Lecture 1 - Into To TA Dow Theory

Introduction to Technical Analysis & Dow
Theory
FINA 408 - Building a Profitable Trading Strategy

(Using Technical Analysis)
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Technical analysis is the study of market action, which consists of
price, volume and open interest through the analysis of price charts
and oscillators in order to forecast future price trends and patterns.
Technical analysis (TA) key points:
} The study of market action is the study of human psychology, i.e.
behavioral finance.
} Gives you actionable ideas to time markets and make money.
} Is not a “Holy Grail” or guarantee to making money in financial markets.
} Is an another very useful tool to “have in your toolbox.”
} Under certain market conditions these tools may not work; i.e. trading
ranges and long term forecasting.
} Market (prices) always lead fundamentals.
} Technical analysis DISPLAYS the emotions present in all markets.
} Can be used with fundamental analysis to better time entry and exit
} Must have a profound knowledge of TA to be a successful trader and
gain actionable ideas to build a consistent trading system.
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FINA 408 - Building a Profitable Trading Strategy (Using Technical Analysis)
} Humans behave in a similar manner repeatedly: history some
times repeats, if not it rhymes.
} Prices are determined by supply and demand.
} Price discounts all information: records transactions of all
market participants.
} Prices trend; “the trend is your friend, until it ends”
} Prices develop acknowledged patterns.
} Patterns and trends are fractal in time and size.
◦ Fractal means that trends act similar over different periods
of time, shorter trends make up longer trends.
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} A trend in motion is likely to stay in motion until it changes
(something makes it change) similar to Newton’s first law.
} 3 durations of trends:
1. Primary trend: lasts months to years
2. Secondary/intermediate trend: lasts months to weeks
3. Minor/short term trend: lasts days or less; i.e intraday lasts hours or
minutes
} 3 types of trend: 1) uptrend, 2) down trend and
3) Trendless, or sideways trend also called a trading range
} A valid trend tine can be best used to approximate a trend with
two (2) or more touch points, just connect the peaks or troughs.
} The more touch points that price touches the trend line, and the
longer it is, the more powerful it is to last and more important it
is when broken.
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Fundamental vs. Technical Analysis, similarities and differences
FUNDAMENTAL ANALYSIS TECHNICAL ANALYSIS
Robert Rhea Dow Theory

Founder/Year founded Graham & Dodd 1934
1932,
Edwards &McGee 1948
Professional CFA (Chartered Financial CMT (Chartered Market
designations Analyst) Technician)
What should I buy?
Answers the question What should I buy?
When should I buy it?
Studies the cause of market Studies effect through
movements through: financial market action: price,
Methods of analysis
data; models, earnings, B/S, volume, open interest,
I/S, management, ratios, etc. oscillators, etc.
Trends, support,
DCFs, DDM, Multiples (FCF, resistance, moving
Evaluation methods P/S; P/E, P/CF, EV/EBITDA), averages, relative
etc. strength, patterns,
sentiment, oscillators, etc.
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Studies show that the buy and hold Easy to analyze, adaptable to all
fundamental approach outperforms. markets, can be used to follow many
Evaluation theories have merit, markets, can easily see the big
explanations are logical, availability of picture, risk management
concrete information, proven relationships strategies are clearly defined, it
Advantages
between growth/value and stock prices,
saves time, can be precisely
provides and excellent understanding
defined and tested with objective
of company's business/story - what
signals, analyzes price to
they do and how they could be more or
less successful. forecast price
Info. dissemination can be Oftentimes subjective, must learn

inaccurate, wrong info (financial concepts well (appears illogical to
data misleading, fraudulent and the layperson, i.e. confusion btw.
lagging), different accounting primary, intermediate trends), can
standards, it takes too much time to disregard all fundaments (i.e. what
Disadvantages
analyze the data and the price may does that company do anyways?)
start to move as you are researching, has a short term bias, makes you
better timing needed of when to buy, sell a big winner too early.
can use a logical way to Technical strategies usually
substantiate irrational prices underperform buy and hold.
Fundamentals and technicals are often in conflict with each other and
Problem btw. the two: can give you inconsistent buy/sell signals (i.e. at the beginning and
end of market moves)
For short term trading only, is a
RWH/EMH - prices are not always
self fulfilling prophecy,
completely random/efficient, prices
Criticisms (of one subjective, using past price data
have "memory" and exhibit serial
paradigm vs. the other) to forecast future goes against
correlation, evaluation multiples are
FINA 408 RWT/EMT,
- Building a Profitable )
Trading technical
Strategy analysis
(Using Technical 7 is
Analysis)
relative and subjective too!
"voodoo!"
FUNDAMENTAL ANALYSIS TECHNICAL ANALYSIS
Info. dissemination can be Oftentimes subjective, must learn

inaccurate, financial data concepts well (appears illogical to
misleading, fraudulent and lagging, the layperson, i.e. confusion btw.
different accounting standards, it takes primary, intermediate trends), can
Disadvantages too much time to analyze the data disregard all fundaments (i.e. who
and the price may start to move as you cares what the company does?)
are researching, better timing needed Chart analysis has a short term
of when to buy, can use a logical way bias. Generally does not out
to substantiate irrational prices perform a buy and hold strategy
Fundamentals and technicals are often in conflict with each other and
Problem btw. the two: can give you inconsistent buy/sell signals (i.e. at the beginning and
end of market moves)
TA says that RWH/EMH - prices are FA says that TA is for short term
not always completely trading only, is a self fulfilling
Criticisms (of one random/efficient, prices have prophecy, subjective, using past
paradigm vs. the other) "memory" and exhibit serial price data to forecast future goes
correlation, evaluation multiples are against RWT/EMT, technical
subjective too! analysis is "voodoo!"
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If you recall from your other courses in finance theory…
Efficient Market Hypothesis (EMH)

Empirical analyses have conformed strong and semi-strong efficiency
but found problems with semi-strong, the most consistent being that
stocks with low price to earnings (and similarly, low price to cash-flow
or book value) outperform other stocks. The three forms of efficiency
are:
1. Weak form:
◦ Past prices(information) are fully reflected in current market
prices.
◦ Implies: trends in prices and thus technical analysis does not work
and should not be able to consistently outperform the market.
Then why can some technical analysts accurately forecast prices
in certain cases?
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2. Semi-strong form:
◦ Prices reflect all public information and instantaneously adjust
to new information. *
◦ Implies: No abnormal returns can be made by acting on publicly
available information; i.e. You can’t make money by
fundamental analysis of public information like annual reports.
◦ Implies that fundamental analysis is worthless, but low P/B,
P/E and P/CF, high dividend stocks show otherwise.
3. Strong form
◦ Prices reflect all pertinent public and non-public “insider”
information.
◦ Implies: No one not even company insiders can make abnormal,
excess returns because laws and regulation should prevent
insiders from trading on such information.
◦ Studies show that strong form does not generally hold.
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} Most empirical studies until the late 1980’s showed that well
developed capital markets are highly efficient in the weak
form, reasonably efficient in semi-strong and are not strong
form efficient.
} However since then, computing power and new and omitted
empirical studies have disputed EMH and the random walk
theory to some degree thus leading to an increased
acceptance of the validity of technical analysis, especially in
academia.
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◦ Was the stock collapse predictable using Technical Analysis before
and as the negative fundamental story came out?
◦ The importance of primary up trend breaks*
FINA 408 - Building a Profitable Trading Strategy (Using Technical

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Analysis) 12
} Developed by Charles H Dow – who was the first editor of the
Wall Street Journal and one of the founders of the Dow Jones
Company.
} He is widely regarded as the father of modern technical
analysis. He created the Industrial Average – (which later
became the DJIA – Dow Jones Industrial Average) and the Rail
Average – (which became the Dow Jones Transportation
Average - DJTA).
} He never created these averages to be used as a tool to
forecast stock prices, but rather to be used so that stocks can
be used to gauge general economic conditions.
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*Recent changes were in 2015
Source: djndexes.com
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} He never coined the term ‘DOW THEORY’. That was coined by his
friend A.C. Nelson, who wrote ‘The ABC of Stock Speculation’
which was an analysis of Dow’s Wall Street Journal editorials.
} Though it wasn’t until after his death, that William Peter

Hamilton, his successor at the Wall Street Journal, brought his
theories to a wider audience, with the introduction of his book,
‘The Stock Market Barometer’ in 1922.
} After Hamilton’s death in 1929, Robert Rhea further refined

Dow’s theory when in 1932 he wrote, ‘The Dow Theory: An
Explanation of Its Development and an Attempt to Define Its
Usefulness as an Aid to Speculation’ where he published the 6
tenets of DOW Theory.
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I – THE AVERAGES DISCOUNT EVERYTHING
} Stock prices reflect both, current and future expectations of
general economic activity. Market participants act on both
current information as well as future economic expectations, and
their actions (buying and selling) will affect the averages. Even
‘Acts of God’ (natural disasters) which obviously cannot be
anticipated, are very quickly discounted into the averages.
II – THE MARKET HAS 3 TRENDS
} Dow defined an uptrend as a situation categorized by a series of
rising peaks and troughs and a downtrend as a situation
categorized by a series of successively lower peaks and troughs.
} He considers each trend to be made up of 3 parts: PRIMARY,
SECONDARY and MINOR.
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} The PRIMARY trend represents the TIDE
} The SECONDARY trend represents the WAVES and
} The MINOR trend represents the RIPPLES.
1 – THE PRIMARY TREND represents the longest of the trends. It
represents the overall, broad, long-term movement of security prices.
It can last a long time, sometimes even years. If it is an upward trend
in price action, we would call it a BULL MARKET, if it is a downward
trend, we’d call it a BEAR MARKET.
2 – THE SECONDARY TREND also known as intermediate trend, are the
CORRECTIVE REACTIONS to the primary trend.
} Down in a bull market
} Up in a bear market
} They often retrace 33 – 66% of the preceding gain / loss, although
they usually end at a 50% retracement. They usually last 3 weeks to
3 months. Combats excessive speculation.
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3 – THE MINOR TRENDS are likened to the ripples in a wave.
They are short term and usually last less than 4 weeks.
} They can be misleading and are likened to ‘NOISE’ with

respects to the larger trend. They are sometimes brought
about by daily supply and demand disruptions brought on by
small investors trying to liquidate their positions, particularly
on illiquid issues.
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III – PRIMARY TRENDS HAVE THREE PHASES
BULL MARKET:
1 – ACCUMULATION PHASE: begins at the end of the last stage of the bear
market. Here prices are depressed and economic news is negative.
Farsighted and informed investors start picking up stock at cheap prices in
anticipation of rosier times. (Contrarian buying)
2 – The 2nd stage is characterized by improving economic conditions and

improving corporate earnings. The media catches on and the public
begins to buy as well.
3 – This 3rd and final stage of the bull market is characterized by positive
economic conditions, bullish stories and newscasts, and a buying frenzy.
Investors believe that the market is unstoppable, and bid up prices to high
levels. This is where our farsighted investors (the so called SMART
MONEY) should start selling, as they believe things may have gotten out of
hand..
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BEAR MARKET:
1 – DISTRIBUTION PHASE: began at the end of the last stage of the bull
market. Although economic news is positive, the SMART MONEY investors
start selling, as they fear there is no more room to head higher and take
contrarian positions against the ‘laggard’ retail investors.
2 – The 2nd stage is characterized by strong selling due to negative

economic activity and deteriorating earnings. Volumes start to pick up as
does the rate of selling.
3 – The 3rd and final stage of the bear market is characterized by negative
news stories as fed on by the media. It is characterized by capitulation
selling, as investors who have kept their shares give in to the selling as a
means of raising cash. Prices tumble at this point, as there are not many
people willing to buy. This is where the farsighted investors see opportunity
to buy cheap stock and late in the stage begin buying again, taking us out of
the bear market and starting the process all over again.
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IV – THE AVERAGES MUST CONFIRM EACH OTHER
} DOW THEORY can only be confirmed if BOTH averages, the DJIA

and the DJTA reach new highs or new lows. They do not have to
do so simultaneously, but one signal should soon follow the other
before the first average reverses its initial trend.
} In order for the INDUSTRIALS to be profitable, they need to get

their products to market, i.e. they have to be shipped or
transported to their respective destinations. To Dow, a bull
market in industrials could not occur unless the railway average
rallied as well. Only once this is done, is a healthy economy truly
confirmed.
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Analysis) 23
V – VOLUME CONFIRMS THE TREND
} While DOW focused primarily on price actions, he recognized the value

of volume as an important secondary factor in confirming the major
trend. Volume should expand in the direction of the prevailing trend.
Volume is also important in confirming the strength of the advance,
representing the “true market view”.
} In an upward trend,
} Volume should ↑ when prices are ↑ &
} Volume should ↓ when prices are ↓ during corrective sell offs
} In a downward trend,
} Volume should ↑ when prices are ↓ &
} Volume should ↓ when prices are ↑ during corrective rallies.
} While volume plays an important role in basic trend analysis, Dow held
that it is best suited for use as a tool that confirms other forms of
analysis.
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Analysis) 25
VI – A TREND SHOULD BE ASSUMED TO PERSIST UNTIL IT GIVES
DEFINITE SIGNALS THAT IT HAS REVERSED
} In other words, a trend in motion remains in motion until it

gives signals of a reversal. We are best served by assuming that
the trend is still in effect until there is clear evidence of a
reversal.
} We should not get arrogant and believe that it will turn soon,
and take action against it. We must wait for there to be a clear
reversal signal before taking action.
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} Investors will act after than and before market tops and
bottoms.
} There are lags between the actual turn in the primary trend and
the recognition of the change in the trend. The theory does not
recognize a turn until long after it has occurred and has been
confirmed.
} Different trends are not strictly defined. Often the
interpretation of price swings is difficult to assign to a specific
trend type. Secondary trend beginnings often appear like
primary trend beginning.
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“When you enter the stock market you are going into a competitive
field in which your opinions and evaluations will be matched against
some of the sharpest minds in the business. You will certainly be
exposed to advice, suggestions and offers from all sides. Unless you
are able to develop some market philosophy of your own you will
not be able to tell the good from the bad, the sound from the
unsound.”
- John Magee (Edwards & Magee, 2009)

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Analysis) 28
To help prioritize your required readings for today's class, please read and focus on
the following topics as per course schedule xls doc:
- Advantages/disadvantages/assumptions/criticisms of technical analysis
- Chapter 5, pgs 57-59, 68-71, all else is more for your info
- Dow theory; 3 trend types, tenets, volume, confirmation, criticisms
The rest of the assigned readings for today’s class you will find very interesting but
of lesser importance for testing.
End of chapter questions

} We will suggest to that you self test yourselves with end of chapter questions
that you can test yourself by locating the response in the Chapter readings as
answer solutions are not available and will not be provided.
} Suggested self test questions:
Ch 2; Questions: 5, Ch 4; Questions: 5
Ch 6; Questions: 2,4,7,8, 9,10
See: Practice Exam – CMT 2014 - lecture ques guideline.xlsx
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Introduction to Technical Analysis & Dow

FINA 408 - Building a Profitable Trading Strategy

Robert Rhea Dow Theory

Info. dissemination can be Oftentimes subjective, must learn

Info. dissemination can be Oftentimes subjective, must learn

Efficient Market Hypothesis (EMH)

FINA 408 - Building a Profitable Trading Strategy (Using Technical

} Though it wasn’t until after his death, that William Peter

} After Hamilton’s death in 1929, Robert Rhea further refined

} They can be misleading and are likened to ‘NOISE’ with

2 – The 2nd stage is characterized by improving economic conditions and

2 – The 2nd stage is characterized by strong selling due to negative

} DOW THEORY can only be confirmed if BOTH averages, the DJIA

} In order for the INDUSTRIALS to be profitable, they need to get

} While DOW focused primarily on price actions, he recognized the value

} In other words, a trend in motion remains in motion until it

- John Magee (Edwards & Magee, 2009)

FINA 408 - Building a Profitable Trading Strategy (Using Technical

End of chapter questions

See: Practice Exam – CMT 2014 - lecture ques guideline.xlsx

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