Thursday, September 13, 2012

Can Dow Theory be applied to short term trading as a filter?

While I plan to develop this idea in further posts, the answer is yes. The primary trend of the market as determined by the Dow Theory is so powerful that it is a very good filter to apply to other trading strategies. Hence, even though a trader might think that a trade lasting 1 week can be taken irrespective of the long term trend as determined by the Dow Theory, he is wrong. If he takes the trade according to the primary trend, his performance (measured as average trade or profit factor) can increase by 20-30% depending on the strategy. The longer term the strategy, the more powerful the positive influence of the primary trend on your trading results.

One might ask: “why bother with the Dow Theory to determine the primary trend when one can use as a substitute a 200 day moving average?”.

I have two answers to this objection:

Firstly, per se, the Dow Theory primary trend is less noisy than a moving average. In other words, it performs much better than a moving average filter because it contains more information (i.e. the combined movement of two indices). Let's imagine a system which, by definition, and irrespective of Dow Theory, never takes a trade if the long term moving average is bearish. Theoretically, this would make the Dow Theory primary trend superfluous. Alas, things are not so easy. While the system is profitable with just a moving average as the long trend filter, trading results are dramatically increased when we plug in a “Dow Theory Primary Trend Filter”. The explanation is clear. Dow Theory signals contain more information and less noise than a mere moving average. Bear in mind that for a primary bull market signal to exist, it is necessary that two of the three indices (DJI, Transports and S&P) confirm each other. This is much more information than a mere moving average.

Secondly, in many instances, the Dow Theory is more responsive to market conditions than a long term moving average. In other words, the Dow Theory bull market signals is given before the moving average reading becomes bullish.

This kind of trading is not Dow Theory and I don’t want to be misinterpreted. Dow Theory is not supposed to be “traded”. However, the Dow Theory is so accurate in determining the primary trend of the market (whose median duration is ca. 2.5 years) that it clearly benefits any short term and medium term trading system that seeks alignment with the almost noise-free primary underlying trend. However, I insist again, you have to have your own trading system which you may supplement with a Dow Theory filter. But this is not "Dow Theory trading" or the "new Dow Theory trading method". This would be like raping the venerable Dow Theory. What I suggest here is just a modest a modest addition to the trader's toolbox.

A modest increase of 20% in the average trade is significant for short term traders, since, according to my experience, commission and slippage may account for 20% of their trading costs.

Gross Avg Trade before Dow Filter: 100 USD
Minus slippage & commission:           20 USD
Net Trade:                                             80 USD.

Gross Avg Trade after Dow Filter: 120 USD
Minus slippage & commission:        20 USD.
Net Trade:                                         100 USD.

Profit increases by 100/80 = 25%.

So a mere 20% increase in "gross trade" represents a real 25% increase in profits when trading costs are factored in. 

Maybe I am a bad trader that needs a Dow Theory crutch to improve my trading. However, I can only say that since I integrated my "Dow Theory Primary Trend Filter" into my trading arsenal performance went up (and, more importantly, draw downs were shallower and shorter).

There is much more to it and it is a world in itself. But this suffices as a starter to open up new views.

The Dow Theorist.

1 comment:

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