horizontal ranging formations on the daily chart. They are usually formed in anticipation of some significant news or economic announcement. These narrow consolidations usually result in strong breakouts. Dow Theory recognizes lines as potentially profitable formations, even though they are essentially regarded as minor trends. A line is the only tradable formation under Dow Theory other than inflection point breakouts in the primary trend. See Figure 2.14.
Figure 2.14 Example of a Line on the Daily Chart of the GBPUSD.
Source: MetaTrader 4
We see that each of the three trends is defined by its duration and extent. We shall now look at primary trends in a little more detail.
Primary Trends Have Three Phases
Primary or major trends have three phases. A primary bull or bear market consists of the following three phases:
1. Accumulation phase
2. Trending phase
3. Distribution phase
Accumulation normally occurs after a deep and rapid decline in prices following companies releasing very negative data. The uninformed market participants are usually extremely bearish at this point, selling off whatever shares they have left at any price available. The better informed market participants start accumulating shares at extremely cheap prices. The accumulation phase normally lasts longer than the distribution phase due to less capital and profit at risk.
The trend phase consists of the uptrend and downtrend phase. The uptrend phase is driven by market participants expecting higher prices after an accumulation. The initial general sentiment tends to be slightly less bearish. The public begins to participate as rising prices becomes more obvious and as more bullish news is reported. At higher prices, margin debt starts to increase as the public scrambles to invest in the rapidly rising market. The uptrend phase tends to last longer than the downtrend phase due to less capital and unrealized profit at risk, at lower prices.
The downtrend phase normally starts to accelerate as more companies start to report increasingly bearish news. The uninformed traders and investors begin to unload positions. As prices begin to fall unexpectedly, the public begins to liquidate positions. Bearish sentiment continues to intensify as prices sink to new depths. The downtrend phase tends to be shorter lived than the uptrend phase, due to the larger amounts of capital and unrealized profit at risk, at higher prices.
Distribution normally occurs after a prolonged and rapid rise in prices. Companies tend to outperform and most media and news headlines are extremely bullish. The uninformed market participants tend to be extremely optimistic, buying up whatever shares are available in the market at any price, normally referred to as being in a state of irrational exuberance. Margin debt is at extreme levels. The smart investors continue to liquidate shares in a very gradual manner during the distribution process, again careful not to drive down prices too rapidly so that they may continue to sell at the higher prices. The distribution phase is normally shorter in duration than the accumulation phase, due to the larger amount of capital and unrealized profit at risk at higher prices, at the top of the market. See Figure 2.15.
Figure 2.15 The Idealized Three Phases of a Primary Bull Trend.
Also, the longer the accumulation or distribution lasts, the greater will be its subsequent breakout move. See Figure 2.16.
Figure 2.16 A Real World Example of the Three Phases of a Primary Bull Trend.
A Trend Persists until Its Reversal Is Indicated
In Dow Theory, a trend is assumed to persist until there is evidence to the contrary. Trend changes are identified by a penetration of a previous significant peak or trough. Therefore, unless a prior support or resistance level is breached, the trend is assumed to be still intact. See Figure 2.17.
Figure 2.17 Primary Bull Trend Terminated with a Violation of a Prior Support Level.
Source: MetaTrader 4
There are basically three types of reversal formations that will signal a change in the direction of the existing or predominant trend, namely:
1. Failure swings
2. Non-failure swings
3. Double tops/bottoms
The term failure swing was first used by Welles Wilder in his book, New Concepts in Technical Trading Systems, when describing the oscillator swings on the relative strength index (RSI) indicator. The three basic top reversal formations are illustrated in Figure 2.18. A breach of a prior support signals a potential change in the direction of the trend. It also represents a technical sell signal. Note that the non-failure swing formation provides a more conclusive sell signal at the penetration of the second or lower support level, rather than at the first higher support level. This is because the formation was still in the process of making a higher peak, so more evidence is required to ascertain that a potential trend change is indeed on the way. Nevertheless, many traders use the first higher support level to scale in or out of some positions, with the remainder of the position scaled in or out at the breach of the second lower support level.
Figure 2.18 Top Reversal Patterns.
The three basic bottom reversal formations are illustrated in Figure 2.19. The same rationale applies except in reverse.
Figure 2.19 Bottom Reversal Patterns.
The Averages Must Confirm One Another
In Dow Theory, there is a requirement that both the Industrials Average and the Railroad Average must extend beyond their secondary peaks in order for a trend to be established, that is, the trend in one average must be confirmed by the other average. In Figure 2.20, we observe that the Industrials Average penetrated its secondary peak at T1 while the Railroad Average penetrated its own secondary peak a little later at T2. Hence the uptrend was only confirmed at time T2. As far as Dow Theory is concerned, the uptrend was not confirmed until the Railroad Average penetrated its own secondary peak at T2.
Figure 2.20 Confirmation of the Averages.
In Figure 2.21, we observe that the Dow Jones Industrial Average breached its own secondary peak at T1, which was confirmed later by the Dow Jones Transportation Average breaching its own secondary peak at T2. It is at T2 that the uptrend in the markets was finally confirmed, according to the tenets of Dow Theory.
Figure 2.21 Confirmation of Trend Continuation Based on Dow Theory.
Courtesy of Stockcharts.com
