Friday, March 22, 2019

Dow Theory Special Issue: Capitulation. The ultimate bottom indicator (II)

Definition of capitulation. Betting for a mean reversion

We continue with our saga concerning “capitulation”. I feel this saga is going to keep me busy for quite some time. Here you have the link to the first post.

Capitulation is a bottom detector tool devised by Jack Schannep. Thus, capitulation is by nature mean reverting. It does not follow the established trend but it tries to detect the change thereof. Capitulation has been devised only for the long side. When the market is severely oversold, capitulation bets for a change in trend. I see capitulation as an elastic gum which has been too stretched. Some contracting is due.

While betting for a mean reversal is kind of abhorring for trend followers, Jack Schannep makes clear that both Charles Dow and Robert Rhea were eclectic enough to depart from strict trend following on selected occasions.

I quote from Schannep’s website, which at the same time, quotes Charles Dow and Robert Rhea:

“[a] word [capitulation] Charles Dow never uttered but he clearly alluded to with his discussion of the final phase of bear markets when he described “distress selling of sound securities, regardless of their value…..” Robert Rhea described it asa semi-panic collapse (and) it is wise to cover short position and even perhaps make commitments for long account” (emphasis in original).

Therefore, if the indicator is sound we should be pragmatic. Furthermore, as I will show in a future post, even if the indicator were to fail on a rare occasion in the future our losses would be well contained for three reasons: (a) On most occasions there are stops; (b) even when the knife continues falling, the initial commitment suggested by Schannep is modest (25% or 50% of total capital depending on the kind of trading); (c) the indicator signals a “buy” on extremely rare occasions when the market is really very oversold.

As I wrote in the first post of this saga, capitulation is important for three reasons:

a)     It creates more trades (not many, but something is something)

b)     The trades are very good quality trades (in the sense that the money made greatly exceeds the money lost, which amounts to a high Profit Factor).

c)     It introduces a measure of diversification to our trading by introducing some mean reversal trading. Strategy diversification, even though it does not necessarily increase absolute performance, results in smoothing the equity curve (less drawdowns). When trend following (strict Dow Theory) may be temporarily lagging behind, mean reversion may shine.

While I feel there is some minor part of the indicator which remains proprietary, the basic tenets of the capitulation indicator are as follows:

1.      One calculates a 10 week exponential moving average of the closing prices.
2.      One calculates the ratio between today’s close and exponential moving average at the close.
3.      If the ratio reads 0.9 (that is for example, current close at 90 whereas the exponential moving average stands at 100) and such a ratio is confirmed by the INDU, NYSE and S&P 500, then we have reached “capitulation”.

Once we have capitulation we are advised to buy on the very same day close (with equations one can calculate the closing prices that would render the ratio at 0.9 or below that figure one day in advance so that one can buy at the close) or at next day’s open.

I created a capitulation indicator that plots the current reading of the ratio between the current close and the 10 week exponential moving average. Since weekly bars can be tricky (as the current bar is not completed until Friday), I work with daily bars and avail myself of a 50 days (5 weeks) exponential moving average.

The coding in Easy Language® reads as follows:

input: length(50);

If value1>0 then value2=c/value1;

Plot1(value2, "ratioMA");

With the aid of TradeStation® I created three charts each one containing one index (INDU or NYSE or S&P 500). Below I plot the indicator which shows me the ratio. When the reading of the three charts falls below 0.9 then we have reached capitulation.

My own indicators faithfully signaled capitulation the very same day it happened (12/24/2018), so I needed not Schannep’s “crutch” in order to know when capitulation occurs. 

Here you have the one chart depicting the situation on 12/24/2018 (blue circle highlights the date) where the ratio fell below 0.9 on the three indices. As I told you, I use daily bars and my software calculates de 50 day (10 weeks) exponential moving average.

Capitulation on 12/24/2018. Chart created with TradeStation (r)

Schannep in his book analyses in depth the concept of capitulation. Readers really intent on applying this indicator are well advised to read chapter 8 (pages 79 to 95) of Schannep’s book “The Dow Theory for the 21st Century”. There are no shortcuts. This post is not enough. Go and read the book.

Schannep in his book makes a conclusive case concerning the soundness of his indicator. He compares the accuracy of “capitulation” when signaling bottoms against other well-known similar indicators (i.e. the put/call ratio) and, if the past is to serves us as a guide, capitulation emerges as the most accurate bottom indicator by far.

Furthermore, there is a thing I particularly like about “capitulation”. It is its simplicity. Other competing indicators are more complicated by design. The less parameters, the better when it comes to creating a robust indicator. A ratio between the closing price of 0.9 or less between the closing price and the 10 week exponential moving average very seldom occurs. It really measures a much stretched elastic gum. Since 1960 there have only been 16 instances of capitulation. Hence, the accuracy of the indicator. So clearly, capitulation does not result in overtrading.

More about “capitulation” here on Schannep’s website.

Well that’s all for today.

Next post will deal with what follows capitulation. We will be studying further advances and declines (on rare occasions) following the capitulation signal and the time such advances last.

The Dow Theorist

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