The Handbook of Technical Analysis + Test Bank. Lim Mark Andrew
is defined primarily as successively higher peaks and troughs. A downtrend is defined as successively lower peaks and troughs. Notice in Figure 2.4 that the appearance of a lower high in an uptrend may represent an early indication that the uptrend may be coming to an end.
Figure 2.4 An Uptrend in Terms of Successively Higher Highs and Lows.
In Dow Theory, an indication of a trend continuation or reversal is signaled by the penetration of a previous peak or trough. As such, one of the main criticisms of Dow Theory is that buy and sell signals arrive too late, usually missing out on one-third or more of the entire trend. According to Dow, it is more important to participate in a primary bull or bear trend once it has been confirmed or once it proves that it has the strength to penetrate old peaks or troughs. Dow believes that losing out on some potential profit for the added safety of participating in a confirmed trend is well worth the sacrifice. It should also be noted that all investment and trading decisions are based strictly on the primary trend alone, with the exception of trading lines that may form from the daily price fluctuations. See Figure 2.5.
Figure 2.5 Buy and Sell Signals Based on Dow Theory.
Figure 2.6 depicts a primary bull trend in gold that lasted approximately 12 years.
Figure 2.6 A Primary Bull Trend in Gold.
Courtesy of Stockcharts.com
Figure 2.7 depicts a primary bear trend in the 30-year Treasury bond yield that lasted approximately 23 years.
Figure 2.7 A Primary Bear Trend in the 30-Year Treasury bond Yield.
Courtesy of Stockcharts.com
It should be noted that if trends are defined via trendline violations rather than by the successive sequence of rising or falling peaks and troughs, there may be some discrepancies between exactly when a change in trend actually occurs, especially when different chart scaling is employed. Logarithmically scaled charts tend to give earlier trend change signals since uptrend lines are violated sooner. Conversely, arithmetically scaled charts tend to give slower trend change signals as uptrend lines are violated much later. See Figures 2.8 and 2.9.
Figure 2.8 Bull Market Turning into a Bear Market with Early Trend Change Signals on a Logarithmically Scaled Chart of the Nasdaq 100 Index.
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Figure 2.9 Bull Market Turning into a Bear Market with Late Trend Change Signals on a Arithmetically Scaled Chart of the Nasdaq 100 Index.
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Sometimes it may be hard to decide which scaling to use in order to apply technical overlays in a manner that would provide consistent signals. If an analyst has been using logarithmically scaled charts on a regular basis, his or her interpretation of the price action may differ from an analyst who regularly uses arithmetically scaled charts. Figures 2.10 and 2.11 show Apple Inc. displaying a more bearish flattening-out-type behavior on a logarithmically scaled chart, whereas the arithmetically scaled charts depict a stronger and steadier uptrend for the same stock over the same period.
Figure 2.10 Bearish Flattening Type Action on Apple Inc.
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Figure 2.11 Non Flattening Type Action on Apple Inc.
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(2) The Secondary Trend or Reaction
The secondary trend is also referred to as the secondary reaction because it moves or reacts in the opposite direction of the existing primary trend. It usually lasts from weeks to approximately three months, and frequently slightly longer. It is sometimes referred to as the waves on the tides. The secondary reaction usually retraces from one- to two-thirds of the primary trend’s range. Any retracement or correction beyond two-thirds on high volume usually signifies that the secondary reaction may in fact be a new primary bear market. It is important to note that Dow Theory also stresses the importance and psychological significance of the 50 percent retracement level, a view shared by another prominent technician, W. D. Gann.
A primary bull trend resumes its uptrend once price breaches the highest peak formed by the secondary reaction, while a primary bear trend resumes its downtrend once price breaches the lowest trough formed by the secondary reaction. Figure 2.3 showed the NYSE Composite Index resuming its primary bull market around the beginning of 2011 after breaching the peak formed during the formation of the secondary reaction. Figure 2.12 depicts a 75 percent secondary reaction on the Dow Jones Industrial Average. The primary bull market resumes its uptrend upon breaching the highest peak formed during the secondary reaction.
Figure 2.12 Primary Bull Market Resuming Its Uptrend after Breaching the Highest Peak of the Secondary Reaction on the Dow Jones Industrial Average.
Courtesy of Stockcharts.com
Figure 2.13 depicts various secondary reaction retracements in the EURUSD.
Figure 2.13 Secondary Reactions on the EURUSD Daily Chart.
Source: MetaTrader 4
(3) The Minor Trend
The minor trends are not regarded as important in Dow Theory. In fact, Hamilton commented in his book, The Stock Market Barometer, that “The stock market is not logical in its movements from day to day.”
Minor trends usually last from days to weeks. They are sometimes referred to as the ripples on the waves.
Under Dow Theory, the day’s erratic fluctuations represent market noise and no investment decision should be based on such erratic activity, with the exception of lines being formed. Lines are simply narrow 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.