INTRODUCTION

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INTRODUCTION

Before beginning a study of the actual techniques and tools used in technical analysis, it is necessary first to define what technical analysis is, to discuss the philosophical premises on which it is based, to draw some clear distinctions between technical and fundamental analysis and, finally, to address a couple of criticisms frequently raised against the technical approach.

The author’s strong belief is that a full appreciation of the technical approach must begin with a clear understanding of what technical analysis claims to be able to do and, maybe even more importantly, the philosophy or rationale on which it bases those claims.

First, let’s define the subject. Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends. The term “market action” includes the three principal sources of information available to the technician—price, volume, and open interest. (Open interest is used only in futures and options.) The term “price action,” which is often used, seems too narrow because most technicians include volume and open interest as an integral part of their market analysis. With this distinction made, the terms “price action” and “market action” are used interchangeably throughout the remainder of this discussion.

PHILOSOPHY OR RATIONALE

There are three premises on which the technical approach is based:

• 1. Market action discounts everything.
• 2. Prices move in trends.
• 3. History repeats itself.

Market Action Discounts Everything

The statement “market action discounts everything” forms what is probably the cornerstone of technical analysis. Unless the full significance of this first premise is fully understood and accepted, nothing else that follows makes much sense. The technician believes that anything that can possibly affect the price—fundamentally, politically, psychologically, or otherwise—is actually reflected in the price of that market. It follows, therefore, that a study of price action is all that is required. While this claim may seem presumptuous, it is hard to disagree with if one takes the time to consider its true meaning.

All the technician is really claiming is that price action should reflect shifts in supply and demand. If demand exceeds supply, prices should rise. If supply exceeds demand, prices should fall. This action is the basis of all economic and fundamental forecasting. The technician then turns this statement around to arrive at the conclusion that if prices are rising, for whatever the specific reasons, demand must exceed supply and the fundamentals must be bullish. If prices fall, the fundamentals must be bearish. If this last comment about fundamentals seems surprising in the context of a discussion of technical analysis, it shouldn’t. After all, the technician is indirectly studying fundamentals. Most technicians would probably agree that it is the underlying forces of supply and demand, the economic fundamentals of a market, that cause bull and bear markets. The charts do not in themselves cause markets to move up or down. They simply reflect the bullish or bearish psychology of the marketplace.

As a rule, chartists do not concern themselves with the reasons why prices rise or fall. Very often, in the early stages of a price trend or at critical turning points, no one seems to know exactly why a market is performing a certain way. While the technical approach may sometimes seem overly simplistic in its claims, the logic behind this first premise—that markets discount everything—becomes more compelling the more market experience one gains. It follows then that if everything that affects market price is ultimately reflected in market price, then the study of that market price is all that is necessary. By studying price charts and a host of supporting technical indicators, the chartist in effect lets the market tell him or her which way it is most likely to go. The chartist does not necessarily try to outsmart or outguess the market. All of the technical tools discussed later on are simply techniques used to aid the chartist in the process of studying market action. The chartist knows there are reasons why markets go up or down. He or she just doesn’t

believe that knowing what those reasons are is necessary in the forecasting process.

Prices Move in Trends

The concept of trend is absolutely essential to the technical approach. Here again, unless one accepts the premise that markets do in fact trend, there’s no point in reading any further. The whole purpose of charting the price action of a market is to identify trends in early stages of their development for the purpose of trading in the direction of those trends. In fact, most of the techniques used in this approach are trend-following in nature, meaning that their intent is to identify and follow existing trends. (See Figure 1.1.)

Figure 1.1 Example of an uptrend. Technical analysis is based on the premise that markets trend and that those trends tend to persist.

There is a corollary to the premise that prices move in trends—a trend in motion is more likely to continue than to reverse. This corollary is, of course, an adaptation of Newton’s first law of motion. Another way to state this corollary is that a trend in motion will continue in the same direction until it reverses. This is another one of those technical claims that seems almost circular. But the entire trend-following approach is predicated on riding an existing trend until it shows signs of reversing.

History Repeats Itself

Much of the body of technical analysis and the study of market action has to

do with the study of human psychology. Chart patterns, for example, which have been identified and categorized over the past one hundred years, reflect certain pictures that appear on price charts. These pictures reveal the bullish or bearish psychology of the market. Since these patterns have worked well in the past, it is assumed that they will continue to work well in the future. They are based on the study of human psychology, which tends not to change. Another way of saying this last premise—that history repeats itself—is that the key to understanding the future lies in a study of the past, or that the future is just a repetition of the past.

TECHNICAL VERSUS FUNDAMENTAL FORECASTING

While technical analysis concentrates on the study of market action, fundamental analysis focuses on the economic forces of supply and demand that cause prices to move higher, lower, or stay the same. The fundamental approach examines all of the relevant factors affecting the price of a market in order to determine the intrinsic value of that market. The intrinsic value is what the fundamentals indicate something is actually worth based on the law of supply and demand. If this intrinsic value is under the current market price, then the market is overpriced and should be sold. If market price is below the intrinsic value, then the market is undervalued and should be bought.

Both of these approaches to market forecasting attempt to solve the same problem, that is, to determine the direction prices are likely to move. They just approach the problem from different directions. The fundamentalist studies the cause of market movement, while the technician studies the effect. The technician, of course, believes that the effect is all that he or she wants or needs to know and that the reasons, or the causes, are unnecessary. The fundamentalist always has to know why.

Most traders classify themselves as either technicians or fundamentalists. In reality, there is a lot of overlap. Many fundamentalists have a working knowledge of the basic tenets of chart analysis. At the same time, many technicians have at least a passing awareness of the fundamentals. The problem is that the charts and fundamentals are often in conflict with each other. Usually at the beginning of important market moves, the fundamentals do not explain or support what the market seems to be doing. It is at these critical times in the trend that these two approaches seem to differ the most. Usually they come back into sync at some point, but often too late for the trader to act.

One explanation for these seeming discrepancies is that market price

tends to lead the known fundamentals. Stated another way, market price acts as a leading indicator of the fundamentals or the conventional wisdom of the moment. While the known fundamentals have already been discounted and are already “in the market,” prices are now reacting to the unknown fundamentals. Some of the most dramatic bull and bear markets in history have begun with little or no perceived change in the fundamentals. By the time those changes became known, the new trend was well underway.

After a while, the technician develops increased confidence in his or her ability to read the charts. The technician learns to be comfortable in a situation where market movement disagrees with the so-called conventional wisdom. A technician begins to enjoy being in the minority. He or she knows that eventually the reasons for market action will become common knowledge. It is just that the technician isn’t willing to wait for that added confirmation.

In accepting the premises of technical analysis, one can see why technicians believe their approach is superior to the fundamentalists. If a trader had to choose only one of the two approaches to use, the choice would logically have to be the technical. Because, by definition, the technical approach includes the fundamental. If the fundamentals are reflected in market price, then the study of those fundamentals becomes unnecessary. Chart reading becomes a shortcut form of fundamental analysis. The reverse, however, is not true. Fundamental analysis does not include a study of price action. It is possible to trade financial markets using just the technical approach. It is doubtful that anyone could trade off the fundamentals alone with no consideration of the technical side of the market.

ANALYSIS VERSUS TIMING

This last point is made clearer if the decision making process is broken down into two separate stages—analysis and timing. Because of the high leverage factor in the futures markets, timing is especially crucial in that arena. It is quite possible to be correct on the general trend of the market and still lose money. Because margin requirements are so low in futures trading (usually less than 10%), a relatively small price move in the wrong direction can force the trader out of the market with the resulting loss of all or most of that margin. In stock market trading, by contrast, a trader who finds him or herself on the wrong side of the market can simply decide to hold onto the stock, hoping that it will stage a comeback at some point.

Futures traders don’t have that luxury. A “buy and hold” strategy doesn’t apply to the futures arena. Both the technical and the fundamental approach can be used in the first phase—the forecasting process. However, the question

of timing, of determining specific entry and exit points, is almost purely technical. Therefore, considering the steps the trader must go through before making a market commitment, it can be seen that the correct application of technical principles becomes indispensable at some point in the process, even if fundamental analysis was applied in the earlier stages of the decision. Timing is also important in individual stock selection and in the buying and selling of stock market sector and industry groups.

FLEXIBILITY AND ADAPTABILITY OF TECHNICAL ANALYSIS

One of the great strengths of technical analysis is its adaptability to virtually any trading medium and time dimension. There is no area of trading in either stocks or futures where these principles do not apply.

The chartist can easily follow as many markets as desired, which is generally not true of his or her fundamental counterpart. Because of the tremendous amount of data the latter must deal with, most fundamentalists tend to specialize. The advantages here should not be overlooked.

For one thing, markets go through active and dormant periods, trending and nontrending stages. The technician can concentrate his or her attention and resources in those markets that display strong trending tendencies and choose to ignore the rest. As a result, the chartist can rotate his or her attention and capital to take advantage of the rotational nature of the markets. At different times, certain markets become “hot” and experience important trends. Usually, those trending periods are followed by quiet and relatively trendless market conditions, while another market or group takes over. The technical trader is free to pick and choose. The fundamentalist, however, who tends to specialize in only one group, doesn’t have that kind of flexibility. Even if he or she were free to switch groups, the fundamentalist would have a much more difficult time doing so than would the chartist.

Another advantage the technician has is the “big picture.” By following all of the markets, he or she gets an excellent feel for what markets are doing in general, and avoids the “tunnel vision” that can result from following only one group of markets. Also, because so many of the markets have built-in economic relationships and react to similar economic factors, price action in one market or group may give valuable clues to the future direction of another market or group of markets.

TECHNICAL ANALYSIS APPLIED TO DIFFERENT TRADING MEDIUMS

The principles of chart analysis apply to both stocks and futures. Actually, technical analysis was first applied to the stock market and later adapted to futures. With the introduction of stock index futures, the dividing line between these two areas is rapidly disappearing. International stock markets are also charted and analyzed according to technical principles. (See Figure 1.2.)

Financial futures, including interest rate markets and foreign currencies, have become enormously popular over the past decade and have proven to be excellent subjects for chart analysis.

Technical principles play a role in options trading. Technical forecasting can also be used to great advantage in the hedging process.

Figure 1.2 The Japanese stock market charts very well as do most stock markets around the world.

TECHNICAL ANALYSIS APPLIED TO DIFFERENT TIME DIMENSIONS

Another strength of the charting approach is its ability to handle different time dimensions. Whether the user is trading the intraday tic-by-tic changes for day trading purposes or trend trading the intermediate trend, the same principles apply. A time dimension often overlooked is longer range technical

forecasting. The opinion expressed in some quarters that charting is useful only in the short term is simply not true. It has been suggested by some that fundamental analysis should be used for long term forecasting with technical factors limited to short term timing. The fact is that longer range forecasting, using weekly and monthly charts going back several years, has proven to be an extremely useful application of these techniques.

Once the technical principles discussed in this book are thoroughly understood, they will provide the user with tremendous flexibility as to how they can be applied, both from the standpoint of the medium to be analyzed and the time dimension to be studied.

ECONOMIC FORECASTING

Technical analysis can play a role in economic forecasting. For example, the direction of commodity prices tells us something about the direction of inflation. They also give us clues about the strength or weakness of the economy. Rising commodity prices generally hint at a stronger economy and rising inflationary pressure. Falling commodity prices usually warn that the economy is slowing along with inflation. The direction of interest rates is affected by the trend of commodities. As a result, charts of commodity markets like gold and oil, along with Treasury Bonds, can tell us a lot about the strength or weakness of the economy and inflationary expectations. The direction of the U.S. dollar and foreign currency futures also provide early guidance about the strength or weakness of the respective global economies. Even more impressive is the fact that trends in these futures markets usually show up long before they are reflected in traditional economic indicators that are released on a monthly or quarterly basis, and usually tell us what has already happened. As their name implies, futures markets usually give us insights into the future. The S&P 500 stock market index has long been counted as an official leading economic indicator. A book by one of the country’s top experts on the business cycle, Leading Indicators for the 1990s (Moore), makes a compelling case for the importance of commodity, bond, and stock trends as economic indicators. All three markets can be studied employing technical analysis. We’ll have more to say on this subject in Chapter 17, “The Link Between Stocks and Futures.”

TECHNICIAN OR CHARTIST?

There are several different titles applied to practitioners of the technical approach: technical analyst, chartist, market analyst, and visual analyst. Up until recently, they all meant pretty much the same thing. However, with increased specialization in the field, it has become necessary to make some further distinctions and define the terms a bit more carefully. Because virtually all technical analysis was based on the use of charts up until the last decade, the terms “technician” and “chartist” meant the same thing. This is no longer necessarily true.

The broader area of technical analysis is being increasingly divided into two types of practitioners, the traditional chartist and, for want of a better term, statistical technicians. Admittedly, there is a lot of overlap here and most technicians combine both areas to some extent. As in the case of the technician versus the fundamentalist, most seem to fall into one category or the other.

Whether or not the traditional chartist uses quantitative work to supplement his or her analysis, charts remain the primary working tool. Everything else is secondary. Charting, of necessity, remains somewhat subjective. The success of the approach depends, for the most part, on the skill of the individual chartist. The term “art charting” has been applied to this approach because chart reading is largely an art.

By contrast, the statistical, or quantitative, analyst takes these subjective principles, quantifies, tests, and optimizes them for the purpose of developing mechanical trading systems. These systems, or trading models, are then programmed into a computer that generates mechanical “buy” and “sell” signals. These systems range from the simple to the very complex. However, the intent is to reduce or completely eliminate the subjective human element in trading, to make it more scientific. These statisticians may or may not use price charts in their work, but they are considered technicians as long as their work is limited to the study of market action.

Even computer technicians can be subdivided further into those who favor mechanical systems, or the “black box” approach, and those who use computer technology to develop better technical indicators. The latter group maintains control over the interpretation of those indicators and also the decision making process.

One way of distinguishing between the chartist and the statistician is to say that all chartists are technicians, but not all technicians are chartists. Although these terms are used interchangeably throughout this book, it should be remembered that charting represents only one area in the broader subject of technical analysis.

A BRIEF COMPARISON OF TECHNICAL

ANALYSIS IN STOCKS AND FUTURES

A question often asked is whether technical analysis as applied to futures is the same as the stock market. The answer is both yes and no. The basic principles are the same, but there are some significant differences. The principles of technical analysis were first applied to stock market forecasting and only later adapted to futures. Most of the basic tools—bar charts, point and figure charts, price patterns, volume, trendlines, moving averages, and oscillators, for example—are used in both areas. Anyone who has learned these concepts in either stocks or futures wouldn’t have too much trouble making the adjustment to the other side. However, there are some general areas of difference having more to do with the different nature of stocks and futures than with the actual tools themselves.

Pricing Structure

The pricing structure in futures is much more complicated than in stocks. Each commodity is quoted in different units and increments. Grain markets, for example, are quoted in cents per bushel, livestock markets in cents per pound, gold and silver in dollars per ounce, and interest rates in basis points. The trader must learn the contract details of each market: which exchange it is traded on, how each contract is quoted, what the minimum and maximum price increments are, and what these price increments are worth.

Limited Life Span

Unlike stocks, futures contracts have expiration dates. A March 1999 Treasury Bond contract, for example, expires in March of 1999. The typical futures contract trades for about a year and a half before expiration. Therefore, at any one time, at least a half dozen different contract months are trading in the same commodity at the same time. The trader must know which contracts to trade and which ones to avoid. (This is explained later in this book.) This limited life feature causes some problems for longer range price forecasting. It necessitates the continuing need for obtaining new charts once old contracts stop trading. The chart of an expired contract isn’t of much use. New charts must be obtained for the newer contracts along with their own technical indicators. This constant rotation makes the maintenance of an ongoing chart library a good deal more difficult. For computer users, it also entails greater time and expense by making it necessary to be constantly obtaining new historical data as old contracts expire.

Lower Margin Requirements

This is probably the most important difference between stocks and futures.

All futures are traded on margin, which is usually less than 10% of the value of the contract. The result of these low margin requirements is tremendous leverage. Relatively small price moves in either direction tend to become magnified in their impact on overall trading results. For this reason, it is possible to make or lose large sums of money very quickly in futures. Because a trader puts up only 10% of the value of the contract as margin, then a 10% move in either direction will either double the trader’s money or wipe it out. By magnifying the impact of even minor market moves, the high leverage factor sometimes makes the futures markets seem more volatile than they actually are. When someone says, for example, that he or she was “wiped out” in the futures market, remember that he or she only committed 10% in the first place.

From the standpoint of technical analysis, the high leverage factor makes timing in the futures markets much more critical than it is in stocks. The correct timing of entry and exit points is crucial in futures trading and much more difficult and frustrating than market analysis. Largely for this reason, technical trading skills become indispensable to a successful futures trading program.

Time Frame Is Much Shorter

Because of the high leverage factor and the need for close monitoring of market positions, the time horizon of the commodity trader is much shorter of necessity. Stock market technicians tend to look more at the longer range picture and talk in time frames that are beyond the concern of the average commodity trader. Stock technicians may talk about where the market will be in three or six months. Futures traders want to know where prices will be next week, tomorrow, or maybe even later this afternoon. This has necessitated the refinement of very short term timing tools. One example is the moving average. The most commonly watched averages in stocks are 50 and 200 days. In commodities, most moving averages are under 40 days. A popular moving average combination in futures, for example, is 4, 9, and 18 days.

Greater Reliance on Timing

Timing is everything in futures trading. Determining the correct direction of the market only solves a portion of the trading problem. If the timing of the entry point is off by a day, or sometimes even minutes, it can mean the difference between a winner or a loser. It’s bad enough to be on the wrong side of the market and lose money. Being on the right side of the market and still losing money is one of the most frustrating and unnerving aspects of futures trading. It goes without saying that timing is almost purely technical in nature, because the fundamentals rarely change on a day-to-day basis.

LESS RELIANCE ON MARKET AVERAGES AND INDICATORS

Stock market analysis is based heavily on the movement of broad market averages—such as the Dow Jones Industrial Average or the S&P 500. In addition, technical indicators that measure the strength or weakness of the broader market—like the NYSE advance-decline line or the new highs-new lows list—are heavily employed. While commodity markets can be tracked using measures like the Commodity Research Bureau Futures Price Index, less emphasis is placed on the broader market approach. Commodity market analysis concentrates more on individual market action. That being the case, technical indicators that measure broader commodity trends aren’t used much. With only about 20 or so active commodity markets, there isn’t much need.

Specific Technical Tools

While most of the technical tools originally developed in the stock market have some application in commodity markets, they are not used in the exact same way. For example, chart patterns in futures often tend not to form as fully as they do in stocks.

Futures traders rely more heavily on shorter term indicators that emphasize more precise trading signals. These points of difference and many others are discussed later in this book.

Finally, there is another area of major difference between stocks and futures. Technical analysis in stocks relies much more heavily on the use of sentiment indicators and flow of funds analysis. Sentiment indicators monitor the performance of different groups such as odd lotters, mutual funds, and floor specialists. Enormous importance is placed on sentiment indicators that measure the overall market bullishness and bearishness on the theory that the majority opinion is usually wrong. Flow of funds analysis refers to the cash position of different groups, such as mutual funds or large institutional accounts. The thinking here is that the larger the cash position, the more funds that are available for stock purchases.

Technical analysis in the futures markets is a much purer form of price analysis. While contrary opinion theory is also used to some extent, much more emphasis is placed on basic trend analysis and the application of traditional technical indicators.

SOME CRITICISMS OF THE TECHNICAL APPROACH

A few questions generally crop up in any discussion of the technical approach. One of these concerns is the *self-fulfilling prophecy.*Another is the question of whether or not past price data can really be used to forecast future price direction. The critic usually says something like: “Charts tell us where the market has been, but can’t tell us where it is going.” For the moment, we’ll put aside the obvious answer that a chart won’t tell you anything if you don’t know how to read it. The Random Walk Theory questions whether prices trend at all and doubts that any forecasting technique can beat a simple buy and hold strategy. These questions deserve a response.

The Self-Fulfilling Prophecy

The question of whether there is a self-fulfilling prophecy at work seems to bother most people because it is raised so often. It is certainly a valid concern, but of much less importance than most people realize. Perhaps the best way to address this question is to quote from a text that discusses some of the disadvantages of using chart patterns:

• a. The use of most chart patterns has been widely publicized in the last several years. Many traders are quite familiar with these patterns and often act on them in concert. This creates a “self-fulfilling prophecy,” as waves of buying or selling are created in response to “bullish” or “bearish” patterns…
• b. Chart patterns are almost completely subjective. No study has yet succeeded in mathematically quantifying any of them. They are literally in the mind of the beholder…. (Teweles et al.)

These two criticisms contradict one another and the second point actually cancels out the first. If chart patterns are “completely subjective” and “in the mind of the beholder,” then it is hard to imagine how everyone could see the same thing at the same time, which is the basis of the self-fulfilling prophecy. Critics of charting can’t have it both ways. They can’t, on the one hand, criticize charting for being so objective and obvious that everyone will act in the same way at the same time (thereby causing the price pattern to be fulfilled), and then also criticize charting for being too subjective.

The truth of the matter is that charting is very subjective. Chart reading is an art. (Possibly the word “skill” would be more to the point.) Chart patterns are seldom so clear that even experienced chartists always agree on their interpretation. There is always an element of doubt and disagreement. As this book demonstrates, there are many different approaches to technical analysis that often disagree with one another.

Even if most technicians did agree on a market forecast, they would not all necessarily enter the market at the same time and in the same way. Some

would try to anticipate the chart signal and enter the market early. Others would buy the “breakout” from a given pattern or indicator. Still others would wait for the pullback after the breakout before taking action. Some traders are aggressive; others are conservative. Some use stops to enter the market, while others like to use market orders or resting limit orders. Some are trading for the long pull, while others are day trading. Therefore, the possibility of all technicians acting at the same time and in the same way is actually quite remote.

Even if the self-fulfilling prophecy were of major concern, it would probably be “self-correcting” in nature. In other words, traders would rely heavily on charts until their concerted actions started to affect or distort the markets. Once traders realized this was happening, they would either stop using the charts or adjust their trading tactics. For example, they would either try to act before the crowd or wait longer for greater confirmation. So, even if the self-fulfilling prophecy did become a problem over the near term, it would tend to correct itself.

It must be kept in mind that bull and bear markets only occur and are maintained when they are justified by the law of supply and demand. Technicians could not possibly cause a major market move just by the sheer power of their buying and selling. If this were the case, technicians would all become wealthy very quickly.

Of much more concern than the chartists is the tremendous growth in the use of computerized technical trading systems in the futures market. These systems are mainly trend-following in nature, which means that they are all programmed to identify and trade major trends. With the growth in professionally managed money in the futures industry, and the proliferation of multimillion-dollar public and private funds, most of which are using these technical systems, tremendous concentrations of money are chasing only a handful of existing trends. Because the universe of futures markets is still quite small, the potential for these systems distorting short term price action is growing. However, even in cases where distortions do occur, they are generally short term in nature and do not cause major moves.

Here again, even the problem of concentrated sums of money using technical systems is probably self-correcting. If all of the systems started doing the same thing at the same time, traders would make adjustments by making their systems either more or less sensitive.

The self-fulfilling prophecy is generally listed as a criticism of charting. It might be more appropriate to label it as a compliment. After all, for any forecasting technique to become so popular that it begins to influence events, it would have to be pretty good. We can only speculate as to why this concern is seldom raised regarding the use of fundamental analysis.

Can the Past Be Used to Predict the Future?

Another question often raised concerns the validity of using past price data to predict the future. It is surprising how often critics of the technical approach bring up this point because every known method of forecasting, from weather predicting to fundamental analysis, is based completely on the study of past data. What other kind of data is there to work with?

The field of statistics makes a distinction between descriptive statistics and inductive statistics. Descriptive statistics refers to the graphical presentation of data, such as the price data on a standard bar chart. Inductive statistics refers to generalizations, predictions, or extrapolations that are inferred from that data. Therefore, the price chart itself comes under the heading of the descriptive, while the analysis technicians perform on that price data falls into the realm of the inductive.

As one statistical text puts it, “The first step in forecasting the business or economic future consists, thus, of gathering observations from the past.” (Freund and Williams) Chart analysis is just another form of time series analysis, based on a study of the past, which is exactly what is done in all forms of time series analysis. The only type of data anyone has to go on is past data. We can only estimate the future by projecting past experiences into that future.

So it seems that the use of past price data to predict the future in technical analysis is grounded in sound statistical concepts. If anyone were to seriously question this aspect of technical forecasting, he or she would have to also question the validity of every other form of forecasting based on historical data, which includes all economic and fundamental analysis.

RANDOM WALK THEORY

The Random Walk Theory, developed and nurtured in the academic community, claims that price changes are “serially independent” and that price history is not a reliable indicator of future price direction. In a nutshell, price movement is random and unpredictable. The theory is based on the efficient market hypothesis, which holds that prices fluctuate randomly about their intrinsic value. It also holds that the best market strategy to follow would be a simple “buy and hold” strategy as opposed to any attempt to “beat the market.”

While there seems little doubt that a certain amount of randomness or “noise” does exist in all markets, it’s just unrealistic to believe that all price movement is random. This may be one of those areas where empirical observation and practical experience prove more useful than sophisticated statistical techniques, which seem capable of proving anything the user has in mind or incapable of disproving anything. It might be useful to keep in mind that randomness can only be defined in the negative sense of an inability to uncover systematic patterns in price action. The fact that many academics have not been able to discover the presence of these patterns does not prove that they do not exist.

The academic debate as to whether markets trend is of little interest to the average market analyst or trader who is forced to deal in the real world where market trends are clearly visible. If the reader has any doubts on this point, a casual glance through any chart book (randomly selected) will demonstrate the presence of trends in a very graphic way. How do the “random walkers” explain the persistence of these trends if prices are serially independent, meaning that what happened yesterday, or last week, has no bearing on what may happen today or tomorrow? How do they explain the profitable “real life” track records of many trend-following systems?

How, for example, would a buy and hold strategy fare in the commodity futures markets where timing is so crucial? Would those long positions be held during bear markets? How would traders even know the difference between bull and bear markets if prices are unpredictable and don’t trend? In fact, how could a bear market even exist in the first place because that would imply a trend? (See Figure 1.3.)

Figure 1.3 A “random walker” would have a tough time convincing a holder of gold bullion that there’s no real trend on this chart.

It seems doubtful that statistical evidence will ever totally prove or disprove the Random Walk Theory. However, the idea that markets are

random is totally rejected by the technical community. If the markets were truly random, no forecasting technique would work. Far from disproving the validity of the technical approach, the efficient market hypothesis is very close to the technical premise that markets discount everything. The academics, however, feel that because markets quickly discount all information, there’s no way to take advantage of that information. The basis of technical forecasting, already touched upon, is that important market information is discounted in the market price long before it becomes known. Without meaning to, the academics have very eloquently stated the need for closely monitoring price action and the futility of trying to profit from fundamental information, at least over the short term.

Finally, it seems only fair to observe that any process appears random and unpredictable to those who do not understand the rules under which that process operates. An electrocardiogram printout, for example, might appear like a lot of random noise to a layperson. But to a trained medical person, all those little blips make a lot of sense and are certainly not random. The working of the markets may appear random to those who have not taken the time to study the rules of market behavior. The illusion of randomness gradually disappears as the skill in chart reading improves. Hopefully, that is exactly what will happen as the reader progresses through the various sections of this book.

There may even be hope for the academic world. A number of leading American universities have begun to explore Behavioral Finance which maintains that human psychology and securities pricing are intertwined. That, of course, is the primary basis of technical analysis.

UNIVERSAL PRINCIPLES

When an earlier version of this book was published twelve years ago, many of the technical timing tools that were explained were used mainly in the futures markets. Over the past decade, however, these tools have been widely employed in analyzing stock market trends. The technical principles that are discussed in this book can be applied universally to all markets—even mutual funds. One additional feature of stock market trading that has gained wide popularity in the past decade has been sector investing, primarily through index options and mutual funds. Later in the book we’ll show how to determine which sectors are hot and which are not by applying technical timing tools.

INTRODUCTION

Charles Dow and his partner Edward Jones founded Dow Jones & Company in 1882. Most technicians and students of the markets concur that much of what we call technical analysis today has its origins in theories first proposed by Dow around the turn of the century. Dow published his ideas in a series of editorials he wrote for the Wall Street Journal. Most technicians today recognize and assimilate Dow’s basic ideas, whether or not they recognize the source. Dow Theory still forms the cornerstone of the study of technical analysis, even in the face of today’s sophisticated computer technology, and the proliferation of newer and supposedly better technical indicators.

On July 3, 1884, Dow published the first stock market average composed of the closing prices of eleven stocks: nine railroad companies and two manufacturing firms. Dow felt that these eleven stocks provided a good indication of the economic health of the country. In 1897, Dow determined that two separate indices would better represent that health, and created a 12 stock industrial index and a 20 stock rail index. By 1928 the industrial index had grown to include 30 stocks, the number at which it stands today. The editors of The Wall Street Journal have updated the list numerous times in the ensuing years, adding a utility index in 1929. In 1984, the year that marked the one hundredth anniversary of Dow’s first publication, the Market Technicians Association presented a Gorham-silver bowl to Dow Jones & Co. According to the MTA, the award recognized “the lasting contribution that Charles Dow made to the field of investment analysis. His index, the forerunner of what today is regarded as the leading barometer of stock market activity, remains a vital tool for market technicians 80 years after his death.”

Unfortunately for us, Dow never wrote a book on his theory. Instead, he set down his ideas of stock market behavior in a series of editorials that The

Wall Street Journal published around the turn of the century. In 1903, the year after Dow’s death, S.A. Nelson compiled these essays into a book entitled The ABC of Stock Speculation. In that work, Nelson first coined the term “Dow’s Theory.” Richard Russell, who wrote the introduction to a 1978 reprint, compared Dow’s contribution to stock market theory with Freud’s contribution to psychiatry. In 1922, William Peter Hamilton (Dow’s associate and successor at the Journal) categorized and published Dow’s tenets in a book entitled The Stock Market Barometer. Robert Rhea developed the theory even further in the Dow Theory (New York: Barron’s), published in 1932.

Dow applied his theoretical work to the stock market averages that he created; namely the Industrials and the Rails. However, most of his analytical ideas apply equally well to all market averages. This chapter will describe the six basic tenets of Dow Theory and will discuss how these ideas fit into a modern study of technical analysis. We will discuss the ramifications of these ideas in the chapters that follow.

BASIC TENETS

1. The Averages Discount Everything.

The sum and tendency of the transactions of the Stock Exchange represent the sum of all Wall Street’s knowledge of the past, immediate and remote, applied to the discounting of the future. There is no need to add to the averages, as some statisticians do, elaborate compilations of commodity price index numbers, bank clearings, fluctuations in exchange, volume of domestic and foreign trades or anything else. Wall Street considers all these things (Hamilton, pp. 40–41).

Sound familiar? The idea that the markets reflect every possible knowable factor that affects overall supply and demand is one of the basic premises of technical theory, as was mentioned in Chapter 1. The theory applies to market averages, as well as it does to individual markets, and even makes allowances for “acts of God.” While the markets cannot anticipate events such as earthquakes and various other natural calamities, they quickly discount such occurrences, and almost instantaneously assimilate their affects into the price action.

2. The Market Has Three Trends.

Before discussing how trends behave, we must clarify what Dow considered a trend. Dow defined an uptrend as a situation in which each successive rally

closes higher than the previous rally high, and each successive rally low also closes higher than the previous rally low. In other words, an uptrend has a pattern of rising peaks and troughs. The opposite situation, with successively lower peaks and troughs, defines a downtrend. Dow’s definition has withstood the test of time and still forms the cornerstone of trend analysis.

Dow believed that the laws of action and reaction apply to the markets just as they do to the physical universe. He wrote, “Records of trading show that in many cases when a stock reaches top it will have a moderate decline and then go back again to near the highest figures. If after such a move, the price again recedes, it is liable to decline some distance” (Nelson, page 43).

Dow considered a trend to have three parts, primary, secondary, and minor, which he compared to the tide, waves, and ripples of the sea. The primary trend represents the tide, the secondary or intermediate trend represents the waves that make up the tide, and the minor trends behave like ripples on the waves.

An observer can determine the direction of the tide by noting the highest point on the beach reached by successive waves. If each successive wave reaches further inland than the preceding one, the tide is flowing in. When the high point of each successive wave recedes, the tide has turned out and is ebbing. Unlike actual ocean tides, which last a matter of hours, Dow conceived of market tides as lasting for more than a year, and possibly for several years.

The secondary, or intermediate, trend represents corrections in the primary trend and usually lasts three weeks to three months. These intermediate corrections generally retrace between one-third and two-thirds of the previous trend movement and most frequently about half, or 50%, of the previous move.

According to Dow, the minor (or near term) trend usually lasts less than three weeks. This near term trend represents fluctuations in the intermediate trend. We will discuss trend concepts in greater detail in Chapter 4, “Basic Concepts of Trends,” where you will see that we continue to use the same basic concepts and terminology today.

3. Major Trends Have Three Phases.

Dow focused his attention on primary or major trends, which he felt usually take place in three distinct phases: an accumulation phase, a public participation phase, and a distribution phase. The accumulation phase represents informed buying by the most astute investors. If the previous trend was down, then at this point these astute investors recognize that the market has assimilated all the so-called “bad” news. The public participation phase, where most technical trend-followers begin to participate, occurs when prices

begin to advance rapidly and business news improves. The distribution phase takes place when newspapers begin to print increasingly bullish stories; when economic news is better than ever; and when speculative volume and public participation increase. During this last phase the same informed investors who began to “accumulate” near the bear market bottom (when no one else wanted to buy) begin to “distribute” before anyone else starts selling.

Students of Elliott Wave Theory will recognize this division of a major bull market into three distinct phases. R. N. Elliott elaborated upon Rhea’s work in Dow Theory, to recognize that a bull market has three major, upward movements. In Chapter 13, “Elliott Wave Theory,” we’ll show the close similarity between Dow’s three phases of a bull market and the five wave Elliott sequence.

4. The Averages Must Confirm Each Other.

Dow, in referring to the Industrial and Rail Averages, meant that no important bull or bear market signal could take place unless both averages gave the same signal, thus confirming each other. He felt that both averages must exceed a previous secondary peak to confirm the inception or continuation of a bull market. He did not believe that the signals had to occur simultaneously, but recognized that a shorter length of time between the two signals provided stronger confirmation. When the two averages diverged from one another, Dow assumed that the prior trend was still maintained. (Elliott Wave Theory only requires that signals be generated in a single average.) Chapter 6, “Continuation Patterns,” will cover the key concepts of confirmation and divergence. (See Figures 2.1 and 2.2.)

5. Volume Must Confirm the Trend.

Dow recognized volume as a secondary but important factor in confirming price signals. Simply stated, volume should expand or increase in the direction of the major trend. In a major uptrend, volume would then increase as prices move higher, and diminish as prices fall. In a downtrend, volume should increase as prices drop and diminish as they rally. Dow considered volume a secondary indicator. He based his actual buy and sell signals entirely on closing prices. In Chapter 7, “Volume and Open Interest,” we’ll cover the subject of volume and build on Dow’s ideas. Today’s sophisticated volume indicators help determine whether volume is increasing or falling off. Savvy traders then compare this information to price action to see if the two are confirming each other.

Figure 2.1 A long term view of the Dow Theory at work. For a major bull trend to continue, both the Dow Industrials and the Dow Transports must advance together.

6. A Trend Is Assumed to Be in Effect Until It Gives Definite Signals That It Has Reversed.

This tenet, which we touched upon in Chapter 1, forms much of the foundation of modern trend-following approaches. It relates a physical law to market movement, which states that an object in motion (in this case a trend) tends to continue in motion until some external force causes it to change direction. A number of technical tools are available to traders to assist in the difficult task of spotting reversal signals, including the study of support and resistance levels, price patterns, trendlines, and moving averages. Some indicators can provide even earlier warning signals of loss of momentum. All of that not withstanding, the odds usually favor that the existing trend will continue.

Figure 2.2 Examples of two Dow Theory confirmations. At the start of 1997 (point 1), the Dow Transports confirmed the earlier breakout in the Industrials. The following May (point 2), the Dow Industrials confirmed the earlier new high in the Transports.

The most difficult task for a Dow theorist, or any trend-follower for that matter, is being able to distinguish between a normal secondary correction in an existing trend and the first leg of a new trend in the opposite direction. Dow theorists often disagree as to when the market gives an actual reversal signal. Figures 2.3a and 2.3b show how this disagreement manifests itself.

Figures 2.3a and 2.3b illustrate two different market scenarios. In Figure 2.3a, notice that the rally at point C is lower than the previous peak at A. Price then declines below point B. The presence of these two lower peaks and two lower troughs gives a clear-cut sell signal at the point where the low at B is broken (point S). This reversal pattern is sometimes referred to as a “failure swing.”

Figure 2.3a Failure Swing. The failure of the peak at C to overcome A, followed by the violation of the low at B, constitutes a “sell” signal at S.

Figure 2.3b Nonfailure Swing. Notice that C exceeds A before falling below B. Some Dow theorists would see a “sell” signal at S1, while others would need to see a lower high at E before turning bearish at S2.

In Figure 2.3b, the rally top at C is higher than the previous peak at A. Then price declines below point B. Some Dow theorists would not consider the clear violation of support, at S1, to be a bona fide sell signal. They would point out that only lower lows exist in this case, but not lower highs. They would prefer to see a rally to point E which is lower than point C. Then they would look for another new low under point D. To them, S2 would represent the actual sell signal with two lower highs and two lower lows.

The reversal pattern shown in Figure 2.3b is referred to as a “nonfailure swing.” A failure swing (shown in Figures 2.3a) is a much weaker pattern than the nonfailure swing in Figure 2.3b. Figures 2.4a and 2.4b show the same scenarios at a market bottom.

THE USE OF CLOSING PRICES AND THE PRESENCE OF LINES

Dow relied exclusively on closing prices. He believed that averages had to close higher than a previous peak or lower than a previous trough to have significance. Dow did not consider intraday penetrations valid.

Figure 2.4a Failure Swing Bottom. The “buy” signal takes place when point B is exceeded (at B1).

Figure 2.4b Nonfailure Swing Bottom. “Buy” signals occur at points B1 or B2.

When traders speak of lines in the averages, they are referring to horizontal patterns that sometimes occur on the charts. These sideways trading ranges usually play the role of corrective phases and are usually referred to as consolidations. In more modern terms, we might refer to such lateral patterns as “rectangles.”