, isdesigned for the layman, the business or professional man who cannot spendall his hours on his investing or trading operations, but to whom theseoperations are, nevertheless, of sufficient importance or interest to warranthis devoting at least a few minutes a day to their study and management.(EN9: In retropsect an underestimation of the importance of the work. In the 21stcentury the best professionals are acutely aware of the importance of trend analysisand use this work as their text book.) The theories and methods outlined hereinwill require only the simplest form of stock chart — a record of the pricerange (high and low), closing price, and volume of shares traded each day.These daily graphs will be supplemented, for certain purposes which willbe discussed farther on, by weekly or monthly charts, which for most stockscan be purchased ready-made and which are easily generated by almost allcommercially available investment software.Nearly all the illustrations throughout the following pages are examplesof such daily charts. They are easy to make and maintain manually, requiringonly a supply of graph or cross-section paper (almost any kind can serve),a daily newspaper which gives full and accurate reports on stock exchange9
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Technical Analysis of Stock Trends
dealings, a sharp pencil, and a few minutes of time. EN: Alternatively, numerous data services are available for use with computer software packages, not tomention Internet sites (which are mentioned in Resources). The use of this technology eliminates the burden of manual chart keeping altogether. If there is a drawbackto this technology it might be in the loss of the “feel” the investor gets throughmanual charting.It is customary in preparing ordinary daily stock charts to let the horizontal axis represent time, with the vertical cross-lines (or as some prefer,the spaces between them) from left to right thus standing for successive days.The vertical scale is used for prices, with each horizontal cross-line thenrepresenting a specific price level. Space is usually provided at the bottomof the sheet to plot volume, i.e., the number of shares which change handseach day. The newspapers publishing complete stock market reports givethe day’s turnover or volume (exclusive of odd-lot transactions which mayfor our present purpose be disregarded), the highest and lowest price atwhich each stock sold during the day, the closing price (which is the priceat which the last sale effected during the day was made), and usually theopening or first sale price. On our charts, the daily price range is plotted bydrawing a vertical line connecting the points representing the high and thelow. Then a short horizontal “tick” is added, either crossing the vertical rangeline or extending out to the right from it, at the level of the closing price.Sometimes all transactions in a stock during a day take place at one and thesame price; the high, low, and close are thus all on a level and the only markon our chart will then be the horizontal dash representing the closing figure.Volume is depicted by drawing a vertical line up from the base line of thechart.The opening price need not be recorded.* Experience has shown that itseldom, if ever, has any significance in estimating future developments,which is all that ordinarily should interest us. The closing price is important,however. It is, in fact, the only price which many casual readers of thefinancial pages ever look at. It represents the final evaluation of the stockmade by the market during the day. It may, of course, be registered in thefirst hour of trading, provided no other sales are subsequently effected, but,it becomes, nevertheless, the figure upon which a majority of prospectivetraders base their plans for the following day. Hence, its technical significance, which will appear in various contexts in later chapters.
Different Types of ScalesMany specific suggestions as to the details of charting are deferred fordiscussion in the second section of this book, but there is one chart featurewhich may well be considered here. Until recent years, nearly all stock price* EN: Edwards considered the opening price unimportant. Some technicians, myself included, do observeit to be of use. And in some charting systems it is indispensable, for example, candlestick charting whereit is accorded enormous importance.
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Chapter two:
Charts
11
charts were kept on the common form of graph paper ruled to what is knownas plain or arithmetic scale. But more and more chartists have now come touse what is known as semilogarithmic paper, or sometimes as ratio or percentage paper. Our own experience indicates that the semilogarithmic scalehas definite advantages in this work; most of the charts reproduced in thisbook employ it. The two types of scale may be distinguished at a glance bythe fact that on arithmetic paper, equal distances on the vertical scale (i.e.,between horizontal lines) represent equal amounts in dollars, whereas onthe semilogarithmic paper, they represent equal percentage changes. Thus,on arithmetic paper the distance between 10 and 20 on the vertical scale isexactly the same as that from 20 to 30 and from 30 to 40. On the logarithmicscale the difference from 10 to 20, representing an increase of 100%, is thesame as that from 20 to 40 or from 40 to 80, in each case representing another100% increase.Percentage relations, it goes without saying, are important in trading insecurities. The semilogarithmic scale permits direct comparison of high- andlow-priced stocks and makes it easier to choose the one offering the greater(percentage) profit on the funds to be invested. It facilitates the placing ofstop-loss orders. Area patterns appear much the same on either type of paperbut certain trendlines develop more advantageously on the ratio scale.Almost anyone can quickly become accustomed to making entries on semilogarithmic paper. We recommend its use. However, its advantages are notso great as to require one to change, one who, because of long familiarityand practice, prefers an arithmetic sheet. Such percentage calculations, asmay seem to be required, can, after all, be made on another sheet or in thehead and the results then entered on the arithmetic chart if a record is desired.Several firms specializing in the manufacture of graph paper and otherengineers’ and architects’ supplies now offer sheets specifically designed forstock charting, on which heavier lines to define the business week mark eachsixth day on the time scale, and the price scale is subdivided into eighths torepresent the standard fractions of the dollar in which stocks are traded onall American exchanges. (EN9: Eighths went the way of the New Haven and nowdecimals reign.) These sheets are available in various sizes and with eitherarithmetic or logarithmic price and volume scales. EN: This paper of course isonly of interest to the manual chartist, as modern software, as detailed in AppendixD on Resources, enables the computer chartist to easily switch between price scalesand methods of charting. References to such paper are also found there.On weekly charts, each vertical line represents a week’s trading. Theprice range for the week is plotted thereon and usually the total volume, butthe closing price may or may not be omitted. The range extends, of course,from the highest price at which the stock sold on any day during the weekto the lowest price at which it sold on any day; these two extremes might,and sometimes do, occur on the same day, but the weekly chart makes nodistinction as to day. Monthly charts are prepared in the same way but donot, as a rule, record volume. These two — often referred to as long-term ormajor charts — are used chiefly for determining important Support and
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Resistance Levels and marking long-term trends. Weekly charts — if thereader prefers to keep his own — can be posted easily from the Sundaymorning editions of those daily newspapers (e.g., The New York Times orBarron’s Business and Financial Weekly) that publish a summary of the previousweek’s transactions.In concluding this chapter on the construction of the charts that we shallstudy in succeeding chapters, it can well be said that there is no specialvirtue, certainly no magic, in the chart itself. It is simply a pictorial recordof the trading history of the stock or stocks in which we may be interested.To the man possessed of a photographic memory, no chart work is necessary;his mind records all the necessary data — he carries his charts in his head.Many of the expert “tape-readers” who have no use for charts are giftedwith that rare memory talent which renders reference to graphic recordsunnecessary. But most of us are not so blessed; to use the chart is necessaryand useful because it lends itself conveniently to the type of analysis whichindicates future probabilities.There is a saying on Wall Street to the effect that “there is nothing wrongwith charts — the trouble is with the chartists,” which is simply anotherway of expressing the truth that it is not the chart itself but its interpretationthat is important. Chart analysis is certainly neither easy nor foolproof. Yet,it is not at all uncommon for some casual investor who has no idea whateverof market technics to pick up a chart by chance and see in it something whichhe had not hitherto suspected, something perhaps which saves him frommaking an unfavorable commitment.If you have never used stock charts, never paid much attention to them,you may be surprised at some of the significant things you will quicklydetect as soon as you begin to study them seriously.EN9: Surprise and astonishment are the words to describe the reactions of evenprofessionals when they are fully exposed to a coherent presentation of the methodsof Edwards and Magee. I have often commented that no understanding of other(non-chart) methods of technical analysis is possible without a firm grasp of theconcepts and principles of this book.Some other comments are worth noting relevant to Edwards’ discussion above.For manual charting semi-log remains the superior scale. Given the ease of changingscale and time frames on Internet sites (e.g., prophet.net and stockcharts.com) andin the stand alone software one may switch from a close up of a month to a longrange perspective of years. In this process it is important to maintain perspective.Multiyear log charts of large ranges lose graphic importance at the top as chartintervals shrink. This distortion must be countered by breaking the time frame intosmaller increments. So instead of 5 years of a chart which spans a range of 10 to200 we look at five charts of a year each as well as the 5-year chart.
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chapter three
The Dow TheoryThe Dow Theory is the granddaddy of all technical market studies. Althoughit is frequently criticized for being “too late,” and occasionally derided (particularly in the early stages of a Bear Market) by those who rebel at acceptingits verdicts, it is known by name to nearly everyone who has had anyassociation with the stock market, and respected by most. Many who heedit in greater or lesser degree in determining their investment policies neverrealize that it is purely and simply “technical.” It is built upon and concernedwith nothing but the action of the stock market itself (as expressed in certain“averages”), deriving nothing from the business statistics on which the fundamentalists depend.There is much in the writings of its original promulgator, Charles H.Dow, to suggest that he did not think of his “theory” as a device for forecasting the stock market, or even as a guide for investors, but rather as abarometer of general business trends. Dow founded the Dow–Jones FinancialNews Service and is credited with the invention of stock market averages.The basic principles of the theory, which was later named after him, wereoutlined by him in editorials he wrote for The Wall Street Journal. Upon hisdeath in 1902 his successor, as editor of the Journal, William P. Hamilton,took up Dow’s principles and, in the course of 27 years of writing on thestock market, organized them and formulated them into the Dow Theory aswe know it today.Before we proceed to an explanation of the theory itself, it will be necessary to examine the stock averages which it employs. Long before the timeof Dow, the fact was familiar to bankers and businessmen that the securitiesof most established companies tended to go up or down in price together.Exceptions — stocks that moved against the general financial tide — wererare, nor did they as a rule persevere in that contrary course for more thana few days or weeks at a time. It is true that when a boom was on, the pricesof some issues rose faster and farther than others, and when the trend wastoward depression, some stocks declined rapidly while others would put upconsiderable resistance to the forces that were dragging the market down,but the fact remained that most securities tended to swing together. (Theystill do, needless to say, and always will.)
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This fact, as we have said, has long been commonly known andaccepted — so completely taken for granted that its importance is usuallyoverlooked. For it is important — tremendously important from many anglesin addition to those which come within the province of this volume. One ofthe best of all reasons for a student of market technics to start with the DowTheory is because that theory stresses the general market trend.Charles Dow is believed to have been the first to make a thorough effortto express the general trend (or, more correctly, level) of the securities marketin terms of the average price of a selected few representative stocks. As finallyset up in January of 1897, in the form which has continued to date, and usedby Dow in his studies of market trends, there were two Dow–Jones Averages.One was composed of the stocks of 20 railroad companies only, for therailroads were the dominant corporate enterprises of his day. The other,called the Industrial Average, represented all other types of business, andwas made up, at first, of only 12 issues. This number was increased to 20 in1916 and to 30 on October 1, 1928.
The Dow AveragesThe stocks included in these two Averages have been changed from time totime in order to keep the lists up to date and as nearly representative aspossible of their respective groups. Only General Electric, of the present30 industrial stocks, was included in the original Industrial Average, andthat was dropped at one time (in 1898) and subsequently reinserted. In 1929,all stocks of public utility companies were dropped from the IndustrialAverage and a new Utility Average of 20 issues was set up; in 1938 its numberwas reduced to 15. The 20 rail, 30 industrial, and 15 utility stocks are nowaveraged together to make what is known as the Dow–Jones Stock Composite. The history of these Averages, the various adjustments that have beenmade in them and their method of computation, is an interesting story initself which the reader may want to look up elsewhere. EN: Cf. Resources forreferences. Note also that there is now a proliferation of Dow–Jones Averages. Forour present purpose, it remains only to add that the Dow Theory pays noattention to the Utility or Composite Averages; its interpretations are basedon the Rail and Industrial Averages only. EN: “Rails” now known as “Transportation.”In recent years, the values of the Dow–Jones Averages have been computed for the end of each hour of trading as well as the end of the day.EN: Now computed in real time and available over the Internet. These hourly figuresare published in The Wall Street Journal as well as on all market tickers. In factpresently the Averages are computed in real time, a necessity for options and futurestrading which takes place based on them. The Wall Street Journal also prints ineach issue a summary of the important highs and lows of each average bydate for the preceding two or three years. Their daily closing prices arereported in many other metropolitan daily newspapers.
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Chapter three:
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Basic TenetsTo get back to the Dow Theory itself here are its basic tenets:1. The Averages Discount Everything (except “Acts of God”) — Because they reflect the combined market activities of thousands ofinvestors, including those possessed of the greatest foresight and thebest information on trends and events, the Averages in theirday-to-day fluctuations discount everything known, everything foreseeable, and every condition which can affect the supply of or thedemand for corporate securities. Even unpredictable natural calamities, when they happen, are quickly appraised and their possibleeffects discounted.2. The Three Trends — The “market,” meaning the price of stocks ingeneral, swings in trends, of which the most important are its Majoror Primary Trends. These are the extensive up or down movementswhich usually last for a year or more and result in general appreciation or depreciation in value of more than 20%. Movements in thedirection of the Primary Trend are interrupted at intervals by Secondary Swings in the opposite direction — reactions or “corrections” thatoccur when the Primary Move has temporarily “gotten ahead ofitself.” (Both Secondaries and the intervening segments of the Primary Trend are frequently lumped together as Intermediate Movements — a term which we shall find useful in subsequent discussions.) Finally, the Secondary Trends are composed of Minor Trendsor day-to-day fluctuations which are unimportant to Dow Theory.3. The Primary Trends — These, as aforesaid, are the broad, overall,up and down movements which usually (but not invariably) last formore than a year and may run for several years. So long as eachsuccessive rally (price advance) reaches a higher level than the onebefore it, and each Secondary Reaction stops (i.e., the price trendreverses from down to up) at a higher level than the previous reaction, the Primary Trend is Up. This is called a Bull Market. Conversely,when each Intermediate Decline carries prices to successively lowerlevels and each intervening rally fails to bring them back up to thetop level of the preceding rally, the Primary Trend is Down and thatis called a Bear Market. (The terms Bull and Bear are frequently usedloosely with reference, respectively, to any sort of up or down movements, but we shall use them in this book only in connection withthe Major or Primary Movements of the market in the Dow sense.)Ordinarily — theoretically, at least — the Primary is the only one ofthe three trends with which the true long-term investor is concerned.His aim is to buy stocks as early as possible in a Bull Market — justas soon as he can be sure that one has started — and then hold themuntil (and only until) it becomes evident that it has ended and a Bear
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Technical Analysis of Stock TrendsMarket has started. He knows that he can safely disregard all theintervening Secondary Reactions and Minor Fluctuations. The trader,however, may well concern himself also with the Secondary Swings,and it will appear later on in this book that he can do so with profit.4. The Secondary Trends — These are the important reactions thatinterrupt the progress of prices in the Primary Direction. They arethe Intermediate Declines or “corrections” which occur during BullMarkets, the Intermediate Rallies or “recoveries” which occur in BearMarkets. Normally, they last for 3 weeks to many months, and rarelylonger. Normally, they retrace from one third to two thirds of thegain (or loss, as the case may be) in prices registered in the precedingswing in the Primary Direction. Thus, in a Bull Market, prices interms of the Industrial Average might rise steadily, or with only briefand minor interruptions, for a total gain of 30 (or 300) points beforea Secondary Correction occurred. That correction might then beexpected to produce a decline of not less than 10 points and not morethan 20 points before a new Intermediate Advance in the PrimaryBull Trend developed.Note, however, that the one third/two thirds rule is not anunbreakable law; it is simply a statement of probabilities. Most Secondaries are confined within these limits; many of them stop veryclose to the halfway mark, retracing 50% of the preceding PrimarySwing. They seldom run less than one third, but some of them cancelnearly all of it.Thus we have two criteria by which to recognize a SecondaryTrend. Any price movement contrary in direction to the PrimaryTrend that lasts for at least 3 weeks and retraces at least one third ofthe preceding net move in the Primary Direction (from the end ofthe preceding Secondary to the beginning of this one, disregardingMinor Fluctuations) is labeled as of Intermediate Rank, i.e., a trueSecondary. Despite these criteria, however, the Secondary Trend isoften confusing; its recognition, its correct appraisal at the time itdevelops and while it is in process, poses the Dow theorist’s mostdifficult problem. We shall have more to say about this later.5. The Minor Trends — These are the brief (rarely as long as 3 weeks —usually less than 6 days) fluctuations which are, so far as the DowTheory is concerned, meaningless in themselves, but which, in toto,make up the Intermediate Trends. Usually, but not always, an Intermediate Swing, whether a Secondary or the segment of a Primarybetween successive Secondaries, is made up of a series of three ormore distinguishable Minor Waves. Inferences drawn from theseday- to-day fluctuations are quite apt to be misleading. The MinorTrend is the only one of the three trends which can be “manipulated”(although it is, in fact, doubtful if under present conditions even thatcan be purposely manipulated to any important extent). Primary and
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Secondary Trends cannot be manipulated; it would strain the resources of the U.S. Treasury to do so.Right here, before we go on to state a sixth Dow tenet, we may well taketime out for a few minutes to clarify the concept of the three trends bydrawing an analogy between the movements of the stock market and themovements of the sea. The Major (Primary) Trends in stock prices are likethe tides. We can compare a Bull Market to an incoming or flood tide whichcarries the water farther and farther up the beach until finally it reacheshigh-water mark and begins to turn. Then follows the receding or ebb tide,comparable to a Bear Market. But all the time, during both ebb and flow ofthe tide, the waves are rolling in, breaking on the beach, and then receding.While the tide is rising, each succeeding wave pushes a little farther up ontothe shore and, as it recedes, does not carry the water quite so far back as didits predecessor. During the tidal ebb, each advancing wave falls a little shortof the mark set by the one before it, and each receding wave uncovers a littlemore of the beach. These waves are the Intermediate Trends, Primary orSecondary, depending on whether their movement is with or against thedirection of the tide. Meanwhile, the surface of the water is constantly agitated by wavelets, ripples, and “cat’s-paws” moving with or against or acrossthe trend of the waves — these are analogous to the market’s Minor Trends,its unimportant day-to-day fluctuations. The tide, the wave, and the ripplerepresent, respectively, the Primary or Major, the Secondary or Intermediate,and the Minor Trends of the market.
Tide, Wave, and RippleA shore dweller who had no tide table might set about determining thedirection of the tide by driving a stake in the beach at the highest pointreached by an incoming wave. Then if the next wave pushed the water upbeyond his stake he would know the tide was rising. If he shifted his stakewith the peak mark of each wave, a time would come when one wave wouldstop and start to recede short of his previous mark; then he would knowthat the tide had turned, had started to ebb. That, in effect (and muchsimplified), is what the Dow theorist does in defining the trend of the stockmarket.The comparison with tide, wave, and ripple has been used since theearliest days of the Dow Theory. It is even possible that the movements ofthe sea may have suggested the elements of the theory to Dow. But theanalogy cannot be pushed too far. The tides and waves of the stock marketare nothing like as regular as those of the ocean. Tables can be preparedyears in advance to predict accurately the time of every ebb and flow of thewaters, but no timetables are provided by the Dow Theory for the stockmarket. We may return to some points of this comparison later, but we mustproceed now to take up the remaining tenets and rules of the Theory.
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Major Trend Phases6. The Bull Market — Primary Uptrends are usually (but not invariably) divisible into three phases. The first is the phase of accumulationduring which farsighted investors, sensing that business, althoughnow depressed, is due to turn up, are willing to pick up all the sharesoffered by discouraged and distressed sellers, and to raise their bidsgradually as such selling diminishes in volume. Financial reports arestill bad — in fact, often at their worst — during this phase. The“public” is completely disgusted with the stock market — out of itentirely. Activity is only moderate but beginning to increase on therallies (Minor Advances).The second phase is one of fairly steady advance and increasingactivity as the improved tone of business and a rising trend in corporateearnings begin to attract attention. It is during this phase that the “technical” trader normally is able to reap his best harvest of profits.Finally, comes the third phase when the market boils with activityas the “public” flocks to the boardrooms. All the financial news isgood, price advances are spectacular and frequently “make the frontpage” of the daily papers, and new issues are brought out in increasing numbers. It is during this phase that one of your friends will callup and blithely remark, “Say, I see the market is going up. What’s agood buy?” — all oblivious to the fact that it has been going up forperhaps two years, has already gone up a long ways, and is nowreaching the stage where it might be more appropriate to ask, “What’sa good thing to sell?” In the last stage of this phase, with speculationrampant, volume continues to rise, but “air pockets” appear withincreasing frequency; the “cats and dogs” (low-priced stocks of noinvestment value) are whirled up, but more and more of thetop-grade issues refuse to follow.7. The Bear Market — Primary Downtrends are also usually (but again,not invariably) characterized by three phases. The first is the distributionperiod (which really starts in the later stages of the preceding BullMarket). During this phase, farsighted investors sense the fact thatbusiness earnings have reached an abnormal height and unload theirholdings at an increasing pace. Trading volume is still high, thoughtending to diminish on rallies, and the “public” is still active but beginning to show signs of frustration as hoped-for profits fade away.The second phase is the Panic Phase. Buyers begin to thin out andsellers become more urgent; the downward trend of prices suddenlyaccelerates into an almost vertical drop, while volume mounts toclimactic proportions. After the Panic Phase (which usually runs toofar relative to then-existing business conditions), there may be a fairlylong Secondary Recovery or a sideways movement, and then thethird phase begins.
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Chapter three:
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This is characterized by discouraged selling on the part of thoseinvestors who held on through the Panic or, perhaps, bought duringit because stocks looked cheap in comparison with prices which hadruled a few months earlier. The business news now begins to deteriorate. As the third phase proceeds, the downward movement is lessrapid, but is maintained by more and more distress selling from thosewho have to raise cash for other needs. The “cats and dogs” maylose practically all their previous Bull Advance in the first two phases.Better-grade stocks decline more gradually, because their ownerscling to them to the last. And, the final stage of a Bear Market, inconsequence, is frequently concentrated in such issues. The BearMarket ends when everything in the way of possible bad news, theworst to be expected, has been discounted, and it is usually overbefore all the bad news is “out.”The three Bear Market phases described in the preceding paragraph are not the same as those named by others who have discussedthis subject, but the writers of this study feel that they represent amore accurate and realistic division of the Primary down moves ofthe past 30 years. The reader should be warned, however, that notwo Bear Markets are exactly alike, and neither are any two BullMarkets. Some may lack one or another of the three typical phases.A few Major Advances have passed from the first to the third stagewith only a very brief and rapid intervening markup. A few shortBear Markets have developed no marked Panic Phase and othershave ended with it, as in April 1939. No time limits can be set forany phase; the third stage of a Bull Market, for example, the phaseof excited speculation and great public activity, may last for morethan a year or run out in a month or two. The Panic Phase of a BearMarket is usually exhausted in a very few weeks if not in days, butthe 1929 through 1932 decline was interspersed with at least fivePanic Waves of major proportions. Nevertheless, the typical characteristics of Primary Trends are well worth keeping in mind. If youknow the symptoms which normally accompany the last stage of aBull Market, for example, you are less likely to be deluded by itsexciting atmosphere.
Principle of Confirmation8. The Two Averages Must Confirm — This is the most-often questioned and the most difficult to rationalize of all the Dow principles.Yet it has stood the test of time; the fact that it has “worked” is notdisputed by any who have carefully examined the records. Thosewho have disregarded it in practice have, more often than not, hadoccasion to regret their apostasy. What it means is that no valid signalof a change in trend can be produced by the action of one Average
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Technical Analysis of Stock Trends
d
INDUSTRIAL AVERAGEb
ca
RAIL AVERAGEbd
ac
DIAGRAM 1. A hypothetical daily market chart to show how one average mayfail to confirm the other’s Dow signal. Closing prices, indicated by short horizontaldashes, are connected with vertical lines to make the day-to-day trend easier to follow.
alone. Take, for example, the hypothetical case shown in Diagram 1.In this, we assume that a Bear Market has been in effect for severalmonths and then, starting at a, the Industrial Average rises (alongwith the Rails) in a Secondary Recovery to b. On their next decline,however, the Industrials drop only to c, which is higher than a, andthen turn up to d, which is higher than b. At this point, the Industrialshave “signaled” a change in trend from down to up. But note theRails during this period: their decline from b to c carried them lowerthan a, and their subsequent advance from c to d has not taken themabove b. They have (so far) refused to confirm the Industrials and,hence, the Major Trend of the market must be regarded as still down.Should the Rails go on to rise eventually above their b, then, andthen only, would we have a definite signal of a turn in the tide. Untilsuch a development, however, the chances remain that the Industrials
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Chapter three:
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will not be able to continue their upward course alone, that they willultimately be dragged down again by the Rails. At best, the directionof the Primary Trend is still in doubt.The above illustrates only one of the many ways in which theprinciple of Confirmation applies. Note also that at c, it might havebeen said that the Indust