Thursday, August 30, 2012

The Dow Theory gives us order. It provides us with a framework to analyze the market.

We fail at making money in the markets not because of a lack of tools but because we (1) lack consistency in using our tools, (2) have an undefined time-frame and (3) lack of well defined exits (stops)

Dow Theory addresses these three issues: It allows us to be consistent. Of course, to be consistent you have to believe in it. And such faith in Dow Theory will come from focused study. Dow Theory is based on a definite set of rules which make sense aprioristically and empirically. And we also know that it works, since the Dow Theory has a proven track record spanning more than 110 years. Few technical systems can boast such outstanding “back testing results”. The rules are sufficiently defined and psychologically bearable so that we consistently use them and not jump from one method to the next while our losses mount. When the Dow Theory is properly digested (and hopefully this blog helps you at that) it is easy to buy when it says to buy and to sell when it says “sell” (which usually translates into “get out of danger and run for the exits”).

It has clearly defined time-frames. We know the time it takes for a movement to be qualified as a correction, we roughly know what to expect (at a minimum) of a primary movement both in time and extent. We know that to qualify as a rally price action must have a magnitude of at least 3%. Dow Theory gives us a yardstick with which we can assess market conditions. Personally, without the Dow Theory yardstick I am at a loss when trying to make sense of the markets. It is like being unable to read. Without Dow Theory I feel market illiterate.

And last but not least, the Dow Theory tells us when to run for the exits. As Buffet said the first rule of investing is not to lose money, the second one not to forget the first one. Most fortunes are lost (not only in trading/investing but mainly by entrepreneurs but this is the subject for another post) by not knowing when to get out. In other words, capital is usually lost by poor timing. Dow Theory, while not having hard defined stops (and this is good to avoid stop running), adapts to the vicissitudes of the market and tells us when to get out. Studies show that rarely the Dow Theory gives away more than 10% of the unrealized gains from the top. Hence it helps us keep our power dry and while sitting on the sidelines in cash, expect the next bull wave (primary movement).

Dow Theory gives order to the universe or, at least, a powerful tool to analyze it. When one learns to identify a primary swing, a correction, a rally, etc. one is able to see the market as if through a kaleidoscope. Suddenly all the crystals fall in place.

The Dow Theorist

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