Thursday, May 7, 2020

Dow Theory Special Issue: The Rule of Seven: A vital tool to determine profit objectives


Do Dow Theorists need to establish profit objectives?

Rhea wrote that the Dow Theory could not forecast the extent of a rally or decline. In other words, the Dow Theory determines likely direction, and we take what the market offers us. However, Schannep long time ago incorporated into his arsenal a tool that allows him to establish price objectives.

That tool is named “the Rule of Seven,” and while not created by Schannep, as far as I am aware of, it has been Schannep the investor who has put it most to use, and with documented success.

I know “purists” will be screaming “heresy,” as one of the tenets of the Dow Theory is that neither the time nor the extent of a primary movement can be determined in advance. However, I’d like to point out the following:

1)     Rhea availed himself of loose price objectives based on market action. Yes. In actual trading, Rhea was often trading around secondary reactions. That is buying when he felt that a secondary reaction had run its course (which is a price objective based on retracements), and, more importantly, selling when he thought that there was an impending secondary reaction. A future post will further explain all this, and why we should not attempt to emulate Rhea’s trading when using Schannep’s Dow Theory. The takeaway for this post is that Rhea, in many instances, “sensed” that the bull swing was overdue for a correction (i.e., because the swing has lasted or advanced more than the average swing) and ran for the exits before an actual Dow Theory sell signal was given.

In his Dow Theory Comment number 30 of July 24th, 1933, Rhea advised existing at almost the very top (07/18 and 07/14/1933 for the Industrials and Transports respectively) of an overextended bull swing (which had been running from February 27th, 1933). I quote Rhea (with the express permission of the editor “Alanpuri Trading,” Los Angeles, 2012”):

“It is hoped that no readers of these letters got caught in the crash. It so, it is not the fault of this writer or of Dow’s Theory. In Mailing 29, July 19 (Ind. 103.58, Rls. 54.01) we stated: “The nearby trend is downward”

“The Ind. made a new high – the Rls.  Refused to confirm- then both averages broke down through the preceding minor lows. No believer of Dow’s theory, as interpreted in these letters, should have been caught in the recent panic decline. The warning and the picture were there for all to read”.

Note: Ind. means Industrials, and Rls. means “Rails, that is Transports”.

The funny thing, though, is that Rhea recommended cashing out just one day after the market top of the Industrials (07/18/1933 top). If one reads Rhea’s letters in the weeks leading up to the top, Rhea clearly thought that the market was more than overextended. Hence, at the very first sign of weakness (a minor non-confirmation and the breakdown of a very minor low) Rhea decided to sell out. 

2)     Rhea wrote that higher confirmed highs carry less importance the older the bull swing gets. Eventually, there will be a turning of the trend. Or as legendary trend follower, Ed Seykota said, “the trend is your friend except at the end when it bends”. So while remaining trend followers, there are instances when cashing out may be in order. For this very reason, Schannep uses Capitulation which is just betting for a reversal to the mean. We want to make money in the markets, not to be zealots of one sect called trend following. We know, though, that 90% of the time, we will be in a pure trend following mode simply because it works. However, there will be some occasions when we are buying extreme weakness (capitulation) and selling strength (Rule of Seven, profit objective). The art, which Schannep has fine-tuned to almost perfection, is to know which exceptional weakness should be bought and which strength should be sold.

3)     Even for those reluctant to using price objectives and willing to wait until finally stopped out, sensible price objectives serve to know when to tight stops. I give you an example from my actual practice: When dealing with non-US stock markets, I am forced to use “Rhea’s Dow Theory”, as I don’t have the privilege of having three indices. Readers know that under the classical Dow Theory, unlike Schannep’s, there are no hard and fast rules for determining a secondary reaction, so there is ample room for interpretation, and this is why I insist that outside of the realm of Schannep’s Dow Theory, one is well advised to accept alternative appraisals of secondary reactions to split the risk. This is why Rhea wrote that “no two students would agree on any rule for selecting” secondary reactions. In other words, depending on each one’s interpretation secondary reactions may vary in length and extent, which translates into tighter or looser stops. And here comes the beauty of having price objectives: When I know that prices are in the profit objective zone, I demand fewer days and, normally, less extent to declare the existence of a secondary reaction. Additionally, I pay more attention to non-confirmations at higher highs, and, I even take a look at volume. The result is a “tighter” stop based on a secondary reaction that has been appraised with less time and extent than usual. My next post will surprise you as Rhea went as low as just 7 days (and sometimes he even did away with confirmation) to declare a secondary reaction. However, Rhea was no fool, and he knew when it was time to be satisfied with just 7 days and when it was time to require more time.

For the three reasons given above, I feel the use of good price objectives (as usual “good” is the word, as not all rules to calculate profit objectives do work in actual trading) is a valuable addition to one’s trading arsenal.

It is worth remembering that Schannep nailed it down in his February 1st, 2020 letter to Subscribers. In real-time, based on the price objective established by the application of the “Rule of 7”, Schannep alerted his Subscribers and wrote “I am doing some lightening up in my other accounts.” Please mind: That sentence was written on February 1st, 2020 just days before the market top

If you are really serious about making (or at least not losing) money in the stock market, do yourself a favor: Read at least three times the followed linked Letter (February 1st, 2020) to Subscribers. It’s free.

All in all, the Rule of Seven is a valuable tool to determine price objectives that may be successfully applied in our actual trading decisions. This post does not deal with the entrails of the “Rule of Seven” which are explained with great detail and real trading examples on the Subscribers area of Schannep’s website “”. You can get access to the Rule of Seven report by becoming a free Subscriber. Continue reading.

As I announced here, I joined Schannep’s “” as a contributing editor.

As an expression of gratitude to the followers of this blog, and as an invitation to follow me on my new home “”, I will be offering for the next few weeks a free two months subscription. For a FREE Trial, send an email with your name

SUBJECT: Free Trial

and you will receive a username and password to access Newsletter. 

That's it!

As a reminder Subscribers to “” Letter get real-time information when action is required, something one cannot get in this blog. Furthermore, “” really helped Subscribers navigate through the recent turbulent waters as:

1)     The Rule of Seven nailed the February highs at 29,316 (see February SAMPLE Letter).

2)     Our definition of a Bear market beat all others to the punch in March

3)     Capitulation (the time to start buying) was signaled throughout two weeks in March

4)     Our definition of a Bull market was met earlier last month confirming this up market

5)     We have once again determined the upcoming Rule of Seven target for the new bullish swing.

While my blog is instructive and remains a valuable tool to dig deep into vital aspects of the Dow Theory, those truly intent on getting actionable and real-time advice with a proven and disclosed record should use “” as a companion to this blog.

One Dow Theorist

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