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ESSENTIAL
TECHNICAL
ANALYSIS
Tools and Techniques
to Spot Market Trends
LEIGH STEVENS
JOHN WILEY & SONS, INC.
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ESSENTIAL
TECHNICAL
ANALYSIS
Tools and Techniques
to Spot Market Trends
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ESSENTIAL
TECHNICAL
ANALYSIS
Tools and Techniques
to Spot Market Trends
LEIGH STEVENS
JOHN WILEY & SONS, INC.
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Copyright © 2002 by Leigh Stevens. All rights reserved.
Charts created with TradeStation® 2000i by Omega Research, Inc.
Published by John Wiley & Sons, Inc.
No part of this publication may be reproduced, stored in a retrieval system, or
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MA 01923, (978) 750-8400, fax (978) 750-4744. Requests to the Publisher
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For more information about Wiley products, visit our web site at www.Wiley.com
To my many former colleagues at Cantor Fitzgerald, lost so tragically in September
2001, as well as to the Cantor survivors who are carrying on so ably.
To Mark Weinstein, without whom I would not have the same understanding
of how markets work.
This book is also dedicated to Oscar Ichazo, who provided the insights that
so enhanced my being, living, and doing.
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CONTENTS
FOREWORD
ix
PREFACE
xi
CHAPTER 1
Introduction and Rationale to the Technical Approach
1
CHAPTER 2
Our Trading or Investing Game Plan
18
CHAPTER 3
Charles Dow and the Underlying Principles of
Market Behavior
35
CHAPTER 4
Price and Volume Basics: Chart Types and Price Scales
54
CHAPTER 5
Concepts of Trend and Retracements and
Constructing Trendlines
84
CHAPTER 6
Recognition and Analysis of Chart Patterns
135
CHAPTER 7
Technical Indicators
214
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CHAPTER 8
Confirmation and Divergence
285
CHAPTER 9
Specialized Forms of Analysis and Trading
305
CHAPTER 10
Putting It All Together
336
RECOMMENDED READING LIST AND
OTHER RESOURCES
360
GLOSSARY
363
INDEX
379
viii
CONTENTS
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FOREWORD
Financial markets, by their very nature, attract a wealth of high-caliber
individuals who are genuinely excited by their chosen profession. Their
enthusiasm and their willingness to share their knowledge makes be-
longing to the community of traders, investors, and analysts a great
privilege. It is my experience that an hour spent listening to their stories,
or reading their insights, is often the equivalent to months of study in an
academic environment.
Most of these individuals are successful because they recognize, in a
way that academic analysis still does not, that asset price movements are
not just random fluctuations driven by the rational behavior of indepen-
dent traders. They recognize that human beings are, by nature, gregarious
and communicative, and have an inner drive to belong to groups. Not sur-
prisingly, therefore, group psychology provides a controlling influence over
individual activity and transforms a large quantity of apparently unrelated
decisions into a more certain outcome.
Importantly, this outcome reveals itself in the form of rhythmic, pat-
terned, price movements that bear not only a natural relationship to one
another but also are essentially predictable once they are understood. This
is why the discipline of technical analysis—hearing the message of the mar-
ket via price movements—is such an accurate tool for making profitable
trading decisions.
Furthermore, since markets essentially attempt to anticipate move-
ments in economic and social fundamentals, the accurate use of techni-
cal analysis actually implies an ability to predict those fundamentals.
This is why technical analysis is such an important tool for making in-
vestment decisions.
Leigh Stevens comes from this community of enthusiastic and
knowledgeable individuals. His depth of experience, acquired over very
many years, has generated a deep understanding of, and commitment to,
the discipline of technical analysis. Moreover, he is one of those rare in-
dividuals who have the ability to convey the essence of his ideas, not
only in a wonderfully simple and straightforward way, but also charged
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with appropriate anecdotes and experiences. There are not many people
around who can both walk their talk and talk their walk.
—Tony Plummer
Former Director of Hambros Bank Ltd and
of Hambros Fund Management PLC
Author of Forecasting Financial Markets
x
FOREWORD
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PREFACE
I’ve been fortunate in many respects in my life in being in the right place at
the right time. I took a sabbatical from corporate life to write this book, in
time to not be in my office at Cantor Fitzgerald on the 105th floor of One
World Trade Center, during the tragic events on September 11, 2001. I’m
immensely grateful that I was able to be here to author this book and I sup-
pose you could say that technical analysis saved my life. Thanks also goes
to my editor at John Wiley & Sons, Pamela van Giessen, who provided
guidance and encouragement in the process of writing this book.
My most fortunate opportunity, in terms of technical analysis, pre-
sented itself in 1984 when Mark Weinstein, a world-class trader of stocks
and index futures, began mentoring me. Mark demonstrated to me the
truth of the words of legendary stock speculator Jesse Livermore, as
quoted in Barron’s in 1921, when he said that “Speculation is a business. It
is neither guesswork nor a gamble. It is hard work and plenty of it.”
I was at the time an investments vice president at Dean Witter, now
Morgan Stanley Dean Witter. A friend, who was an active investor and
sometimes speculator in bonds and index futures, came by my office to tell
me of this person, Mark Weinstein, whom he had teamed up with to invest
money—and that he was his wife’s driving instructor. You can be sure that
I did not consider that this fellow could know much about the markets, or
to have been very successful in them! I then met Mark when he came by to
place some orders for his new partner’s account—I was his broker. Mark
Weinstein turned out to be a very intense person, and the focus of that in-
tensity was the stock and commodities markets, as well as technical analy-
sis, the means that he used to make market decisions. He was temporarily
burned out from his life as a professional speculator for the prior 10
years—and was considering buying a driving school, so he was getting a
first-hand look at the basics of the business. He often said that he hoped to
lead a normal life and that maybe some other business would allow him to
do that.
Mark, I discovered, knew about all technical chart patterns, indicators
and their effective use, how to interpret volume and the stock tape, going
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against popular market sentiment, interpreting Elliott wave patterns, and a
lot more. I knew a little about technical analysis from some self-study and
made some use of charts and technical indicators in my business. Mark,
however, had been mentored by many top traders and analysts, such as
George Lindsay. Mark would literally show up on their doorsteps and ask
them if he could learn from them.
What developed over the following two years was that Mark started
teaching me what he had learned about the internal dynamics of the mar-
kets. He didn’t take a position in the market often, but when he did he in-
vested heavily and called in his orders from home. Mark would, for
example, take large index options positions at a market low and hold onto
them for the first and strongest part of a move. He did this multiple times
in this two-year period. I would know when he decided that the market
had turned, as he would call me up and tell me shortly after the fact. One
morning sticks out in my mind when he called and said the market had
bottomed. Nothing was happening in the market either that morning or in
prior weeks, as the market was in the doldrums. However, by the end of
the day the market was up substantially.
Over time I spent many hours on the phone with Mark listening to
him espouse his market knowledge, without arousing much notice in an of-
fice full of other brokers talking to their clients. This wasn’t great for my
business, but I was able to absorb a lot of what he knew. He had time on
his hands then, as he was only in the market sporadically. The hundreds of
hours he spent discussing his techniques and experiences were of immense
value. There are rarely these opportunities to work with such highly suc-
cessful speculators—these are the market professionals whose sole focus
and passion is winning in the market. I sometimes didn’t think that this
man was real, as his knowledge was so superior to anything I had been ex-
posed to on Wall Street up until then. The only analogy is to compare this
to the prowess of a Michael Jordan or a Tiger Woods in the sports world—
no doubt if you played with them, they would seem to inhabit another
realm. Just as with Jordan and Woods, you won’t find the world-class mar-
ket pros teaching what they know—they also just do what they know. Nor
do these top traders write market advice letters or sell winning trading sys-
tems—in fact, Weinstein often debunked this idea, saying that no one
would sell a profitable system, only use it themselves to make money.
In 1986 when I was the stock index and financial futures specialist at
PaineWebber, I brought Mark to the attention of Jack Schwager, then se-
nior technical analyst there, as a candidate for his first Market Wizards
book. Jack was as amazed as I was that Mark claimed he had almost no
xii
PREFACE
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losses, in hundreds if not thousands of trades. Jack checked one of his ac-
count statements and also relied on me as judge of his trading record. I had
known about dozens of Mark’s transactions as they were occurring and
followed the stock, option, or futures as subsequent market action un-
folded. He was the real thing as far as being able to profit from his predic-
tive abilities.
Like all the other top traders Jack Schwager wrote about in his Market
Wizards book, Mark Weinstein was also intently focused on avoiding
losses. He would exit a position with a small profit or with a small loss (a
very rare occurrence), without hesitation, if the market did not move his
way. The other very important lesson learned from this enormously suc-
cessful trader was that the emotional factor makes a difference. Knowledge
is important, but someone could have as much, if not more, market knowl-
edge than Weinstein and still lose in the market because of not having the
right emotional temperament and discipline it takes to be successful plus, a
constant willingness to give up their current notions of market trends when
wrong.
It is the emotional element that is the key to winning and losing big in
the market. Part of that is waiting for the right price, the right moment,
and then having the discipline to stay with your position. And to not over-
stay or invest too much of your capital. So while technical analysis might
be the key to knowing what to buy when, there is this crucial psychological
component to capitalizing on this knowledge.
At PaineWebber, I had the opportunity, besides advising the firm’s bro-
kers, to devise and run a stock index futures fund. I developed a rule-based
system of market entry and exit based on technical criteria and it was these
ideas that were sound. However, I found that I was one of the people who
had difficulty in handling the emotional pressures of running a speculative
fund. I found that I was a better advisor—numerous brokers at PaineWeb-
ber said they profited from my advice—than trader or fund manager. Hav-
ing a natural bent toward teaching, I continue in this vein with this book.
After PaineWebber, where I ended up as senior technical analyst, I had
the opportunity to combine marketing and technical analysis as the Dow
Jones Telerate global product manager for technical analysis in 1993 both
in New York and later in London. While still in New York, I organized the
establishment and rules governing the Charles H. Dow Award, given annu-
ally by the Market Technicians Association (MTA) of which I am a mem-
ber, for outstanding achievement in technical analysis work. Like the man
himself, I stipulated that the Award given in Dow’s name by the MTA in
conjunction with Dow Jones & Co., be awarded for work that stressed the
PREFACE
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practical and involved clarity of writing that was superior. This has always
been the goal of my own writing.
When I took a position at Cantor Fitzgerald, one of the largest institu-
tional bond and equities brokers in the world, I also had the opportunity to
write technical analysis columns for the Cantor Morning News and also
for CNBC.com. This book is an outgrowth of the attention I got from pub-
lishers in 1999–2000 while I was writing these columns. I finally decided to
take on the opportunity and challenge of being able to write more than
1,000 words at a time and to expand on the essential principles of techni-
cal analysis. Making this effort was very much influenced by the hundreds
of e-mail inquiries I received from CNBC.com viewers and their interest in
this subject, as well as the appreciation so many of them expressed of my
efforts to make technical analysis interesting and useful to them. I hope
that this book is the helpful introduction to technical analysis that many of
them said they would like to read.
xiv
PREFACE
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1
INTRODUCTION AND
RATIONALE TO THE
TECHNICAL APPROACH
METHOD AND GOALS OF THIS BOOK
The goal of this book is, like my CNBC.com technical analysis columns
that came before it, to present technical analysis tools and insights that
can help you make more informed, and more profitable decisions relating
to trading and investing. I utilize the U.S. stock market for all examples. I
also discuss some indicators and aspects that are particular to the stock
market.
A major related purpose of the information and stories I present is that
a process is begun whereby you start to look at markets in a different way,
to see beyond the usual way that market information is presented to you or
understood by you. I emphasize again my hope that you will be able to
profit from this information. A major consideration is to discuss and
demonstrate what I consider to be the more useful tools and methods from
technical analysis—for example, demonstrating how to locate stocks that
offer the best hope of gain at the right time, at lowest risk, and with an ef-
fective exit strategy. There are less used technical tools and analysis tech-
niques that could be described but that might be marginal for most people,
in terms of improving trading and investment decisions.
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A second orientation I have is to discuss some of the pitfalls to im-
proved trading and investing decisions, such as your attitude toward the
market—is it gambling or is it profitable investing or trading that you can
master? How much time will you invest in it and how much perseverance
will you maintain? I find that a person’s emotional temperament, work
habits, discipline, and ability to see ahead (foresight) are as, or sometimes
more, important as mastery of some of the more complex areas of techni-
cal analysis. Time spent and perseverance in understanding the most basic
use of charts and technical indicators are more important to most market
participants than exhaustive study of every aspect of this field. And there is
a great tendency among people to think that complex ideas and techniques
must be the way to approach the markets, which after all, are complex
mechanisms. This is wrong, as simple is better in my experience, and I am
not the only one saying this—many top advisors and money managers base
their decisions on a relatively simple set of criteria.
USE OF EXAMPLES
Chart Examples
I use stock and stock averages exclusively for all examples in this book
relating to demonstrating technical patterns and indicators. While I also
have a background in the futures, fixed income, and foreign exchange
markets, I will not provide chart examples from these markets, or dis-
cuss aspects of these markets that are unique to them—for example, de-
scribing open interest and how to use it in futures or the ways of
constructing a continuous contract price series from the various futures
contract–months. I do discuss some custom indicators and methods of
analysis that are unique to the stock market, as I believe I have some-
thing unique to say about these things. However, again I want to empha-
size that all general technical analysis principles, which comprise most
of this book, are applicable to all markets.
All Markets
The popularity of technical analysis owes much to its initial widespread
use in the commodities markets, especially in the 1970s, when these mar-
kets were very active, drawing in many individual futures traders. Techni-
cal analysis is very popular in the biggest single market in the world—the
2
INTRODUCTION AND RATIONALE TO THE TECHNICAL APPROACH
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interbank currency market, usually just called the foreign exchange or FX
market. Having worked in this area in Europe, I can say that I understand
a major reason for this—a chart or a technical indicator is the same in any
language. This said, I do not draw, for example, on FX charts of
dollar–yen or of the eurodollar for my illustrations.
Further Study
I do, however, point you to other books with a more detailed and special-
ized orientation toward other markets or specialized fields within technical
analysis that you may want to study further if you’re interested—for exam-
ple, on candlestick charting or wave analysis. Some of what I consider to
be the best reference works on technical analysis are provided at the end of
the book in a recommended reading list. Some of these books draw on
more examples from the futures markets, for example.
NEED FOR TECHNICAL ANALYSIS
There are plenty, in fact a majority, of successful money managers who say
they don’t use technical analysis at all. There are also rich investors and
speculators who rely mostly on technical analysis. It’s not the method; it’s
the person—just as Jack Schwager found in his wonderful Market Wizard
series of books.
You may not have the emotional temperament or time for short-term
speculation in the market, which is my situation, but you can still vastly
improve your batting average when it comes to longer-term investing, such
as in stocks. You can focus on looking at long-term charts and indicators
only—however, don’t get married to a stock, either. Even very long-term
investors decide it’s time to exit a stock or stock sector and look for other
situations. This group of individuals can benefit from stock market timing
to find a more advantageous (cheaper) entry into a stock or mutual fund or
to exit when a primary trend reverses.
WHAT IS TECHNICAL ANALYSIS?
The word technical comes from the Greek technikos, relating to art or
skillful. Webster’s goes on to define technical as having special and practi-
cal knowledge, something I want to reinforce also. Technical analysis is the
WHAT IS TECHNICAL ANALYSIS?
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study of any market that uses price and volume information only in order
to forecast future price movement and trends. (Consideration of a third
factor, that of open interest, is part of the technical approach in the futures
markets only.)
Technical analysts and technically oriented investors or traders rely on
historical and current price and volume information only. Some other, re-
lated, statistical information is often considered part of technical analysis.
What I refer to here are sentiment indicators, such things as surveys of
market opinion to determine whether the respondent is bullish, bearish, or
neutral on the market. These figures are compiled as percentages of those
surveyed having each type of opinion, for example, the weekly Investor’s
Intelligence opinion survey of market professionals or the American Asso-
ciation of Individual Investors (AAII) poll of its members. Studies of short
interest in stocks or extreme readings in the Arms Index (TRIN) are also in
this category.
A THIRD ELEMENT BESIDE PRICE AND VOLUME
The rationale for studying market opinion is the theory of contrary
opinion. The idea of contrary opinion in market analysis is that there is
value at certain times or in general of going against the predominant
view of stock valuations or expected market direction. Warren Buffett,
considered a master of value investing, looks for value in stocks that
may not be perceived by the majority of fund managers. Market makers
on the New York Stock Exchange (NYSE) buy when others are selling
and vice versa and they make money doing it. The most knowledgeable
investors and traders comprise a top tier of market participants, in terms
of market knowledge. This group often profits handsomely by being
contrary to the investing crowd, buying when others are fearful of a fur-
ther decline and selling when the majority thinks a stock or the market
will go up indefinitely.
Market psychology, sentiment, or contrary opinion, could be called
a third element in technical analysis but is not part of the formal defini-
tion of technical analysis. My favorite sentiment indicator is actually
a ratio of total daily equity call option volume relative to the volume
of equity put options. I tend not to rely on survey type information but
do place significant emphasis on whether options market participants
are speculating or hedging heavily on one side of the market or the
other—whether, as a group, they are betting on a rise or fall in the mar-
4
INTRODUCTION AND RATIONALE TO THE TECHNICAL APPROACH
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ket. Even here I rely on volume information, which is part of technical
analysis input.
TERMS
The terms applied to the use of technical analysis include technical analy-
sis, the technicals or technical factors—not to be confused with tech or
technology stocks or technical factors impacting a market, such as a com-
puter failure or blizzard in causing an exchange to close early. Technical
analysis means a set of principles and analytical tools that are used to make
predictions about the market that predominantly involve the use and study
of price and volume information only.
FUNDAMENTAL ANALYSIS
Fundamental analysis, rather than concentrating solely on the study of
market action itself, relies on examination of the laws of supply and de-
mand relating to a market or to individual stocks. The aim is the same,
to determine where stock prices may be heading. Much of fundamental
analysis revolves around one basic area—earnings. What is a company
likely to earn in its business during the current time frame and going for-
ward? Or what is the earnings potential of an entire group of stocks,
such as the S&P 500? Relative to earnings, what multiple is the market
likely to assign to the value of the stock or market index? Will, or
should, the price of the stock trade at a value that represents 10, 15, or
50 times past and future (projected) earnings in dollar terms? Price/earn-
ings ratios or P/E considerations form the core of fundamental analysis
of stocks.
Relative to P/Es, the broad area of investor sentiment provides an
area where fundamental and technical analysis overlap. Whether a stock
should or will trade at a price/earnings ratio of 10, 15, or 50 is more than
a matter of economic and company growth expectations, it is also a mat-
ter of investors’ bullish or bearish sentiment. Market participants may
decide that they will no longer reward growth stocks with a P/E ratio that
is far above the average simply based on having seen a recent collapse of
such ratios. Or their views of a company’s or industry’s growth prospects
may be good, but a more cautious attitude takes hold, forcing a down-
ward adjustment to stock prices, when even the fast growing companies
FUNDAMENTAL ANALYSIS
5
with rapidly expanding earnings no longer command hefty premiums to
the average stock.
TECHNICAL ANALYSIS RATIONALE
Why would someone rely on just studying charts that plot past and current
price and volume information, as well as perhaps technical indicators or
formulas that use the same information?
The reasons are found in observations of the stock market, as first
noted by Charles Dow in this country and can be described in three ways.
1. Efficient Market. Over time, market prices reflect everything that
can be known about a stock and its future prospects. The market as
a mechanism is very efficient at discounting whatever can affect
prices. Even unforeseen events, such as new competition, legal or fi-
nancial problems, a company takeover, the death of a founder, and
so on are quickly priced into the stock. Even unknown (not yet
publicized) fundamental factors, such as a sharp earnings drop, are
seldom unknown or unanticipated by everyone; those who know
often act on the information, and selling volume starts to pick up
on rallies. Here I am not talking necessarily about facts known only
by company insiders. There are traders, investors, and analysts out-
side a company or an industry who see changes coming, through as-
tute observation and sharp analysis.
2. Trends. The information about a company’s stock and its future
earnings prospects that are reflected in the stock price will also be
reflected in a price trend or tendency to go up or down. Trends are
not only up or down, but sideways as well or what is sometimes
called a trendless pattern—I consider a sideways movement to be
the third trend possibility, for example, a stock moves between 40
and 50 multiple times. A trend is the action of a body in motion
staying in motion until an equal countervailing force occurs.
3. Reoccurrence. Price trends occur and reoccur in patterns that are
largely predictable. The idea of trends reoccurring is that history re-
peats itself. If there was abundant stock for sale (supply) previously
for sale at 50 and that selling caused a retreat in prices, it may well
be the case again when the stock approaches this level again. If it
doesn’t, that tells you something also, as demand was this time
strong enough to overcome selling.
6
INTRODUCTION AND RATIONALE TO THE TECHNICAL APPROACH
The basic technical analysis rationale can be remembered by the ETR
acronym (as in Estimated Time of Arrival). Well, you can estimate arrivals
with technical analysis!
TECHNICAL VERSUS FUNDAMENTAL ANALYSIS
If you are reading this book, I assume you have an open mind as to the
possible validity of technical analysis. I see no contradiction between these
forms of analysis. I often use technical analysis as an adjunct to fundamen-
tal analysis—I may like a market sector or individual stock for fundamen-
tal reasons, for example, computer use is on a path of explosive growth. I
might then use technical analysis for or because of
❙ Market timing—when to get in, for example, a pullback to a trendline
❙ Risk control—judging where to place protective stop (liquidating)
orders, for example, on a break of a major trendline
❙ An end to a trend—applying criteria for when a trend may have re-
versed, for example, a decisive downside penetration of a stock’s
200-day moving average
There are other reasons to use charts, of course, even if you don’t use
technical analysis techniques, such as for seeing price and price volatility
history.
Not only do I not see the two means of analysis to be complementary,
but I also consider technical analysis to be a shortcut or an efficient way to
do stock market fundamental analysis! I may not be able to or want to study
everything about the ongoing progress of a company whose stock I own.
However, there are always an interested body of people who trade the stock
and make informed investment decisions because they know the company or
business quite well. I can ascertain what the informed opinion is on a stock
by seeing what is going on with the price and volume patterns on the chart. I
assume that the market judgment on a stock is right until proven otherwise.
CRITICISMS OF TECHNICAL ANALYSIS
❙ There is no proof that technical analysis works. Actually, there has
been some relevant work done by Dr. Andrew Lo at MIT, who has
answered the question of the predictive power of some technical
CRITICISMS OF TECHNICAL ANALYSIS
7
analysis concepts. He studied a chart pattern recognized as having a
predictive outcome, that of the “head and shoulders” top formation.
Dr. Lo sought to determine if a subsequent price decline was in evi-
dence after this pattern developed—compared to outcomes present
without this condition. Once the pattern was defined mathematically
and tested over the long-term price history of 350 stocks, it was
compared to “random walk” simulations. The results confirmed that
the pattern studied was in fact predictive in nature for a subsequent
price decline.
❙ Technical analysis works only because traders believe it works and act
accordingly, causing the action predicted, for example, traders sell
when a stock falls below its 200-day moving average. While this is
sometimes true, most active stocks have too much trading activity to
cause me to believe in the idea of a self-fulfilling prophecy. If there was
a temporary price decline due to the technical selling related to such a
break, the stock would rebound if the value became too low relative
to its fundamentals. Moreover, the influence of technical analysis is
not that great. If you follow the market related channels like CNBC,
you’ll see a drumbeat of fundamental news all day long. Focus on fun-
damentals is the mainstream approach and the numbers of investors
or traders influenced by technical analysis is small in comparison.
❙ Price changes are random and can’t be predicted. This criticism is re-
lated to the “random walk” theory, as the idea that price history is
not a reliable indicator of future price direction. Adherents of this
view take a different view of the market being efficient. I used this
term previously to mean that the market is an effective mechanism
over time, to reflect everything that can be known about a stock and
its prospects. The efficient market theory holds that prices fluctuate
randomly around an intrinsic value. This point is actually similar to
the one technical analysts make that a market price reflects every-
thing that can be known about that item. The difference is that one
school (random walk) holds that current relevant factors affecting
price are discounted immediately, and the other (technical analysis)
is that this discounting ebbs and flows, taking place over time inter-
vals that are predictable. Random walk adherents suggest that a buy
and hold strategy will offer superior returns, as it is impossible to
time the market. More on the possibility that attempting entry and
exit on intermediate price swings could increase returns, relative to a
buy and hold strategy, is found in Chapter 2.
8
INTRODUCTION AND RATIONALE TO THE TECHNICAL APPROACH
STOCK MARKET DECISION CRITERIA
Even if your primary criteria for making investment or trading decisions
are fundamental ones—for example, you like a company’s business, the
way that company is doing that business and their growth prospects—
there may be much to be learned by using a historical chart of the price and
volume trends of the stock and by applying some simple rules of thumb re-
lated to technical analysis for timing considerations.
For example, is there some likelihood that the stock might drop back
to a lower level as it’s near a prior high, and previously sellers pushed it
lower when it was in this price area? You could couple this information
with a technical indicator that suggests that this stock is overbought. If the
stock goes above its prior high, you can make a purchase at a bit higher
level but with some greater degree of assurance that the stock has willing
new buyers coming in.
Or you could wait until a price comes back to the old high that was
exceeded, as it often does, one more time. If a stock does retreat from its
first advance and you buy in a natural support area, you’ve improved your
purchase price. Better entry prices over years of investing add up. Exiting
soon after a major trend reversal, such as was seen in the Nasdaq in March
and July–August 2000, because you had exit rules based on technical
analysis criteria, could have been a major financial advantage.
BROADER APPLICATIONS FOR TECHNICAL ANALYSIS
Technical analysis can be applied to any market or any stock. Also to any
market sector index by your studying the chart of that market segment, for
example, the semiconductor and oil stock indexes. Or if you are ready to
purchase a mutual fund, it’s possible to obtain and analyze historical data
on the daily closing fund values for major mutual funds. You may also
evaluate the stock market as a whole in the way that Charles Dow ana-
lyzed it. Is the Dow Transportation average lagging the Dow-Jones Indus-
trial average, suggesting a slowdown, not in manufacturing, but in
shipments, a business area that experiences an economic downturn the
fastest? Perhaps this observation would cause you to wait and see if the fa-
mous Dow theory barometer confirmed a continuation of a market trend,
thereby avoiding a big risk by reducing your equity holdings or by waiting
to put more money into stocks.
BROADER APPLICATIONS FOR TECHNICAL ANALYSIS
9
WHOM THIS BOOK IS FOR
Some of these categories of individuals overlap and one person cannot al-
ways be so easily defined, but the following are market orientations that
are common.
❙ Investors in stocks and mutual funds, including those who have a buy
and hold philosophy but who are open to learning the entry and exit
decisions that technical analysis helps provide. Mutual funds can be
charted like stocks also, and there are sources of closing prices you
can download every day if you use a computer. You can chart these
prices daily on graph paper also by using the financial press.
❙ Traders, including day traders and those who trade in and out of
stocks over time as opportunities present themselves. Chart patterns
and indicators work basically the same way whether seen on a 15-
minute, hourly, daily, weekly, or monthly chart. Traders are going to
tend to rely more on computers and Internet information.
❙ The average investor, who combines a bit of both investing time
frames and may combine elements of fundamental and technical or
chart analysis. And, by the way, it’s been shown that the average
holding period for stocks is now down to around 10 months.
❙ Someone who has no prior knowledge of technical analysis. I as-
sume at most that you have some familiarity with stocks, the mar-
ket, and have bought and sold stocks. You may not have shorted
stocks previously.
❙ People willing to put some time into studying the market and keep-
ing track of their stocks and mutual funds, relative to the market and
its sectors. “Never stop evaluating” tends to be the motto of top
money managers and traders.
❙ Pragmatists. Certain core technical analysis principles and precepts
show useful information about market trends, but cannot always be
demonstrated, proven, or even explained. The fact that they do work
can be seen over and over, however. Those less interested in the the-
ory and more interested in what works and its practical use will find
technical analysis helpful.
WHOM THIS BOOK IS NOT FOR
❙ Someone with the expectation of averaging 10–15 percent a month,
instead of annually, in stocks, may learn some things from this book,
10
INTRODUCTION AND RATIONALE TO THE TECHNICAL APPROACH
but they’re also not likely to be prudent in the risks they take, which
is one of my messages.
❙ A person who expects any system of market analysis to have all the
answers all the time. You won’t find that in technical analysis or else-
where that I know of. The best traders and fund managers in the
world always stand ready to admit that they are wrong, and they are
the top people in making money in the market.
❙ Someone who will not put some minimum time into studying the
market and the charts. You can only expect results from effort put
into something. A few hours a week would be sufficient if you are an
active market participant, less if you are not.
HOW THIS BOOK IS ORGANIZED
The chapters that follow are summarized.
Chapter 2
How we invest or trade. Investing versus trading time horizons or orienta-
tion: Choose one or both, at different times, but don’t confuse the two; risk
attitudes, risk control, and a trading strategy—your attitude toward risk is
all-important to winning in the stock market.
Chapter 3
Charles Dow and the underlying principles of market behavior. Under-
standing that the internal dynamics of the market have much to do with in-
vestor attitudes or psychology. How Dow’s concepts form a foundation for
technical analysis and predicting future trends.
Chapter 4
Types of charts and scaling. The different ways that price and volume in-
formation are displayed.
Chapter 5
Concepts of trends, trendlines, and trading. Entering the basics of technical
analysis; the trend is your friend and trendlines your best friend.
HOW THIS BOOK IS ORGANIZED
11
Chapter 6
Pattern analysis and recognition: price and volume. Price movement is the
president or commander-in-chief; volume is the vice-president; identifying
the beginning of major trends; identifying market reversals.
Chapter 7
Technical indicators. Did you need them always? The times they preserve
profits or your skin; moving averages; overbought/oversold indicators; ad-
vance/decline figures and other stock market specific indicators.
Chapter 8
Confirmation and divergences. Charles Dow said it best in the West; vol-
ume divergences; not all divergences are tops but tops often have diver-
gences.
Chapter 9
Specialized forms of analysis and trading, people, and systems. The easy
Elliott wave primer; Gann principles and techniques; developing trading
systems and back-testing; optimization; indicator and pattern screening
techniques.
Chapter 10
Putting it all together. Developing your checklist; some fun stuff.
MORE PERSONAL HISTORY
I came to technical analysis, like many other things in my life, by the
process of trial and error leading to discovery and by the fortuitous cir-
cumstances of having someone around who could help me discover how
markets work. This almost always was a process of uncovering something
about the inner workings of the market as a dynamic process of individuals
interacting with each other and with outside forces. In the early stages of
my learning about technical analysis, it was usually not about the obvious.
I think Joe Granville said that “if it’s obvious, it’s obviously wrong.” Vari-
12
INTRODUCTION AND RATIONALE TO THE TECHNICAL APPROACH
ous events and experiences I had taught me that there was something be-
yond the obvious.
THE 1970S—MY FIRST BUBBLE AND PIGS IN A POKE
In the 1970s there was a speculative bubble in the commodities markets,
especially in the gold and silver markets. You may be of an age to remem-
ber people melting down their heirloom silverware to sell it when prices
went from $3 to $30 an ounce and higher. There is no precise definition for
a bubble, but generally it’s a rise so steep in the market that it’s a very rare
event. This was a decade of inflation, and tangible assets like real estate
and commodities were seen as safe havens, whose price appreciation
would stay ahead of rising prices.
I fled to it myself and decided to become a commodity futures broker
at Merrill Lynch where they had offices specializing in this type of broker-
age. One of my early clients, someone who knew the commodities markets
firsthand as the president of Continental Grain Company, was an active
trader of the live hogs contract. This contract called for future delivery of
the porkers in the pens, before they got cut up into bacon (pork bellies).
Merrill Lynch’s livestock analyst at the time was an old pro. Growing up in
Michigan, I happened to have heard this analyst at times on a farmer-ori-
ented radio show hosted by a neighbor. This expert had a calm voice of au-
thority and his manner gave no doubt that he knew this market and what
was going on.
Many years later in the late 1970s in the Merrill Lynch commodities
office on Fifth Avenue where I worked, it happened that this same expert
was our livestock analyst. He would attempt to predict where prices were
likely to be headed in the coming season based on all the known factors of
supply and demand. I emphasize known here, as another study of the obvi-
ous. Based on his own and my firm’s experienced market analyst, my client
bought a sizable number of hog futures contracts—maybe 50 contracts,
which is a lot—a dime change in the price per pound for hogs was worth
$15,000. Then prices started falling. My firm’s expert was saying, “Don’t
worry; it’s a temporary downturn and not justified by the fundamentals.”
You can guess the rest of the story. As prices sank so did my spirits.
My client was a very knowledgeable man in the commodities markets and
I had the advice of the best fundamental analyst out there, but we were
stumped by what was happening. I remember my client ended up selling
most, if not all, of his position at a substantial loss. It was a shock to me, as
THE 1970S—MY FIRST BUBBLE AND PIGS IN A POKE
13
I didn’t know what else to rely on but the kind of analysis related to supply
and demand projections I was getting. I don’t remember what reason came
out finally to explain the substantial price drop. I became very interested in
how I could be forewarned about price reversals in the future.
An old friend and a commodities broker himself, Jeff Elliott, told me
about using something called an oscillator and that this indicator could
give me an idea when a market was overbought. This was a term in tech-
nical analysis suggesting a price rise that was so steep as to be unsustain-
able—and a situation that would most likely be relieved by prices
dropping back to a level where supply and demand equilibrium would be
more in balance. The suggestion was that I should not rely just on funda-
mental analysis and our expert’s interpretation of the price influencing
factors. I could also rely on price action itself to see if a market might be
vulnerable to a substantial price trend reversal.
I THOUGHT I KNEW SOMETHING
UNTIL I HEARD GEORGE LINDSAY
In early 1982, with inflation under control and a prospective investing shift
to financial assets, I was in the process of becoming a registered stockbro-
ker. In February 1982, George Lindsay, a technical analyst with the institu-
tional and specialist firm Ernest & Company, appeared on the PBS
television program Wall Street Week. Interestingly, through subsequent
years I met many people that also saw that broadcast and remembered it
quite well. George Lindsay, by then in the late stages of his career and an
unimposing figure, spoke softly and often referred to a small piece of pa-
per. At this time, stocks had been underperforming every other asset class
for many years and stockbrokers were becoming real estate brokers. Lind-
say stated flatly on the program, that in August, some six months away, a
stock market rally of monster proportions would begin. In the prior 20
years the S&P Index had gained only 55 percent.
Figure 1.1 tells the story for the market after August 1982, using the
S&P 500 Index, which comprises the stocks forming the core mutual fund
holdings in the United States. From mid-February, around the time of
Lindsay’s public prediction, the market declined approximately 8 percent
from the mid-February peak into mid-August. In August a broad advance
got underway and in the next 18 years, the S&P gained nearly 1,400% as
measured to the weekly closing high in March 2000—using the March
2001 close, the gain is more than 1,000%.
14
INTRODUCTION AND RATIONALE TO THE TECHNICAL APPROACH
TE
AM
FL
Y
Team-Fly®
Of course, anyone can have a lucky guess. But doing some research on
Lindsay, I found other even more startling predictions, including a docu-
mented political one from 1939, that Russia would experience a severe col-
lapse and a prolonged period of hard times 50 years hence—1989, of
course, corresponded to the fall of the Berlin Wall and ushered in hard
times in the U.S.S.R. No, Lindsay wasn’t another Nostradamus, just a mas-
ter of cycles. The importance to me of George Lindsay’s predictive abilities
at the time was the possibility that someone really could know where the
market was heading and that I could learn some of this or similar methods.
At the time, in February 1982, I had no frame of reference for any kind
of basis or validity to this kind of prediction, even though by then I was
studying chart patterns, using some technical indicators and was learning
to read the stock tape. To predict market turning points so far ahead of
time was a curious novelty at best with the possibility of its being a lucky
guess. However, like many others I was struck by Lindsay’s confident air of
authority when he talked about what the market was going to do well in
advance—it was like he was reading the road map ahead on that little piece
of paper.
I THOUGHT I KNEW SOMETHING UNTIL I HEARD GEORGE LINDSAY 15
Figure 1.1
Lindsay, it turned out, had a reputation in professional market circles
of being so accurate in his forecasts for market trends, that some traders
were said to go away on lengthy vacations if the market wasn’t doing
much and come back weeks later to buy heavily when he indicated an up-
trend was due. Lucky guesses—I suppose he made a lot of them! The other
question is whether his forecasts were self-fulfilling prophecies, because he
had a sizable professional following. It’s doubtful that he or anyone else
ever had or will have that kind of influence, as the U.S. stock market is just
too huge for it. Years later, someone who had studied with him told me
that Lindsay had discovered 12 master cycles to the stock market that had
predictable patterns in the way they unfolded—once he identified which
one (of the 12) we were in, he could forecast things like “the market will
experience a moderate uptrend for three months and then move down
sharply beginning in December.”
No one whom I know of has been able to continue Lindsay’s work,
at least with the accuracy and authority he had. His methods, which he
kept quite private, may have died with him. Or it may be that the market
doesn’t conform to such analysis anymore. But he was an inspiration for
learning more about the predictive power of the forms of technical analy-
sis that I could learn.
FAST FORWARD TO 2000
Events I describe leading to my wanting to learn more about how markets
work, are similar to the shock many investors had in the collapse of the
stock market in 2000—after a multitude of Wall Street analysts continued
as cheerleaders for stocks at the time of the hyperinflated values of early
2000. During the months following its March peak and while the market
sank to its worst performance in many years, most of the technology and
Internet stock analysts kept their buy recommendations intact. At one
point, when the Nasdaq Composite Index was down 60 percent from its
top, less than 1 percent of analysts’ recommendations were to sell.
It may well be that this same event led you to consider other ways to
analyze the markets that will not only get you in the market, but tell you
when it’s time to exit also. The bursting Nasdaq bubble is our most recent
lesson to look beyond the obvious—up until March 2000, as Nasdaq stock
values rose to astronomical heights, the obvious accepted truth was that
the new Information and Internet Age was going to change everything. We
no longer had to use the old valuation models that defined normal price to
16
INTRODUCTION AND RATIONALE TO THE TECHNICAL APPROACH
earnings ratios. I heard from many people via my CNBC.com technical
analysis columns who held on during the steep downturn—not many said
they blamed the analysts and market commentators who gave only buy
recommendations. However, if the analyst community can’t do better, then
investors need to themselves. One way is to gain some practical basic
knowledge of technical analysis, as it will provide a means to evaluate
when market trends are overdone.
SUMMARY
Tools and techniques to spot market trends is the theme of this book. I as-
sume people are looking for some guidance on this and the subject of tech-
nical analysis in general. I hope to save you time and loss by pointing you
toward what I’ve found are the most effective ways to employ technical
analysis. I invested the time and took the losses to get to this point. Not to
say that you don’t need to have your own experiences in using technical
analysis—experience is the best teacher. But this book will also guide you
in certain directions, and I don’t see all techniques and tools as having
equal value.
It’s my expectation from this book alone that you can learn to spot
emerging new trends developing and also see that a trend is ending. How-
ever, it’s also my hope that this book will also stimulate your interest
enough for you to continue to perhaps read other books in this field. Most
importantly, start to look at charts—as many of them as you can. And
make notes, mental or otherwise, of how you think the trend is unfolding
and how it might end. As time goes on, see where you were on or off the
mark—if events surprised you, see if there was some other way of seeing
the situation that you overlooked.
SUMMARY
17
2
OUR TRADING OR
INVESTING GAME PLAN
INTRODUCTION
This book is designed to explain and demonstrate the technical analysis
methods to both shorter-term traders and to investors. You may wonder
why I am first discussing the topic of our style of market participation and
tactical things like a market game plan. It is because as a veteran trader, in-
vestor, analyst, and market advisor I have seen all the pitfalls of trying to
make money using technical analysis principles and tools. And these pit-
falls often have little to do with technical analysis per se, which actually
works quite well. The shortcomings are more due to our inability to see
and apply these methods objectively or artfully, due to the difficulties of
overcoming our market biases, impatience, and fears.
The biggest obstacle to making money in the market is our own self.
We know the saying well, that we are our own worst enemy. It is even
more true in the market because it is a game where we are pitted against
some of the smartest professionals on the planet. The person who is learn-
ing the investing game in a more volatile time of fast moving markets may
not have a long time to decide about whether to stay in or exit a losing
position before facing a big loss—and we can be locked into losses for a
long time if we don’t have a game plan and exit strategy. Increasingly,
18
when market participants are disappointed with a stock, there is less incli-
nation to be patient and wait for the situation to get better. As our atti-
tudes are the foundation for our ability to use technical analysis
effectively, this chapter examines the attitudinal and market strategy ques-
tions that relate to:
❙ The temperament needed for market success
❙ A trading versus investing orientation
❙ Trading can be tempting
❙ Our attitude toward risk and willingness to take a loss
❙ Use of stop orders
❙ Shorting the market
TRADING AND TRADERS
Traders range from people who buy and sell stocks looking to profit from
price swings as short as hourly and who probably consider themselves to
be mostly or exclusively day traders, to those who are in a stock for a de-
fined price objective only. This latter group, comprising a larger number of
individuals than day traders, might think a stock is undervalued and due
for a bounce. They may exit a stock if it goes up or down a few dollars.
Traders may be in a stock for a few days or a few weeks. The term profit
taking applies to this group’s activities if they have profits to be taken.
There is an old trader saying to “take quick profits.” That is, if there is
a sudden run up on speculation of a takeover or sale of a company, an im-
pending piece of business or just some piece of news that reflects favorably
on a company’s sales and profit outlook, it is tempting to book the gain.
There is a tendency for investors to think that the highest high for a
stock was a profit they had, and then lost, if the stock comes back down
substantially. It is important to remember that all profits are unrealized
gains until you sell what you bought or buy back what you sold short.
Market participants who have a trading orientation and style are less
likely to think this way. They tend to be more quick, often too quick, to
exit if they have a small profit. This group may not have been nimble
enough to exit on a good-sized upswing if they were not watching closely
enough or expected more upside. However, when the stock heads back
down toward their entry price, they are quick to exit while they still have
any, or a small, profit.
TRADING AND TRADERS
19
A trading versus investing orientation is more than a matter of the time
horizon, but that is a big part of it. The trader is concerned with what
Charles Dow called the day-to-day fluctuations of the market and of indi-
vidual stocks, or the secondary movement of the market, which he defined
as any substantial rallies in a primary bear market or reactions (down-
swings) in a primary bull market that take place over a few weeks.
More on these terms later, but these are the time frames. Keep in mind
that the average time that a stock is owned is down to 10 months, shorter
than what Charles Dow defined as the duration of a primary market trend of
a year or more. Of course, this average holding period is skewed by the large
number of market participants attempting to trade shorter-term price swings.
INVESTORS
The investor is, or should be, primarily concerned with what Dow called
the primary movement in the market, which tends to run over a period of at
least a year and sometimes over periods of multiple years. A drop could oc-
cur in just a few months, such as in 1987, but be so steep that it is consid-
ered a primary bear trend. A decline can be this short, but not in an advance
considered to be a primary bull market. An old market saying is that “they
slide faster than they glide”—markets go down faster than they go up.
Jesse Livermore, one of the legendary stock speculators in his day (the
1920s), used to say that there are always lots of early bulls in a bull mar-
ket, or early bears in a bear market. But he made most of his money by
“sitting.” He stated that these early bulls or bears lose their conviction.
The market as a mechanism is almost guaranteed to shake you out of your
conviction as the news is still quite bearish in early rally stages and quite
bullish in the early beginnings of a decline.
THE TEMPTATION TO TRADE
An example of some stock charts with some intermediate price swings both
up and down, within a primary trend and that have already been com-
pleted—giving the benefit of hindsight—will demonstrate the attraction or
temptation to trade in and out of a stock to increase the possible return.
Some people can do this, of course—many others will not have the tem-
perament, trading discipline, or focus on watching the stock closely
enough to do this.
20
OUR TRADING OR INVESTING GAME PLAN
Figure 2.1 shows the chart and assumes we take an investing approach
and purchase Alcoa in the beginning of 1999, at $20.72. This was in the
early stages of a rise that took the stock above its prior year’s trading
range—a good technical signal for entry. Assume also that the stock was
sold in June 2001, after a sizable run up in the preceding 8 months and af-
ter the stock started to sink and fell first under its 50-day moving average
and then to below its up trendline. Our hypothetical investor then decides
that there was not much further upside potential with the stock, as the
trendline break was an exit indication, and got out at the closing price on
that same day, 6/14/01. The liquidation sell price was $39.22. The increase
over the 30 months of holding the stock netted a gain of $18.50 or a very
respectable 89.2 percent return. On an annual basis, the return on the
money invested is approximately 36 percent, which was outstanding given
that the S&P 500 Index was down about 4 percent during the same period.
The entry and exit points for our investing approach are seen in the weekly
chart of Figure 2.1.
Taking a trading approach, where there is purchase and sale every time
there appears to be an opportunity for profit, we’ll assume the same initial
THE TEMPTATION TO TRADE
21
Figure 2.1
entry point at $20.72. However, over the same time period the stock was
bought and sold 5 times, based on technical criteria using trendline analy-
sis—trendlines will be discussed in a later chapter. Substantial assistance in
plotting strategy was provided when, over the course of March–November
1999, Alcoa’s stock formed a large triangle pattern, which provided an up-
side objective for the subsequent rally after November when the stock
moved sharply higher—more on triangles later, but this pattern is traced
out anyway on Figure 2.1.
The five trades’ entry and exit points are noted by up and down ar-
rows both in Figure 2.1 and Figure 2.2, a chart of the daily closes, pro-
viding a more close up view of some of the price swings of the stock and
the relevant trendlines. It is assumed that our hypothetical trader was al-
ways in the market. After selling to liquidate a long position, a short po-
sition was also established and vice versa—after a purchase to offset a
short position, a long position was also established by purchasing dou-
ble the amount of stock that was held short. Our trader entered or ex-
ited only if there was a favorable penetration of the trendline on a
closing basis.
22
OUR TRADING OR INVESTING GAME PLAN
Figure 2.2
An assumption was also made that our hypothetical trader was able
to monitor the close and place an order near the close of a trading ses-
sion, on the few occasions where prices were near enough to the trendline
being monitored that it might be penetrated. To make the example as
simple as possible and to determine the entry price more exactly (the
close), it’s assumed that only a close above or below a trendline deter-
mined a new trade. A short sale is assumed at the same price as a sell, but
this is an approximation only due to having to short on an up tick—more
on this later also.
The 5 trades are detailed in Table 2.1. In our hypothetical trading sce-
nario outlined in the table, there is a perfect record of wins and no instance
of where the person misinterpreted how the trendlines were unfolding. By
unfolding I mean the necessity to periodically redraw trendlines due to
market action and with the hope they are drawn correctly, such that a shift
above or below will in fact highlight a reversal in the trend.
Of course, I have the benefit of hindsight to figure out how the trend-
lines were best constructed. Nevertheless, this stock provided a good ex-
ample of how a person with a good aptitude for trading coupled with a
good trading strategy, could greatly increase profits by trading in and out
of a stock. In this case the effective trading strategy made very expert use
of a major technical analysis tool, trendlines. The gross trade profits—ver-
sus net profits after commissions—jumped to a whopping 200 percent be-
cause the stock traded had some wide-ranging and well-defined price
swings. I emphasize that the real world of trading is different from a hypo-
thetical example like this, when you can’t practice rear view analysis and
your emotions are let loose.
Figure 2.3 provides another example to demonstrate the allure of in-
and-out trading. The increase of trading activity of recent years is facili-
THE TEMPTATION TO TRADE
23
Table 2.1
(AA) Alcoa Inc. LAST—Weekly
Trade Entry
Buy
Selling
Entry
Exit
Gain
Date of
Date
(B)
Short(SH)
Price
Price
(Loss)
Exit
1/8/99
B
20.72
40.00
$19.28
1/14/00
1/14/00
SH
40.00
32.38
7.62
8/7/00
8/7/00
B
32.38
32.63
.25
8/29/00
8/7/00
SH
32.63
28.25
4.38
10/30/00
10/30/00
B
28.18
39.22
11.04
6/1/01
Total
$42.57
tated by better information and the ease of online trading—but also
from people looking at charts like those I have just shown you and cal-
culating their own “what if” scenarios. And turnover has increased dra-
matically as the average holding period for stocks had shrunk to about
10 months by 2000, from a multiyear time period a decade before. More
on the pitfalls of trying to profit from all possible intermediate price
swings later.
Figure 2.3 consists of a weekly bar chart of the high, low, and close for
Hewlett-Packard (HWP) for the 1999 period into mid-2001. For an in-
vestor who thought HWP had some promise, and decided to use some ba-
sic technical criteria as to the right time to purchase the stock, they might
have bought it at $28.55 the week of 4/9/99, when the stock closed above
its down trendline. Chances are they then rode the stock up in 1999 and
back down into 2000. This time, when the stock had an even bigger ad-
vance in 2000, our wiser investor decided to exit the stock if it closed un-
der the weekly uptrend line. The criteria of a weekly close below the steep
24
OUR TRADING OR INVESTING GAME PLAN
Figure 2.3
TE
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up trendline triggered their exit during the week of 9/15/00—assuming the
trade was closed out at the close at $51.50, there was an 80 percent profit
or $23. Thank you very much, stock market!
Our nimble trader could reasonably have had four trades executed,
two purchases and offsetting sales and two short sales, with offsetting
purchases, and they are also noted on Figure 2.3. The last profitable exit
was in March 2001 for a profit on the short side of $19.80—the first three
of our hypothetical gains were $14.45 (purchase and sale), $11.17 (short
sale and then buy back), and $19.67 (buy and sell), for a total gross profit
of $65. Relative to the first purchase price of $28.55, same as our in-
vestors, there was a profit of some 288 percent. Even if we assumed that
no trades were taken on the short side, only two purchases and sales
based on the trendline criteria, the profit on the two long side transactions
increased roughly 40 percent. There could be many other entry and exit
rules and refinements, but this one has the benefit of simplicity and ease of
demonstration.
The trading examples particularly present a best-case trading strat-
egy. In the real world of the market and with participation by someone
following this and other stocks on a part-time basis, it is not likely that
the outcome would be as profitable as the one presented. Nevertheless,
someone with the necessary temperament for trading the market and
who works at it consistently could achieve a greater return than the per-
son following a buy and hold strategy if there are two-sided trading
swings of sufficient size. In a major stock bull market or bear market, es-
pecially in the steepest part of the trend, a strategy of just holding a
stock, not trading, is usually what garners the best return. However, tech-
nical analysis used properly could also tell you that this was the type of
market cycle that existed.
Many individuals will not maintain the necessary attention to detail or
have the time consistently to devote to trading. Even though the transac-
tions were relatively few in number in our examples, it meant fairly fre-
quent monitoring of the charts and multiple decisions regarding re-drawn
trendlines, continuing evaluation of the chart and the overall market pat-
terns as they change, and possibly some attention to technical indicators.
And multiple instances of calculating the right levels, then canceling old ex-
iting stop orders and re-entering new ones. Use of preset stop orders that
are always in place is my preferred trading strategy and the one designed to
prevent the all-too-common big loss. However good your trading strategy
and considering the time and potential stress involved, our would-be trader
might quickly become an investor again.
THE TEMPTATION TO TRADE
25
HOW TRADERS BECOME INVESTORS BY GETTING STUCK
Many stock traders inadvertently become investors and I know from per-
sonal experience one major way that this transformation occurs—in-
vestors also get stuck in stocks with bad performance in the same way.
That way is the lack of risk control or predefined risk points, especially
through always having a stop order for every stock owned or held short,
where a stock ends up being held at a substantial loss, for a prolonged pe-
riod, relative to the purchase price.
ATTITUDE TOWARD THE MARKET AND RISK CONTROL
Before I mention a few details of stop orders and short selling, I’ll first dis-
cuss risk. You may wonder why an introductory book on technical analysis
first talks about your trading philosophy and strategy as it relates to losing
money. You probably got this book to find out how to make money. The
reason why I go over the topic of risk and always having an exit strategy is
that not controlling losses is a killer of consistent profits in the market, re-
gardless of how skillful you become in your use of technical analysis. My
goal in using technical analysis is not only to be right in the market, but
also to profit from being right. And then to keep the lion’s share or as
much as possible of any prior realized, or current unrealized, gains and not
give them back due to market fluctuations.
If your attitude is that the market is a gamble and you are just rolling
the dice, you begin at a major disadvantage to the multitude of market pro-
fessionals who are in the market every day. It is true that the market is
more speculative than, say, the fixed income market and certainly more so
than money market instruments like U.S. Treasury bills. Market profes-
sionals do a better job of getting out of losing trades and investments or
they won’t last long in the profession—they, by necessity, have to minimize
the chance that their most precious commodity will be wiped out, which is
their trading or investing capital. There is an old market saying that the
small loss is the easy one. Here are seven trading rules related to how you
manage your trading strategy, capital, and risk.
1. Right entry—Buy early in a trend when a stock or index has initial
technical signals suggesting a trend is beginning, and don’t wait. Or
buy or sell short after a setback (reaction) to the trend that is under-
way, for example, when a stock comes back to natural technical
26
OUR TRADING OR INVESTING GAME PLAN
support or resistance points. Waiting and patience are the greatest
virtues in the market.
2. Determine an objective when you are thinking of buying or short-
ing a stock. This is important because (and it may seem strange) it’s
necessary to change your focus from how much you can make to
how much you are willing to lose. Set profit objectives—how much
we’re willing to risk or lose is defined in relation to how much we
think the item could move in our favor, based on technical analysis
criteria, of course!
3. Do the math—If you set a stop (your risk point) equal to one-half
or one-third of what you hope to make, here is the calculation: On
a 2:1 reward to risk—we calculate entry only when we could make
$2 for every $1 risked—you could be stopped out or exited on one-
half of your trades and still make a substantial gain, minus commis-
sions, as long as the other transactions achieve your profit
objectives on average.
In 10 transactions on a 2:1 risk/reward basis and where a loss is
taken 5 times and a gain 5 times, but the average profit is double
the average loss, the net result is that total profits are double total
losses. However, then also assume that 1 or 2 losses get away from
us. We decide to watch and see what happens—it’s not apparent
why the stock, for example, is not performing. We hope the setback
is temporary—but the stock ends up losing more than several ear-
lier winning transactions. This then upsets the profit equation and
we quickly are at break even or down substantially from where we
started.
4. Physically place the stop—Many investors don’t actually enter
stops, preferring to take a wait and see attitude. After all, they are
in this for the long haul. But think of all the surprises that occur in
companies and their competitive positions in the marketplace.
Traders are afraid of stops being hit or activated, only to see the
stock go back up. The underlying problem with both of these atti-
tudes is related to stock trading tip number 1: Select an entry at an
optimal point, where there is an effective place (either under sup-
port or above resistance) to place a liquidating stop order that is
both not likely to get hit and is relatively small in relation to your
entry price. With mutual funds, it’s suggested you set mental stops,
however wide, and adhere to them by liquidation when the loss
point is exceeded.
ATTITUDE TOWARD THE MARKET AND RISK CONTROL
27
5. Use trailing stops—Sell stops protect a long position or initial pur-
chase and buy stop orders protect a short position. Canceling and
re-establishing stop orders as needed so that they trail along with
the ongoing price trend requires some work and diligence as you
need to periodically raise or lower your stop orders. This insures
that your stops can reflect what is a moving target—the point at
which a trend reversal has begun. As things move in your favor, this
process first gets your liquidating stop order to a break-even point,
where you would have no loss if you exit. Assuming a further fa-
vorable trend, you can next begin to lock in some of that profit you
had projected.
For example, when you are in a stock that reaches your price tar-
get, the question arises whether to sell at your preset objective—a
question without a set answer. If a price objective is based on the
fulfillment of an objective implied by a chart pattern, then comple-
tion of the objective may remove the reason you had to take the
trade. In other instances, I view initial projections as minimum
hoped-for objectives within a trend. I also like to stay with, and in,
a favorable trend. Once the price has passed a hoped-for objective,
simply be vigilant to the trend reversing and protect as much profit,
by use of a stop, as is warranted by technical considerations, as we
are going to study in the chapters ahead.
6. Be willing to get out or get back in—As soon as the reasons for be-
ing in a position or in a trade are no longer present, it is best to exit.
You may have bought a stock because it was in a strong uptrend.
You purchased it right, the stock went up, and now you have a
probable break-even situation due to moving a stop up to your en-
try point. However, the stock then goes into a sideways trend and
basically moves laterally for many weeks. If you got into the stock
because of its having a strong uptrend or the expectation of one,
now may be the time to exit. The reasons you bought the stock are
no longer present, particularly if the overall market continues to
trend higher.
Let’s examine further the case of a stock that goes against you.
The object is to never let a loss get out of control, not to forget
about or get negative on the stock(s) in which you were and may
still be, interested in. If you get stopped out of such a stock and the
countertrend runs its course, with the stock then resuming its prior
trend, a repurchase may be warranted. But again, use favorable
28
OUR TRADING OR INVESTING GAME PLAN
risk-to-reward criteria: If you risk to a point where liquidation
would result in losing 10 percent of the money invested, but upside
potential is calculated for at least 20 percent or more, and enough
of these transactions average out this way over time, the result is a
substantial overall profit.
7. Stick to your game plan or strategy and to sound money manage-
ment rules—If you are successful in business or whatever profession
you are in, you have probably had a particular plan or methodol-
ogy you adhered to. You didn’t change the plan when it didn’t pro-
duce results right away or even for a prolonged period, assuming
you were following time-tested practices. Setbacks are part of this
and of stock market investing. Time and patience are required. You
can’t force a business, or the market, to do what you want it to.
You have to be sufficiently capitalized also. In investing or
trading, just like in business, you need to have sufficient reserves
to stay in business. In the same way, don’t commit all of your in-
vestment or trading money to the market. I suggest keeping one-
third to one-half in reserve, the larger figure when you’re in more
speculative markets or stocks. If your losses are more than you
anticipate as you gain experience, that experience you gain will
be of no use to you if you are out of the market due to lack of
money to invest. As well, some people will get very aggressive
and not only be 100 percent invested but buy on margin or bor-
rowed money. I have seen many people lose considerable
amounts in the end, even after having substantial profits at one
time, because they were on margin and didn’t having staying
power because of it—this is the well-known forced margin selling
situation. The market might come back in your favor, but you
can no longer profit from it.
I also suggest reducing the size of your position if the market
turns difficult and gets into turmoil. It would be best to not be in
only one or two sectors of the market. I love tech stocks myself, but
also find a lot to like in health care and drug stocks, for example, as
they reflect another dominant and earnings-favorable investment
theme, that of an aging population. If you like a stock, you don’t
have to buy all that you would hope to buy initially. See how it be-
haves. If it looks good, buy some more after the first setback, and
see how it behaves after that. If the item resists going down further,
an eventual rally may develop.
ATTITUDE TOWARD THE MARKET AND RISK CONTROL
29
There was the story told by Jesse Livermore of a great stock tip he gave
to a veteran stock investor. Instead of doing what Livermore expected, this
man promptly sold some of the stock and Livermore protested that this
was hardly what he expected from this gift of information. The potential
investor calmly watched the stock tape for a time. Finally, he began buying
a substantial amount of the stock, saying to the young Jesse Livermore that
he had first wanted to see how the stock behaved when he sold some. If it
was being accumulated by a well-funded group of investors, any selling
would be absorbed easily, and it was. His test was how the stock did when
there was some selling against it. This is a good lesson, and also reflects go-
ing against the obvious and expected behavior.
Jack Schwager, in the Wizard Lessons summary chapter from his book,
Stock Market Wizards, found many common traits in his group of super-
successful money mangers and speculators. I’ll mention some of these
lessons that reinforce what my own experience has shown. A universal
trait, regardless of the method used to select stocks, was that individuals in
this group had effective trading strategies and stuck to a game plan that ac-
counted for all possibilities. They would assume that everything that could
go wrong would go wrong—it’s all downhill after that. Great traders and
money managers are marked by their flexibility. They were willing to see
their pet ideas and theories proven wrong and change accordingly. This in-
cludes never falling in love with a stock. Save that for your spouse. It also
takes time to become successful. Don’t give up.
Something I’ve discussed and Jack puts very well about his supersuccess-
ful market professionals, is the role of hard work. Ironically, many people
are drawn to the markets because it seems like an easy way to make a lot of
money. Wrong! This group is, as was my own market wizard mentor, Mark
Weinstein, extremely hard working—he, like most other big market winners,
has a major passion for the market. Have a little passion and carve out a few
hours a week from your busy lives, if you want a moderate success potential!
Last, all the very successful market participants that I’ve known are
constantly, and I do mean constantly, concerned with avoiding loss and
with how they manage their trading capital. The professionals believe that
one of the most common mistakes made by novices is to expend great en-
ergy on finding the big potential winning stocks and a good entry price.
They spend comparatively little time on preventing and controlling losses
as time goes on. This point also goes back to the work ethic that is re-
quired, to frequently assess and reassess your strategy and assumptions
you may have made that could be wrong. Think about when to get out and
keep thinking about it until you are out.
30
OUR TRADING OR INVESTING GAME PLAN
I have congratulated myself many times on getting in at the right time
on a stock, for example, only to go to sleep, so to speak, and miss seeing
the point at which upward or downward momentum slowed and then
stopped. By the time the reversal was well underway, I was still hanging
on because of having suspended my ongoing evaluation. I then missed the
profit potential that was to be had. I expended good effort to research
and find the trade but then wanted the work part to be over. This is a
common fallacy and situation. I can only suggest that you remember
when this happens to you so that you can correct it once experience has
shown you this lesson.
All the above lessons and points have the common ground of being led
astray by the great dual enemies of fear and greed. Greed is what drives
many of the initial mistakes. We don’t expect to get rich quickly in most
businesses and professions. Yet somehow when we see a stock make a huge
move, we start to imagine finding just that kind of stock next. This tends to
lead to haste in selection, or bad timing because we don’t wait for those
special situations, as well as overcommitment of capital to the big hoped-
for winner. Fear comes mostly from letting losses get out of control and
overtrading. There used to be a saying among traders to “sell down to a
sleeping level.” If you are so worried about your losses, actual or imagined,
then reduce the size of your holding. I have sold stocks that I was sitting
with at a loss, thinking I had no choice but to hope for the stock price to
rebound. But by taking the loss and then being careful to select and closely
monitor some other stock or stocks that looked promising, I started in-
creasing the value of my portfolio again. And perhaps as important, I
found a renewed interest in the market. And renewed commitment to not
make the same mistake or mistakes I made before.
STOP ORDERS
A stop order is a suspended market order (to sell at the best price at that
moment) that is triggered when the stock or other item trades at or
through that price. For example, a market closed at 10.5, but opens at 9,
and our stop is at 10—the item will be sold at 9 or the best price that can
be obtained. A sell stop order, which is the most common stop, is placed
under the current market price. A buy stop order is the reverse of the sell
stop, in that it is a suspended buy order that is placed above the current
market price. Its purpose is usually to cover or offset a short position. How-
ever, the buy stop order can also be used to initiate a new long position.
STOP ORDERS
31
Such an order might be part of a technical trading strategy, because you
wish to buy if the price exceeds the high end of a recent trading range or the
stock breaks out above a trendline. A sell stop order would not be used to
initiate a new short position in stocks because of the rule allowing a short
position only on an up tick, whereas it could be used in the futures markets.
Good Til Canceled (GTC) stop orders are not always actually until
canceled in practice. Most brokers will have a time limit in which the or-
der is effective, for example, a couple of months, which they inform you
of. In an active market, you may have canceled and replaced the order one
or more times during this period, but otherwise it’s important to keep
track not only of what stop orders you have in place, but of how long they
are effective.
SHORT SELLING
Selling short is a very underused trading strategy by the investing and
trading public. Keeping aside the tax consideration that any resulting
profit will never be long term in nature, shorting is something you may
want to consider as part of your market strategy. One reason is that half
of all possible trading opportunities in an average year, are the result of
price declines or downswings. The other very good reason is that profits
can come very quickly, due to the fact that when support for a stock or
other market crumbles, the imbalance of selling drives the item down with
little resistance.
Short selling in stocks means simply that you are borrowing the partic-
ular stock from your broker, which is owned by someone else. Chances are
the broker has the stock in house, being held by someone in their account.
Or the broker will borrow the stock from another institution, for a small
fee, in order to lend it to you in a short sale. You owe the broker the stock
and you anticipate or hope to buy it back at a lower price and thereby off-
set your obligation to replace the stock. The gain or loss is calculated like a
purchase and sale, as the difference between the two prices. If you sell
XYZ short at $25 and buy it back the following month at $20, your net
gain is $5. If you buy it back at $30, you will have a loss of $5.
In stocks, you must sell short on an up tick—the stock can only be
shorted if the traded price represents a value that is above the immediately
preceding transaction in the stock. You must also have a margin account,
as opposed to a cash account, in order to affect a short sale. Other than
these considerations, the short sale is a relatively easy transaction to make,
32
OUR TRADING OR INVESTING GAME PLAN
especially in actively traded stocks where the stock can be readily bor-
rowed from your brokerage firm. In futures and some other markets, there
is no rule to prevent selling short when prices are declining. This fact alone
tends to make these markets more volatile.
Stocks and many other markets fall generally much faster than they
rise. When fear sets in, the resulting worry and panic causes action on a
much-compressed timescale, whereas buying may have occurred over a
long period. By and large, most institutional holders of stocks representing
you and me in our mutual fund holdings, as well as you and me as individ-
ual investors, are long, or owners of stocks. So there is a mountain of sell-
ing that can occur when a company is adversely affected in its earnings or
by other news. You can see how relatively easy it could be to go with this
avalanche and profit from the fall. Back in Figure 2.3, a weekly chart of In-
tel Corporation (INTC), the fluctuations in the stock are seen from late
1998 into early 2001. The stock took 23 months to go from just under
$19, in early September 1998, to its closing peak at $74.87 in late August
2000. After that, a steep break in the stock down to the $23 area occurred
over just 7 months—during that timeframe, the stock dropped approxi-
mately $40 in one 27-day trading period!
SUMMARY
Technical analysis is an outcome of attempts to better understand the dy-
namics of market movements and trends. Its overarching purpose has been
to enable more accurate investment decisions and investment advice. How-
ever, making profitable use of this form of analysis has proven to require
something that comes before and along with mere accuracy in identifying
the dominant trend in effect, movements within that trend, and prediction
of trend reversals. The other major component to success with technical
analysis involves other elements—in the broadest sense, profiting from
technical analysis also requires (1) adopting a style of investing or trading
that best suits the individual’s temperament and abilities and (2) effective
risk management.
1. Adopting a style of investing and trading that best suits the individ-
ual means determining and defining such things as how much to
commit to the market, whether the objective is long-term capital ap-
preciation or shorter-term speculation, and so on. Whether commit-
ting for the long term or shorter term, it’s crucial to have patience
SUMMARY
33
and not exit just because there is no immediate success. Under-staying
can be as much of a problem as over-staying. Let your liquidating stop
take you out of the market or item in question—otherwise, there can
be many occasions when you see your price objectives met, but with-
out your participation. Don’t do short-term trading unless you have a
definite ability to be successful in it, as proven by your profit and loss
statement—otherwise, be an investor.
2. Effective risk management means determining risk-to-reward para-
meters, investing or trading only amounts of money that are appro-
priate to the total you have to work with and, most importantly,
using stop orders that are in place at the outset and kept in place.
This area of focus also includes being willing to exit the market if,
and as soon as, you determine that a market position is no longer
valid. Flexibility is a key ingredient of ultimate success.
We could add that ongoing assessment of your portfolio or trading is
important. For example, you buy in a strong bull market, the trend
continues, and everything goes well. However, every entry decision
also means being alert about when to exit if you want to retain the
maximum extent of the gains that a market has given you. And, as
the old saying goes, “Never confuse brains with a bull market.”
In the following chapter we look at origins, and hence some of the ra-
tionale, of technical analysis. We begin with Charles Dow, the creator not
only of the Dow averages, but of the very idea of a market average.
34
OUR TRADING OR INVESTING GAME PLAN
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3
CHARLES DOW AND THE
UNDERLYING PRINCIPLES
OF MARKET BEHAVIOR
INTRODUCTION
There is a tendency to think that every important bull market is driven by
some new dynamic, and that perhaps this latest megabull market is immune
to the cyclical nature of financial markets. It is true that technology continues
to compress time, so to speak, and provides more goods and services faster
than ever before. However, human nature has not changed nor have the
workings of human behavior across markets. Nowhere is this clearer than in
the fact that the work of the pioneers of technical analysis date to the 1700s
and 1800s and remain foundations of accurate market predictions in the new
millennium. In the 1800s this was the seminal work of Charles Dow in this
country and, in the 1700s, the observations of one of the greatest of Japanese
rice traders, Munehisa Homma, who formulated the rules that govern the use
of candlestick charts, now in widespread use in the West.
CHARLES DOW
In this country, the originator of what became technical analysis is Charles
H. Dow, the late 1880s cofounder of Dow Jones & Co. and its flagship
35
newspaper, the Wall Street Journal. Charles Dow was born in 1851 in Con-
necticut and had the image of what is sometimes associated with a New
England type of personality—sober, industrious, and rather serious minded.
He was a reporter and editor most of his life, which ended in 1902. In his
starting out years he worked for the famous newspaper man Samuel
Bowles, who had the distinction of demanding that a reporter put it all in
the first sentence of a news story—who, what, when, where, and why—a
widely used practice today in journalism, including Internet news stories.
Charles Dow’s market observations, as presented in a series of Wall
Street Journal editorials, were highly original and insightful. I find them a
worthwhile inclusion even in this introductory book on technical analysis,
because it helps understand the practical underlying rationale for technical
analysis—a descriptive term unknown in Dow’s day.
Also occurring in the 1880s and 1890s was Charles Dow’s formulation
of the first stock market averages, which became, over time, the Dow Jones
30 Industrial, 20 Transportation and 15 Utility stock averages known to-
day. I tend to call the 30 Dow Industrial stocks, the Dow 30 as these stocks
have become more technological, manufacturing, and service oriented and
less industrial, unlike the case of the heavy industry stocks like U.S. Steel
that were part of the early Dow Industrial average. Today, common par-
lance is the Dow, the Dow Jones or the Dow 30 stock average. This average
of 30 stocks is not capitalization weighted, as is the case of the Standard &
Poor’s 500 or Nasdaq Composite indexes. Dow stocks of companies that
have become price laggards, even if they’re much smaller than, for example,
General Electric, will have a dragging effect in the equal weighted Dow 30
average, unlike indexes that give more weight to larger companies—by the
way, only GE was an original member of this average and still is.
Only the Dow Industrials and Dow Transportation (then a group of
railroad stocks) averages are used in what became known as “Dow the-
ory.” Charles Dow never called the market principles he wrote about “a
theory,” only observations on how the economy and the market func-
tioned. Charles Dow’s principles were later discussed in a book by the
Wall Street Journal editor succeeding Dow, William Hamilton, that was
called The Wall Street Barometer. Robert Rhea is credited with distilling
the ideas of Dow further and wrote a book in the early 1930s called
Dow Theory.
This background given, I will describe the basic tenets of Charles Dow
and discuss their continued present-day relevance. Robert Edwards and
John Magee, who wrote what many consider to be the bible of technical
analysis, The Technical Analysis of Stock Trends, popularized the descrip-
36
CHARLES DOW AND MARKET BEHAVIOR
tion and analogy of market trends to “tides, waves, and ripples,” although
these terms did not originate with them.
THE MARKET DISCOUNTS EVERYTHING
Dow determined which stocks, using them to make up his averages, best
represented the overall market. He believed that every possible fact and
factor relating to the price of a stock within his averages was quickly
priced into the current traded price of that stock and hence into the aver-
ages. Down saw that the traded price reflected all knowledge that existed
about a company and its current and future prospects, in terms of its earn-
ings power. Even so-called insider information will show up in the price
and volume patterns that can be seen by astute observers of the trading in
that stock. This group will in turn act on that information and that activity
will become apparent to an ever-widening group. This principle is even
truer today, given the extremely rapid and widespread distribution of in-
formation that occurs on the financial channels and on the Internet.
CYCLES OF BULL AND BEAR MARKETS
HAVE THE SAME REOCCURRING PHASES
The point to emphasize here is that the phases of both bull and bear mar-
kets, while different depending on whether it’s a bull market or a bear mar-
ket, are similar in terms of two factors:
❙ Relative knowledge about the market
❙ Investor sentiment (attitude) about the market that ranges from dis-
interested to indifferent to interested, with varying degrees of inten-
sity within disinterested and interested
Bull Markets
A bull market, named for the animal that charges ahead, comes after a
lengthy and substantial decline in stock values that comes about due to a
downturn in the economy or a recession. Major market advances are usu-
ally, but not always, divided into three phases. These phases are marked by
who participates in them and what they are doing in each phase.
CYCLES OF BULL AND BEAR MARKETS
37
1. Accumulation Phase. In the first phase of a bull market, there is
accumulation of stocks or buying over a period of time, during
which very knowledgeable investors with good foresight about a
coming business upturn, begin buying stocks offered by pessimistic
sellers who want out. This group of knowledgeable buyers will
also start to pay higher prices as the willing sellers exit. The econ-
omy and business conditions are still often quite negative. The
public, and this is mirrored by the financial press, is quite disinter-
ested in the market, to the point of where owning stocks is very un-
attractive to them and they are out of the market. The people who
lost money in the last bear market are actively disgusted with the
market. Market activity is modest at best but is picking up a bit on
rallies, but this is mostly only noticed, if at all, by professional
market participants.
2. A Steady Climb. The second phase is one of a fairly steady advance,
but one that is not dramatic. There is a pickup in business and en-
couraging economic reports as an improving economy leads to a
pickup in corporate earnings. This phase is also a period where
money can be made relatively safely, as technical indicators turn
positive and there is an absence of volatile trading swings.
3. Main Street Adopts Wall Street. The third phase, which at one and
the same time can be both highly profitable and ultimately risky, is
marked by heavy public interest and participation in the market.
The economic news is good during this period, and suddenly, front
pages of magazines have articles heralding the new bull market.
The new stock issue market gets going as the public now has an ap-
petite for new companies. This is the phase where you will hear
banter at parties about the stock market, how well so-and-so is do-
ing in stocks and where, today, market-related Internet chat rooms
are quite active. Price advances can be huge and volume is equally
large. The more speculative stocks continue to advance but it is here
that the blue chip stocks of the most established big-name compa-
nies start to lag the overall market. Some sharp downswings occur
among stocks that fall out of favor. Speculation is intense as seen in
increased option activity, the first-day closes of hot new issues and
in the level of buying stocks on margin. The end of this phase is al-
ways the same, varying degrees of collapse. This can come after a
year or two or even after several years have passed from the begin-
ning phase.
38
CHARLES DOW AND MARKET BEHAVIOR
Bear Markets
This animal analogy is quite apt, as the bear can be both very fierce and
unforgiving or can just go to sleep for a long period. Bear markets can usu-
ally also be divided into three phases. That this does not always occur is
seen in the 1987 bear market that was sharp and steep, but with the de-
cline only lasting two months. After that, there was a slow gradual process
of advancing prices during which there remained significant bearish senti-
ment and the public tended to stay out of the market. This phase didn’t
reach the typical bearish price extremes, however, as within 7–10 months
the Dow had recovered nearly half of its October–November decline.
1. Distribution Phase. The first phase of a primary bear market tends
to be a period of distribution of stocks. This period begins in the fi-
nal phases of the bull market. It is the phase where selling begins
with the same type of experienced investors that didn’t get overly
swept up in the extremes in emotion and paying high prices. This
group has sufficient market knowledge to understand that company
earnings and profits have probably reached their peak and that the
price multiples paid (the P/E ratios) for those earnings are also at ex-
treme levels. They begin to sell or distribute stocks to the still eager
and willing buyers. Volume of trading begins to slow. The public is
still in the market heavily but begins getting frustrated as the rate of
price increase slows down and not all stocks participate in rallies.
The distribution phase is also one where people who are not
usually in the market become buyers of stocks. A friend of mine
who had always invested only in real estate told me near the 2000
market top, that he had decided to buy some stocks, but had mod-
est expectations as he “only” expected or wanted to make 20 per-
cent on his money. This kind of expectation for stocks that
historically return 10 percent on average and had already been go-
ing up sharply for months, was the final telling event that got me
out of the market. I had noticed the froth, that the volume was
slipping and profits harder to come by, but my friend’s actions and
comment was my shoe shine boy event—referring to the famous
story of Bernard Baruch, who one day got a stock tip from the fel-
low who shined his shoes. After this, Baruch went and sold his
holdings, saying that when shoe shine boys give him stock tips,
this was the time to sell. I was struck by a similar occurrence in
2000 at Cantor Fitzgerald, a large institutional broker, where I
CYCLES OF BULL AND BEAR MARKETS
39