verage andthe Transportation Index. Figure 18.1 shows the past 20 years of history forthe three most important averages. Dow Theory now uses these three averages, the Industrials, the Transportation Index, and the Utilities.
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FIGURE 18.1
Dow Industrials, Utilities, and Transportation Indices, 1981–1999.Dow originally created the industrial and railway averages to hide the large, erratic price movescaused by price manipulation and lack of liquidity. Dow Theory has been adapted to use thecurrent versions of the major indices, the Industrials (top panel), the Utilities (center panel), andthe Transportation Index (bottom panel).
THE BASIC TENETS OF THE DOW THEORYThere are six fundamental principles of the Dow Theory. We’ll look at eachin turn.
1. The Averages Discount Everything (except “Acts of God”)At the turn of the century (that is, 1900) there was considerably less liquidityand regulation in the market; therefore, manipulation was common. By creating averages, Dow could reduce the frequency of “unusual” moves in a single market, those moves that seemed unreasonably large or out of characterwith the rest of the market.If you averaged 30 stocks, then one odd move would only be 1⁄30 of thetotal, reducing its importance to somewhere near insignificance. The averagealso represented far greater combined liquidity than a single stock. The only
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large moves that would appear on a chart of the average price were priceshocks, or “Acts of God.”
2. There Are Three Classifications of Trends:Primary Trends, Secondary Swings, and MinorDay-to-Day FluctuationsThe primary trend, also called the wave, is the trend on a grand scale. It is abull or bear market. It is a major move over an extended period of time, perhaps a few years. A clear bull market can be seen in the S&P weekly chart(Figure 18.2) from 1984 to mid-1987 and again on the monthly chart (see Figure 18.3) from the end of 1987 to early 1998 or into 2000, depending uponwhether you consider the decline in 1998 too large to be included in theextended bull market.Bull and Bear Market Formation (for Monthly or Weekly Prices). Bulland bear markets are determined using a traditional breakout signal based onlarge swings in the index value. The bull market signal is at the point where
FIGURE 18.2
S&P primary trend. On a weekly chart, a major bull market (the primarytrend) can be seen from 1984 through September 1987.
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265
FIGURE 18.3
A longer view of a primary trend in the S&P. The monthly chart of the S&Pshows the major bull market (the primary trend) beginning at the end of 1987 and continuinginto 2000. Some analysts would consider the 1998 price drop as the end.
prices confirm the uptrend by moving above the high of the previous rally.The bear market signal occurs on a break below the low of the previousdecline (see Figure 18.4).It is commonly accepted that a bull or bear market begins when pricesreverse 20 percent from their lows or highs. In order to get an upward breakout signal needed for a new bull market, we would want to look at supportand resistance levels separated by about 10 percent based on the value of theindex. This 10 percent would be considered the minimum swing value discussed in Chapter 7, Event-Driven Trends.Bull and Bear Market Phases. In Dow Theory the primary trends arethought to develop in three distinct phases, each characterized by investoraction. It is particularly easy to see these phases in the Nasdaq bull market ofthe late 1990s and the subsequent bear market (see Figure 18.5). Becausemost of us have experienced this recent market cycle, we should find thefinal phase of the bull market, in 2000, as a sad and chilling event.
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Bear marketsignal
Bull market signal
FIGURE 18.4 Bull and bear market signals. Bulland bear markets are recognized using traditionalbreakout signals, but on a larger scale. A bull marketbegins when prices rise above the previous resistancelevel after trading at low levels. The bear market beginswhen prices break below a previous support level. Withprimary trends the size of the swing must be large,perhaps 10 percent.
FIGURE 18.5
Nasdaq from April 1998 through June 2002. A clear example of a bull andbear market with a classic pattern of volume.
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The Bull Market• Phase 1 is the accumulation phase, where cautious investors select onlythe safest stocks to buy. They limit purchases to deeply discountedstocks at depressed prices and consider only primary services and industries, most often buying utilities and high-yielding stocks.• Phase 2 is characterized by increasing volume, rising prices, and animproving economic picture. A broader range of investor enters the market convinced that they have seen the bottom of the market. Secondarystocks become popular.• Phase 3 has a final explosive move, the result of excessive speculationand elation of the general public. Everyone is convinced that profits willcontinue, and buying becomes indiscriminate. Investors borrow to buystocks. Value is unimportant because prices keep rising. Companiesdon’t need to have positive earnings to be scooped up.The Bear Market• Phase 1 is the distribution phase. Professionals begin selling while thepublic is in the final stages of buying. Stocks go from stronger to weakerhands. The change of ownership is forced by less experienced investorscoming to the party late and paying what turn out to be unreasonablyhigh prices.• Phase 2 is the panic phase. Prices decline more than at any other timeduring the bull market and fail to rally. The news talks about the end ofthe bull market. The public sees an urgency to liquidate. Investors whoborrowed money to invest late in the bull market, trading on margin orleverage, now speed up the process. Some are forced to liquidate becausetheir portfolio value has dropped below the critical point.• Phase 3 is the final sustained erosion of prices, affecting even thestrongest stocks. All news is viewed as negative. Pessimism prevails. It’sthe summer of 2002.Secondary Trends (Secondary Reactions Using Weekly or Daily Prices).Secondary reactions are also called corrections or recoveries. Corrections inbull markets are attributed to the prudent investor taking profits. This profitphase can have an erratic start but is considered over when prices rise abovethe previous secondary rally. The bull market is back in force when a newhigh occurs (see Figure 18.6).
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Profittaking
Bull marketresumes
Potential end tosecondary reaction
Bullmarket
Reentering longpositions
FIGURE 18.6 Secondary trends and reactions. A reactionis a smaller swing in prices that ends when a new high reinstatesthe bull market. Reactions are identified using smaller swingsthan those used for bull and bear markets. If the bull market isstill intact, a trader can buy the breakout confirmation at the endof the reaction.
Lines may be substituted for secondary movements. In Dow Theory, aline is a sideways movement lasting from 2 to 3 weeks to months, trading inabout a 5 percent range.Characteristics of a Secondary Reaction• There are a number of clear downswings.• The movement is more rapid in the reversal (down during a bull market)than in the primary move.• They last from three weeks to three months.• If the volume on the drop is equal to or greater than the volume just priorto the decline, then a bear market is likely. If volume declines during thedrop, then a reaction is confirmed.• The “atmosphere” surrounding the decline is important. If there is a lot ofspeculation, then a bear market may develop.The Perception of Who Is Winning and Losing. It is interesting to notethat declines in stock prices are always attributed to investors taking profits.We would all be quite wealthy if that were really the case. There are a largenumber of traders who will buy and sell for small profits and small losses.
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Phase 3 of the bull market clearly states that there is a large surge of publicbuying near the top of the market. Are these the investors who are takingprofits after the bear market is in full glory? It’s not likely.Minor Trends (Using Daily Prices). In Dow Theory, minor trends are theonly trends that can be “manipulated.” They are usually under six days induration. Because they are considered market noise they are seen as frequent up and down movements.
3. The Principle of ConfirmationFor a bull or bear market to exist, two of the three major averages (DJIA,DJT, DJU) must confirm the direction. Although a lot has changed sinceDow devised this rule, the purpose is to assure that the bull or bear market is a widespread economic phenomenon and not an industry-relatedevent.
4. Volume Goes with the TrendVolume must increase as the trend develops, whether a bull or bear market.Volume will be greatest at the peak of a bull market and during the panicphase of a bear market.
5. Only Closing Prices Are UsedDow had a strong belief that the closing price was the most important. It wasthe “evening up” at the end of the day. Although liquidity was a problem during Dow’s time, any stock price can be pushed around during a quiet period.There is always high volume on the close of trading, and investors with shortand long time frames come together to decide the fair price.
6. The Trend PersistsA trend should be assumed to continue in effect until its reversal has beendefinitely signaled. This rule forms the basis of all trend-following principles.It applies the trend to a long-term price move, and it suggest that trends persist. It is difficult to anticipate the end of a trend because a trend can continue longer than expected.
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INTERPRETING TODAY’S MARKETSUSING DOW THEORYIs the S&P in one of the bull or bear market phases defined by the Dow Theory? In Figure 18.7 we can see two distinct bull market patterns. The first,beginning 1983 ended abruptly in October 1987 when prices plunged. Beforethat, the steadily rising prices accompanied by a clear increase in volumemarked the classic Phase 2 of a bull market. Not every pattern has a smoothtransition.
Transition from Bull to Bear in the S&PAfter 1987, S&P prices continued higher, but that advance was not confirmedby volume. Only in 1994 did the general public seem to recognize that theeconomy was strong. Prices began to move up faster.In mid-1997 we see a drop in volume as prices become more volatile,even though they continue higher at the same pace. A sharp drop in mid-1998can be called a secondary reaction, although it was big enough to scare awaysome investors.
Top is end ofPhase 3
Secondaryreaction?
Volume indicates beginning of bull marketVolume starts declining
FIGURE 18.7
Dow Theory applied to the S&P. Most of Dow’s principles apply, but eachmajor move has its own special pattern.
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271
After the secondary reaction in 1998, volume continues to drop whileprices rise. We might justifiably (and using hindsight) call that a divergence.Rising volume confirms a price move; declining volume does not. However,there was still a year and a half of significant profits to be made before thetop was reached.In 2000 we see a price peak on continued lower volume. Prices declinedfaster than they rose. At the price of 1320, after a 20 percent retracementfrom the highs, we are told that the bear market has “officially” started. Volume is still dropping, but it doesn’t look like a buying opportunity.
EVOLUTION IN PRICE PATTERNSA change has occurred in the market because of the ability to trade the S&P500 index directly rather than individual stocks. S&P futures have become anactive vehicle for both speculation and hedging. If you think that stock pricesare about to fall because of a pending interest rate announcement by theFed, you can protect your portfolio by selling an equivalent amount of S&Pfutures. Afterward, when you have decided that prices have stabilized, youcan lift your hedge and profit from rising prices. It’s an easy and inexpensiveway to achieve portfolio insurance.When institutions and traders buy or sell large quantities of the S&Pfutures, that price can drop while the share prices of the stocks that comprisethe S&P Index may not have fallen yet. Enter the big business of programtrading. If you have enough capital and the difference between the S&Pfutures price and the S&P cash index is sufficiently large, you can buy theS&P futures and sell all of the stocks in the S&P 500 cash index. It is a classic arbitrage that brings prices back together.How does program trading, or just the trading of S&P futures, affect theprice patterns of individual stocks? The answer is that all the stocks in theS&P Index move together at the same time. It doesn’t matter whether IBM isfundamentally stronger the GE, or that Xerox is at a resistance level andFord is at support, or even if Enron is under investigation. When you buy theS&P you buy all of the stocks at the same time.Today’s technical trader must keep one eye on the individual stock andthe other eye on the index. Exxon may have moved above its recent resistance level but stops because the S&P Index is at its own resistance level, andthere are more traders watching the S&P than Exxon. In today’s market, youcan anticipate when a stock will find support and resistance by looking at theS&P chart rather than at the stock chart.
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FIGURE 18.8 Similar patterns in the S&P, GE, and Exxon. There is a clear similarity inthe up and down patterns of the three markets. Heavy trading in the S&P index forces arbitragethat keeps all stock prices within the index closely aligned to the index price. Unless there is astrong fundamental reason for one stock moving either up or down, they will all show a patternvery similar to the S&P index.
Figure 18.8 shows the S&P 500 index, GE, and Exxon over the sameperiod from October 1999 through December 2000. The overall patterns ofthe three markets are remarkably similar, with most tops and bottoms occurring at the same time. How likely is it that the fundamentals of each companywould result in a similar price pattern? Not likely.During times where there is no news, the stocks all move together. Whenthere is positive news for a specific company, it will gain over other stocks,but it will still meet resistance where the S&P as a whole meets resistance.This change in the way stocks are traded reduces the ability to get diversification by trading across sectors and increases your risk. Short-term traderswill not be as affected as those holding positions longer.
Will Your Trading Method Withstand the Test of Time?Dow Theory has withstood the test of time. Will your method of trading stillwork after five years? It will if you focus on the bigger picture. As a long-termtrader you’ll want to stay with the trend that reflects economic policy. As a
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short-term trader, you need to look past trends and concentrate on volatilityand overbought/oversold situations. Combine your style of trading with thetime frame that complements those methods.Above all, practice risk control. Start with a small commitment and buildas you improve. Figure out the risk of a trade before you get excited aboutthe potential reward. You need to control your risk in order to keep trading.Treat it as a business, not a game.
Questions1. In Dow Theory, what are the three waves of stock market movement
called?2. Why did Dow use averages?3. Why did Dow want confirmation of more than one index?4. What is the price pattern that gives you a bull market signal?5. In Dow Theory, what are the terms describing the first phases of a bull or
bear market?6. In Dow Theory, how do you tell the difference between a secondary reac-
tion in a bull market and a downturn signaling a bear market?7. In Dow Theory, what happens to volume in a bull market? In a bear
market?
ReviewQuestions
The following questions are a review of the entire course and draw on knowledge from across chapters. The answers appear in the final chapter. You canscore yourself. There are 210 points possible for 94 questions. All questionshave points shown. Keep your answers brief.If you score greater than 145, points then you are a solid “A” student.1. What is technical analysis? (2 pts)2. State three important positives and two negatives for using technical
analysis? (5 pts)3. When viewing a daily and weekly chart of the same stock, what would
be the most obvious difference in the price patterns? (2 pts)4. What are the obvious differences between the way prices behave when
prices are low compared to when prices are high? (2 pts)5. What is a price shock? (2 pts)6. How can you plan to make money from a price shock? (2 pts)7. What is market noise? (2 pts)8. What are three ways of measuring price volatility? (3 pts)9. When trading individual stocks, why would you want to know the
direction of the S&P? (2 pts)
275
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REVIEW QUESTIONS
10. In Figure R1.1, show at least seven different one-day price patterns
(e.g., gaps), but no more than two of any one type. Mark them directlyon the chart. (7 pts)
FIGURE R1.1
11. In Figure R1.2, show one each of three continuation patterns (e.g.,
triangles). (3 pts)
FIGURE R1.2
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277
12. On Figure R1.3, identify 20-, 40-, and 60-day moving average
lines. (3 pts)
FIGURE R1.3
13. If you wanted to see the price trend more clearly, would you use a
daily, weekly, or monthly chart? Why? (2 pts)14. What causes the lag in trend techniques such as a moving average?
(3 pts)15. What does conservation of capital mean when applied to a moving
average system: (a) investing a smaller amount, (b) a few large lossesand many small profits, or (c) many small losses and a few large profits?(1 pt)16. When applying a trend method to a stock or futures contract that
you haven’t seen before, which is likely to make more money: movingaverage, exponential smoothing, linear regression, or breakout system?(2 pts)17. On Figure R1.4, draw the major downtrend line and uptrend line. Show
where you would have gotten a perfect buy and a perfect sell signal.On the right part of the chart, show the point of confirmation wherethe topping formation is over. (5 pts)
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REVIEW QUESTIONS
FIGURE R1.4
18. On Figure R1.5, prices are about to start down. Draw and identify where
the two major support levels would be located, and where the nexttwo minor support levels would be located. They may be a combination of trendlines, retracements, and the 200-day moving average. (5 pts)
FIGURE R1.5
Review Questions
279
19. Which is not true: Trending techniques are not useful for fast trading
because (a) market noise interferes with identifying the trend,(b) transaction costs are too high, or (c) you cannot apply profittaking? (1 pt)20. Why is it more likely that a long-term MA will work and a short-term
MA will not (for example, using T-notes)? (3 pts)21. When does profit-taking work best: (a) anytime you have more than a
10 percent profit, (b) in a noisy market, or (c) as a long-term trendfollower? (1 pt)22. As a chartist, how do you draw a upward-sloping channel? (2 pts)23. How would you use an upward sloping channel for trading? (2 pts)24. What are Bollinger bands? (2 pts)25. If you were a mean reversion (countertrend) trader, how would you
use Bollinger bands? (2 pts)26. From the perspective of trading, what is the primary difference
between a bar chart and a point-and-figure chart? (2 pts)27. When does a standard buy signal occur using point-and-figure charts?
(2 pts)28. What is the purpose of a stop-loss? (2 pts)29. If you are basing your trading on support and resistance breakouts
and you get a buy signal, where would you place your initial stop-lossorder? (2 pts)30. As your trade becomes profitable, how would you change your stop-
loss? (2 pts)31. Which triangle formation is more likely to appear in the middle of a
prolonged downtrend: (a) ascending, (b) descending, or (c) symmetric?(1 pt)32. When the price breaks the head-and-shoulders neckline moving down,
where is the traditional target price level? (2 pts)33. What are the three most popular retracement levels (in percent)?
(2 pts)34. Write the first seven numbers in the Fibonacci series. (2 pts)
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REVIEW QUESTIONS
35. If a volume spike occurred on a highly volatile day with prices drop-
ping, would you expect the next day’s price to (a) continue lower, (b)move sharply higher, or (c) neither 1 or 2? (1 pt)36. If prices have been moving higher, name five technical points that you
would look for to indicate a likely change of direction? (2.5 pts)37. Fill in the table below with the trend and strength of the trend using
“up” and “down” for the trend direction, “weak” and “strong” for thestrength, and “none” for no trend. For example, if the trend is downbut weak, enter “weak down.” (4.5 pts)PriceVolume
Increasing
Unchanged
Decreasing
IncreasingUnchangedDecreasing
38. What is momentum? (2 pts)39. Is a 10-day momentum (a) smoother, (b) noisier, or (c) the same as
price movement? (1 pt)40. If prices are increasing or decreasing $1 each day, what is the maxi-
mum value a 10-day momentum may have? (2 pts)41. A one-day momentum has which special quality: (a) smoothing prices,
(b) limiting price movement, or (c) removing the trend? (1 pt)42. The MACD is most reliable when used for which of the following:
(a) trending signals, (b) overbought and oversold signals, or (c) bullishand bearish divergence? (1 pt)43. Describe the pattern needed in prices and an oscillator in order to get
a bullish divergence. (2 pts)44. On an MACD oscillator chart, which is faster: (a) the MACD line,
(b) the signal line, or (c) the trend line? (1 pt)45. Using the MACD, the sell signal comes following a bearish divergence,
when which two lines cross in what direction? (2 pts)46. When momentum reaches high values which of the following hap-
pens: (a) it immediately reverses, (b) it remains at high levels for
Review Questions
281
long periods of time, or (c) it remains at high levels for an uncertainperiod of time? (1 pt)47. What is the most recent value of the five-day momentum value given
the following prices: $52.50, $52.75, $53.00, $52.80, $52.75, $52.90,$53.10, $53.40, $54.00, $53.50? (2 pts)48. Which of the following is false: Market sentiment is (a) a driving force
behind market moves, (b) difficult to measure, or (c) used as a leadingindicator for a change of price direction? (1 pt)49. In your own words, what does the 10-day raw stochastic measure? (2 pts)50. In order to create the slow-K and slow-D from the raw stochastic value
K, what do you do? (3 pts)51. For the stochastic chart to be useful, the stochastic value needs to
be in the extreme zones (e.g., above 80 and below 20) when: (a) all ofthe time, (b) about 50 percent of the time, (c) about 20 percent of thetime, or (d) rarely. (1 pt)52. Which of the following is false: The stochastic is most useful as
(a) a trending indicator, (b) an entry timing indicator, or (c) an overbought and oversold indicator? (1 pt)53. The Relative Strength Index (RSI) is created from which ratio:
(a) high and low prices, (b) first differences of high and low prices,or (c) upward and downward price changes? (1 pt)54. True or false? It is best to use a very fast stochastic (e.g., under
10 days) in order to get more divergence signals? (1 pt)55. True or false? It is possible to create a very smooth trendline with a
small lag by double smoothing if you first start with price differencesinstead of prices. (1 pt)56. To find the true range of the day, you need to find the largest of what
three values (using high, low, and closing prices)? (2 pts)57. When trading (not holding a stock for an indefinite period), which
entry technique is the least desirable: (a) scaling down, (b) averagingin, or (c) buying your entire position at one time? (1 pt)58. In Figure R1.6, using technical analysis, explain why you think prices
will go higher or lower. Draw any trendlines or formations necessaryand explain the basis for your conclusions below the chart. Referencethe volume and MACD charts as needed. (10 pts)
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REVIEW QUESTIONS
FIGURE R1.6
59. Which statement is false? The best protection from a price shock is
(a) having a trading system that is correctly positioned for a priceshock, (b) being out of the market as much as possible, or (c) usingthe lowest leverage when trading. (1 pt)60. You have $10,000 in capital and want to trade four stocks that are risk-
adjusted by volatility. If you wanted to use all of your capital, howmany shares would you trade of each stock if the current prices andvolatilities were in the table? (10 pts)
Stock AStock BStock CStock D
Price
Volatility
$10.00$50.00$50.00$100.00
$0.50$1.00$1.50$5.00
No. of Shares
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Review Questions
61. You have $1 million to trade the S&P and T-notes. Because of the risk
you want to invest only 50 percent of your capital in the market andyou want to equalize the risk between the two markets. Based on thefollowing information, how many contracts do you trade of each market?T-note prices and volatility are in 32nds. (8 pts)
S&PT-notes
Price
Volatility
ConversionFactor
Margin
1100.00102/00
20.00/24
2501000
20,0003,000
No. ofContracts
62. When targeting a level to take profits, is it best to (a) exit the entire
trade at one point, (b) scale out at multiple levels looking for an average price, or (c) wait for a trend reversal? (1 pt)63. Which of the following are true? In Dow Theory, the index was used
because (a) markets were manipulated, (b) volume was low, or(c) trends were undependable for individual stocks. (1 pt)64. In Dow Theory, to what do the (a) tides, (b) waves, and (c) ripples
refer? (1 pt)65. In the principle of confirmation, why did Dow think it necessary to
have two of the indices confirm the bull or bear market? (2 pts)66. In Dow Theory, the formation in which prices are at their lowest level
and remain there preceding the period of increased volume is calledwhat? (2 pts)67. When we using a trend, are we (a) predicting where prices will go,
(b) assuming that the trend persists, or (c) expecting prices to changedirection? (1 pt)68. Is profit-taking best used (a) with any technical method, (b) with
longer-term positions that generate large profits, or (c) with short-termtrading? (1 pt)69. The phenomenon of a price trend is not caused by which of the follow-
ing: (a) periodic news releases, (b) anticipation of news, or (c) publicopinion (market sentiment)? (1 pt)70. Figure R1.7 shows DELL (top) and CPQ (second). You want to create
a market neutral strategy, one that is long one stock and short theother with equal risk based on volatility. You have $1,000 to invest. In
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REVIEW QUESTIONS
which one would you be long and which one would you be short?Support your answer with technical analysis based only on thesecharts and indicators (DELL MACD is in the third panel and CPQMACD is in the fourth panel). (10 pts)
FIGURE R1.7
71. When a company announces earnings greater than the previous
quarter and greater than a year ago, prices will do which of the following:(a) always rise, (b) rise if the overall market is stronger that day, or(c) decline if earnings are lower than anticipated? (1 pt)72. Why would there be a similarity between the price movements of
Exxon-Mobil and those of Wal-Mart? (2 pts)73. State one situation in which diversification conspicuously fails. (2 pts)74. Trend-following methods typically have which of the following: (a) an
equal number of profitable and losing trades, (b) a larger number oflosing trades, or (c) a larger number of profitable trades? (1 pt)75. An MACD oversold signal is best at which of the following times:
(a) when the MACD value reaches historic lows, (b) anytime theMACD goes negative and then the signal line crosses the MACD line,or (c) at the same time prices make a new low? (1 pt)
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285
76. True or false? You would use a price order (limit order) when you
want to buy at a lower price. (1 pt)77. True or false? A stop order becomes a market order when the price is
touched. (1 pt)78. Yesterday’s closing price was $51.00 and you have placed an order to
“buy 51.50 stop” to protect your short position. The stock opens thenext day