Why Dow Theory matters: Outstanding Risk Reward Ratio thanks to the Dow Theory’s trailing stop.

Today we have an important money making (or rather  money “saving”) post. 

Please mind that I am writing this before the open with the closing prices of Friday, September 7. 

In the last Saturday’s post “The price of not heeding the Dow Theory: From 06/29/2012 to date 5.8%” (click here), I insisted that the odds clearly favor a continuation of the primary bull movement that started on June 4 and was identified by the Dow Theory on June 29.

But you may not be convinced and say to yourself: “What would happen if the market suddenly reverses? After all, I don’t have any faith in this bull market, all the Dow Theory Investment posts notwithstanding”

Here is my answer: Even if, contrary to the prevailing odds, the market reverses its course and enters a new primary bear market, the losses to our portfolio should be minor, if any. Why?

Why?

Why?

Why? (it is not a typo. I want you to think it over)

Because under Dow Theory we know that the last primary bear market lows were made on June 4 at 128.1 for the SPY. And we know that since then the SPY gained 12.4%. 

When or at what level would be given a sell signal under Dow Theory? It is given when a new primary bear market is signaled. 

As of this writing the indices have not undergone a secondary reaction. If we had had one, then under Dow Theory, such lows would be the lows that would trigger a sell signal.

However, we didn’t have such secondary reaction yet, as the market shoot straight up since June 4^th to date. Under Dow Theory the lows we have to check for a primary bear market signal to be given are the lows of the last leg of the primary bear market which ended on June 4^th, namely 128.1 for the SPY and 12,101.46 for the Industrials. 

If  you want to better understand what I mean by “secondary reaction” go here 

If you think hard about this, maybe you begin to see that I welcome and embrace open armed secondary reactions. Why? Am I insane? Do I like seeing my unrealized gains being vaporized? No, I’m not insane. Since a correction tends to retrace between 1/3 and 2/3 of the previous primary upward movement, this means that, by definition, the last correction lows are higher than the preceding ones. In other words, as the market undergoes corrections our “exit” point is lifted higher and higher. Thus, the Dow Theory provides us with a very effective trailing stop that automatically adjusts to the advancing trend. 

But, as I said, we have not had the “privilege” of undergoing a secondary reaction yet, so, for now, the only lows whose violation would determine the end of the bull market are the lows made on June 4^th (final bear market lows). 

We know that the “distance” that separates the lowest lows made in June and the current market level is 12.67%. But since the follower of the Dow Theory entered the market at 136.1 on 06/29/2012, this means that the maximum loss if the markets were to plunge and violate the June 4^th lows would be a 6.25% Loss.

Please mind that this is 6.25% is the maximum loss we would make under the most adverse conditions, namely:

a)      That the market goes straight down to the lows of the last primary bear movement made on 06/04/2012.

b)      That the market fails to make any further advance by which the lowest low of the next reaction is (under normal circumstances) lifted up as well.   

       

We know that primary bull market movements tend to make on average at least 40% in the first year after the bull signal was issued (that is in our case after 06/29/2012). This means that if things play out just “normal” we are facing a potential reward of ca. 40% against a potential maximal loss (which should be diminishing as the primary bullish trend “survives” secondary reations) against a potential loss of 6.6%. In the jargon of trading we would say that there is a RRR (risk reward ratio) of 40/6.6 = 6.06 which is an outstanding RRR.

The bottom line: Dow Theory fulfills the two the tenets all successful investors have in common: Keep your losses short, which it does thanks to the trailing stop we have just described. Under Dow Theory, we always know how much we stand to lose whereas the profits are open ended, thus also satisfying the second rule of the good traders: Let your profits run. 

The chart below shows you how two successive corrections within a bull market result in higher trailing stops (based on the last registered correction low). Please mind that this chart reflects Oct 2009-March 2010 market conditions and is not related to current market action.

Proper use of the Dow Theory results in trailing stops following each correction

The red thin line is the first Dow Theory trailing stop which was set a 12 days correction finished. The orange thicker line is the higher trailing stop which was set after a new 14 days correction established a higher low. Please mind that the only significant lows are the reaction (correction) lows; not the lows made on normal pullbacks that do not qualify as a secondary reaction under Dow Theory.

Here you have the numbers:

 

DOW THEORY PRIMARY TREND MONITOR
			SPY
Bull market started		06/04/2012	128.1
Bull market signaled		06/29/2012	136.1
Last close		09/07/2012	144.33
Current stop level: Bear mkt low			128.1
Unrlzd gain %	Tot advance since start bull mkt	Max Pot Loss %
6.05%	12.67%	6.25%