Saturday, June 1, 2013

Dow Theory special issue: Dissecting the classical/Rhea Dow Theory record. Profit factor and more

Part 2: Final statistics.

Eight days ago, I posted “Dissecting the classical/Rhea Dow Theory record." In that post, I examined vital statistics concerning the positions taken in pursuance of the Dow Theory primary bull and bear market signals.

Today, we will expand further our analysis by focusing on:

·        Win to lose ratio.

·        What percentage of time I am in the market?

·        What’s the profit factor?

·        Do secular bull and bear markets affect the Dow Theory signals?

With no more preambles let’s get started.


Win to lose ratio: 8.86


If you divide the average win by the average loss, then you get the “win to lose” ratio. To judge the merits of the “win to lose” ratio, one has to take into account the percentage of winners. A “win to lose” ratio of 5 is exceptional when coupled with 90% winning trades. However, same ratio of 5 would be a disaster with only 10% winning trades.

From the preceding post, we know that 76.3% of the transactions taken in accordance with the Dow Theory ended up being winners. A win to lose ratio of 8.86 coupled with 75.3% of winners is something really outstanding. Any trader worth his salt, acquainted with the assessment of trading systems can attest to this.

Such a high ratio tells us that winners exceed losers by a huge factor. Thus, the Dow Theory complies with the investing tenet “let your profits run and cut your losses short." We win a lot when we win; we lose a little when we lose. Not bad.

Percentage of time on the market: 64.07%


If my spreadsheet doesn’t fail me, 40770 days elapsed from July 12, 1897 (first buy signal) and June 4, 2012 (last sell signal). Total time on the market was 26125 days (summation of time corresponding to all transactions taken). Thus, 64.07% of the time we were invested on the market. This implies that 35.93% of the time, one was on the sidelines sitting on cash.

Thus, we can say that roughly 1/3 of the time, we were out of the market. 1/3 of the time is the average duration of primary bear markets versus bull markets. This implies that the Dow Theory did a great job in spotting primary bear markets and keeping the investor on the sidelines while the storm was decimating buy and hold investors.

The “Rhea/classical” Dow Theory outperforms by ca. 2% buy and hold, by being roughly only 2/3 of the time on the market (and avoiding thus hair-curling drawdowns). In my opinion, this is a remarkable feat: to outperform 2%, reducing drawdowns (the risk component of the ratio) and doing all this “using” only 2/3 of the available time.

Of course, I don’t advocate for shorting when a primary bear market is signaled. Shorting is not so easy. As I summarized here, shorting is not so advisable because:

• Primary bear markets last less than primary bull markets.

• Primary bear markets decline percentage wise less than bull markets.

• Hence, the amount likely to be made is lower than in primary bull markets, whereas the potential loss is higher (market reversal).
• Furthermore, shorting costs money: dividends have to be paid, and most brokers charge expensive shorting fees, which grow higher the longer the trade (it is like paying interest on the amount shorted).

• Shorting forces you to use a margin account. This is not the most suitable account for a long-term investor concerned with safety because it also implies that, when being long, shares can be loaned out.
• Thus, I don’t favor a short position along the primary bear market.

For those who know very well what they do, short term shorting along a primary bear market (and even in a primary bull market at very sweet spots with selected equities) may be OK. However, such shorts:

• Try to exploit bearish secondary reactions (optimally within a primary bear market).

• Last a few days.

• Only short when an excellent risk reward ratio is present.

And don’t forget that the longer your time frame, the less likely your shorts are going to perform well.

The profit factor of the Dow Theory is a whooping 23.

Here I draw on trader's terminology. The efficiency and soundness of a trading system is measured in the trading world, among other benchmarks, by the so-called  profit factor. Profit factor is simply the total amount of gains divided per the total amount of losses. Thus, if one trading system has made USD 100 K in the last 10 years, but lost USD 50K in the same period of time, then the profit factor is 2 (100/50). In trading circles any profit factor exceeding 1.7 is a very decent one. Anything exceeding 2 is really good. In real trading, where bad fills, no-fills, unknown unknowns and commissions deplete the trading account achieving a profit factor of 1.5 is a remarkable feat. Maybe I am a bad trader, but this is my experience. Systems that when back tested feature a respectable profit factor of 2, inevitable degrade in real life.
While such “real life” under performance can certainly affect the Dow Theorist, the starting point is so high that, even allowing for slippage, commissions, bad fills, power outages, etc., the odds continue to be stacked in favor of the investor. 23, or for that matter, any profit factor greater than 3, is an excellent profit factor.

I derived the profit factor by adding the percentage gains of all winning signals and of all losing signals. Here you have the excerpt from the spreadsheet:

Winners Pctg won






























Avg win
Tot win

As to the losers:

Losers Pctg Lost










Avg loss
tot loss

If you divide 1283.80 by 54.95 you get a Profit factor of 23.36.

Do secular bull and bear markets affect the Dow Theory signals?

Yes. Secular bull and bear markets affect the Dow Theory signals. Secular bear markets tend to increase the number of transactions taken (and their average time is reduced accordingly). Profitability, while not extinguished, is reduced during secular bear markets. A more in-depth study on the impact of secular bull and bear markets on the “cyclical” bull and bear markets traded by the “classical/Rhea” Dow Theory will follow soon. The numbers you will see are really interesting.

Have a nice weekend.


The Dow Theorist

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