SOME CRITICISMS OF DOW THEORY
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SOME CRITICISMS OF DOW THEORY
Dow Theory has done well over the years in identifying major bull and bear markets, but has not escaped criticism. On average, Dow Theory misses 20 to 25% of a move before generating a signal. Many traders consider this to be too late. A Dow Theory buy signal usually occurs in the second phase of an uptrend as price penetrates a previous intermediate peak. This is also, incidentally, about where most trend-following technical systems begin to
identify and participate in existing trends.
In response to this criticism, traders must remember that Dow never intended to anticipate trends; rather he sought to recognize the emergence of major bull and bear markets and to capture the large middle portion of important market moves. Available records suggest that Dow’s Theory has performed that function reasonably well. From 1920 to 1975, Dow Theory signals captured 68% of the moves in the Industrial and Transportation Averages and 67% of those in the S&P 500 Composite Index (Source: Barron’s). Those who criticize Dow Theory for failing to catch actual market tops and bottoms lack a basic understanding of the trend-following philosophy.
STOCKS AS ECONOMIC INDICATORS
Dow apparently never intended to use his theory to forecast the direction of the stock market. He felt its real value was to use stock market direction as a barometric reading of general business conditions. We can only marvel at Dow’s vision and genius. In addition to formulating a great deal of today’s price forecasting methodology, he was among the first to recognize the usefulness of stock market averages as a leading economic indicator.
DOW THEORY APPLIED TO FUTURES TRADING
Dow’s work considered the behavior of stock averages. While most of that original work has significant application to commodity futures, there are some important distinctions between stock and futures trading. For one thing, Dow assumed that most investors follow only the major trends and would use intermediate corrections for timing purposes only. Dow considered the minor or near term trends to be unimportant. Obviously, this is not the case in futures trading in which most traders who follow trends trade the intermediate instead of the major trend. These traders must pay a great deal of attention to minor swings for timing purposes. If a futures trader expected an intermediate uptrend to last for a couple of months, he or she would look for short term dips to signal purchases. In an intermediate downtrend, the trader would use minor bounces to signal short sales. The minor trend, therefore, becomes extremely important in futures trading.
NEW WAYS TO TRADE THE DOW AVERAGES
For the first 100 years of its existence, the Dow Jones Industrial Average could only be used as a market indicator. That all changed on October 6, 1997 when futures and options began trading on Dow’s venerable average for the first time. The Chicago Board of Trade launched a futures contract on the Dow Jones Industrial Average, while options on the Dow (symbol: DJX) started trading at the Chicago Board Options Exchange. In addition, options were also launched on the Dow Jones Transportation Average (symbol: DJTA) and the Dow Jones Utility Index (symbol: DJUA). In January 1998, the American Stock Exchange started trading the Diamonds Trust, a unit investment trust that mimics the 30 Dow industrials. In addition, two mutual funds were offered based on the 30 Dow benchmark. Mr. Dow would probably be happy to know that, a century after their creation, it would now be possible to trade his Dow averages, and actually put his Dow Theory into practice.
CONCLUSION
This chapter presented a relatively quick review of the more important aspects of the Dow Theory. It will become clear, as you continue through this book, that an understanding and appreciation of Dow Theory provides a solid foundation for any study of technical analysis. Much of what is discussed in the following chapters represents some adaptation of Dow’s original theory. The standard definition of a trend, the classification of a trend into three categories and phases, the principles of confirmation and divergence, the interpretation of volume, and the use of percentage retracements (to name a few), all derive, in one way or another, from Dow Theory.
In addition to the sources already cited in this chapter, an excellent review of the principles of Dow Theory can be found in Technical Analysis of Stock Trends (Edwards & Magee).
INTRODUCTION
This chapter is primarily intended for those readers who are unfamiliar with bar chart construction. We’ll begin by discussing the different types of charts available and then turn our focus to the most commonly used chart—the daily bar chart. We’ll look at how the price data is read and plotted on the chart. Volume and open interest are also included in addition to price. We’ll then look at other variations of the bar chart, including longer range weekly and monthly charts. Once that has been completed, we’ll be ready to start looking at some of the analytical tools applied to that chart in the following chapter. Those readers already familiar with the charts themselves might find this chapter too basic. Feel free to move on to the next chapter.
TYPES OF CHARTS AVAILABLE
The daily bar chart has already been acknowledged as the most widely used type of chart in technical analysis. There are, however, other types of charts also used by technicians, such as line charts, point and figure charts, and more recently, candlesticks. Figure 3.1 shows a standard daily bar chart. It’s called a bar chart because each day’s range is represented by a vertical bar. The bar chart shows the open, high, low, and closing prices. The tic to the right of the vertical bar is the closing price. The opening price is the tic to the left of the bar.
Figure 3.2 shows what the same market looks like on a line chart. In the line chart, only the closing price is plotted for each successive day. Many chartists believe that because the closing price is the most critical price of the trading day, a line (or close-only) chart is a more valid measure of price
activity.
Figure 3.1 A daily bar chart of Intel. Each vertical bar represents one day’s action.
Figure 3.2 A line chart of Intel. This type of chart produces a solid line by connecting the successive closing prices.
A third type of chart, the point and figure chart, is shown in Figure 3.3. Notice here that the point and figure chart shows the same price action but in a more compressed format. Notice the alternating column of x’s and o’s. The x columns show rising prices and the o columns, declining prices. Buy and sell signals are more precise and easier to spot on the point and figure chart than on the bar chart. This type of chart also has a lot more flexibility. Chapter 11 covers point and figure charts.
CANDLESTICKS
Candlestick charts are the Japanese version of bar charting and have become very popular in recent years among western chartists. The Japanese candlestick records the same four prices as the traditional bar chart—the open, the close, the high, and the low. The visual presentation differs however. On the candlestick chart, a thin line (called the shadow) shows the day’s price range from the high to the low. A wider portion of the bar (called the real body) measures the distance between the open and the close. If the close is higher than the open, the real body is white (positive). If the close is lower than the open, the real body is black (negative). (See Figure 3.4.)
Figure 3.3 A point and figure chart of Intel. Notice the alternating columns of x’s and o’s. The x column shows rising prices. The o column shows falling prices. Buy and sell signals are more precise on this type of chart.
The key to candlestick charts is the relationship between the open and
the close. Possibly because of the growing popularity of candlesticks, western chartists now pay a lot more attention to the opening tic on their bar charts. You can do everything with a candlestick chart that you can do with a bar chart. In other words, all the technical tools and indicators we’ll be showing you for the bar chart can also be used on candlesticks. We’ll show you a bit later in the chapter how to construct bar charts for weekly and monthly periods. You can do the same with candlesticks. Chapter 12, “Japanese Candlesticks,” provides a more thorough explanation of candlestick charting.
Figure 3.4 A candlestick chart of Intel. The color of the candlestick is determined by the relationship between the open and the close. White candlesticks are positive, while black candlesticks are negative.
ARITHMETIC VERSUS LOGARITHMIC SCALE
Charts can be plotted using arithmetic or logarithmic price scales. For some types of analysis, particularly for very long range trend analysis, there may be some advantage to using logarithmic charts. (See Figures 3.5 and 3.6.) Figure 3.5 shows what the different scales would look like. On the arithmetic scale, the vertical price scale shows an equal distance for each price unit of change. Notice in this example that each point on the arithmetic scale is equidistant. On the log scale, however, note that the percentage increases get smaller as the price scale increases. The distance from points 1 to 2 is the same as the distance from points 5 to 10 because they both represent the same doubling in
price. For example, a move from 5 to 10 on an arithmetic scale would be the same distance as a move from 50 to 55, even though the former represents a doubling in price, while the latter is a price increase of only 10%. Prices plotted on ratio or log scales show equal distances for similar percentage moves. For example, a move from 10 to 20 (a 100% increase) would be the same distance on a log chart as a move from 20 to 40 or 40 to 80. Many stock market chart services use log charts, whereas futures chart services use arithmetic. Charting software packages allow both types of scaling, as shown in Figure 3.6.
Figure 3.5 A comparison of an arithmetic and logarithmic scale. Notice the equal spacing on the scale to the left. The log scale shows percentage changes (right scale).