Technical Analysis 101 – The “Tao” of Technical Analysis Pt2

TA as a concept is nothing new. Some say its origins date back to 1600’s Japan where traders used TA to analyse rice futures. In the 1800’s analysts were using P&F charts but it wasn’t until the late 1800’s that the foundations were laid for what we now know as today’s technical analysis. These foundations were laid by Charles H Dow. If you look into his work in some detail, you can clearly see how his ideas and theories have rippled down into todays current TA. in the last 20 years TA has really taken off due to IT and technological developments. Today TA is a staple part of todays financial markets.

In this blog we are going to look in a bit more detail the works of Mr Dow, the “daddy” of modern TA as an understanding of his works is critical to an understanding of todays TA.

July 3rd 1884, Dow published the first stock market average to determine the economic health of the country. This was his goal – economic analysis not for forecasting the direction of the stock market. Most of his theoretical work applied to his equity indices averages but can apply equally as well to other spheres of asset class.

There are 6 underlying principles to his works:

  1. The averages discount everything
  2. The market has 3 trends
  3. Major trends have 3 phases
  4. The averages must confirm each other
  5. Volumes must confirm the trend
  6. A trend is assumed to be in effect until it gives definite signals it has reversed

I’m not going to spend too much time on the six underlying principles. That is for another time.

1. The averages discount everything:

  • Meaning that “everything” is reflected in the price of a market average such as the Dow.
  • Shocks not factored in are quickly discounted in to the price once they occur.

2. The market has 3 trends:

  • Dow determined a trend as higher highs and lower lows.
  • The 3 trends are: Primary, Secondary, Minor
  • He compared these to the sea: The Tide, The waves, The ripples
  • Trend length: Primary >1yr+, Secondary 3 weeks to 3 months – intermediate corrections retracing 1/3rd to 2/3rds of previous trend. Minor < 3 weeks

3. Major trends have 3 phases:

  • Dow focused mainly on the primary and secondary trends
  • 3 phases: Accumulation: (Buying by astute investors)

Public participation (TA follows join in)

Distribution (newspapers print stories – rest jump in)

  • Similar to Elliott Wave Theory used today (This topic will be blogged soon)

4. Averages must confirm each other:

  • His 2 key averages must be in confirmation with each other
  • In todays TA confirmation, divergence, continuation patterns all come off the back of this theory.

5. Volume must confirm trend:

  • Volume should expand or increase in the direction of the major trend.
  • Using the secondary component for confirmation.

6. A trend is assumed to be in effect until it gives definite signals it’s reversed:

  • Foundation for trend following techniques: support and resistance, patterns, trendlines, moving averages.
  • Dow theorists disagree on trend break analysis / reversals in price action.
  • 2 ideas on this: a. Failure swing 2b. Non-failure swing

Concluding thoughts on Dow theory.

At its time this was truly revolutionary thinking. Problem now is its just a bit dated with changes in technology, thinking etc. But as you will see as the blogs on TA evolve that his work really did lay the foundations for TA that is used today.

Other problems are that the markets have also changed. It’s a lot faster. Today traders trade more the “ripples” than the “tides”. Benchmarking Dow theory is difficult and a little unfair as he never really intended it as a trading tool (although it has done a good job) but as an economic tool where major bull and bear market trends could be identified.

One last comment. Up until 1997 you could not trade the Dow Jones Industrial Average (DJIA). Now you can trade both futures and options on it via the CBOT (Chicago Board of Trade) exchange.

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