style="font-size:15px;"> 7. The averages must confirm each other: The rationale behind this logic is that in a healthy economy, the goods produced by industry are in great demand and this is evidenced by the amount of transport activity generated in trying to ship these goods to the consumers. Therefore, underperformance in either the industrial or transportation averages leading to non-confirmation would logically signal potential trouble in the economy. Unfortunately, the Dow Jones Industrial Average today is composed of many stocks that do not produce any physical product that requires shipping or transport, in general. Many of today’s companies are more involved in financial products, telecommunications, and insurance. This severely diminishes the effectiveness of confirmation between the industrials and the transports. Many practitioners today prefer to look for confirmation between large cap and smaller cap indices like the S&P500 and Russell 2000 as a more reliable barometer of market action.
2.4 CHAPTER SUMMARY
As we have seen, Dow Theory forms the basis for much of technical analysis in the twenty-first century. Although technical analysis has evolved significantly since Dow’s time, many practitioners still regard the basic application of Dow Theory as one of the most reliable approaches in determining and confirming the existence of a trend. The incorporation of the concept of market phases and volume confirmation within Dow Theory has also significantly impacted the way investors and traders participate in the market, more than a century after its introduction.
CHAPTER 2 REVIEW QUESTIONS
1. Describe the basic tenets of Dow Theory.
2. Give examples of the primary trend being manipulated.
3. Is Dow Theory still relevant in today’s market?
4. Describe the main weaknesses of Dow Theory.
5. Explain why volume should expand in the direction of the existing trend.
6. In what ways is accumulation similar to distribution?
7. Why is the secondary reaction more problematic than the primary trend?
8. What are the main differences between Dow’s and Ralph N. Elliott’s determination of a trend?
REFERENCES
W. P Hamilton. 2006. The Stock Market Barometer. New York: Cosimo Classics.
S. A. Nelson. 2007. The ABC of Stock Speculation. Marketplace Books.
Robert Rhea. 1994. The Dow Theory. Flint Hill, VA: Fraser Publishing Co.
Richard Schabacker. 1997. Technical Analysis and Stock Market Profits. Upper Saddle River, NJ: FT Press.
Jack Schannep. 2008. Dow Theory for the 21st Century: Technical Indicators for Improving Your Investment Results. Hoboken, NJ: John Wiley & Sons.
CHAPTER 3
Mechanics and Dynamics of Charting
After studying this chapter, you should be able to:
• Understand chart construction and how technical data is incorporated and displayed
• Describe the process by which OHLC data is created and its relationship to various charts
• Identify and differentiate between contango and backwardation and understand the connection with negative and positive roll yields
• Understand the adverse effects of the bid-ask spread on trading performance
• Construct various charts using constant measures of time, range, volatility, trade volume, and number of transactions
• Set up a volatility-neutral chart for consistent viewing of price action
Traditional charting is a two-dimensional matrix upon which technical data or information is viewed. It affords the practitioner a means of tracking technical data in a meaningful way, revealing various repetitive price pattern behavioral traits and market volatility. In addition, charting also clearly reveals price distortions and illiquidity in the market. It allows for the application of technical analysis such as the drawing of trendlines, channels, envelopes, and chart patterns on price, helping to uncover important price reaction levels, which are driven by the consistent underlying psychology and perception of all market participants. In this chapter, we shall cover the basics of chart construction and how technical data is displayed.
3.1 THE MECHANICS AND DYNAMICS OF CHARTING
There are many ways that a technical analyst can analyze and display market data. Data may be displayed either in a numerical or graphical form. All numerical data may be displayed graphically, if required. Analysts using numerical information to study market action may also resort to various quantitative and statistical techniques in an attempt to predict future price direction and volatility. These quantitative analysts and statisticians employ various forms of time series and stochastic analysis and conduct back and forward testing on technical data. They also try to identify price anomalies and arbitrage opportunities using sophisticated software programs and high-speed data connectivity.
More traditional analysts prefer to work using only a graphical representation of technical data, which comes in the usual form of a price-time chart, where the vertical axis tracks the movement of price and the horizontal axis tracks the motion of time. The price axis may be scaled in an arithmetic (linear) or logarithmic (ratio) fashion. On some charts, the time axis may not always be plotted in equal increments or units of time, but rather acting more as a counter for new blocks of data rather than an explicit representation of the passing of time. On such charts, time is regarded as implicit along the x axis.
Traditional analysts study classical chart patterns, trendlines, window oscillators, overlay indicators, and various other price formations. Analysts who use charts to study technical data are called chartists. Note that quantitative analysts and statisticians also tend to use charts to display numerical data, although it is optional.
Technical Data
Some of the more common technical data or information employed to construct charts include:
• Price Data:
• Open (O)
• High (H)
• Low (L)
• Close (C)
• Transaction-Related Data:
• Volume (V)
• Open Interest (OI)
• Market-Breadth Data:
• Advances (A)
• Declines (D)
• Total Issues (T)
• Up Volume/Down Volume (UV, DV)
• New Highs/New Lows (NH, NL)
• Bullish Percent Data
• Sentiment Data:
• Put/Call Ratio
• Short Interest
