover that on logarithmic charts
the price moves so frequently lie along straight lines, forming “trend
channels” that may run for months, or years. For example, the long-term
uptrend in International Business Machines ran from the end of 1953 to
the beginning of 1962 (see Chart 6 ), over 8 years, in one straight trend
channel so precise you could lay a steel ruler along it and it would not
violate the upward sloping trends at any point. Incidentally, when it did
break this trend, in January 1962, the price dropped precipitously from
over 600 to 300 in less than 6 months (see Chart 10). The trends of stocks
normally move down faster than they move up.
It is easy to verify the existence of these straight-line trends. It is easy
to see that stocks do not ordinarily jump around in completely random
fluctuations but move in more or less orderly progression for considerable
periods. However, knowing this does not automatically, and by itself,
solve all problems. As a matter of fact, though it is worth knowing, it
solves no problems. Before one can buy or sell a stock, it is necessary
to have some clear idea of what constitutes a change in the trend, so that
as far as possible one will not linger on the wrong side of the major
trend. This is a matter calling for the most intense observation and study.
It may require auxiliary studies. (For example, the volume of trading times
the price of a stock represents the number of dollars involved in the
market action on a particular day. It makes a great difference whether
the total trading amounted to $10,000 or $10 million.) As we said before,
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Chart 6. IBM. Straight Trend from 1953 to 1962 and subsequent recovery. Cour-
tesy of M.C. Horsey & Co. Inc. With permission.
the chart is merely a tool, a means of setting down graphically some data
about the market action.
This is like learning in any field. The surgeon, the lawyer, the musician,
and the executive must continually face new problems not precisely like
any encountered before. But they must have had the experience of analyzing
other problems from the past that are in some significant ways similar. Thus,
when the technician is confronted with an entirely new problem, he can
draw on this storehouse of experience and, by “playing it by ear,” put to
use the intuitive knowledge he has gained from these past events.
We cannot make the point too strongly that chart interpretation and
technical market wisdom is not learned overnight. We cannot stress too
much the importance of looking back, and if the technician has noted
his past opinions and evaluations on the charts (as he should, to get the
most value from them), of checking these out and seeing where his
judgments were good, where they failed, and, if they failed, whether it
seemed to be because of some correctable error in judgment or whether
it was because of an unexpected and unpredictable change of conditions.
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Chart 7. Ebay, Largely Horizontal at this Moment in Time. The sideways channel is probably as common as, or perhaps even more
common than, uptrend or downtrend channels. Here once again illustrating support and resistance, and also the failure of support,
Ebay also offers good short-term trading opportunities. It is a common technique for traders to sell the top of a trading range or
horizontal channel and buy the bottom. In this chart the arrows illustrate this technique, taking key reversal days as the signal.
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The August volume is probably mutual fund managers running for the exits. At the least it is unhappy bulls helping to create a bottom.
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Chart 8. Dow-Jones Industrials. Three Bull Market Tops: 1929, 1987, 1998. The reader will note the common element to all these
bull market tops: an important trendline has been broken. Continuing price action under the trendline (especially in Magee’s
opinion if by 2% in the case of the Dow) is an escalating warning. An investor might be justified in setting his stop line at or
under the forming rectangle or pattern if the market were not of such long duration — but at the end of bull markets of these
The Introduction to the Magee System of Technical Analysis
durations extreme caution is a sign of market wisdom, not paranoia or cowardice. At the very least hedging is in order.
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and if some others felt as he did, they might well be willing to pay a little
more than the market price to get their shares. If there were enough eager
buyers, this could use up all the available stock offered at the prices at
which this stock had been selling and eventually force the bids considerably
higher in order to attract sellers willing to part with some of their holdings.
Whether or not a particular breakout of this sort will be the beginning
of a long and profitable advance depends on whether the original infor-
mation was correct and whether the expected action takes place and other
factors. But, when a big move in a stock does take place, it is likely to
emerge from just this kind of situation. If the trader is not too impetuous,
does not jump in too heavily and risk too much, and if he is prepared
to get out again, often with a loss in case the move fails, he is likely to
pick up one of the important instances in which a new major trend is
getting under way.
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Chart 9. Microsoft. How a Historic Bull Market Ended. At the top of the Microsoft
bull market is a fine rectangle that advertises itself as a consolidation, especially
with the runaway days on breakout. But the short cap after the runaways and the
return to their base are ominous signs. Beneath the surface the general bull market
is ending, and Microsoft is locked in a death struggle with the Justice Department
and assumes that like all its other struggles it will prevail here also. As a further sign
that its day in the sun is done (for the moment), the Dow-Jones Company adds
Microsoft to the Dow-Jones Industrials. Spectacularly bad timing for all involved.
No technical analyst would have held the stock in spite of its long glorious record
when the medium and then the long-term trend lines were broken. That is what
technical analysis is for, to make obvious the unbelievable, that Microsoft could fall.
All stocks eventually suffer intermediate- or long-term decline. Nothing lasts forever.
like absolute certainty. If the investor is satisfied his method and original
basis of decision were correct, if the situation changes greatly, he must
be prepared to face the fact that some new conditions have arisen, and
he must act accordingly. It is no reflection on his method that he should
have to revise his opinion or reverse his decision in light of new facts.
One of the most damaging, sometimes ruinous, points of view is that of
the man who is so “wedded” to his original conclusion that he cannot
face the fact that the situation is different this month from what it may
have been 3 months ago.
affair, with bursts of high volume as new peaks are reached and then
periods of a few days or a few weeks with shrinking volume of trading,
followed by another advance on increasing volume. Some setbacks may
be short and of limited extent — a few days or a week, perhaps. Others,
especially after a series of minor advances, may be of greater extent and
may last for a number of weeks or several months. Yet all these may fit
into the category of major uptrend.
No method of determining whether or not the major trend is still in
effect is infallible. However, there are a number of methods of estimating
whether or not an important change of trend has occurred.
The simplest of these is to draw a trendline — that is, a line which
touches the bottoms of two or more reactions if the major trend is up
(see Diagram 9). (In the case of downmoving stocks, the trendline would
be drawn across the tops of two or more rallies.) In many cases the trend
follows a straight line, especially on logarithmically scaled charts, and a
sharp breakdown through the trendline dramatically underscores the
change of the trend.
A case in point would be the long-term trend in International Business
Machines (IBM). After more than 8 years of following a perfectly straight
trendline, IBM broke through that line in January 1962 and by the end of
May had dropped several hundred points. However, after that 1962 cor-
rection, IBM resumed the long-term trendline through 1989 (see Chart 10).
In spite of the clear evidence that trends do exist and that they follow
straight lines on logarithmic charts, the simple trendline is not by any
means the whole answer to stock analysis — far from it. It is not always
easy or possible to find clear points of reference through which to draw
the trendline. Quite frequently, the chart shows a sideways movement
that will penetrate the trendline without volume or any substantial decline.
It is necessary to understand that the way in which the trendline is broken
may be as important as, or more important than, the fact it is broken (see
Chart 11).
Chart 10. IBM. January 1962, End of Another Historic Bull Market. Courtesy of
M.C. Horsey & Co. Inc. With permission.
tends to stabilize the picture and eliminate certain types of false or trivial
moves, but it also introduces some other problems peculiar to moving
averages. There have been methods in which two moving averages, a
short-term and a longer-term one, are used together to give indications
of change of trend when they cross (see Chart 35). There are a number
of other methods using trendlines, moving averages, and some other
devices to catch early signs of a major turn.
Although none of these methods is entirely satisfactory, any of them
is better than no method at all. They may not catch the exact or optimum
point at which a decision could best be made, but they will at least ensure
that an investor who follows them will not allow himself indefinitely to
hold a stock that is piling up losses for him after a major reversal.
There are other indications of turn and some suggest a continuation
of the major trend. The latter we have called consolidation patterns. The
former we call reversal patterns.
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Chart 11. Advanced Micro Devices, Inc. Stocks tend to make straight-line trends,
either up, down, or horizontally. The trends do not necessarily move in the same
direction as “the Dow Jones Average” or “the general market.” Here, for example,
we see a strong downtrend in a particular stock at a time when the “general
market” was moving sideways to higher. From June to December, AMD declined
by nearly 50% in the face of a generally bullish market. Although this issue did
enjoy a rally back to 11 during the first half of 1989, the downtrend resumed the
following June while the “averages” were challenging old highs. You will find
some issues moving sharply higher in bear markets and others, like AMD, moving
down in bull markets. This type of action does not strike us as “random.” Appar-
ently, some economic or psychological factors were operating to affect public
opinion. But it is not necessary for the market technician to know what these
factors may have been. The chart speaks for itself.
Chart 12. B.F. Goodrich Company. Not only can chart patterns be described in
several ways, many can be either reversal or continuation patterns. The Goodrich
chart shows two unusually good examples, quite close together, of the dual nature
of some chart patterns. After moving steadily higher in 1986 and early 1987, this
issue turned sideways. From April through July, we see a series of advances and
declines which all together add up to a narrowing symmetrical triangle. In mid-
July, on sharply higher volume, Goodrich broke out of the pattern to resume its
previous uptrend. Using the width of the pattern as a measure, you would have
anticipated a move to the 63 area and not been disappointed when Goodrich
peaked in early September around 64½. This is a symmetrical triangle as a
continuation pattern. Following the September peak, another series of fluctuations
emerged, also taking the shape of a symmetrical triangle. This time the decisive
breakout was contra to the prevailing uptrend, illustrating a reversal symmetrical
triangle. Notice the excellent double bottom that formed on the December test
of the October low. The late December rally through 37, on rising volume, was
a clear signal that the downtrend was over. During the next two years, Goodrich
rallied to 70.
at or near the low for the day’s trading. Such a climax day or one-day
reversal is quite commonly the peak, the end of the advance for the time
being. Following it, there may be a few days, a week or so, or a number
of weeks, of decline or at least of inconsequential sideways movement,
and this period is usually marked by irregularly shrinking volume.
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Whether or not the one-day reversal will prove to be of more than minor
importance or not, we cannot tell at this stage, although many high-water
marks preceding a severe Bear Market have been made on exactly this
sort of day.
What seems more important here is that the one-day reversal, or, at
any rate, a climax day of high volume, quite often marks the end of one
phase of an advance.
Chart 13. Bankamerica Corporation. There are those who will tell us that the
movements of stocks are as completely random as the stumblings of a drunk in
a public square late at night, or as meaningless as the scores of a blindfolded
dart player. Anyone who has kept daily charts of stocks knows that the charts do
not provide “all the answers,” nor do they infallibly “predict the future.” But it
is hard to believe that the trends such as the uptrend shown here in BankAmerica
or the uptrend and downtrend in Advanced Micro Devices could be the result of
the gyrations of a drunk or the scores of a blindfolded dart player. In the Bank-
America chart you will also notice two other typical patterns, the falling wedge
and rectangle. The first is considered a bullish pattern, and confirmation is given
when the upper boundary line is decisively broken on increasing volume. Rect-
angles, on the other hand, can be continuation or reversal patterns, depending
on which way they break out of the formation. Generally speaking, rectangles
define a tug of war between two groups of approximately equal strength. The
stock will bounce back and forth, trading within two horizontal boundary lines,
until one side or the other is exhausted. The measuring implication of this pattern
(i.e., the expected minimum movement after the breakout) is the width of the
rectangle. A rectangle 2 points wide, for example, should move at least 2 points
beyond its breakout point.
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be followed by some quick profit taking, and a reaction sets in. However,
many observers believe that prospective buyers who may have missed
the original breakout may then come into the market on the reaction. It
is this buying that constitutes the support that so frequently appears at
or near the bottoms of rectangles (or in bearish moves, the resistance that
appears at or near the bottom of rectangles).
There is another type of market action that is somewhat similar to the
rectangle. This type has the form of a more or less symmetrical triangle,
and we call it by that name (see Chart 14).
It is marked, usually, by a heavy volume climax as it goes into its first
turning point, which is followed by a series of declines and rallies that,
instead of forming two parallel lines, as is the case of the rectangles, tend
to narrow, so that the lines drawn across the turning points make a
downsloping and upsloping side to the triangle. It is a “narr owing”
formation, ordinarily accompanied by shrinking volume. The triangle may
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Chart 15. Lucent, Descending Triangle. This top of Lucent is marked by a particularly vicious descending triangle, particularly
vicious because it contains a false breakout, a bull trap which would have left the impatient or inexperienced bull long just in time
for the air pocket and given him firsthand experience with catastrophic risk. Lucent is, of course, psychotic. But at least it makes
The Introduction to the Magee System of Technical Analysis
a bottom after the plunge in the form of a symmetrical triangle, which is tradable but which, when it returns to the cradle of the
triangle, is offering a hint to the wise: go find another stock to trade. Was crashing with the stock a necessity? Not really. A 3-month
trendline was decisively broken well before the plunge, and the use of the basing-points procedure would also have taken out a
systematic technician. Perhaps an even more elemental procedure would have avoided the whole situation in the first place —
that is, the careful choice of stocks that make up the portfolio. On the other hand, the bungee trader using very sensitive tactics
might be delighted with Lucent.
SL302Xch03 frame Page 45 Thursday, December 13, 2001 9:41 PM
Chart 18. Gap, Inc. GPS was a spectacular performer in the decade of the 1980s.
From under 1 in 1980, this issue exceeded 76 at its 1987 peak. Along the way,
it also suffered some substantial setbacks. To look at a long-term chart (monthly),
these downturns look as if they materialized out of thin air. Although it is true
that stocks can reverse dramatically when some sort of fundamental news hits
everyone by surprise, like a particularly disguised takeover attempt, or a disaster
like the gas leak in Bhopal, India, which hurt Union Carbide, more often than
not, signs of a change of direction will show up in the daily chart. In GPS, for
example, it was hard to miss the deteriorating technical position which occurred
through the summer of 1987. Oscillating higher, on generally weakening volume,
(note that each high from June on occurred on lower volume), GPS formed a fine
rising wedge pattern. Just opposite of the falling wedge (see Comdisco chart),
this pattern has bearish implications. Well before the rest of the market collapsed,
Comdisco (CDO) had fallen through support and was heading sharply lower. An
excellent bear flag, evident at the end of September, was also completed before
the October crash in the general market.
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Chart 20. Dillard Department Stores Inc. This is a head-and-shoulders top. The
head-and-shoulders patterns, top and bottom, are the most well-known of the
classical charts; they are also the most reliable of the major reversal patterns.
Here, the price action traces the head-and-shoulders very clearly, breaking away
on the downside with an open gap. During what proved to be the 1987 peak in
the “averages” in August and September, a significant number of individual stocks,
such as DDS, were clearly showing topping activity. The actual breakdown in the
stock market in October, therefore, was not surprising; only the speed and the
depth of the collapse were. It should be noted, however, that stocks almost always
go down faster than they go up. Except for takeover situations, you will make
money quicker on the short side of the market than on the long side. Indeed, it
took Dillard 4 months to drop from roughly 58 to 24; it took 17 months to recoup
the loss. This head-and-shoulders top exhibits the typical volume characteristics
of the pattern — higher trading volume on the left shoulder than the head, and
relatively flat volume on the right shoulder. The penetration of the neckline
showed higher volume but would also be valid on low volume as long as it were
broken by 3%.
the neckline, and the dropoff from here is likely to be precipitous and
on greater volume.
is, the height from the top of the head to the neckline will represent the
minimum expected drop from the point of penetration of the neckline.
The comment may well be made that this is not such a great drop,
and that if this is all there is to it, it might be best to hold the stock or
even buy it on the decline. This, however, is not the whole story. When
a major uptrend has been in effect for a long time, say, 6 months or a
year or more, and then a pattern of this sort appears, either a head-and-
shoulders, a large descending triangle, or a long rectangle broken on the
downside, it may indicate a change in the major tr end. There is a
presumption, or at least a suspicion, that the successive rallies will come
lower and lower and that the stock may plunge in a series of drops that
may far exceed the minimum implications of the original top formation.
We would never disregard a clearly formed and definitely broken head-
and-shoulders top or any other typical top pattern.
We have spoken about the simple head-and-shoulders top, but there
are many minor variations of this pattern. There may be a double head;
there may be two or more left shoulders at about the same height, or
two or more right shoulders. In the case of slow-moving, large-issue
investment stocks, this type of pattern may become a rounding top (see
Chart 21), having few, if any, definite rallies and declines but with the
general picture of heavy upside volume gradually petering out and then
increasing again as the stock “rounds over” and starts its downtrend.
In the case of head-and-shoulders (or Kilroy) bottoms (see Diagram 8
and Chart 19), the situation is similar but reversed. The formation is
“upside down” and some writers have referred to it as a pendant bottom.
Here, we have the heavy volume on the left shoulder, a rally, then a
further drop to a new low (the head), and a recovery move that is likely
to be marked by somewhat more volume than we have seen on a rally
for some time. A corrective reaction on low volume takes the stock part
way down again (right shoulder), and then a sharp advance occurs (which
must be on heavy volume), smashing through the neckline defined by
the two previous minor rallies.
The main differences between the head-and-shoulders tops and bot-
toms are that (1) the top formations are often completed in a few weeks,
whereas a major bottom of any sort usually takes longer, and, in some
cases, may cover from several months to a year and a half; and (2) the
breakout move from head-and-shoulders top formations may not be
marked by much increase in volume, whereas, the breakout from the
head-and-shoulders bottom must have volume confirmation.
In concluding this discussion of daily charts and their use, we would
once more like to emphasize that the chart is merely a map of what the
market is doing and the market action is a composite of what people are
thinking about a stock or about the market. There is no magic to a chart
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Chart 21. Citicorp, Rounding Top. In all likelihood the technician would have (or
should have) been long before the breakaway gap and runaway gap in May. The
rounding pattern does not become obvious until August, but what might be a
neckline or a trendline constructed across the lows of the top should take the
trader out before or around the gap. Basing-point stops would also have preserved
the major part of profits. A short position might well have been established, in
fact, especially on the symmetrical triangle from which prices plunge in September.
Courtesy of Metastock, www.equis.com.
TREND CHANNELS
At the start of this trend study, we applied the term “basic trendline” to
the line that slopes up across the wave bottoms in an advance, and to
the line that slopes down across the wave tops in a decline. And we
noted that the opposite reversal points (i.e., the wave crests in an advance
and the wave troughs in a decline), were, as a rule, less clearly delimited.
That is one of the reasons that our discussion up to this point has been
devoted to basic trendlines. Another reason is, of course, that the technician’s
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Chart 22. Oracle with Trend Channel and Earnings Gap. Oracle habitually forms
nice smooth trend channels often consolidated by rectangles and sideways chan-
nels. It also frequently hits air pockets, usually caused by news or earnings
announcements. Frequently enough that a clever technician might hedge all or
part before earnings announcements. Oracle seems sufficiently known and regular
to offer a good investment vehicle, but the frequent gaps and air pockets should
be programmed into the trading strategy — for example, the long-term investor
might disregard them, but that would involve a different kind of vigilance — say,
a long-term moving average as a warning, or an ear to the wind as to the
fundamental prospects of the company, say, by checking Value Line. Also secondary
and intermediate trends should not be ignored. Courtesy of AIQ, www.aiq.com.
most urgent task is to determine when a trend has run out, and, for that
purpose, the basic line is all-important.
In a fair share of normal trends, however, the minor waves are suffi-
ciently regular to be defined at their other extremes by another line. That
is, the tops of the rallies composing an intermediate advance sometimes
develop along a line which is approximately parallel to the basic trendline
projected along their bottoms. This parallel might be called the return line
because it marks the zone where reactions (return moves against the
prevailing trend) originate. The area between basic trendline and return
line is the trend channel.
Nicely defined trend channels appear most often in actively traded
stocks of large outstanding issues and least often in the less popular and
the relatively thin equities which receive only sporadic attention from
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investors. The value of the trend channel concept for the technical trader
would hardly seem to require extended comment.
Its greatest utility, however, is not what usually appeals to the beginner
when he first makes its acquaintance, namely, the determination of good
profit-taking levels. Experienced technicians, rather, find it more helpfu1
in a negative sense. Thus, once a trend channel appears to have become
well established, any failure of a rally to reach the return line (top parallel
of the channel in an intermediate advance) is taken as a sign of deterioration
of the trend. Further, the margin by which a rally fails to reach the return
line (before turning down) frequently equals the margin by which the
basic trendline is penetrated by the ensuing decline before a halt or
throwback in the latter occurs.
By the same token, given an established trend channel, when a reaction
from the return line fails to carry prices all the way back to the basic
trendline but bottoms out somewhere above it, the advance from that
bottom will usually push up out of the channel on the top side (through
the return line) by a margin approximately equal to the margin by which
the reaction failed to reach the bottom of the channel (basic trendline).
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Diagram 10. Construction of Downtrend Line — the Bearish Line. The comments
on construction of an uptrend line could almost be turned on their head to
describe the construction of the downtrend line. The line pictured is the ideal
theoretical calm drifting downtrend: lower highs, lower lows, a continuing pro-
cess. The process is unmistakable though, and one should begin to see prices
cross previously drawn uptrend lines and lines drawn from support and resistance
from previous time in the chart. As with the uptrend line, basing points may be
established and used, and often prices will fall away from the line entirely.
Alternatively, rallies in the bear trend may be used to construct a line, always
keeping in mind that one wants clear points on the chart and patience must be
exercised in allowing the chart to develop — like a photograph coming clear in
developing fluid.
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Diagram 12. Formation of Downtrend Channel. The downtrend channel pictured here is
a nice orderly retreat without panic on one side or enthusiasm on the other. This kind of
emotion produces an orderly, easily defined trend channel. It’s a nice coherent picture of
price deterioration. Obviously the technician will be short. Anyone long at this point is
not an experienced technician. The experienced practitioner will be short and watching
the lines defining the channel because it is unlikely that it will last forever. Failure to touch
the return line — in other words, an acceleration of the trend for the aggressive trader —
might be a signal to pyramid, or, more conservatively put, to position build, although
whichever you call it, pyramiding is less dangerous on the short side than on the long.
(Except at market tops when selling strength.) The channel is important only as long as it
continues, but its mere existence allows the analyst to get the rhythm and state of the
particular issue involved.
Diagram 13. Formation of Sideways Channel. Like the up and down channels, the side-
ways channel represents an understandable, manageable, situation. As the downtrend
pictures an orderly preponderance of sellers over buyers, and the uptrend presents an
orderly preponderance of buying over selling, the sideways trend channel pictures a balance
between the forces. Like all trends it should be expected to continue, and like all trends
the longer it continues the less probable is its continuation. It is true that the longer it
continues the farther it will go when it breaks out and finds its valid direction.
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Diagram 14. Formation of Uptrend Channel. Many of the comments made of the down-
trend channel might also be made of the uptrend channel. This uptrend channel represents
the orderly advance of prices with only enough stock being offered to satisfy but not
quench demand, and reasonable supplies are called forth by higher prices. There are, of
course, less orderly channels, meaning broader and more difficult to confine within two
lines, and when the channel becomes completely disorderly it has lost its usefulness and
other interpretations must be called on. It is worth noting, in regard to this point, that
when the pattern or situation does not lend itself to any understanding on the part of the
technician, he should either abandon the issue in question or trade it with a high/low
system or a moving average. The important matter about the trend channel, up or down,
is that it gives the analyst a firm handle on what is happening at the time. It also gives
him a firm handle on what can be expected to happen. First, the trend itself should continue,
even if the channel becomes disorderly. If price falls short of the return line it is a yellow
light, and if it then breaks the uptrend line a selling decision may soon be involved,
depending on the stop methodology the trader is using. Alternatively, if price soars through
the return line a different blow-off strategy may be called for, or near progressive stops.
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4
OTHER IMPORTANT
PATTERNS OF
SHORT-TERM IMPORT:
GAPS, SPIKES, REVERSALS
GAPS
A gap in the language of the chart technician represents a price range at
which (at the time it occurred) no shares changed hands. This is a useful
concept to keep in mind because it helps to explain some of the technical
consequences of gaps.
Gaps on daily charts are produced when the lowest price at which a
certain stock is traded on any one day is higher than the highest price at
which it was traded on the preceding day, or when the highest price of
one day is lower than the lowest price of the preceding day. When the
ranges of any two such days are plotted they will not overlap or touch
the same horizontal level on the chart. There will be a price gap between
them. For a gap to develop on a weekly chart it is necessary that the
lowest price recorded at any time in one week be higher than the highest
recorded during any day of the preceding week. This can happen, of
course, and does, but, for obvious reasons, not as often as daily gaps.
Monthly chart gaps are rare in actively traded issues; their occurrence is
confined almost entirely to those few instances in which a panic decline
commences just before the end of a month and continues through the
first part of the succeeding month.
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Gaps Exhaustion
Gap
Runaway
Gap
Common
Gap Breakaway
Gap
Diagram 15. Diagram Illustrating Different Kinds of Gaps. There is more than one lesson
to be learned in studying gaps. The first and obvious lesson is the specific, about gaps qua
gaps. That is, there are common gaps, breakaway gaps, runaway gaps, and exhaustion gaps.
Common gaps occur within patterns or formations or trading ranges and have little if any
significance. In fact, it might be said their main significance is to confirm the fact that
price is confined to a congestion area. Breakaway gaps are generally pretty obvious as they
occur after a congestion area and break away from its upper or lower boundary on
noticeable volume. There cannot be a runaway gap without a breakaway gap, so by
definition the second gap after a breakaway should be a runaway gap. It is possible that
the second gap will be an exhaustion gap, and this would be explainable on analyzing the
post gap action and the nature of the pattern and breakaway gap that proceeded it.
Ordinarily though, a runaway gap will be the second gap and mark the power of buyers
over sellers. It is also common for the runaway gap to be followed by price continuation
as far as price has come from the breakout. In other words, if symmetry reigns, the
breakaway will be halfway of the move. Then as the move peters out another gap appears
which would seem to be even more buyer enthusiasm; and in fact it may be yet another
runaway gap. (This is not unusual in commodities.) If this subsequent gap is an exhaustion
gap, it will soon be covered and price will lose its steam. The exhaustion gap may be
prelude to a blowoff, in which case it will appear to be another runaway gap, but a short
time will reveal the truth.
The second lesson to be learned from the study of gaps is a general lesson which is not
just about gaps but about all market phenomena. That lesson is about context and situation.
In other words, the importance and significance of any pattern, formation, or market action
lies not in itself alone. It must be interpreted in context. Context means the general
condition of the market, the broad trend, the secondary trend, and market volatility. In
addition, the same factors must be evaluated for the specific issue.
Thus a gap occurring within the obvious context of a rectangle is a common gap, but a
gap leaping out of the rectangle on volume is a breakaway. Similarly, a key reversal day
occurring after a 5% advance in conditions of average volatility will not have the same
importance as a key reversal day occurring after a 100% advance, surging volatility, and
irrational exuberance. The pattern and the gestalt. Not a knee-jerk reaction. That is what
is important.
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Breakaway Gaps
The breakaway type of gap also appears in connection with a price
congestion formation, but it develops at the completion of the formation
in the move that breaks prices away. Any breakout through a horizontal
pattern boundary, such as the top of an ascending triangle, is likely to
be attended by a gap. In fact, it is safe to say that most of them ar e
attended by a gap. And, if we consider what goes on in the market to
create a flat-topped price formation, it is easy to see why breakaway gaps
should be expected. An ascending triangle, for example, is produced by
persistent demand for a stock meeting a large supply of it for sale at a
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fixed price. Suppose that supply is being distributed at 40. Other holders
of the stock who may have intended originally to liquidate at 40½ or 41
see quotations come up to 40 time after time, stop there, and turn back.
They tend, in consequence, either to join the crowd selling at 40, or else
to figure that, once through 40, prices will go much higher; they may
either lower or raise their selling price. The result is a “vacuum” on the
books, a dearth of offerings in the price range immediately above the
pattern. Hence, when the supply at 40 in our ascending triangle example
is finally all absorbed, the next buyer of the stock finds none offered at
40⅛ or 40¼, and he has to bid up a point or more to get his shares, thus
creating a breakaway gap.
Exhaustion Gaps
The breakout gap signals the start of a move; the runaway gap marks its
rapid continuation at or near its halfway point; the exhaustion gap comes
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Chart 23. IBM, Double Top in a Relatively Complex Situation. IBM tells an interesting
and instructive story in this chart, beginning with a breakaway gap, a large breakaway
gap on impressive volume. A trade on the breakout day would have been completely
justifiable technically. The second gap, which should be a runaway gap, is quickly
covered, but until this reaction there has been no point on which to place a trendline.
Subsequent reactions give other points for even tighter trendlines. If a trader were
trading a multilevel (or multiunit) position, the liquidation of a unit on the gap through
the trendline in July would be indicated. Another unit might be taken off with the
breaking of the trendline in August. The failure of the advance in September is ominous
and one might immediately begin to suspect a double top. The drop through the neckline
at 117 is ample notice to abandon hope, a propitious warning in view of the plunge in
October. It is interesting but not coincidental that the price drop is arrested around the
support level of 94. Among the other interesting lessons here is the rectangle that makes
the bottom in October and November.
at the end. The first two of these are easily distinguished as to type by
their location with respect to the preceding price pattern, but the last is
not always immediately distinguishable from the second.
Exhaustion gaps, like runaway gaps, are associated with rapid, exten-
sive advances or declines. We have described the runaway type as the
sort that occurs in the midst of a move, that accelerates to high velocity,
then slows down again, and finally stops as increasing resistance over-
comes its momentum.
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Chart 24. Consolidated Edison. If we take the history from early 1965, when it reached
its all-time high of 49¼, we find that like almost all of the other electric utilities, ED
had declined more than 50% by 1973. And, like most other utilities, the dividends were
steady, and the earnings good. But, at 18, the stock did not look healthy as you can
see. And then on Tuesday, April 23, the bottom fell out completely, and, within 4 weeks,
it was down to 7, later to 6. The stock was not showing strength at any point in 1974.
It did not look like “a bargain” at 18. And it most certainly did not look like a bargain
at any time after the great downside gap. ED is unusual only in that the breakdown was
so spectacular. Actually, other stocks in the group have also looked unattractive to buy
or sell. And rather than considering these as “bargains,” we would be asking why, if
they are so good, should they be passed over by the important institutions in Wall Street?
It would take some solid evidence of assertive, eager buying to make these utilities look
good. In a situation like this, it would seem best to stay out or sell short.
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Chart 25. Apple, Brought Low by Earnings Hysteria. The infamous earnings gaps from
the turn of the millennium. As the Great Clinton–Gore bull market began to top in 1999
and 2000 it became obvious that shorting stocks that had soon to report earnings was
a profitable tactic. As almost all stocks were overbought and selling at very high price
earnings ratios there was little risk in a company’s reporting surprising earnings. On the
other hand, the least disappointment in earnings figures resulted in breathtaking pun-
ishment by traders. Earnings gaps of 6% — even up to 43% — occurred. Easy money
for the alert trader.
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Diagram 16. Diagram of Island Reversal. The island reversal has been chosen here
because its meaning is so clear and obvious. Even the novice should have no difficulty
reading the message. It is like an exclamation mark at the end of a long sentence. Note
that it should be at the end of a long sentence. Just as we discussed in the case of gaps,
the context must be evaluated.
And what is the other important matter about the island reversal, the general matter
which it has in common with all market phenomena? That, like all market phenomena,
you do not know definitively the nature of the pattern until it is complete. As in all
technical analysis, patience is required to allow the market to complete the message.
That is why, besides intelligence, patience is the most important attribute of a trader.
should overlap to some extent) so that the whole area stands out as an
island on the chart, isolated by the gaps from the rest of the price path.
We have said that an island does not of itself appear as a major reversal
formation, but islands frequently develop within the larger patterns at
turning points of primary or important intermediate consequence, as, for
example, in the head of a dynamic head-and-shoulders top. By the same
token, they appear occasionally at the extremes of the minor swings that
compose a triangle or a rectangle (in which event, of course, the gaps
that set them off are really better classified as common or pattern gaps).
The reasons islands can and do develop — in other words, why gaps
can and do repeat at the same price level — become more apparent
when we think back on the general subject of support and resistance (see
Chapter 2). Suffice it to repeat, at this point, that prices can move most
rapidly and easily, either up or down, through a range where little or no
stock changed hands in the past, in other words, where previous owners
have no “vested interest.”
Sometimes, the second gap — the breakaway that completes the
island — is closed a few days later by a quick pullback or reaction. More
often it is not. Rarely, the first gap — the exhaustion gap that starts the
island — is covered in a few days before the second gap appears, in
which event the island congestion takes on a sort of V-shape (if it is a
top), and there is no clear “open water” across the chart horizontally
between the island and the trends preceding and following it. In any of
these variations, however, the interpretation remains the same: The pre-
ceding minor move should be practically retraced.
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Spikes
A spike is a day whose bar on the chart protrudes markedly above the
previous and succeeding days. Clearly at the time it occurs the trader does
not know whether it is a runaway day (see below) or a spike. The Errol
Flynn (or Indiana Jones) type trader though, if possessed of exquisite
timing and judgment and luck, might catch a market top by correctly
identifying the day as a spike at the moment, thus selling short at the
top. The gold markets of the 1980s ended with just such a spike. And
one of my associates sold it short at $1000 an ounce: a nice trade. When
making this trade the trader must be prepared to experience subsequent
run days (runaway days) against his position.
Reversal Days
Sometimes a spike is also a reversal day — that is, a day on which the
price opens strong, takes off like a rocket, pierces new highs, and then
reverses and closes on the low. If long, this is not a pleasant sign and is
worth close watching — and, perhaps, depending on the status of the
market, may justify a hasty exit.
75 LU LAST-Daily 09/20/2000
70
65
60
55
50
45
40
35
30
80000000
60000000
40000000
20000000
Chart 26. Lucent, Illustrating Key Reversal Days. As the great Clinton–Gore bull market
expired, many high-flying stocks developed long rectangles and congested trading pat-
terns, offering easy low-risk opportunities for short scalps on key reversal day patterns.
Some stocks are better for this than others, and study of the stock itself is advised before
this or any other trading strategy like this is implemented.
5
WHEN TO BUY, WHEN TO
SELL: STOPS, HAIR-TRIGGER
STOPS, PROGRESSIVE STOPS
STOPS
Stop orders, or as everyone refers to them, stops, are the instructions
given to the broker or the market or the computer to buy or sell a security
depending on specific criteria. For example, “Sell my 100 shares of IBM
if the market price declines to 99.” Or, “Buy 100 shares of IBM if the price
rises to 101.” Stops may be used as indicated for buying and selling. Here
in this discussion we are concerned only with the use of stops for
protective purposes, that is, to stop a loss from running, or to protect an
accumulated profit.
First, no stop system is perfect. Regardless of the way stops are
calculated, and there are myriad ways, losses will occur, profits will not
be efficiently seized, money will be left on the table. It is unfortunately
an imperfect world. But almost any stop system is better than indecision,
confusion, and doubt. John Magee developed a number of stop systems,
all of them good. Their use often depends on the particular market
situation and can be relatively complex (consult Technical Analysis of
Stock Trends, 8th ed.), but here we cover the basics.
Two situations exist in which stops should be calculated and used:
entry and profit protection.
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if the market moves against our position. Such a move is almost guaranteed
to occur in trend trading. The way we deal with counter moves is to plan
the trade so as to limit the loss up front. There are two ways to set the
initial stop — using a money management rule or finding a technically
analyzed point.
In the first case the trader would determine the percentage risk to be
taken from the entry price and set the stop that distance below the entry
(e.g., entry price 100; percentage risk 8%; stop price 92). Or, on the same
trade the analyst might have found a support level at 95 — the bottom
of a rectangle or a triangle support line — and set his stop there. Or, he
might find the support level and add a fudge factor — 2% or 3% to the
support level. Say, 95 plus 2 or 93. In either case the sum at risk is called
(by this author) the Operational Risk.
It is entirely possible that the market will take out this stop. It is also
entirely possible that IBM will decline to 20, making the stop at 93 look
like an act of genius. For the wisdom of this kind of policy see the “Best
and Brightest Case” (Appendix A, page 149).
some traders might set a stop ⅛ under the spike day and be taken out shortly. The longer-term trader would have found a new
basing point at 6 (81.625 and 77.54). A rectangle develops with 7 as one of its points and also as a basing point (85.063 and
80.80). Between 7 and 8, price comes back as might well be expected but, because of the filter of 5%, leaves the position intact.
The reaction cannot be taken as a basing point because that would cause a lowering of the stop which is against the rules. The
reaction at 8, though small, offers another point, perhaps more judgmental, moving the stop to 86.87 in relation to the point at
91.438. Between 8 and 9 the x indicates a point which does not see 3 days of action away from the price on the upside, but
9 does (94.875 and 90.13). Then in an interesting development the trade is terminated in late February by the basing point stop,
and, coincidentally(?) the 14-month-long trendline is broken. Note the horizontal resistance/support line at 96 which is also
penetrated at the same time. This is, of course, the top of the Microsoft bull market, and the breakout in December 1999 is of
course a cruel joke — sometimes known as a bull trap. The technical analyst has numerous tools to exercise here — the trendline,
the basing points, the runaway days (which might be answered with the hair-trigger stop as discussed for the spike between 5 and
6), the round over after the runaway days and the return to the base of the runaway days (which might be taken as a throwback,
When to Buy, When to Sell: Stops, Hair-Trigger Stops, Progressive Stops
but certainly not after the relative high after 9), and the failure of the support line at 96. In the markets of the millennium, these
runaway days occurred many times and the result was almost always dismaying.
77
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III
MAGEE’S METHODOLOGY:
RISK MANAGEMENT,
PORTFOLIO MANAGEMENT,
AND RHYTHMIC TRADING.
PRAGMATIC PORTFOLIO
THEORY FROM
PROFESSOR BASSETTI.
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6
THE MAGEE METHOD
81
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The opposite extreme, that of “putting all one’s eggs in one basket
and then watching the basket closely,” carries the obvious risk that a
single “bad” investment could wipe out a significant portion of one’s assets.
Our experience suggests that portfolio diversification and managerial
efficiency combine usefully when the number of positions varies from
2 to 10 and funds available for investment vary from $10,000 to $200,000.
For example, if an investor has $10,000 to invest initially, we would
recommend the selection of two positions of $5000 and $5000 each. A
$100,000 investor might begin with 6 or 7 positions of $15,000 each. While
at $200,000, approximately 10 positions averaging $20,000 each would be
appropriate. The benefits of diversification decline sharply as the number
of positions held rises above 10; thus, for even a $1 million account, we
would recommend holding no more than 10 to 12 positions. (As the reader
will see, the Editor feels these ideas were later refined by Magee more in
the directions recommended in the next chapter. In addition it is my feeling
that a $10,000 portfolio is probably better off in ishares than in individual
stocks; see Case 24, Appendix A.)
Additional diversification criteria that we have found useful include
industry and liquidity. For a theoretical $120,000 portfolio of eight $15,000
positions, we certainly would not want all eight positions to be in steel,
or oil, or electronics, or any other single industry. Thus, we suggest a
policy of individual stock selection that provides industry diversification.
For our theoretical $120,000 portfolio, a “concentration limitation” of two
holdings in any one industry (25% of total portfolio) is desirable, with
one position per industry being ideal.
To the extent that one’s stock positions become sizable (1000 shares
and up of a stock), we add “liquidity.” As a stock position totals 100
shares or even a few hundred shares of a nationally listed company, a
high degree of liquidity can be assumed. But when it is time to head for
the exits with larger positions, one’s ability to sell and move quickly may
be sharply reduced in many of the “thinner,” less actively traded stocks
that may be found on the exchanges. Our rule is that no more than half
the issues in any individual industry should be illiquid.
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7
FURTHER DEVELOPMENTS
TO THE MAGEE METHOD:
PORTFOLIO MANAGEMENT,
RISK CONTROL,
INCLUDING RHYTHMIC
TRADING AND PRAGMATIC
PORTFOLIO THEORY
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construction, (3) risk measurement and control, and (4) personal psycho-
logical management.
Technical Analysis
By technical analysis Magee meant the bar charting and dispassionate
analysis of objective data from the markets — primarily price and volume.
Charting the markets and acting on hard data alone not only mean the
choice of objective data as the input to analaysis. They also mean the
deliberate shunning of fundamental analysis, that is, the study of earnings,
cash flow, sales figures, and on and on — that is all the data that can be
manipulated and misrepresented or cooked by creative accountants. The
Wall Street Journal does not misreport the data for trading on the New
York Stock Exchange. Like the sports scores, that is not permitted in our
society. But earnings reports are only as good as the integrity of the
people who make them. Technical analysis also means ignoring the din
of touts, brokerage house recommendations, tips from barbers and taxi
drivers, and, worse, television talking heads (except for the coauthor).
This choice of an analytical method is complemented by the observa-
tion that the most efficient trading horizon or term is the mid- to long-
term trend. Mid- to long-term trends, in general, last at the extreme several
years but might be only months in duration, as opposed to a secular trend
which might last many years — as in the case of the great bull market
of the late 20th century which began in 1982 and lasted until 2000. Trading
on the Dow Theory certainly was rewarding over the last century. The
mid-term analyst should have done even better, not being constrained by
the long periods necessary to generate signals.
Thus, in detail, Magee gathers data from the market that is uncontested —
price and volume rather than hypothetical earnings. He presents these
data in bar charts. From long experience and investigation he analyzes
the chart and identifies situations in which the probabilities are in his
favor. For example, he finds a trading range defined as a rectangle, and
when price breaks out of the rectangle he commits a portion of his capital
to it. At the same time, he sets a stop beneath his trade in case his
experiment is unprofitable. If the market moves in his favor he system-
atically raises his stops to protect his profits. He pursues this policy until
the trend proves to have definitively changed.
Hedged
As refers to hedged, Magee thought that a portfolio should be biased in
the direction of the general market, and the percentage it should be biased
in the direction of the broad market was determined by the analysis of the
market, the MEI. The MEI is constructed by analyzing the market or market
segment and classifying it into strong, weak, and neutral layers. This creates
a kind of oscillator with which one may find broad market tops and bottoms.
And one may also use it to allocate the portfolio to longs and shorts. If the
MEI is 60% bull, then the portfolio is 60% long or thereabouts (thereabouts —
is close enough; only in professional trading do teenies really matter). The
rest of the portfolio is allocated to shorts and sidelines.
Simple
Magee thought, in general, leaving aside considerations of extremely large
and extremely small capital, that 8 to 10 issues were sufficient diversifi-
cation. His mind may have been constrained on this number because of
the difficulty and distraction of managing larger more complex portfolios
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Trend Following
The trend follower diminishes his risk by intending to take the middle
third of a trend. He does not enter his position until the market has in
all probability signaled its intentions. He does not exit his position until
the market signals that it has reversed its direction. Bottom fishers and
top pickers clearly and obviously run the greatest risks. They also, inci-
dentally, in the short run reap the greatest profits.
Trend traders are willing to let them have those greater profits, pre-
ferring to take the least risky part of a trend — the middle third.
Diversification
If all a trader’s capital is concentrated in one issue, the destruction of that
issue lets him experience that most painful of trading experiences: gam-
bler’s ruin — that is, being wiped out, and not being able to play anymore,
which is more distressing than losing all one’s money. Magee thought
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IV
OTHER TECHNICAL
ANALYSIS TOOLS: NUMBER-
DRIVEN TECHNIQUES,
CANDLESTICKS, AND POINT-
AND-FIGURE CHARTING —
ALGORITHMIC TRADING
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that nothing lasts forever, and that the market learns about
successful systems and works to defeat them.
8
OTHER IMPORTANT
TECHNICAL ANALYSIS
METHODS
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and sell weakness, and trading systems sell strength and buy weakness.
Volume analysis attempts to quantify the assessment that the chart analyst
makes of the importance of volume. Although some traders employ
exclusively one or the other trading or trending tool, there is no inherent
conflict in using trading tools within a trend-following system in attempting
to determine when to take profits or hedge. In fact, for all but the longest-
term investors I believe in a diversity of tactics. The markets after all are
infinite in their diversity. Why shouldn’t tactics adjust continuously to
them, depending, of course, on the time frame of the investor?
In fact, let me emphasize, the adjustment of technique to the market
rhythm may be the most important factor in trading success. This adjust-
ment occurs naturally for the chart-based trader.
To teach a mechanical number-driven system to make this adjustment
requires more than a little mathematical and systems-building sophistication.
NATURAL METHODS
Candlestick Charting and Point and Figure charting will be illustrated and
placed in perspective.
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90
85
80
75
120
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30
12/98 1999 2/99 3/99 4/99 5/99 6/99 7/99 8/99 9/99 10/99 11/99 12/99 2000 2/00 3/00
Stochastic Indicator
Why George Lane called the stochastic indicator “stochastic” is a mystery.
The word as understood by lexicographers means “a naturally occurring
random process.” What Lane meant, and as the business understands it, is
the relating of the closing price to the range in prices for a prior time
period — usually 21 days for Lane’s purposes. The idea is based on the
observation or belief that in rising markets closing prices have a tendency
to cluster near the top of the range, the reverse being true in downmoving
markets.
The 21-day stochastic relates today’s close to the price range from the
previous 21-day period. The price range is the difference between the
highest price and the lowest price. Expressed as a percentage, the point
is plotted on a scale of 0 to 100. Above 80% is taken as overbought and
below 20% is taken as oversold. Generally this tool may work well in a
trading market and less well or not at all in a strongly trending market
(see Chart 29).
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100
90
80
70
60
100
80
60
40
20
12/98 1999 2/99 3/99 4/99 5/99 6/99 7/99 8/99 9/99 10/99 11/99 12/99 2000 2/00 3/00
Bollinger Bands
Bollinger Bands were created by John Bollinger. Rather than an outright
trading indicator, they are more a tool used in conjunction with other tools
and techniques. Bollinger bands are calculated based on standard deviation
from price — usually 2 standard deviations. This is charted as an envelope,
above and below the price line. This means that the envelope expands
and contracts about the price plot. Unusual shrinking of the envelope is
usually associated with potential for price breakout (see Chart 30).
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65
25
10
-5
-20
12/98 1999 2/99 3/99 4/99 5/99 6/99 7/99 8/99 9/99 10/99 11/99 12/99 2000 2/00 3/00
Rate of Change
ROC is a simple indicator, simply constructed. The present price is compared
to the price n days ago. As an example, if the ROC were 10 days, today’s
price would be compared to today minus 10 days (and tomorrow’s price
compared with tomorrow minus 9 days). The result, plotted as a continuous
series, then oscillates about an equilibrium line to give one a measure of
overbought and oversold conditions. Chart 31 is a representative chart.
A ROC indicator is not a definitive or totally dependable measure of
overbought and oversold conditions. A stock can go from being over-
bought to being very overbought. And then to very, very overbought.
And then to unbelievably overbought as those who measured it over-
bought shorted it, only to see it become even more overbought. Then be
caught in the boa constrictor of short squeeze. In the reverse situation,
the oversold becomes very oversold, and so on.
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Microsoft (104.375, 108.000, 104.141, 106.562, +2.9370), Relative Strength Index (52.7618)
120
115
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10000
5000
x100
ruary March April May June July August September November 2000 February
100
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3
0
-3
12/98 1999 2/99 3/99 4/99 5/99 6/99 7/99 8/99 9/99 10/99 11/99 12/99 2000 2/00 3/00
10500
10000
9500
9000
8500
8000
7500
4/1998 7/1998 10/1998 99 4/1999 7/1999 10/1999 00 4/2000 7/2000 10/2000
Chart 34. The Dow, Circa 2000. A Broadening Top and Moving Average.
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75
70
65
60
55
50
11/98 12/98 1999 2/99 3/99 4/99 5/99 6/99 7/99 8/99 9/99 10/99 11/99 12/99 2000 2/00
Chart 36. A 200-Day Moving Average on the Dow-Jones at the Turn of the Century. A market which slithers back and forth across
a moving average is the definition of a trading range. In this case a very long-term moving average. When this occurs after the
greatest bull market in history its message is clear to those who look and listen: The yellow caution light is blinking and the alarm
103
is ringing. This behavior suspends trend trading operations, and also leads to hedging, and if so inclined, to short-term trading tactics.
SL302Xch08 frame Page 104 Thursday, December 13, 2001 10:00 PM
stop if the herd turned out to be lemmings pouring over a cliff. And one
would also like to know if it were a herd of bulls in firm control of the market.
A 10-day moving average will result in frequent trading regardless of
permutations introduced. A 200-day moving average results in much
slower trading. Some futures traders use 4- and 7-day moving averages,
and some use these lengths as crossover signals (i.e., trading when the
4-day crosses the 7-day).
the short term rises above the long term, we would expect to see rising
prices following the conventional theory of volume — that rising prices and
rising volume are bullish, and rising prices and falling volume are bearish
signs. Moderately declining prices with declining volume can be a bullish
sign. Increasing volume and falling prices are ominous signs. However, it
should be noted that volume interpretation can sometimes be a mysterious
process and judgment must be exercised before believing any indicator.
Equivolume
Invented by Richard W. Arms, Equivolume is a clever graphic way of
looking at volume.
Top of the box is volume high, the bottom the volume low. The width
of the box is the normalized volume, which is obtained by dividing the
volume for the period under consideration by total volume on the chart.
The idea behind this indicator is that shares are more important than time
in determining future direction. Arms says, “If the market wore a wrist-
watch, it would be divided into shares, not hours.”
CANDLESTICKS
There are more techniques in the technical analysis tool kit than bar charting
and number-driven tools. Two other techniques of great interest are used
by many analysts: candlestick charting and point-and-figure charting.
Candlestick charting is an ancient Japanese way of representing the
standard price data. Because of its particular graphic characteristics and
long experience with the method, candlestick chartists feel they ar e
enabled to interpret graphic patterns to forecast prices. Since its introduc-
tion to American traders in the 1990s, it has attracted numerous followers
and is in my opinion well worth study.
Briefly, a candlestick is formed by taking the standard price data —
open high, low close — and drawing a graphic which has a body
composed of the difference between the open and close prices (the real
body) and a stick (or bar) (the upper or lower shadow) marking the high
and low of price action (see Diagram 18 for an illustration). With the real
body colored according to the direction of prices (white for up, black for
down) interesting new dimensions are added to graphic analysis. Just as
by the mere act of bar charting prices we bring order to price analysis,
candlestick charting adds color and formations to our graphic analysis.
Based on the observations of generations of Japanese traders, certain
patterns and formations are taken to indicate vital information about the
nature of the market under study.
As an illustration of these concepts, see Chart 37, from Microsoft, using
conventional bar charting, followed immediately by a candlestick chart
(Chart 38) of the same data.
Numerous candlestick patterns and formations are recognized and
purport to have predictive value. But the method is not discussed exten-
sively here. Rather, the reader should be advised that candlestick charting
is not the philosopher’s stone either. It requires experience and judgment
and use within a sound and balanced practice. Further study of this
interesting method might start with Japanese Candlestick Charting Tech-
niques by Steve Nison (New York: Merrill Lynch).
Diagram 18. (continued) after an extended downtrend. The morning star signi-
fies a potential bottom and may be white or black. The piercing line is bullish
and is the opposite number to the dark cloud cover. It is the relationship of one
day’s close to the next which determines their significance. More than halfway
into the body carries meaning for the candlestick analyst. The ominously named
hanging man lines are bearish found after a significant uptrend. As may be seen,
they quite graphically (pun intended) represent the tight range of open and close
and dramatize the long range traversed by prices outside of the narrow open/close
relationship. This selection of candlestick patterns is necessarily limited here and
the interested reader should pursue the subject in Nison’s work and other refer-
ences at www.johnmageeta.com.
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POINT-AND-FIGURE CHARTING
One school of chartists who have on occasion had marked success in the
markets is the point-and-figure group. P&F charting (see Chart 42) is quite
a different animal from other charting techniques. The horizontal axis is
not used for time periods as on other charts. It does, however, mark
changes in the direction of price with each new column noting a reversal
of prices. The reader will note that Chart 39 provides a new representation
of the information in Charts 37 and 38.
The P&F chart is constructed as a series of Xs and Os, each entry
being a box and box size (i.e., price value) being a critical factor in
construction of the chart. The X represents upward price movement, and
the next up box is not marked until price has moved equal to or more
than the value of the box. For example, if the box size is 1 point the box
will not be marked on a half-point move. In addition to box size, a reversal
value must be specified. Reversal will indicate the number of points of
movement in the opposite direction to start a new column. If, for example,
the reversal value is set to 3, then price must move 3 points in the opposite
direction to start a new column, which, again by definition, will have
three boxes immediately filled.
P&F chartists identify formations considered to be of predictive impor-
tance, as do other chartists. In Diagram 19, some top and bottom forma-
tions and triangle formation are produced. Numerous other formations
are recognized by P&F chartists and the reader may pursue study of this
important school with references found in the Appendix on Further Study.
Most popular technical analysis software packages switch easily among
the various charting methods — from bar charting to candlestick or P&F
among their other capabilities. An excellent way of learning the nuts and
bolts of these methods is by taking a market with which the student is
well acquainted in bar-charting format and studying the case in different
graphic and number-driven formats (candlesticks, P&F, moving averages,
etc.).
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115
110
95
90
85
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Runaway gap
80
75
8/1999 9/1999 10/1999 11/1999 12/1999 00 2/2000 3/2000 4/2000
Chart 37. Microsoft, once more, to continue the case. See Charts 9 and 27. Here once again we see Microsoft at the top. Having
considered the previous charts as well as the lessons we have learned through the entire book, we are ready to look at the same
The Introduction to the Magee System of Technical Analysis
thing. But to see it differently. Now we know the end of the story, so this situation may be looked at with special perspective.
Having examined the previous lessons on stop systems and methods we know that it was possible not to go down with Microsoft.
If only we can separate ourselves from belief. In this chart and the two following charts we see the same data represented in three
different modes: the bar chart, which should by now be second nature to us, and which should allow us to extend our knowledge
to other forms of representation — that is, to candlesticks and point-and-figure.
SL302Xch08 frame Page 111 Thursday, December 13, 2001 10:00 PM
V
CONSIDERATIONS FOR
TRADERS/INVESTORS
OF WHATEVER STRIPE —
DAY TRADERS TO
LONG-TERM INVESTORS
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But. And. An awareness of the state of the market, its present rhythm,
its direction and nature are indispensable to the survival and prosperity
of the great majority of investors. In 1972, a group of the “best and
brightest” Wall Street analysts chose a group of stocks that they said the
investor could buy, throw in a drawer, and forget. Read further to see the
results of this kind of fundamental analysis and “buy and hold” investing.
Keeping in mind several kinds of investors, Bassetti has proposed some
sample trading plans for various investment types, which if followed might
avoid long-term busts. No guarantees are ventured for day traders. Gam-
blers are directed to the nearest casino. Or, actually, Las Vegas is a
happening place.
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9
CONSIDERATIONS FOR
SHORT-TERM TRADERS,
SPECULATORS, AND MID-
AND LONG-TERM INVESTORS
117
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Annual
Mean Return = 11.1000
Probability of loss = 23.6
Hourly
Mean return = .0055
Probability of loss = 49.4
1 2 3 4 5 6 7
Diagram 20. (continued) Each person must place himself on this spectrum,
either through deliberate discipline and choice or as a matter of natural temper-
ament. Identity is style, or vice versa. And the individual must recognize his
nature — day trader or long-term investor — and fit that nature to the markets
in terms of the instruments he trades, the rhythm he follows, and the tools he
uses. The obvious prejudice of the authors of this book is for the midterm
speculator, as Magee called himself, but each person must find his own identity —
not just in life, but in the markets.
SL302Xch09 frame Page 120 Thursday, December 13, 2001 10:12 PM
that the utility companies have made of energy deregulation and their
feckless investments in nuclear energy. Conservative investors will not
speculate in pork bellies, and their use of options and futures will be of
an insurance hedging nature.
In the next chapter I suggest some hypothetical trading plans for
different species of traders/investors.
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10
SOME HYPOTHETICAL
GENERAL TRADING PLANS
Here are some potential trading plans for various types, from gamblers
to the long-term investor.
GAMBLERS
There is no satisfactory trading plan for gamblers. They are, in fact, best
off in casinos where they can lose their money in a stimulating atmosphere
with good music and amusing comedians and cheap food. Professional
gamblers are not really gamblers. They are businessmen who like to take
easy money from gamblers.
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LONG-TERM INVESTORS
A Simple Plan Following the Dow Theory
The simplest of all trading plans for the long-term investor might be to go
with the Dow Theory. Buy the Dow on bull market signals; sell it on bear
market signals. If a sporting type, sell it short on bear market signals.
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VI
TRADING IS ONLY HALF
SYSTEMS AND METHODS —
THE OTHER 90% IS MENTAL
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11
THE MENTAL SIDE
AND THE PHILOSOPHICAL
FOUNDATIONS*
* The alert reader will note here that some material has been repeated from earlier
in the book. This is not an accident.
129
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mechanism were not meaningless but were directed toward the orderly
creation of a definite pattern in the cloth which would have meaning to
anyone when he saw the finished product.
At the first or second lectures in a course, groups of students in
technical analysis of stock trends are often skeptical as to the meaning
or orderliness of the market. When they discover, as they do, that the
long-term trends of stocks, covering a period of a number of years, show
definite trends which often appear as straight-line channels on semiloga-
rithmic charting paper, they are likely to be overcome with enthusiasm,
sometimes to the point at which it is necessary to warn them that the
existence of trends, though true, is not the entire key to success in the
stock market but merely one of a number of important facts that appear
in the study of charts. In this field, “a little” knowledge can be a dangerous
thing indeed.
EVERYDAY PREDICTION
On the other hand, every one of us makes predictions involving the future
every day of our lives. In fact, we depend on our ability to predict; we
could not live or work without it. Whenever a man tells his wife he will
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You see, in this view, if your predictive method is “right” it will give
you the “right” result. If the stock goes up in price, then you are “right,”
and your prediction is “right,” and your predictive method is “right.” But
if the stock goes down, you are “wrong,” your prediction is “wrong,” and
your predictive method is “wrong.”
This leads to trouble. You might be quite “right” about BankAmerica
this month. You might be “right” about Advanced Micro Devices next
month, and about B.F. Goodrich the following month. But, sooner or later,
you will be “wrong” on one. This, almost by definition, makes your method
itself “wrong,” at least in that particular case. It either discredits your
method entirely or it casts a shadow and a doubt on it. At the very least,
it destroys your confidence
Let me suggest here that we consider for a moment other kinds of
prediction, outside the market. We will see how this same failure and
demoralization can occur wherever we attempt to set up a “perfect”
“either/or” predictive method.
But we do not have to do it in a two-valued, absolute way. We can
recognize certain limits of predictive expectation in terms of probabilities,
and then we will not continually be afraid to use our method because of
our lack of confidence in it. We will not be expecting more from our
method than we can reasonably hope for. And we will not be basing our
method on a few accidental “successes.”
Is this clear? It is clear that a stupid method of prediction (such as
betting even money that one can draw a spade from an ordinary deck
of cards) could at times produce a succession of “wins.” If we see someone
make such a bet over and over again, would we feel it was a “right”
method of prediction, even if he won eight times in succession?
Or, to put it another way, suppose we were to have the chance of
betting even money that we would not draw a spade from the deck.
Every time we drew a heart, a diamond, or a club, we would win. Only
when we drew a spade would we lose.
Under these conditions, if we were to lose several times in a row on
this bet, would we discard our method as “wrong?” Would we reverse
our method and bet that we would draw a spade, merely because of a
run of luck against us?
Isn’t it possible to say that, providing the deck of cards is an honest
one, containing the usual cards and properly shuffled, it makes no
difference how many times we “win” or how many times we “lose”? This
does not affect the “rightness” or “wrongness” of our method of evaluation.
And our best policy is to continue to use our evaluative method as long
as we are convinced that it is based on adequate data and valid reasoning.
Of course, we know this. We know this from what we have previously
abstracted from our experience in drawing cards from decks. It seems
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can offer his stock at $60. But, here again, he will not get his price as
long as there are others willing to sell for $50.
Thus, regardless of formulas and theories, ratios, and economic break-
downs, the value of a stock, in terms of what we pay or what we get, is
determined by what the investing public feels it should be. The price is
the result of the bids and offers of all the investors: those who feel it
should be higher and those who feel it should be lower.
It is easy to say, and many have said, that a price determined in this
way by public auction may be unrealistic, that it might be the result of
psychological forces — a wave of optimism, a spell of panic. It is true
that if an investor had perfect insight and a complete understanding of a
situation, he might set the value higher or lower than the market sets it.
If he were right, and if things worked out as he anticipated, this would
be highly profitable to him.
However, to set one’s own opinion squarely against the judgment of
the market calls for a degree of wisdom (or a degree of sheer folly) that
few of us would claim. As far as the internal and corporate affairs of a
company are concerned, there are officers and directors whose livelihood
and business future depend on knowing their own company and its
prospects. There are also employees, many of whom may also be investors
in the company’s stock, who are in a position, at least, to know more
about what is going on than the outside stock trader. There are professional
analysts and managers for large institutions — the banks, insurance
companies, mutual funds, pension funds, etc. There are individual inves-
tors who may have been studying a certain industry or a certain stock
for many years. When a man tells us that a particular stock, selling now,
say, at $50, is really worth $100, we should realize that he is expressing
an opinion, his own judgment, and he is setting that judgment against
the serious evaluation of other investors whose dollars are at stake in this
evaluation.
If we seem to have wandered a considerable distance from discussion
of the charts themselves, it is because this discussion is of paramount
importance in understanding what it is that charts tell us, and why we
do not insist that they not only tell us what is happening but also why
it is happening.
To round out this section, one more important point must be covered.
Clearly, whatever happens in the market to a stock reflects something
that somebody thinks, feels, or believes will affect the future value of that
stock: the record of past earnings or dividends on the assumption of a
continuation of past performance or the projection of a past trend. Today’s
price for any stock reflects and includes all the hopes or fears anyone
may have for its future. It is each man’s opinion merged with the opinion
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of every other investor interested in the stock, and the resulting figure is
the ultimate meeting point — ”the bloodless verdict of the marketplace.”
Thus, the market price at any time (which is what the chart gives us
graphically) is a prediction of the future as seen through many eyes. It is
the best educated guess of all those concerned.
But it should be clearly understood that although all of us have to
make predictions as to the probable consequences and outcome of our
action when we buy a house, when we get married, when we take a
new job, or whatever we do, it is not possible to make these predictions
“absolute.” It might be someone’s prediction that at five o’clock he would
get his car at the parking lot and drive home in time for dinner. This
might be a good and reasonable prediction of that future event. But it is
possible for the conditions to change. The car might have a bad battery
and might not start. There might be a highway tie-up that would prevent
his getting home until very late. His wife might have sprained her ankle
and gone to bed. We have to make predictions, the best we know how.
But, we must be prepared, always, to change our plans and to make a
new evaluation if the situation changes in some unexpected way.
This is a key point in the use of charts or in any investment planning.
It is necessary to use the best current data we can get and to apply it in
light of our experience to estimate the probable developments. But we
must never become so “frozen” to today’s opinion that we are unable to
change it tomorrow if there is new evidence calling for “a revised map.”
In discussion of the use of daily charts, we are assuming that the
market price at any moment represents a meeting of bids and offers of
those who want to buy and those who want to sell — therefore, the
market value at that moment — and the chart provides a visual history
of the market action in such a form that it is easy to see, at a glance, the
trend of the stock’s price and any important changes in price trend or in
volume of trading. For such a chart, it is possible to draw some inferences
and form some valid opinions as to the probable future market action.
In other words, the chart is a tool; it is, in fact, merely a factual record,
and its interpretation and use depend on the experience and judgment
of the investor who is using it. Trends and patterns do not cause move-
ments in the market. (We would question even the limited psychological
effect they might have in influencing the trends of large and important
stocks, because large and institutional holders of stocks cannot buy or
liquidate heavily overnight, and among individual investors only a small
percentage are willing or able to act on technical market action.)
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VII
APPENDICES
After basic training and drill the army enters the battle. How
well does the theory and method hold up in the heat of
combat? Appendix A presents a number of cases from real
life and explores a number of cases from the experience of
Magee’s advisory company. About the only way that market
wisdom can be transmitted is through the examination of
particular cases from actual experience. Some students can
even absorb these lessons without needing to directly expe-
rience the pain which opens one’s eyes to being able to
absorb the lessons.
B. Tekniplat Charting
C. Continuing Study Plan
D. Resources
141
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Appendix A
SOME SELECTED
JOHN MAGEE LETTERS
Section 3. Portfolios
Case 9. June 5, 1982. Managing Money
Case 10. April 2, 1983. New Issues, High Technology, Wonder Stocks,
and the Like
143
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INTRODUCTION
For untold decades John Magee ran John Magee Inc., an investment
advisory business which published a weekly letter commenting on the
markets. In 1963, after learning some painful lessons firsthand in the
markets and hitting the books (Technical Analysis of Stock Trends, 5th ed.)
I became a client and subsequently student of this old-shoe, totally
unpretentious master of the craft. I do not know how many wild and
crazy phone calls he handled from me, but he was always the soul of a
master who knows that he has a passionate and dedicated student on his
hands. On my visits to him I was always impressed by the calmness of
his office, the dry-as-dirt application to the business at hand — even when
I tried to lure him into commodity trading in 1972.
Magee’s letters were notable for their graphic elegance as well as their
deep insight into the markets. It is obviously impossible to reproduce
those letters in facsimile here, but Richard McDermott (the distinguished
editor of the previous edition of this book) chose a sampling of those
letters that I consider invaluable for the beginning (and sometimes the
professional) trader.
I have supplemented these letters, or, as I have called them, cases,
with some instances of my weekly letter which seem educational. Some
of these letters read like new editions of cases from Magee.
The cases are organized into five sections and their contents are
indicated by the section title.
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Section 1
BENEFITS OF PROFESSIONAL
MANAGEMENT
CASE 1
Benefits of Professional Management. From the Files of John Maggee
Technical Analysis:: Delphic Options Research Ltd. www.johnmageeta.com.
Chart 40. Anonymous. A Lesson for Quick Learners. The reader is invited to take
ruler in hand, summon up the lessons he has learned so far, and decide whether he
would buy or sell at this point. The name of the stock is kept anonymous for the
moment in order to give the reader a chance to make a decision uninfluenced by
hindsight. Make an analysis; make a decision; annotate your reasons for your decision
and the outcome will be discussed hereafter. Do this before going to the next page.
145
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Chart 41. Juniper, a Lesson for Mutual Fund Managers. Here is a continuation
of the previous Chart 40. At this point the reader knows that the stock is a
promising supplier of pickaxes, gold panning pans, and burros to the Internet
gold rushers and, thus, as in the case of Levis, an infinitely better bet than the
companies buying its equipment. Now would you buy the stock?
Chart 42. Juniper, a Lesson for Mutual Fund Managers. The end of the story. Sad
ending.
Continuation of Case 1
It will be remembered that in Chapter 1 we talked about slammed stocks,
or is a collapse a disaster or a buying opportunity? Here is the end of the
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CASE 2
The Best and the Brightest. Buy and Hold Investing.
In 1972 a group of the most prominent brokerage house analysts (funda-
mental) on Wall Street got together and picked out a group of stocks to
buy and hold — to buy, throw in the drawer, and forget. The reader will
easily imagine the reaction of Magee, myself, or any moderately competent
technician to this proposition.
On the other hand, as John Kennedy’s economist used to say, who
could quarrel with the list of stocks they chose? A list of the bluest of the
blue chips: Avon Products, Eastman Kodak, IBM, Polaroid, Sears Roebuck,
Xerox. The reader should cast his mind back to 1972. No better blue chips
existed than these regardless of what one might think of these stocks now.
Chart 43 shows what happened to IBM in 20 years. Chart 44 shows Xerox.
It would not be so bad if these two were exceptions to the blue-chip
chosen portfolio. Unfortunately, this buy-and-hold strategy was a Titanic
disaster. The table below shows the performance of the entire portfolio.
Worst of all to a technician, the analysts chose these stocks at the top of
the 1972 market. It does make one wonder about fundamental analysts.
The reader will be amused to read Case 13, in connection with this case.
Following are the results of investing with “the best and brightest.”
Chart 43. IBM, Best and Brightest. In 1972 a group of the “Best and Brightest”
Wall Street analysts engaging in a drill which could only be described as a chance
to get egg on your face (a panel on so-called One-Decision Investing) picked IBM
as a stock to buy and put away. Twenty years later several smarter analysts
reviewed their decision. The foolhardiness of this kind of methodology is amply
demonstrated by the chart. First of all, the call was made at a market top in the
stock — showing that even professionals can buy the top of markets. Second, no
stop was set on the transaction, which resulted during the 20-year period in an
immediate loss of more than 50% (in 1974). Some years later in October 1987,
the analysts would have tasted sweet vindication seeing their recommendation
double in value. Ah, but for too short a joyful time. October 19 came and went,
and the top came and went, and after 20 years the one decision stock languished.
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XRX LAST-Monthly
160
140
120
100
80
60
40
Chart 44. Xerox, Best and Brightest. Another example of those “Best and Bright-
est” analysts making a “one-decision investment.” The decision in this case is
especially ironic and painful because for the next 20 years Xerox never again
regained the price at which those particular pundits had expressed their conven-
tional wisdom. The lesson is clear: Believe the charts, not the experts.
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Section 2
ANALYZING — TIMING —
THE MARKET
CASE 3
August 21, 1982. Buying Panic (and What It Means)
Two records were set on Wall Street this week (see Chart 4). Both may
endure for quite some time. On Tuesday, the Dow-Jones Industrial Average
rose 38.81 points on near-record trading of 92,860,000 shares, the largest
153
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CASE 4
September 4, 1982. Dangerous Spikes
During the recent stock market explosion, a common bottoming pattern
has occurred which is anything but common, technically. Specifically, many
stocks — just after piercing support and establishing a new trading low —
have reversed direction dramatically to establish new interim trading highs,
breaking through one or more levels of resistance in the process.
The three charts shown (in the original letter) are particularly dramatic
examples of this unusual technical behavior. In the case of Allegheny
Corporation, a new trading low of 35 ⅝ was reached early last month,
easily exceeding previous important lows of 37¼ (July 1982) and 41⅛
(March, 1982) and confirming the downtrend then in force. Within
3 weeks, however, Y had soared to 43, decisively penetrating July resis-
tance at 41⅞. The moves in American Express (35 to 46) and Western
Union (25 to 34) showed similar disregard for classic bottoming behavior
as well as for previous resistance levels.
These unique spike reversals from new lows to new highs show many
similarities with the broadening, or “megaphone,” patterns usually asso-
ciated with major tops (see Edwards and Magee, Technical Analysis of
Stock Trends, 8th ed.). Because successively lower lows are interspersed
with progressively higher highs, these patterns inherently reflect price
instability and increasing volatility. Stated another way, it is impossible to
state technically whether such an issue is in a downtrend or an uptrend.
Despite the seeming attractiveness of such turn-on-a-dime stocks, we
have avoided recommending these issues in recent weeks. Instead, more
classic trendline reversals combined with traditional bottom formations
have been favored. If we did find ourselves owning these spiking issues,
we would be inclined to sell or sell short against the box at least half the
position, or, as an alternative, to write covered calls at a strike price near
or slightly below the current market price.
To the extent that these dramatic spike rallies reflect the enthusiastic
reaction of investors to the recent sharp decline in interest rates, they may
be regarded as a bullish signal of better times ahead. In selecting which
stocks to buy now, however, we continue to favor those with the reversal
patterns typically associated with the technical bottoming process.
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CASE 5
February 19, 1983. Reflections
This week we were both pleased and honored to receive a copy of a
small booklet titled The Stock Market Innovators Survey. We were pleased
because the book contained a compilation of the investment strategies of
12 professionals “whose consistent success” supports the premise that
“there are investment strategies and stock picking techniques which, albeit
imperfect, vastly improve our ability to profit from buying and selling
common stocks,” and honored because our technical work at John Magee
Inc. is the subject of one of the book’s chapters. We particularly enjoyed
reading the comments (reprinted here with the permission of the pub-
lisher) of William LeFevre, investment strategist, Purcell Graham & Com-
pany, Inc., regarding the inability of many investors to “recognize” a bull
market — particularly in the early stages when one is upon them:
CASE 6
October 27, 1984. Calling the Turn: A Case of Missing the Point
Recently, we received a copy of an article “Calling the Turn,” which
appeared in the August 1984 issue of Registered Representative Magazine.
Ordinarily, we pass over such reports, forecasts, predictions, and the like
with only the briefest of glances. But in this one case we did hesitate, set
aside the article, and attacked it with relish shortly thereafter. After all,
“Calling The Turn” is a headline with universal appeal. And we are only
human.
The article, it turns out, was really an optimistic assessment of the
outlook for natural gas in the United States. “Are we at the Bottom of a
classic commodity cycle in natural gas?” asks the subtitle. The author then
proceeds to list a number of issues that suggest that, over the long term,
a recovery in natural gas prices is likely. Typical of the points raised are
that (1) “the depression in drilling activity means we’re not replacing the
reserves we’re using,” and (2) “production from existing gas wells is
starting to decline very rapidly.”
Although the author acknowledges that “natural gas prices are probably
not going to get any Major, immediate boost from the crossover between
supply and demand,” he nevertheless advises registered representatives
to approach their clients with confidence and simplicity: “I think we’ve
identified a Major turnaround in the making, and it’s got some great
earnings potential for investors like you.”
Now, our understanding of the meaning of “turning point,” at least in
the context of stocks and commodities, and the marketplaces in which
they trade, is that point at which a change in the major direction or trend
of price occurs. In our view, a recitation of trends affecting the price of
a particular stock or commodity really has little or nothing to do with the
issue of calling the turn of price itself.
A recent case in point, of course, is the behavior of interest rates in
the United States. Certainly, major factors affecting the level of interest
rates in the U.S. throughout 1984 were the strong United States economy
and the huge federal deficit. We are aware of numerous economists and
forecasters who based their predictions of further escalating interest rates
on these underlying factors which to date remain in force. Yet, since June,
there has been a major turning point in Treasury Bills (December 1984),
and decline in interest rates, as Chart 46 illustrates.
We conclude that any article or prediction that heralds a turning point
without specifically considering supply and demand as measured by price
and trading activity in the marketplace is not worth the paper it is printed
on. Or, stated another way, no pun intended, we think the authors of
articles such as “Calling the Turn” have missed the point entirely.
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90.8
TREASURY BILLS
90.6
(DECEMBER '84)
90.4
90.2
90.0
89.8
89.6
89.4
89.2
89.0
88.8
88.6
88.4
88.2
88.0
87.8
CASE 7
February 1, 1986. We Would Not Want to Get Scared Out
of the Market Too Soon
We note that a highly regarded colleague, a technician in fact, has likened
the recent “widely publicized 52-point shakeout in the Dow Industrials”
to “the stock market’s performance in early 1946. In February of that year,”
he states, “the Dow Industrials declined…following that February 1946
shakeout, the Dow Industrials recovered by late May before beginning a
23% decline by the final quarter of 1946.” He concludes, “I believe investors
should be prepared for at least the type of declines witnessed in 1946,
and on six occasions during the past two decades.”
There is no doubt that riding herd on a portfolio of stocks, especially
in an active and sharply advanced market, is a tense, nerve-wracking
business. We have often noted that the owners of stocks that are going
up in price rapidly seem to suffer more anxiety than the holders of stocks
that are going down in a bear market. Apparently, the threat is mainly to
the ego. It is always possible to rationalize holding a stock as it topples
and slides to new lows. One can buy more of it, “average” the cost,
accumulate stock at “bargain prices,” and undoubtedly defend it loyally
with optimistic predictions by the chairman of the board.
But when a stock is going up by leaps and bounds, the strain on its
owner seems unbearable. To sell it after a 20-point rise…and then see it
continue up another 20 points (like Union Carbide recently)…can hurt
one’s self-regard. And to hang onto it, and then have it crumble and sag
and fall to pieces before one’s eyes, can also hurt (like Storage Technology
last year).
Thus, it is no wonder that there are so many worried-looking people
pacing up and down at the back of boardrooms these days. They are the
investors who happen to be holding one or more profitable stocks which
have advanced at a rapid clip and in which they are holding a substantial
profit.
It might be easier on the nerves, and, ultimately, on the pocketbook, if
these investors faced the question as a problem in probabilities. They might
ask whether there was any evidence to date that the particular stock was
weakening, and whether this evidence was sufficient to justify selling it. Or,
quite reasonably, after a big runup, decide to put a close stop order just
below the previous day’s close, to gain the benefit of any further straight-
line advance, but to be safely out in case of the slightest reaction. This
would mean, to be sure, sacrificing the ultimate hope of maximum long-
term gains if the trend were interrupted by a normal period of reaction and
then continued up. But it would represent a positive decision and, for some,
it might be worth the possible loss of future profits to be “off the hook.”
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Or, the investor might continue to hold the stock through any “normal”
reaction, until or unless it showed symptoms of a major reversal, and then
sell it summarily. Although such an approach never captures the extreme
of any move, holdings retained until a major reversal occurs often yield
large capital gains.
Discomfort is a normal component of speculating, which is what all
investment really is. Whichever investment approach one follows, it surely
helps to understand the element of uncertainty which is part of the picture;
and to realize that buy or sell decisions made on a stock-by-stock basis
have a better chance of working out well than do dramatic across-the-
board decisions to buy or sell all stocks because “the DJIA is about to go
up (or down) 50 points.”
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CASE 8
January 24, 1987. The Elusive Crystal Ball
With the DJIA exploding into all-time new highs, we found this article
written by John Magee nearly 25 years ago, still an appropriate comment
on the often asked question, “How far do you think the market will go?”
“I always tell them to sell at the top as they will then make so
much more. When they ask me, ‘What is the Top or how can
one tell the Top?’ I tell them, without smiling, ‘When a stock
does not go any higher, that is the Top.’ When they ask me
when do I expect the Top to be reached, I tell them, ‘At exactly
two o’clock this fall.’”
You could say a silly question rates a silly answer, and we think
some of these questions are silly. But we realize that investors
are really very seriously concerned about this market now (or
for that matter the market any time), and we are not indifferent
or unsympathetic. But, as we have said before, there is a good
deal of nonsense talked and written about the market, and a
great deal of conversation goes back and forth across the board
rooms, over the coffee tables, and around the cocktail lounges
that really amounts to nothing, gets nowhere, settles no prob-
lems and means very little in terms of practical strategy and
market planning.
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In case you didn’t know, we will tell you a secret. That crystal
ball never did work very well. There are some good ways to
operate in the market, we believe, but they don’t depend on
being able to “forecast the future” with absolute certainty and
pinpoint accuracy.
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Section 3
PORTFOLIOS
CASE 9
June 5, 1982. Managing Money
Let this be specific. We are thinking of a particular man whom we know.
His name is not Kenneth Hudson, but he is a very real person.
Ken has been highly successful and has a fine business reputation.
The value of his securities at the time we first talked with him amounted
to something over $300,000, a loss of about $100,000 from cost. At that
time he appeared very worried, quite unhappy. If he is still holding the
stocks he held then, he is considerably more worried and considerably
more unhappy today.
There can be no question as to Ken’s competence in his chosen field.
For many years he ran a difficult family business very profitably. When
it came time to sell, he negotiated an excellent transaction, divided
proceeds with several family members, and started another successful
business. He is regarded as a man of superior abilities, high intelligence,
and great determination.
However, a single look at his portfolio, or an hour of conversation
with Ken, and one realizes that he is absolutely ignorant of the nature of
his securities, has had no training or preparation in this area, has no
feeling of self-assurance or confidence, and suffers a great deal of anxiety.
Just for openers, he owns 41 different stocks and bonds. Now there
is such a thing as overconcentrating in a single stock, and there is a good
deal to be said for having some diversification. But to follow the financial
developments of 41 stocks and bonds at once is certainly beyond the
abilities of anyone who is also working at a breakneck pace in his business
or profession.
But there was more evidence of Ken’s confusion. Within the common
stock section of the portfolio, more than 50% of the holdings were in one
167
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CASE 10
April 2, 1983. New Issues, High Technology, Wonder Stocks,
and the Like
Recently, in one of our favorite daily financial publications, we read about
“the return of the little guy” to the stock market. On the front page, there
was the paving contractor from Chicago who dumped a considerable
portion ($1,300) of his rainy day “nest egg” into 1000 shares of TechBomb
(not its real name) at $1.25 per share. Before the day was over, his mother
had invested $700 in the company and his younger brother $1,300. “It’s
like going to Las Vegas,” he was quoted as saying. “Don’t sit around
worrying about it. Just do it.”
The article went on to mention several other new issues, high tech-
nology, and wonder stocks which have captivated the public’s imagination
recently, often doubling or tripling in a short period. Not that all new
issues or concept stocks are hot air, or close to it, or even that most of
them are, but the enthusiasm generated by the current bull market, as
with every bull market, is undoubtedly producing excesses particularly
dangerous to the new or uninformed investor.
It all reminds us of a piece we wrote a year or so ago entitled “Hole-
In-One.” We noted at the time:
Section 4
CASE 11
December 3, 1983. The Reason(s) for the Move
Rarely, if ever, do we feature the same chart in two consecutive editions
of Page One. This week, however, the instant gratification from copper’s
breakaway explosion was simply too powerful to ignore. After leaping
out of the potential reversal pattern on a 100-point gap on Monday, it
advanced Wednesday to a high of 69.30 before retreating. For agile traders,
the 300+ point, 3-day move was tantamount to a 75% profit per fully
margined copper contract. Impressive gains were also posted by copper-
related stocks such as Newmont Mining and Phelps-Dodge, as well as by
other metal issues caught up in the storm.
We have no idea as to the reasons behind Monday’s sudden explosion
in copper. And we were more than a bit surprised (and amused) to read
that it was all due to last week’s great London gold robbery!
171
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And there you have it. The surge in copper was due to the work of
a gang of London gold thieves!
Our own thought processes admittedly being somewhat slow, we are
skeptical of the “reasons” for the gold (and copper) advances as reported
in our favorite newspapers. With just a slight stretch of the imagination
we could envision a happy group of suddenly wealthy thieves sitting
around a cauldron, melting down their $37 million in ill-gotten gold,
readying it for return to the marketplace. The result in our mind — little
or no effect on supply and demand.
Our founder, John Magee, summarized his views on the reasons for
market moves most eloquently:
CASE 12
October 13, 1984. Which Way the Market, and Why
Everyone wants to know “which way the market will go.” The trouble is,
nobody really knows. Usually, there are numerous opinions as to the
future course of stock prices, and just as numerous “theories” behind
those opinions. From time to time, there is even a consensus — most of
the “experts” who have an opinion agree. When that does happen,
however, as often as not the exact opposite actually occurs.
Granted, forecasting the future of anything is difficult; in the stock market
it is particularly so. In fact, so complex are the workings of the stock market
that few “experts” can even agree on the reasons for market movements
that have already occurred. Our favorite source of entertainment on this
score is the stock market column that appears daily in just about every
newspaper. Some recent examples follow.
On September 27, in the Wall Street Journal, we learned from the vice
president of a major wire house: “Some institutions also were buying to
get more stocks in their portfolios before the end of the quarter. Being
invested was the way to look smart (to clients) this quarter,” he said.
Only a week later in the same column, investors were advised by the
senior vice president of the St. Louis office of another major brokerage
firm: “The relatively low volume lately suggests that many institutional
players also are sitting this market out. If you had a real fright in the
market, you would see volumes of 120 million to 130 million plus. But
we are merely in a lackluster market, and whenever volume dries up
prices slide a bit.”
If all this isn’t crystal clear, perhaps the October 10 comments by the
senior executive vice president of a very large wire house can clarify
matters: “The market can’t sustain a rally temporarily. The problem is that
most money managers and the general public are either selling or sitting
on the sidelines.”
We couldn’t agree more. Either the institutions are buying, sitting on
their hands, or selling. That about exhausts the possibilities. True, stock
market columns can make for good, relaxing entertainment, along with
sports columns, TV and movie columns, and the like. But they certainly
shouldn’t be taken as gospel in a matter as serious as investing. As our
founder John Magee noted more than 20 years ago:
86 COPPER
(MARCH '84)
84
82
80
78
76
74
72
70
68
66
64
62
60
JUN JUL AUG SEP OCT NOV
CASE 13
September 14, 1985. The Hemline Barometer and Other “Mood”
Measures as Crystal Balls to the Future
Followers of Edwards and Magee are familiar with the basic tenets of the
pattern recognition school of technical analysis, particularly the hard-to-
measure psychological bias which underlies the individual trader’s deci-
sion-making process. Fundamentalists can argue about rational, fact-filled
reasons to buy or sell. But clearly, the emotional state of the investing
public is a major factor in the movement of the stock market. As chartists,
we are constantly attempting to measure these changes with systematic
analysis of price and volume. On a broader scale, however, an astute
observer can also anticipate changes in the basic emotional foundation
of the public by observing popular culture itself, a sort of “stepping back
from the trees to look at the forest” approach.
Although this is not a new, or even a surprising, theory, we had not
given the matter much thought — aside from a chuckle or two over using
the “hemline” barometer as a measure of bullishness — until we read a
recent article (Barron’s, September 9, 1985) by Robert Prechter of Elliott
Wave fame. Apparently, there is more than a shapely calf to meet the eye
in hemlines and other changes in public taste. Indeed, Mr. Prechter
postulates that popular art, fashion, and mores reflect the dominant public
mood and that the stock market, being a highly reflective arena of
emotional behavior, moves in concert with these major shifts in public
attitude. He further suggests that these dominant moods, whether negative
or positive, have a great deal to do with the character, and are possibly
the cause of, historic events. “Major historic events that are often consid-
ered important to the future (i.e., economic activity, law-making, war) are
not causes of change: they are the result of mass mood changes that have
already occurred.” If this is so, then one can argue, as Mr. Prechter does,
SL302XchAppA frame Page 176 Thursday, December 13, 2001 10:14 PM
CASE 14
December 15, 1984. The Elliott Wave Theory: Perspective
and Comments
This week we had the pleasure of attending the December meeting of
the Market Technicians Association (MTANY) of New York.
Long-term subscribers will remember the MTANY as the organization
which honored John Magee with its “Man of the Year” award in 1978.
The speaker was Robert Prechter, publisher of “The Elliott Wave Theorist,”
an investment advisory which bases its forecasts on interpretations of R.N.
Elliott’s work on the stock market.
Of primary interest to Magee subscribers are Prechter’s comments on
technical analysis itself. The Elliott Wave Theory, it must be remembered,
is really no more than a “catalog” of stock market price movements, laid
one on top of the other, so to speak, until a grand, underlying and
enduring pattern is observed; in short, pure technical analysis. Among
Prechter’s definitions and observations regarding fundamental analysis are
the following:
completed and 54% error for the year ahead. The weakest
link, however, is the assumption that correct earnings esti-
mates are a basis for choosing stock market winners. Accord-
ing to a table in the same Barron’s article, a purchase of the
ten DJIA stocks with the best earnings estimates would have
produced a ten-year cumulative gain of 40.5%, while choosing
the ten DJIA with the worst earnings estimates would have
produced a whopping 142.5% gain.
CASE 15
June 6, 1987. Earnings Forecasts: Dangerous to Your Financial Health!
A recent article in Forbes, “Upward Bias,” asked the question, “Is it possible
that analysts concoct future earnings to justify today’s lofty stock prices?”
The answer appears to be yes. In a group of 20 issues, which analysts
were forecasting as the fastest-growing companies 2 years ago, the author
showed that there was a whopping (surprise) error factor of minus 73%.
This means the average earnings forecast for this group of stocks was
73% under the actual earnings result.
This got us to thinking about a significant peril in fundamental analysis
which we read about a few years back in Contrarian Investment Strategy,
by David Dreman. Dreman, in fact, was quoted in the Forbes article.
Because it is clothed in presumably hard data, with an air of academic
certainty, fundamental research reports are often taken as “gospel.”
Although Dreman is not an advocate of technical analysis, for the often-
cited reason that academic evidence is lacking, his comments on the
pitfalls in fundamental analysis were especially cogent and important when
one considers how it dominates the decision-making process in the
financial industry. According to Dreman, “Research has demonstrated that
earnings and dividends are the most important determinants of stock
prices over time. The core of fundamental analysis is, thus, the develop-
ment of techniques that will estimate these factors accurately.” But, he
concludes, after looking at the record, “a system that appears eminently
sensible in theory has proved exceptionally refractory in practice.”
Without going into considerable detail in this article, we believe
Dreman made a strong case for the argument that the root problem has
to do with the fact that “there are very serious flaws in the analytical
methods (of fundamental forecasting) that lead to consistent investment
error.” Briefly, the problem lies with man’s information-processing capa-
bilities. The human mind processes data in a linear manner. It moves from
one point to the next in a “logical sequence.” However, analyzing complex
financial data requires the ability of the analysts to change the interpre-
tation of any single piece of information depending on how he evaluates
many other inputs. This is called configural reasoning and, from various
tests on the subject, it appears that most of us just cannot do it very well.
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Section 5
TECHNICAL QUESTIONS —
STOPS
CASE 16
May 7, 1983. Beyond the Limits
Aside from wanting to know what’s hot, or how far the DJIA will go up
(or down), the most frequently asked questions we receive have to do
with protective stop limits.
Most of the inquiries on the subject ask about a particular limit for a
particular stock. Others, however, want a specific formula for limit place-
ment. And a few suggest that we have substantially deviated from John
Magee’s methodology.
It is true that there has been a change in our method of setting limits
over the past few years. John Magee wrote about using a formula based
on a limit 5% under the last minor low, adjusted for volatility and stock
price level (higher-priced issues make smaller percentage moves than
lower-priced ones). The crux of this formula was a sensitivity index, but
it did not prove to be particularly successful over the years and ultimately
was discarded by the current staff.
However, as Magee wrote, “There is no perfect and absolutely satis-
factory rule.” We agree that a hard and fast formula is not practical. In
general, our guideline for establishing protective stop limits is as follows.
The initial or opening limit for a stock is placed at a point at which
important support is evident (under a trading range or channel, under a
major low, etc.). Most often, this will be a relatively wide limit reflecting
several substantial support zones which have evolved in the basing pattern
preceding our recommendation. An important objective of these initially
wide opening limits is to provide every opportunity for a new recommen-
dation to achieve its potential.
181
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CASE 17
September 1, 1984. Big Money in Brain Surgery: Learn at Home this
Quick, Easy Way
Some Wall Street wisdom is timeless. This commentary, written by John
Magee on July 23, 1966, is as insightful today as it was 18 years ago.
And, too, the new investor is often trying to reduce the market
to a much-too-simple affair. He will cram his bookshelves and
his desk with reports and data, stuff his head with figures,
master a dozen rule-of-thumb “methods.” He will have facts,
sometimes too many irrelevant facts. And he may not realize
that thousands of people are watching the market, studying it,
analyzing it by various means, making their evaluations in their
own ways, and some of these people have a great deal of
insight plus a great deal of experience. They know what to do
“if all goes well, according to rule,” but they also know when
“it is time to throw the book out the window” and improvise.
We believe that this ability to roll with the punch, to confront new or
unexpected situations with courage and calmness, does not come from
theory alone or facts alone but from deep awareness of both the mechanics
and the psychology involved: a knowledge that usually comes hard, and
is learned mostly in the “School of Hard Knocks.” Like brain surgery, it
is a matter not to be acquired in a few easy lessons but by actual
experience and insight.
SL302XchAppA frame Page 185 Thursday, December 13, 2001 10:14 PM
CASE 18
September 22, 1984. Forecasting: No Such Thing as a Sure Thing
Almost nightly we turn on the television (or call the weather number) to
hear a rather pleasant fellow as he tells us about the low extending
southward from Pennsylvania and extending as far west as the Mississippi;
the Canadian cold front, now moving slowly southeastward at a speed of
about 10 miles per hour; the relative humidity; present temperature at
Logan Airport; and the small-craft warnings from Block Island to Long
Island Sound. Also, that the next 2 days will be marked by much colder
air moving into the area, and chances of precipitation are 3 out of 10.
To a good many people, this is either (1) the gospel or (2) the next
best thing to it.
It is certainly not the gospel, however. There are competent men and
women with long experience in the Weather Bureau, who are telling us
what the probabilities seem to be at this time in light of their knowledge
and the data before them. They would be the first to tell you that they
do not know with certainty what the weather will be on Sunday, because
winds can shift and new factors can come into the picture. But, taking it
on balance, the predictions do represent an informed and intelligent
“estimate” of what is most likely to happen. And yet there are some people
who feel personally injured when rain appears at the picnic instead of
the “sunny and clear” which was predicted, and they want to go down
and take a swing at the poor, hard-working weatherman.
Sometimes a meteorological prediction is quite definite. The other night
our friendly weatherman wrote on the board under chances of precipita-
tion the figures 10/10, that is 10 chances out of 10, or “certainty.” Actually,
we did get some rain. But if you had pinned him down on that 10/10
prediction, he would undoubtedly have conceded that a more realistic
figure might have been 95/100 or 98/100 — “close to” certainty but not
“absolute.” There is always a certain element of doubt, calling for tentative
judgment. It is good to know what seems most likely to happen but
always necessary to be prepared to revise a plan when and if data change.
In stocks, many investors are likely to accept the reports or data they
may have as “final” and “absolute,” the veritable “sure thing.” But the
stock that looked strong in August may run into trouble: a reduced
dividend, a bad quarterly report, or whatever. And the weak-looking stock
may turn around and start up. Operating successfully in an environment
of uncertainty, however, is not “just a matter of luck.” It is possible to
make reasonable and good recommendations and decisions as long as
one realizes that stocks, like the weather, are continually changing and
call for the ability of an investor to change his or her mind when conditions
call for it. In fact, there is no such thing as a sure thing. Consistent success
requires constant monitoring of a stock’s trend and the flexibility to
recognize and take action if the trend changes.
SL302XchAppA frame Page 186 Thursday, December 13, 2001 10:14 PM
CASE 19
March 16, 1985. When a Stock Collapses: Crisis or Opportunity?
In recent weeks, holders of several big-name technology stocks have been
subjected to the agony of a “delayed opening – news pending” announce-
ment followed by a severe decline in the market price of their shares. It
all began 4 weeks ago when Data General announced that “current quarter
earnings could be below expectations of Wall Street analysts” (from its
Monday, February 11 closing price of 72⅞). DGN collapsed to an intraday
low of 56½ before recovering to close at 58¾, off 14⅛ for the day.
On Tuesday of this week, holders of Wang Labs were subjected to a
spine-chilling decline of approximately equal proportions, as were holders
of Computervision (see Chart 48) on Wednesday when that company
predicted “break-even results on less-than-expected sales” for the current
quarter. For Wang, the drop amounted to 9⅜ points. The 1-day 9¾-point
plunge in CVN (to 23⅞) amounted to an astounding $270 million reduction
(one-third) of that company’s market value.
Whereas the foregoing events constituted a crisis for existing holders
of Data General, Wang, and Computervision, they represent an unfolding
opportunity for the balance of the investing public. Just as computer and
technology stocks were the “darlings” of the 1982–1983 stock market rally
and are today its “black sheep,” many of these issues will undoubtedly
score large advances from current levels. In Wall Street, the wheel turns.
Technical analysis is unusually well-suited for such occasions. First, no
technical tenet would justify bottom picking, or buying into a “decline”
such as those currently under way in DGN, WANB, and CVN. Often such
declines are precursors to substantial further declines. What technical
analysis requires after such a jarring decline is a settling-down or cooling-
off period. Typically, these last a minimum of 3 weeks and as long as
several months. And typically, the bottoming process after such drastic
declines involves a series of recognizable events — a rally of 30% to 50%
of the preceding decline followed by a low-volume test of the “crisis”
low. The final configuration of the basing process — head-and-shoulders,
rectangle, or double bottom — cannot be ascertained in advance. One
thing is clear, however; most of today’s fallen angels will be available at
current prices or lower for some time to come. And when the trend is
about to reverse, that fact will be evident on the daily price and volume
chart. Corporate announcements, as so clearly shown this week, simply
do not occur in time to be useful for investor decision making.
SL302XchAppA frame Page 187 Thursday, December 13, 2001 10:14 PM
CASE 20
July 6, 1985. The First Shoe Drops
A few weeks back, at the invitation of Barron’s, we penned an article
about the classic technical pattern that often precedes corporate takeovers,
or takeover-related activities. Entitled, “Worth a Thousand Words,” the
Barron’s article (May 6, 1985) highlighted four companies “whose charts
exhibit classic pre-takeover patterns but for which no takeover has (yet)
been announced.” The four companies were Allied Stores, Amerada Hess,
Time, and United Brands.
When contacted by Barron’s, spokesmen for Allied Stores, Time, and
United Brands were quick to deny any knowledge about pending takeover
or takeover-related activities. “We are not talking to anybody,” said Orren
Knauer, an Allied vice president. Time spokesman Louis Slovinsky reported
that “the company isn’t talking to any suitors,” and that the company had
“put in some anti-takeover provisions such as staggered election of direc-
tors.” Even more specific was the spokeswoman for Carl Linder’s American
Financial Corporation which, according to Barron’s, owned 58% of United
Brands’ stock. “There have been no talks either about buying the rest of
the stock or about selling American Financial’s stake,” she declared. As
for Amerada Hess, they failed to return a phone call from Barron’s.
Imagine our surprise on Friday of this week, then, when a company
called FMI Financial offered to buy 4 million shares of United Brands at
20. FMI Financial, the news release went on to say, is controlled by Carl
Lindner, principal shareholder in both American Financial and United
Brands.
Return for a moment to the United Brands chart shown in Barron’s.
To the date of the article, the United Brands chart contained “no less than
five Friday spikes, an extraordinary number in our experience,” we
reported. Add to that the current offer to purchase 4 million shares made
on July 5 — also a Friday! An astounding coincidence, we are sure.
We have often referred to technical analysis as the art of following
footsteps on the charts. Price and volume data do reflect the activities of
“informed players,” as well as all others, and these often do pr ovide
unmistakable clues to impending events. Certainly, this was the case with
United Brands. The jury is still out in the matters of Allied Stores, Amerada
Hess, and Time. Which shoe will drop next?
SL302XchAppA frame Page 189 Thursday, December 13, 2001 10:14 PM
1985
19
18
UNITED BRANDS
17
16
15
14
13
12
BARRON'S ARTICLE
11
10
...11722
9
600
400
200
CASE 21
July 13, 1985. Protecting Stock Market Profits, or a Trip Into
the Wild Blue Yonder and Back
Except for the names (which have been changed), this is a true story
about a woman investor we know who got wind of a big move coming
up in Blue Yonder Computer Corporation. According to rumors, the
company had developed a new process by which it could store the King
James version of the Holy Bible on a memory chip the size of your
eyelash, and major production was just around the corner. In June 1983,
Linda High Hopes bought 2,000 shares of Blue Yonder stock for 80 cents
each, or $1600; not an inordinate amount to place in an extremely
speculative stock.
Those around the office, however, shook their heads. How many times
had they heard about impressive new products, discoveries, or processes,
all in connection with low-price (penny) stocks — only to see the bubble
burst in the dawn’s early light?
They were not even particularly impressed when Blue Yonder rose to
$1.20 a share in July, a heady 50% advance in 30 days. They were even
more impressed, moreover, when Linda called up and bought another
1000 shares at $1.25.
Their indifference turned to profound respect (and a little bit of envy)
the following year when Blue Yonder reached $2.80, at which price their
friend bought 2000 additional shares in June), and then when she pur-
chased another 2000 shares in December at $4. By early this year Linda
had accumulated 7,000 shares at an average cost of $2.46 per share. Her
unrealized gain approached $30,000 this spring as Blue Yonder traded
above $6 on the NASDAQ National Market.
Along the way, Linda’s broker suggested she sell half her holdings
(thereby getting her investment back plus a considerable gain), while
“letting her profits run on the balance of the position.” The advice was
received politely but not acted on. And Blue Yonder, which had previously
been something of an erratic performer, settled down into a long holding
pattern at $6. Then in a short time, Blue Yonder sold off sharply, dropping
to $3.60 a share where it again held briefly. No, Linda was not disturbed
by this weakness, nor did she ask for quotes on a daily basis any longer.
It had become a long-term holding.
Imagine everyone’s surprise, however, when Linda’s broker received
a phone call to sell 7000 shares of Blue Yonder last week. We punched
out BYON on the quote machine. It was selling for $1.20 per share! After
some consultation, Linda decided to hold her shares a bit longer, not a
bad decision based on their recent price of $1.80. Her loss, if she sold
today, would be less than $5000 — not overly damaging in the world of
SL302XchAppA frame Page 191 Thursday, December 13, 2001 10:14 PM
high finance. But the foregone profits of nearly $30,000 are a great loss.
To be successful as an investor, one must learn how to realize profits as
well as how to protect against major losses.
In our service we have noted repeatedly that investors are continually
subjected to information, rumors, and tips of every sort — most of them
well intended — and that unless each investor develops his own philos-
ophy with regard to buying and selling, he will be unable to operate
successfully in the stock market. In the case of Linda High Hopes and
Blue Yonder, simple maintenance of a daily chart, attention to trendlines,
and a firm resolve to “get out of a stock once it turns weak” would have
made all the difference.
SL302XchAppA frame Page 192 Thursday, December 13, 2001 10:14 PM
CASE 22
December 20, 1986. Flags, Triangles, and River Sediment
What does the thickness of river sediments have to do with classic technical
analysis? Quite a lot according to an interesting article in the December
1986 issue of Technical Analysis of Stocks and Commodities, one of the
better monthly magazines devoted to the subject. The author, Curtis
McKallip, Jr., is a consultant on risk analysis in oil exploration. McKallip
wrote his master’s thesis on the Markov transitions in river sediments of
the Triassic age in East Central New Mexico (you would not need a
sleeping pill if you had that tome by your bed). The statistical method
used to measure the shifting sediments of the river is applied to equally
“shifty” transitions between stock patterns as defined by Technical Analysis
of Stock Trends by Robert D. Edwards and John Magee.
The pattern base for the study, which was titled “Investigating Chart
Patterns Using Markov Analysis,” was weekly prices of 19 commodities
from 1970 to 1979. McKallip marked the obvious formations on his weekly
charts, using the one that was best defined when one pattern enclosed
another. Complex patterns, however, were broken into component parts;
that is, the head-and-shoulders pattern was not measured as a unit but
was considered a collection of trends, triangles, and flags. The article did
include a long-term chart of wheat in which the various patterns were
marked and identified. As a long-time practitioner of pattern recognition,
we had problems with some of the author’s chart interpretations and
nomenclature. What he calls a symmetrical wedge, for instance, is a
rectangle. Chartists, of course, will disagree on formations and our differ-
ences of opinion probably would not have altered McKallip’s results.
Once the charts were marked up, the next step was to count the
transitions from one pattern to another and use the data to set up a
Markov matrix which uses chi-square calculations. McKallip has included
in the article a two-page description of his methodology plus references
(ours included).
This writer is not well grounded in statistical probability and has almost
lost his ability to add or subtract without the use of a calculator. Therefore,
I will not attempt to clarify a subject which is not clear to me. However,
those with a mathematical frame of mind and access to a computer can
obtain a copy of this magazine (for $8) from Technical Analysis, Inc., 9131
California Avenue SW, Seattle, WA 98136; (202) 938-0570; now at
www.traders.com.
Without getting bogged down in the methodology, we can appreciate
the results of the study. The total number of transitions tabulated in the
article was 738. A number of them were too infrequent in the sample
data to be of any statistical value; surprisingly, this included rectangles
SL302XchAppA frame Page 193 Thursday, December 13, 2001 10:14 PM
CASE 23
January 17, 1987. Big Blue — From Bellwether to Bust!
International Business Machines has gone from a market leader to a
laggard during the past year. Over the summer, while it had already slipped
from its bellwether status in performance, it did, in fact, reflect the internal
technical condition of the majority of issues then struggling along in a
consolidation phase (see “Taking the Market’s Temperature,” June 21,
1986). But our “temperature gauge” metaphor for Big Blue faltered when
new lows were consistently made during the second half of 1986 while
the DJIA, and the majority of the market, were holding within consolidation
boundaries. Indeed, the spark of fire that enticed us back into IBM in
November has been reduced to a smolder following Wednesday’s plunge
through support. The breakdown was greatly aided, we might add, by
The Wall Street Journal’s redoubtable “Heard on the Street” column which
contained, among a few distant bullish cries, the following pearls of bearish
wisdom:
Chart 50. IBM, 1975–1987. Testing a Thesis Based on Long-Term Trend Analysis.
We are not fundamentalists, and, perhaps, IBM’s ills are terminal. But
there are clearly some solid technical reasons to buy Big Blue during the
current reaction notwithstanding the bearish comments in Wall Street.
However, for those wishing to wait for a reversal, it would be wise to
use a penetration of the downward-slanting channel at 132 to enter or add.
SL302XchAppA frame Page 196 Thursday, December 13, 2001 10:14 PM
CASE 24
September 28, 1985. An Oversold Market
This week, the MEI fell to 9% strong, its deepest penetration into the
oversold quadrant this year. Not since June 1984 has this index been lower
(see Chart 51). Shortly after its June low of 8% strong, the MEI headed
steadily higher, giving an aggressive buy signal throughout late June and
July.
The June 1984 MEI low of 8% strong, together with the 8% level
reached on February 25, 1984, constituted a double bottom oversold
reading for this index. It corresponded to the 1079 bottom recorded by
the DJIA on June 18, 1984, after which that index advanced steadily to
its recent July peak of 1372.
For more than 20 years, all major stock market bottoms have corre-
sponded with extremely low MEI readings. During the “turbulent period,”
when the stock market oscillated violently but showed no gain at all, MEI
readings of 5% strong or less corresponded with all major DJIA bottoms
until the June 1982 low of 9% strong, which immediately preceded the
stock market’s upward explosion.
That slightly higher than “5% strong or less” bottom was an important
clue that a reinvigorated stock market was at hand; the straight-line DJIA
advance from 770 to nearly 1300 ended a 17-year “do-nothing” period for
stock prices and ushered in the “renewed upswing” period shown on the
chart.
In this context, the “8% strong bottom” of June 1984 and the current
MEI reading of 9% strong take on added meaning. If, in fact, we are in
a period of renewed (or major secular) upswing, stock market bottoms
will tend to be less severe and tops more extremely overbought than
would otherwise be the case. Both the June 1982 DJIA low and that of
June 1984 fit this model. Because secular stock market waves tend to last
for many years even decades, the likelihood is that the current MEI reading
of 9% strong will also define a major DJIA low.
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Appendix B
TEKNIPLAT CHARTING
The purpose of this discussion is to explain the nature of the bar chart,
something of the history and development of the use of charts in the
evaluation of securities, the philosophy and rationale of charting, some
of the technical patterns seen on charts and their use and interpretation,
methods and details of application and use, and comments and suggestions
as to the setting up and maintaining of daily charts.
199
SL302XchAppB frame Page 200 Thursday, December 13, 2001 10:36 PM
the closing price, using a short line to the left of the vertical range for
the opening and a short line to the right to indicate the close.
The volume of trading may be shown on a separate scale near the
bottom of the sheet, directly under the vertical lines showing the daily
price range. For weekly charts or monthly charts, the procedure is exactly
the same except that each horizontal interval represents a week or a
month instead of a day.
Because the horizontal scale on the chart provides a “calendar,” it is
possible to enter any other data in which one may be interested directly
on the chart. This will include, of course, dividend or ex-distribution dates,
the dates of stock splits, and any data that might seem important as to
earnings, mergers, announcements of new products, etc. By noting on
the proper date the purchase or sale of a stock and the price paid or
received, investors will have a record of these transactions right on the
chart; this will make it easy to check the status of a transaction, the profit
or loss on it, and this record will serve as a valuable study later as to the
degree of success of one’s decisions.
19 38 76 152 304
9 18 36 72 144 288
17 34 68 136 272
8 16 32 64 128 256
15 30 60 120 240
TYPE RU
7 14 28 56 112 224
13 26 52 104 208
6 12 24 48 96 192
SCALE FOR 11 SCALE FOR 22 SCALE FOR 44 SCALE FOR 88 SCALE FOR 176 SCALE FOR
15 30 60 120
1
3 /2 7 14 28 56 112
13 26 52 104
3 6 12 24 48 96
11 22 44 22
and a move of 10% or 35%, or any other percentage, will always appear
as the same vertical distance on the chart regardless of the price of the
stock. Thus, chartwise, a move from $1000 a share to $1500 a share would
look exactly like an advance from $10 to $15, or from $50 to $75; any
advance of 50% in a stock would cover the same vertical distance. This
makes it possible to compare the action of a stock with any other stock
directly, or to compare the action of a stock with a group average, or to
compare stocks or groups with general market averages similarly scaled.
The objection one sometimes hears about logarithmic charts is that the
“squeezing” of the scale as the price advances makes it impossible to chart
precisely to the last eighth when the price has moved up greatly. In other
words, a move of ⅛ point will be shown plainly on stocks in the 10s and
20s but will not show precisely on stocks selling in the 100s. But, one
should realize a move of ⅛ point is quite important, say, when a stock is
selling at $5 a share, and is insignificant on one that is quoted at $150.
The other question new users bring up regarding the logarithmic scale
is that continually “shrinking” intervals seems strange (at first) to them if they
have been used to using plain cross-section paper (i.e., arithmetically scaled
sheets). Actually, the changing log scale provides points of reference that
the eye soon learns to recognize, and there is less chance of entering a price
at the wrong place than when using paper that has a perfectly uniform scale.
block of 100 shares, and that the difference between the value of a stock
selling at $100 and one at $105 is also $5, or $500 on a block of 100
shares. But, in this latter case, there is a great deal more capital involved.
For example, if you put $1000 into a stock at $5, you would get
(disregarding commission) 200 shares. And if you sold these at $10, you
would receive $2000. You would have a profit of $1000, or 100%. But, if
you put your $1000 into a stock selling at $105, you would be able to
buy only 9 shares And when you sold 5 points higher at $110, your profit
would be only $45 or 4.5%.
It will give you a better comparison of the percentages of profit in
various stock transactions if the price scale of your chart is designed to
show equal percentages of advance or decline as equal vertical distances,
regardless of the price of the stock. This is exactly what the Tekniplat
charting paper does. A certain vertical distance on the paper will always
indicate the same percentage change, and a trend moving at a certain
angle will always indicate the same rate of percentage change, no matter
what the price of the stock may be.
Clearly, one point of advance or decline is much more important to
you in a stock selling at $5 or $6 a share than in one selling at $100.
Thus it should not surprise you that the interval between $5 and $6 is
much larger than that between $100 and $101. And, because the stocks
at lower prices make larger percentage moves for each point, or half
point, or one-eighth point, these moves will show up more plainly on
their charts Actually, it is not possible on the Tekniplat paper to show a
single eighth of change for a stock selling as high as $100. But this is just
another way of saying that a single eighth is not important at that price.
You might well be concerned about the difference between 1¼ and 1⅜.
But you would not care too much whether you sold at 103 or 103⅛.
Because all your stocks will be plotted on a proportional basis, you
can compare directly the action of any one stock with any other as to
pattern, trend, etc. Thus, a stock selling at $16 can be compared with a
stock selling at $56. However, although the percentage moves will be
strictly comparable, it should be pointed out that, typically, the high-priced
issues make smaller percentage moves than the low-priced ones.
from center to top, with each of the smallest spaces representing ¼ point.
In the lower half of the chart, the bottom line will be 10, the intermediate
heavy lines to the center will be 11, 12, 13, 14, 15, 16, 17, 18, and 19,
and each of the smallest spaces will be ⅛ point. Because the spaces get
smaller as one goes up the chart, one bank shades into the next, making
a continuous scale. Clearly, you could have 20 at the top, 10 at the center,
and 5 at the bottom; or 10 at the top, 5 at the center, and 2½ at the bottom.
You may have some trouble at first with the different values assigned
to the small spaces at different price levels; you may wonder whether a
single small space represents ¼ or ⅛ or perhaps a full point. Do not let
this bother you. You can see from the scale where 19 is and where 20
is, and obviously 19½ is the midpoint, 19¼ is one-quarter of the way up,
and so on. Very quickly, you will find that your mind and your eye adjust
almost instantly without any conscious thought or effort.
Where a stock goes off the top or bottom of the paper, it is a simple
matter to rescale by moving the chart scale down one bank. If the chart
runs off the top at 40, mark the center of the paper 40; the top becomes
80 and the bottom, 20.
For uniformity, and because the paper is so ruled that you can divide
either bank of the heavy intermediate lines into 10 parts, with smaller
spaces representing standard stock-trading fractions of these main divi-
sions, you must use the figures 5, 10, 20, 40, 80, etc. as the values for
the center lines, tops, and bottoms of charts.
For selection of scales on stocks for which you are starting new charts,
use the table below.
A
224 and 448 320 640 160
112 and 224 160 320 80
56 and 112 80 160 40
28 and 56 40 80 20
14 and 28 20 40 10
7 and l4 10 20 5
3½ and 7 5 10 2½
1¾ and 3½ 2½ 5 1¼
a
and the fact that the omitted day was a holiday may be indicated
by placing the letter “H” at the bottom of the chart.
depriving the trader of “feel” that comes with hard work. On the other
hand, this brute advance allows the investor to process — or filter — an
unlimited number of stocks. Filtering simply means establishing some
criteria as to stocks that will be considered. For example, we might say
that we wanted only to look at stocks above their 150-day moving average,
or above their 4-week high. That would be a filter. And it could be applied
literally to all stocks.
This ability to process large numbers of stocks — as it were to maintain
an enormous chart case — can be important if the investor is running an
MEI, in which case it would be necessary to look at and classify the chart
of each issue in the group under study.
In addition, experimentation and play with the data are unrestricted.
The investor can skip merrily from daily to weekly to monthly, from bar
charts to candlestick to point-and-figure, ad infinitum.
In the end, the ability to accomplish and compress this large amount
of effort with this tool is the most important element of computer analysis.
Further investigation of computer software and technology, including
references to Internet sites, may be pursued in Appendix D.
At the turn of the millennium, the Exchanges are finally switching their
systems to trade stocks in pennies instead of fractions — reluctantly. So
soon the old Tekniplat chart paper will, like the slide rule, be obsolete.
At the Web site (www.johnmageeta.com) investors interested in manual
charting will be able to get chart paper designed for the new market
facts — decimals and 24/7 trading.
SL302XchAppB frame Page 210 Thursday, December 13, 2001 10:36 PM
SL302XchAppC frame Page 211 Thursday, December 13, 2001 10:37 PM
Appendix C
CONTINUING STUDY PLAN
On risk:
Bernstein, Peter, Against the Gods, New York: John Wiley & Sons,
1996.
Jorion, Philippe, Value at Risk, New York: John Wiley & Sons, 1996.
Risk Management 101 (software), Zoologic Inc., New York.
Edwards, Magee, Bassetti, Technical Analysis of Stock Trends, 8th ed.,
St. Lucie Press, Boca Raton, FL, 2001.
211
SL302XchAppC frame Page 212 Thursday, December 13, 2001 10:37 PM
On candlesticks:
Nison, Steve, Japanese Candlestick Charting Techniques, New York:
New York Institute of Finance, 1991.
Nison, Steve, Beyond Candlesticks, New York: John Wiley & Sons,
1994.
On point-and-figure charting:
Cohen, A. W., How to Use the Three Point Reversal Method of Point
and Figure Stock Market Trading, Larchmont, NY: Chartcraft,
1984.
Bassetti, W. H. C., Bassetti, C. D. H., Technical Analysis: Natural and
Unnatural Methods, San Geronimo, CA: Maomao Press, 2002.
On futures:
Schwager, Jack, Schwager on Futures, Technical Analysis, New
York: John Wiley & Sons, 1996.
On portfolio management:
The Journal of Portfolio Management
Risk Management 101 (software), Zoologic, Inc.
On day trading and short term tactics:
Wyckoff, R. D. and Bassetti, W. H. C., Technical Analysis for Tacti-
cians, San Geronimo, CA: Maomao Press, 2002.
SL302XchAppD frame Page 213 Thursday, December 13, 2001 10:38 PM
Appendix D
RESOURCES
Of General Interest
AARP Investment Program www.aarp.scudder.com
Accutrade www.accutrade.com
ADR.com www.adr.com
American Association of Individual www.aaii.com
Investors
213
SL302XchAppD frame Page 214 Thursday, December 13, 2001 10:38 PM
Resources 215
Morningstar www.morningstar.net
National Assoc. of Securities Dealers www.nasd.com
National Discount Brokers www.ndb.com
Net Investor www.netinvestor.com
New York Stock Exchange www.nyse.com
Online Investor www.onlineinvestor.com
Philadelphia Stock Exchange www.phlx.com
Quick & Reilly www.quickwaynet.com
Quicken www.quicken.com
Quicken Financial Network www.qfn.com
Realty Stocks www.realtystocks.com
Reuters www.reuters.com
SEC Enforcement [email protected]
Securities and Exchange Commission www.sec.gov
Securities Industry Association www.sia.com
Securities Investor Protection www.sipc.org
Corporation
SmartMoney www.smartmoney.com
Social Security Online www.ssa.gov
Standard & Poor’s Fund Analyst www.micropal.com
Standard & Poor’s Ratings Services www.ratingsdirect.com
Stock Guide www.stockguide.com
Stockpoint www.stockpoint.com
Suretrade www.suretrade.com
1040.com www.1040.com
The Motley Fool www.fool.com
TheStreet.com www.thestreet.com
T. Rowe Price www.troweprice.com
TreasuryDirect www.publicdebt.treas.gov
Vanguard Brokerage Services www.vanguard.com
Wall Street Access www.wsaccess.com
Wall Street Journal Interactive Ed. www.wsj.com
Yahoo! Finance www.quote.yahoo.com
Zacks Investment Research www.zacks.com
ZD Interactive Investor www.zdii.com
SL302XchAppD frame Page 216 Thursday, December 13, 2001 10:38 PM
Brokerage Houses
GLOSSARY
Accumulation: The first phase of a bull market. The period when far-
sighted investors begin to buy shares from discouraged or distressed
sellers. Financial reports are usually at their worst and the public is
completely disgusted with the stock market. Volume is only moderate
but beginning to increase on the rallies.
Activity: See Volume.
Apex: The highest point; the pointed end or tip of a triangle.
Arbitrage: The simultaneous buying and selling of two different, but
closely related, instruments to take advantage of a disparity in their
prices in one market or different markets; for example, the discount
of Dow-Jones futures to cash would result in the immediate purchase
of futures and the sale of cash. In takeovers or acquisitions this is not
arbitrage, but spreading, ersatz arbitrage, or faux arbitrage. True arbi-
trage has two forms, strong and weak (or risk). Strong arbitrage realizes
a profit when initiated and only requires time or distance to realize
the profit. Weak or risk arbitrage has uncontrolled factors, or factors
that must be constantly adjusted to realize the profit.
Area gap: See Common gap.
Area pattern: When a stock or commodity’s upward or downward
momentum has been temporarily exhausted, the ensuing sideways
movement in the price usually traces out a design or arrangement of
form called an area pattern. The shape of some of these area patterns,
or formations, has predictive value under certain conditions. See
Ascending triangle, Broadening formations, Descending triangle, Dia-
mond, Flag, Head and shoulders, Inverted triangle, Pennant, Rectangle,
Right-angle triangles, Symmetrical triangles, and Wedges.
Arithmetic scale: Price or volume scale where the distance on the vertical
axis (i.e., space between horizontal lines) represents equal amounts
of dollars or number of shares.
Ascending (parallel) trend channel: When the tops of the rallies com-
posing an advance develop along a line (sometimes called a return
line), which is also parallel to the basic up trendline (i.e., the line that
217
SL302XchGlossary Page 218 Friday, December 14, 2001 11:48 AM
Glossary 219
Bull market: A period when prices are primarily rising, normally for an
extended period. Usually, but not always, divisible into three phases.
The first phase is accumulation. The second phase is one of fairly
steady advance with increasing volume. And the third phase is marked
by considerable activity as the public begins to recognize and attempt
to profit from the rising market.
Call: An option that gives the buyer the right to buy the underlying
instrument at a specific price within a certain time period and which
obligates the seller to sell the instrument.
Call margin: See Margin call.
Candlestick chart: Japanese charting method where bars are color coded
according to direction of price movement.
Cats and dogs: Low-priced stocks of questionable investment value.
Channel: If the tops of the rallies and bottoms of the reactions develop
lines that are approximately parallel to one another, the area between
these lines is called a channel. See also Ascending trend channel,
Descending trend channel, and Horizontal trend channel.
Chart: A graphic representation of a stock or commodity in terms of
price and or volume. See also Bar chart, Candlestick chart, and Point-
and-figure chart.
Clean-out day: See Selling climax.
Climactic top: A sharp advance, accompanied by extraordinary volume
(i.e., much larger volume than the normal increase), which signals the
final “blow-off” of the trend, followed by either a reversal or at least by
a period of stagnation, formation of consolidation pattern, or a correction.
Climax day: See One-day reversal.
Climax, selling: See Selling climax.
Closing price: The last sale price of the trading session for a stock. In
commodities it represents an official price determined from a range
of prices deemed to have traded at or on the close; also called a
settlement price.
Closing the gap: When a stock or commodity returns to a previous gap
and retraces the range of the gap. Also called “covering the gap” or
“filling the gap.” See Gap.
Coil: Another term for a symmetrical triangle.
Commission: The amount charged by a brokerage house to execute a
trade in a stock, option, or commodity transaction. A commission is
charged for each purchase and each sale. In commodities, a commis-
sion is charged only when the original entry trade has been closed
with an offsetting trade. This is called a round-turn commission.
Common gap: Also called area gap. Any hole or gap in the chart
occurring within an “area pattern.” The forecasting significance of the
common gap is nil. See Gap.
SL302XchGlossary Page 221 Friday, December 14, 2001 11:48 AM
Glossary 221
Glossary 223
Glossary 225
bottoms of the secondary (intermediate) rally. When the third fan line
is broken, it signals the resumption of the primary trend.
50-day moving-average line: Determined by summing the closing price
over the past 50 trading days and dividing by 50, and so on.
Five-point reversal: See Broadening pattern.
Flag continuation pattern: A flag is a period of congestion, less than
4 weeks in duration, that forms after a sharp, near vertical, change in
price. The upper and lower boundary lines of the pattern are parallel,
though both may slant up, down, or sideways. In an uptrend, the
pattern resembles a flag flying from a mast, hence the name. Flags are
also called measuring or half-mast patterns because they tend to form
at the midpoint of the rally or reaction. Volume tends to diminish
during the formation and increase on the breakout. Minimum measur-
ing formula: add the distance from the breakout point, which started
the preceding “mast” rally or reaction, to the breakout point of the flag.
Floating supply: The number of shares available for trading at any given
time. Generally the outstanding number of shares, less shares closely
held and likely to be unavailable to the public. Shares of a company
held by its employee pension fund, for example, would not generally
enter the trading stream and could be subtracted from the outstanding
shares.
Formation: See Area patterns.
Front-month: The first expiration month in a series of months.
Fundamental: Information on a stock pertaining to the business of the
company and how it relates to earnings and dividends. In a commod-
ity, it would be information on any factor that would affect supply or
demand.
Futures: An investment contract between buyer and seller in which the
parties contract to receive or deliver the underlying instrument at a
fixed price by a fixed time in the future. Generally a speculative
instrument that requires very low “margins” (or performance bonds)
but that is marked to market daily, requiring the losing party to supply
cash as his equity fluctuates. Used extensively for hedging by com-
mercials — grain companies, mining companies, etc. Primary impor-
tance to stock traders are futures contracts on the Industrials and the
S&P at the CBOT.
Gap: A hole in the price range that occurs when either (1) the lowest
price at which a stock or commodity is traded during any time period
is higher than the highest price at which it was traded on the preceding
time period, or (2) the highest price of one time period is lower than
the lowest price of the preceding time period. When the ranges of
the two time periods are plotted, they will not overlap or touch the
same horizontal level on the chart — there will be a price gap between
SL302XchGlossary Page 226 Friday, December 14, 2001 11:48 AM
Glossary 227
if you buy a stock on 50% margin, you control $1 of stock for every
50 cents invested or leverage of 2-to-1.
Limit move: A change in price that exceeds the limits set by the exchange
on which the contract or security is traded.
Limit order: A buy or sell order that is limited in some way, usually in
price. For example, if you placed a limit order to buy IBM at 100, the
broker would not fill the order unless he could do so at your price
or better (i.e., at 100 or lower).
Limit up, limit down: Commodity exchange restrictions on the maximum
upward or downward movement permitted in the price for a com-
modity during any trading session.
Line, Dow Theory: A line in the Dow Theory is an intermediate sideways
movement in one or both of the averages (industrial and or transpor-
tation) in the course of which prices fluctuate within a range of 5%
(of mean price) or less.
Logarithmic scale: See Semi-logarithmic scale.
Magee Evaluative Index: Constructed by examining each stock in the
universe under consideration and ranking it weak, neutral, or strong
and compiling the percentages. Extreme readings in the industrials
(5–8% strong for bottoms, 80% for tops) mark major market bottoms,
and tops.
Major trend: In the Edwards and Magee book, Technical Analysis of
Stock Trends, the term “major” (or “primary”) refers to a trend (or
pattern leading to such a trend) that lasts at least 1 year and shows
a rise or decline of at least 20%.
Margin: The minimum amount of capital required to buy or sell a stock.
The rate, currently 50% of value, is set by the government. In a
commodity, margin is also the minimum (usually about 10%) needed
to buy or sell a contract. But the rate is set by the individual exchanges.
The two differ in cost as well. In a stock, the broker lends the investor
the balance of the money due and charges interest for the loan. In a
commodity, margin is treated as a good faith payment. The broker
does not lend the difference so no interest expense is incurred.
Market on close: An order specification that requires the broker to get
the best price available on the close of trading.
Market order: An instruction to buy or sell at the price prevailing when
the order reaches the floor of the Exchange.
Market reciprocal: Normal average range of a stock based on the
average range for a number of years, divided by the current average
range. The result is the reciprocal of the market movement for the
period. Wide market activity, for example, would show a small dec-
imal, less than 1. Dull trading would be a larger number.
Mast: The vertical rally or reaction preceding a flag or pennant formation.
SL302XchGlossary Page 229 Friday, December 14, 2001 11:48 AM
Glossary 229
Glossary 231
Glossary 233
borrowing shares from the broker and replacing them when the
offsetting repurchase takes place. In the commodity market, contracts
are created when a buyer and seller get together through a floor
broker. As a result, the procedure to sell in the commodity market is
the same as it is to buy.
Shoulder: See Head-and-shoulders patterns.
Smoothing: A mathematical approach that removes excess data variability
while maintaining a (presumably) correct appraisal of the underlying
trend.
Spike: A sharp rise in price in a single day or two.
Stochastic: Literally means random. Adopted by some technicians to
name process of analyzing closing prices relative to trend direction.
Stock split: A procedure used by management to establish a different
market price for its shares by changing the common stock structure
of the company. Usually a lower price is desired and established by
canceling the outstanding shares and reissuing a larger number of
new certificates to current shareholders. The most common ratios are
2-to-1, 3-to-1, and 3-to-2. Occasionally, a higher price is desired and
a reverse split takes place when one new share is issued for some
multiple number of old shares.
Stop: A contingency order that is placed above the current market price
if it is to buy, or below the current market price if it is to sell. A stop
order becomes a market order only when the stock or commodity
moves up to the price of the buy stop, or down to the price of a sell
stop. A stop can be used to enter a new position or exit an old
position. See Protective stop or Progressive stop.
Stop loss: See Protective Stop.
Stop systems: Magee constructed several stop systems — all of them
interesting and valuable. These may be classified as follows: (1) support
and resistance, (2) trendline, (3) hair-trigger or near progressive stops,
and (4) 3-days-away procedure. These are simple for the long-term
investor, complex for the speculator. Refer to Technical Analysis of
Stock Trends (8th ed.).
Supply: Amount of stock available at a given price.
Supply line: See Resistance.
Support level: The price level at which a sufficient amount of demand
is forthcoming to stop, and possibly turn higher for a time, a downtrend.
Symmetrical triangle: Also called a coil. Can be a reversal or continu-
ation pattern. A sideways congestion where each minor top fails to
attain the height of the previous rally and each minor bottom stopping
above the level of the previous low. The result is upper and lower
boundary lines that converge, if extended, to a point on the right.
The upper boundary line must slant down and the lower boundary
SL302XchGlossary Page 235 Friday, December 14, 2001 11:48 AM
Glossary 235
GLOSSARY OF PATTERNS
237
SL302XchGlossary Page 238 Friday, December 14, 2001 11:48 AM
Diagram 21. Major Bullish (Bottoming) Patterns: Triple Bottom, Fan, Head-and-
Shoulders (Kilroy) Bottom (Simple), Head-and-Shoulders (Kilroy) Bottom (Com-
plex). Note usefulness of describing complex H-and-S Bottom a Kilroy Bottom,
as various “shoulders” can be described as “fingers.”
SL302XchGlossary Page 239 Friday, December 14, 2001 11:48 AM
Glossary 239
Diagram 22. Major Bullish (Bottoming) Patterns: 1-Day Reversal, Island Rever-
sal, Rounding Bottom (Bowl/Saucer), and Dormant Bottom.
SL302XchGlossary Page 240 Friday, December 14, 2001 11:48 AM
Diagram 23. Major Bearish (Topping) Patterns: Triple Top, Fan, Head-and-Shoul-
ders Top (Simple), and Head-and-Shoulders Top (Complex).
SL302XchGlossary Page 241 Friday, December 14, 2001 11:48 AM
Glossary 241
Diagram 24. Major Bearish (Topping) Patterns: 1-Day Reversal, Island Reversal,
Rounding Top (Inverted Bowl), Broadening Top.
SL302XchGlossary Page 242 Friday, December 14, 2001 11:48 AM
Glossary 243
Glossary 245
LIST OF DIAGRAMS
1. How Resistance Forms.................................................................... 22
2. How Support Forms........................................................................ 22
3. Old Resistance Becomes New Support ......................................... 23
4. Valid Support Levels........................................................................ 23
5. The Bull Trap................................................................................... 24
6. The Bear Trap.................................................................................. 24
7. Decoding a Bar Chart ..................................................................... 25
8. Kilroy Bottom................................................................................... 26
9. Construction of Uptrend Line......................................................... 55
10. Construction of Downtrend Line.................................................... 56
11. Construction of Sideways Trendlines............................................. 57
12. Formation of Downtrend Channel ................................................. 58
13. Formation of Sideways Channel .................................................... 58
14. Formation of Uptrend Channel ...................................................... 59
15. Diagram Illustrating Different Kinds of Gaps ............................... 62
16. Diagram of Island Reversal............................................................. 68
17. Equivolume Graphic...................................................................... 105
18. Illustration of Candlestick Method ............................................... 106
19. Point-and-Figure Patterns .............................................................. 109
20. A Spectrum of Investors (Nonprofessional) ......................... 118-119
21. Major Bullish (Bottoming) Patterns: Triple Bottom, Fan,
Head-and-Shoulders (Kilroy) Bottom (Simple), Head-and-
Shoulders (Kilroy) Bottom (Complex) ......................................... 238
22. Major Bullish (Bottoming) Patterns: 1-Day Reversal, Island
Reversal, Rounding Bottom (Bowl/Saucer), and Dormant
Bottom ............................................................................................ 239
23. Major Bearish (Topping) Patterns: Triple Top, Fan, Head-
and-Shoulders Top (Simple), Head-and-Shoulders Top
(Complex)....................................................................................... 240
24. Major Bearish (Topping) Patterns: 1-Day Reversal, Island
Reversal, Rounding Top (Inverted Bowl), Broadening Top ...... 241
25. Indeterminate Patterns: Rectangle, Diamond, and Triangle
(Symmetrical) ................................................................................. 242
26. Major Continuation Patterns (of Previous Trend): Head-and-
Shoulders (Kilroy) Consolidation, Pennant, Flag, and Wedge
(Rising) ........................................................................................... 243
27. Measurement Patterns: Flag and Triangle ................................... 244
28. Measurement Patterns: Rectangle, Head-and-Shoulders
(Kilroy) Bottom, and Wedge (Rising) .......................................... 245
SL302XchGlossary Page 247 Friday, December 14, 2001 11:48 AM
Glossary 247
INDEX
A B
Accumulation, 217 Balanced program, 79, 218
Activity, see Volume BankAmerica, 41
Advanced Micro Devices, Inc., 38 Bar chart
Against the Gods, 211 construction of, 200–202
Air pocket gap, 42, 44, 53 definition of, 11, 199–200, 218
Allegheny Corporation, 156 patterns in, 238–245; see also specific
Allied Stores, 188 types
Amerada Hess, 188 predictive value of, 12, 130
American Airlines, 45 scales on, see Scale
American Express, 20, 156, 157 use of, as a tool, 2, 11–12, 84
American Financial Corporation, 188 Barron’s, 175, 177–178, 188
American Stock Exchange (AMEX), 87, 123, Basic trendlines, 52–53
227, 235 Basing points, 18, 44, 52, 75, 218–219
Apex, 43, 217 Basis points, 219
Apple, 67 Basket trades, 219
Appreciation, 7 Bassetti, C.D.H., 212
Arbitrage, 217 Bassetti, W.H.C., 90, 211, 212
Area gaps, 62–63; see also Common gap The Battle for Investment Survival , 118
Area pattern, 19–21, 217 Bear flag, 47, 50
Area reversal pattern, 219 Bear market, 1, 39–40, 219, 230; see also
Arithmetic scale, 217 Bearish patterns
Arms, Richard W., 105 Bear trap, 24
Ascending trend channel, 217–218 Bearish patterns, 106–107, 240–241
Ascending trendline, 217–218 descending triangle, 43, 222
Ascending triangle pattern, 19, 43, 45, downtrend line, 56
63–64, 218–219 rectangles, 42
249
SL302X_frame_IDX Page 250 Wednesday, January 16, 2002 11:05 AM
right-angled broadening triangle, 232 Broadening top pattern, 100, 219, 241
rising wedge, 47 Broadening triangle pattern, right-angle,
Bent neckline, see Head-and-shoulders 231–232
neckline pattern Buffet, Warren, 119
Bernstein, Peter, 211 Bull market
The Best and the Brightest group, 74, 116, definition of, 1, 220
149–151 example of, 8, 32, 35, 37
Beta, 219 indicators of, 175–176; see also Bullish
Beyond Candlesticks, 212 patterns
B.F. Goodrich Co., 39 phases of, 217, 220, 222
Big Blue, see International Business recognition of, 158–159
Machines (IBM) and runaway days, 70
Black-Scholes options pricing model, 208 Bull trap, 24
Block trades, 219 by American Airlines, 45
Blow-off strategy, 59, 62; see also Climactic by American Express, 20
top; Tactics by day traders, 122
Blue chip companies, 4, 149–151, 219 by Lucent, 44
Bollinger, John, 96 by Microsoft, 35, 77, 110, 112
Bollinger’s Bands, 96, 99 Bullish patterns, 106–107, 158–159, 238–239
Book value, 219 ascending triangle, 43, 218
Booms, 13, 171–172 falling wedge, 41, 46
Bottom pattern sawtooth, 158
dormant, 223, 239 uptrend line, 55
double, 39, 109, 223 Busts, see Collapses; Crashes; Panics
Kilroy, see Kilroy bottom pattern Buying, see also Tactics
pendant, see Kilroy bottom pattern after consolidation, 40
rounding, 223, 232, 239; see also Scallop and-selling vs. buy-and-hold, 1, 104,
pattern 149–151
triple, 235, 238 in head-and-shoulders pattern, 49
Bounce, dead cat, 146–147 of low-priced stocks, 15
Boundary, 219 on the reaction, 42
Bowl pattern, see Rounding bottom pattern as support, 19
Bracketing, 219 without technical analysis, 169–170,
Breakaway gap 190–191
after island reversal pattern, 68–69, 227 Buying order, limited, 228
definition of, 62–64, 219
example of, 45, 52, 65, 146–147
Breakout
C
bona fide, as confirmation, 221 Call, 124, 156, 220, 230
definition of, 219 Candlestick Charts, 106–107, 111, 220; see
end run after, 224 also Beyond Candlesticks
failure of, 224 Capital
false, 13, 44, 46, 224 management rules, for portfolio,
movement, minimum after, see 124–125, 229
Measuring formula margin, minimum amount of, 54, 228
premature, 231; see also False breakout risk per trade, 87, 232
of prices, on charts, 19–21, 25 Cats and dogs stocks, 220
support and resistance after, 41–42 CBOT, see Chicago Board of Trade (CBOT)
Breakout pattern, 30, 36–37, 62–64 Channel, trend, see Trend channels
Bridge Rule, 75 Channeling stocks, 21
Broadening formation, 156, 219, 222 Chart paper, 201–207, 209
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Index 251
Chart patterns, list of, 247–248 Consolidation patterns, 19, 37–39, 221
Charts, 220; see also Interpreting charts; diamonds, 222
Predictive methods flags and pennants, 45–48
bar, see Bar chart horizontal trend channels, 40
candlestick, 106–107, 111, 220 inverted head-and-shoulders, 226
computer generated, 208–209; see also Kilroy bottom, 226
Internet; Software rectangles, 40, 231
P&F, see Point-and-figure (P&F) charting symmetrical triangles, 40, 43, 234–235
Tekniplat, 201–207, 235 Continuation gaps, see Runaway gap
Chicago Board of Options Exchange, 208 Continuation patterns, 243; see also
Chicago Board of Trade (CBOT), 124 Consolidation patterns
Chicago Research and Trading Co., 208 Contrarian Investment Strategy, 179
Church spire top pattern, 42 Convergent pattern, 221
Citicorp, 52 Copper prices, chart of, 174
Clean-out day, see Selling Correction, 221
Climactic top, 220 Cost, averaging, 218
Climax day, 39–40; see also Island reversal Cost, transaction, 232
pattern Cradle point, 43–44, 222
Clinton-Gore administration, 8 Crashes, 13, 21
Closing price, 218, 220 Crystal ball, 164–165, 175–176; see also
gap in, 38–39 Philosopher’s Stones
in Stochastic Indicator, 95 Currency, as a trading vehicle, 122
use of, in bar charts, 11
use of, in Candlestick charting, 106
Closing the gap, 220 D
Cohen, A.W., 103, 212 Daily range, 222
Coil, 220 Data collection, 11–12, 28–29, 129, 200,
Collapses, 13, 186–187; see also Crashes; 206–207
Panics Data General, 186–187
Comdisco, Inc. (CDO), 46 Day traders, see Short-term traders
COMEX, 171 Dead cat bounce, 146–147
Commission, 220 Demand, 222
Commodity exchange restrictions, 228 DeMark, Thomas, 212
Common gap, 62–63, 220 Depreciation, 7
Comparative relative strength, 221 Descending trend channel, 222
Complex head-and-shoulders pattern, 221; Descending trendline, 222
see also Diamond pattern Descending triangle pattern, 21, 43, 44, 219,
Composite average, 221 222
Composite leverage, 84–85, 221 DIA
Computervison, 186–187 investment in, 87, 123, 125
Confirmation, 4–5, 221, 224, 235 percentage of DJIA, 18, 227
Congestion period web site, 211
breakout from, 40, 194 Diagrams, list of, 246
consolidation patterns in, see Diamond pattern, 222, 242
Consolidation patterns Dillard Department Stores Inc., 50
definition of, 221 Distribution, 222
example of, 22–24 Divergence, 221–222, 229
gaps in, 62–64 Divergent averages, 5
reversal patterns in, see Reversal patterns Divergent pattern, 222
support and resistance in, 63 Diversification, 81–82, 85–87, 124–125, 223
Consolidated Edison, 66 Dividends, 11, 179, 205–206, 223, 224
SL302X_frame_IDX Page 252 Wednesday, January 16, 2002 11:05 AM
DJIA, see Dow-Jones Industrial Average Elliott Wave Theory, 113, 175, 177
(DJIA) End run, 43, 46, 224
Donchian’s systems, 229 Entry and profit protection, 73–74
Dormant bottom pattern, 223, 239 Equilibrium market, 224
Double bottom pattern, 39, 109, 223 Equivolume, 105
Double top pattern, 109, 223 European Currency Unit (Euro), 122
Double trendline, 36, 223; see also Trend EveryMan’s EveryStock, 25, 74–75
channels Ex-dividend, 11, 224; see also Dividends
Dow, Charles, 1–4, 48, 109, 223, 230 Exchange Traded Funds, see Ishares
Dow-Jones futures and options web site, Exercise, 224
211 Exhaustion gap
Dow-Jones Futures Contract, 124 before island reversal pattern, 68, 227
Dow-Jones Industrial Average (DJIA) definition of, 62, 64–65, 224
150-day moving average line, 104 example of, 112
200-day moving average chart, 103 Exit orders, 182
advance, record, 153–155 Expiration, 224
in a bull market, examples of, 8, 32 Exponential moving average, 101
“buying the market” with, 3 Exponential smoothing, 224
in the Composite average, 221
confirmation/divergence chart, 5
confirmation of, by Transportation, 4 F
definition of, 223
fundamental analysis of, 177–178 Falling wedge pattern, 41, 46, 224
MEI chart, 196 False breakout, 13, 44, 46, 224
Microsoft added to, 35 Fan lines, 32, 224–225, 238, 240
shakeout in, 162 Feedback, 11–12, 28–29, 129
sideways trend chart, 10 Filtering, 75, 77, 102, 209
uptrend chart, 8 Five-point reversal, see Broadening
Dow-Jones Transportation Average, 4, 5, formation
223 Flag, bear, 47, 50
Dow-Jones Utility Average, 5, 221, 223 Flag pattern
Dow Theory, 1–6, 57, 122–123, 221, 228 breakout from, 48
Down channel, see Descending trend in consolidation patterns, 45–48
channel definition of, 225
Downtick, 224 example of, 243
Downtrend, 7, 9, 19, 21, 192–193; see also formed by support and resistance, 17–18
Descending trendline in Markov analysis, 192–193
Downtrend channel, 58 mast pattern before, 228
Downtrend line, 56 Floating supply, 225; see also Thin issue
Dreman, David, 179 FMI Financial, 188
Dynamic trendline, see Moving average Forbes, 179
Forecasting, 1, 179, 185, 220; see also
Predictive methods
E Formation
area, 19–21, 217
Earnings, forecasting, 179 broadening, 156, 219, 222
Earnings gap, 53, 67 congestion, see Congestion period
Earnings reports, 67, 84 “M,” 223
Eastman Kodak, 149 narrowing, 42
Ebay, 31 “W,” 235, 240
Edwards, Robert D., 211 Formula, minimum measuring, see
Elliott, R.N., 113, 175, 177 Measuring formula
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Index 253
J M
Japanese Candlestick Charting Techniques, “M” formation, 223
106, 212 MACD, see Moving Average
John Magee Technical Analysis::Delphic Convergence/Divergence
Options Research, Ltd. (MACD)
(JMTA::DOR), 145, 213 Magee Evaluative Index (MEI)
John Magee’s Inc. and asset allocation, 79–80
e-mail address, 107, 213 calculation of, for the NASDAQ, 122
objective, 3 and computer charting, 209
portfolio strategy, 81 definition of, 18, 228
in The Stock Market Innovators Survey , DJIA, relationship to, 197
158 newsletter on, 197
web site, 211 and an oversold market, 197
Jorion, Philippe, 102, 117, 211 panics, reaction to, 154–155
The Journal of Portfolio Management, 212 and portfolio management, 85
Juniper Networks, 146–148 Magee, John, see also John Magee’s Inc.
Justice Department vs. Microsoft, 35 developer of stop systems, 73
The Magee Method, 81–87
methodology of, 79–80
K Technical Analysis of Stock Trends, 211
Winning the Mental Game on Wall
Key reversal day, 31, 45, 62, 71, 122 Street, 74
Kilroy bottom pattern, 26, 49, 51, 226, 238 Major trend
consolidation patterns in, 40
definition of, 7, 228
L evaluation of, 27, 33–36
head-and-shoulders pattern in, 51
Lane, George, 95
waves in, 48
LeFevre, William, 158
Malraux, Andre, 87, 89
Leverage, 227–228 Margin, 54, 228
Leverage, composite, 84–85, 221 Market on close, 228
Limit move, 228 Market order, 228
Limit order, 228 Market reciprocal, 228
Limit up/Limit down, 228 Market Technicians Association of New
Linder, Carl, 188 York (MTANY), 177
Line, in Dow Theory, 228 Markov analysis, 192–193
Liquidity, 80, 82, 85 Mast pattern, 228
Loeb, Gerald, 118 McDermott, Richard, 144
Logarithmic scale on charts, 200–202; see McKallip, Curtis, Jr., 192
also Semi-logarithmic scale McMillan, Lawrence G., 211
trend channels shown on, 27 Measuring formula, 41, 229
trendlines shown on, 36 for ascending triangle, 43–45, 218
use of, in technical analysis, 15 for broadening top, 219
Long-term investors for descending triangle, 222
characteristics of, 118–119, 132 for double bottom, 223
choice of analytical method for, 84 for double top, 223
considerations for, 117, 119–120 for falling wedge, 224
mental preparation of, 132–140 for flags, 225, 244
moving average, use by, 102–104 for head-and-shoulders, 50–51, 226, 245
trading plans for, 122–125 for rectangles, 41, 231, 245
Lucent, 44, 71 for rising wedge, 232
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Index 255
Index 257
Index 259
Technical analysis, see also Data collection electronic, 91, 208–209; see also Software
basic assumptions of, 4–5, 14–15, 21 number driven/statistical, 91–93
basic tenets of, 3, 5–6 Top pattern
feedback, see Feedback double, 109, 223
foundation of the Magee Method, 83–84 rounding, 51–52, 77, 232, 241
vs. fundamental analysis, 84, 149–151, triple, 235, 240
177–179 Touts, 84, 213
and the MEI, 18, 85 Trades, 219, 231
origin of, 2 Trading
price in, 6–7, 84 model-based, 208
psychological preparation for, 127–140 rhythmic, 79–80, 85, 229
skills, learning of, 28–29, 33–35, 51–52 Trading, insider, 6, 14, 227
of stock value, 134, 175, 186 Trading market, 219
tools for, 89–114 Trading plans, 124–125
validity of, 3 Trailing stops, see Progressive stops
volume in, 6 Training plan, 211–212
Technical Analysis for Tacticians, 212 Transaction cost, 232
Technical Analysis: Natural and Unnatural Transactions, 224, 233–234, 236
Methods, 90, 212 Trap, bear, 24
Technical Analysis of Stock and Trap, bull, see Bull trap
Commodities, 192 Treasury bills, chart on, 161
Technical Analysis of Stock Trends, 211 Trend channel patterns
Tekniplat charting, 201–207, 209, 213, 235 ascending, 217–218
Test, 235, 236 descending, 222
Thin issue, 223, 235 down, 58
Three-Days-Away-Procedure, 75–77, 235 horizontal, 63, 227
Throwback, 19–21, 77, 231, 235 rectangular horizontal, see Rectangular
Time frames horizontal channel
for charts, 11 sideways, 58
for cooling-off period, 186 up, 59
for a double bottom pattern, 223 Trend channels, 27, 53–54, 58–59, 220, 235;
for a double top pattern, 223 see also Double trendline
for efficient trading, 84 Trending market, 235
for exhaustion gaps, 224 Trendline patterns
for falling wedge pattern, 224 ascending, 217–218
for flags, 225 basic, 52–53
for intermediate trend, 227 descending, 222
for investment, 125 double, 36, 223; see also Trend channels
for island reversal pattern, 227 down, 56
for a major trend, 228 horizontal, 227
for minor trends, 229 sideways, 57
for moving average, 102–104 simple, 36
for a rising wedge, 232 Trendlines, 18, 36, 52, 55–57, 235; see also
for scallop pattern, 233 Moving average
for secondary trend, 227 Trends
for technical analysis, 102–104 categories of, 7; see also specific types
on Tekniplat paper, 205, 206–207 definition of, 235
Time, Inc., 188 dishonest manipulation of, 14, 84
Timing, analyzing the market, 153–165 in Dow Theory, 5–6
Tools following of, 86
charts, see Charts in price range violations, 21
SL302X_frame_IDX Page 260 Wednesday, January 16, 2002 11:05 AM
V
X
Validity of trendline penetration, 236
Valley, 236 Xerox, 9, 151
Value at Risk, 102, 117, 211
ValueLine, 53
Y
Volatilities, web sites on, 211, 213, 232
Volatility, 236; see also Risk Yields, 219
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