A study on the proper appraisal of secondary reactions as taught by Rhea
I am re-reading (for 10th, 11th time?) Rhea’s book “The Dow Theory,” and I am unearthing many gems.
Those gems relate to the thorny issue of appraising secondary reactions. The proper ascertainment of a secondary reaction is vital. The lows of secondary reactions serve as our exit point (stop-loss) when broken down, or as an entry point (stop-buy) when its highs a broken up (always with confirmation). More about secondary reactions as stops here.
Thus, if we are too quick in determining secondary reactions, we may probably end up by having too narrow stops, which may render the Dow Theory less effective (lower profit factor). By the same token, if we are too slow in determining secondary reactions, we may probably end up being always late to the party (late entries and exits due to the excessive amount of time and/or extent required for the existence of the secondary reaction). So we are confronted with a Goldilocks situation: Neither too hot nor too cold.
Market lore has it that Rhea’s Dow Theory requires at least three weeks of price action against the primary trend and a retracement of the preceding primary bull or bear swing between 1/3 and 2/3.
Jack Schannep, whose rendering of the Dow Theory I label as “Schannep’s Dow Theory,” was considered “heretical” by some self-appointed wardens of the Dow Theory because he dared to do three things. Several names of inquisitors come to my mind, some famous, some wannabes, all of them bad performers compared to Schannep. I’d better forget their names and let the readers guess. These are the three main features of Schannep's Dow Theory:
Firstly, Schannep shortened the time requirement for a secondary reaction (just 8 trading days as the average of 3 indices, and at least 2 calendar weeks on two indices).
Secondly, Schannep disregarded the 1/3 retracement requirement. If the rally/pullback exceeded on a confirmed basis 3%, then the extent requirement was confirmed.
Thirdly, he introduced the S&P 500 as a third index.
I’ll focus on the two alleged “variations” introduced by Schannep. Please mind the word “alleged.” As, in truth, Schannep was more faithful to Rhea than many interpreters of the Dow Theory.
I contend that a careful reading of Rhea’s book proves that Schannep’s is closer to Rhea’s than many mainstream Dow Theorists who wrongly feel they are keeping the Dow Theory deposit of knowledge intact. Readers of this blog should know that Rhea was an excellent trader with a real “bottom line” (as Schannep is). Hence, if we want to be even moderately successful in the markets, we better led Rhea’s wisdom to soak in (and also read at least five times Schannep's book "The Dow Theory for the 21st Century").
Hence, Jack Schannep and his interpretation of the Dow Theory are no “heretical” after all. Rhea, if one reads him carefully, offers many clues as to the proper determining of secondary reactions. Of course, we all would have liked Rhea to lay down his ideas in a more structured way. But good traders, trade, don’t write books. So we have to thank Rhea (and Schannep) who, besides being good traders, have left us books. Luckily enough, my writing this blog until now has not impaired my trading performance, but I must remain alert as there seems to exist a negative correlation between writing and performance.
In a future post, I will prove two things by quoting Rhea:
- That a secondary reaction may last less than three weeks.
- That the famous 1/3 retracement rather than being one requirement for a secondary reaction to exist, is just an observation, once through other means, its existence has been determined. The minimum 1/3 retracement may come in handy in dubious cases. However, Rhea did appraise secondary reactions even when the retracements fell short of 1/3.
Proving that we can be more “flexible” (as Schannep is) when appraising secondary reactions is vital. It is the key to call the turns in the trend accurately. By the way, “flexible” is not tantamount to being “sloppy” or to “cut corners.” Flexible in our Dow Theory context means to be able to be attuned to the changes in trends. “Inflexible” traders (and Dow Theorists) end up calling the turns of the trend when it’s too late. One blatant example (and a good explanation on secondary reactions as per Rhea's Dow Theory) of being too late is given here. More recently (March 2020) you can find another example of being extremely late because of failing to timely pinpoint secondary reactions, as explained here.
More about Rhea, Schannep, and the proper appraisal of secondary reactions in the next post of this new “saga.”
One Dow Theorist