Friday, October 2, 2020

Dow Theory Update for October 2: Why I favor using two alternative ways of appraising secondary reactions?


In-depth explanation about the current secondary reaction in precious metals coming soon



In my last post, I summarily informed that the secondary trend for precious metals had turned bearish. However, I didn’t provide accurate calculations nor any charts. Since the appraisal of secondary reaction is vital for Dow Theorists, as we derive signals from them, I think it is in order to provide the followers of this blog with a more thorough explanation. However, today I’d like to address one important aspect.


I have been asked why I have been segmenting my market analysis into two sections. The first one, by being flexible and appraising secondary reaction with less than three weeks. The second one, the “mainstream” one, which inflexibly requires more than three weeks and 1/3 retracement for a secondary reaction to exist.


On the surface, making a “dual” analysis for the same pair of markets (i.e. gold and silver) may look contradictory or confusing. One could say: “Hey, Manuel, if you are so convinced about your analysis, why are you providing two alternative explanations?” However, trading the markets is not a matter of convictions but a matter of weighting odds, and not betting the whole ranch on a single idea (trade). Legendary (and survivor) trader Paul Tudor Jones, when interviewed by Jack Schwager in “Market Wizards” said: “Don’t play macho with the markets”.


The key to becoming at least a surviving trader is to keep losses short. One could argue that a tight stop-loss sees to it. However, there is a limit as to the “tightness” of the stop. If you want to limit your risk in a Dow Theory trade to only 2%, most probably you’ll be stopped out. The issue of stops is very tricky. It is easy to show them in trading books, but in actual trading, one has to be extra careful with them. My trading experience tells me that tight stops don’t work most of the time. You have to give a trade some room to breathe (oscillate), as most traders lack (I included) the innate gift of calling the exact top or bottom (in which case one could safely trade with narrow stops).


So, if tight stops are not the key to successful (and surviving) trading, the only alternative left to keep losses short is too make a small commitment in each trade. If I invest 10% of my trading equity on any given trade and I lose 10% (which is a relatively large loss if it were a Dow Theory trade), I am only losing 1% of my trading equity. So I have survived. I keep the powder dry for the next trade. Some readers will rightfully retort: “Yes, but if you make so small a commitment in each trade, you’ll also achieve small returns”. This much is true if there is a paucity of trades. However, if I manage to have 10 good trades simultaneously with 10% of my equity invested in each trade, then my returns should not suffer, provided all the trading strategies from which I derive my trades are good ones. On the other hand, by only “betting” 10% on any given trade, I know that even a horrible loss of -20% in one specific trade will only make a small dent of -2% in my global equity.


In this blog (and in my actual trading and investment) I neither need to show to my readers nor myself that I am a smart guy with a Dow Theory crystal ball. Furthermore, we should not forget that one of the tenets of the Dow Theory (and of any winning trading system) is that the theory is not infallible. If it were, it would be arbitraged away. So, I insist, even with sound trading systems, we are merely dealing with probabilities. Sometimes we will win, sometimes we will undoubtedly lose, and we hope that after some trades we will be profitable.


Therefore, the more trades (or trading ideas) we generate, the more likely than we will reduce drawdown as the amount lost on each trade is being diminished through diversification. Furthermore, the larger amount of trades will lift us sooner out of the drawdown (in technical parlance: the positive expectancy of the trading system will reassert itself sooner). You may have a great winning system that only trades once every five years. However, if you had a losing trade of -10%, you’d be in a drawdown for 5 years, no matter the average return over long periods, as no new trade would come to take you out of the drawdown. So be careful with systems that generate too few trades. Overtrading gets a bad rap, and justifiably so when one clutters one’s trading with suboptimal trading strategies. However, if you are convinced as to the soundness of your various trading strategies, more trades will result in milder and shorter-lived drawdowns. Intelligent diversification is alive and well.


This is the essence of my short-term trading. I’m sure there are better traders out there (actually, I know a great one, but I don’t envy his being glued to the screen all day long). However, I manage to be profitable and, more importantly, have mild drawdowns (max. drawdown in the vicinity of -10% and max. 6 months until new equity peaks) because I have many ways of generating trades. Since each of the strategies I use tends to be profitable on its own, the mixture of several strategies which, each of them tends to generate many trades, results in an excellent risk-reward profile. As an aside, it is worth remembering that most of us chicken out and give up when a big string of losses hits. Since I am an average guy turned into an investor by necessity, I know that the only way for investment survival is not to test my own patience. If I have a hard time staying the course when a significant drawdown hits, the only solution is to minimize the likelihood of big drawdowns, to begin with. To this end, I have to tailor my trading strategies to my weaknesses (shared by 95% of investors). I go back to Paul Tudor Jones: “Don’t play macho with the markets”.


While the Dow Theory is not short-term trading, we know that the appraisal of a secondary reaction is not carved in stone. Those adhering to a longer time-frame (i.e., more than three weeks) will generate fewer trades than those more flexible in accepting (when it makes sense, not always) the existence of a secondary reaction even when just two weeks have elapsed.


Any follower of the Dow Theory has been indoctrinated about the more than three weeks time and 1/3 retracement for a secondary reaction to exist. However, this is not what Schannep does (and writes), or Rhea did (and wrote) in their actual practice. So good Dow Theorists know that the time and extent requirement is not carved in stone. More about the demolition of the Dow Theory dogmas here, here and here.


I do not mean that the more than 3 weeks and 1/3 retracement dogmas result in flawed signals. No, I am not saying this. Sticking to the Dow Theory mainstream will result over time in net profits. Look at the classical Dow Theory record and you’ll see it has been a very good investment strategy for over 120 years. Few trading systems can boast such a record. However, depending on market conditions, sometimes a more responsive (that is less time for defining a secondary trend) use of the Dow Theory will result in a lesser drawdown and even more profits. So I am not disparaging the use of the “classical” (mainstream) Dow Theory. I am just advocating for the use of an alternative way to generate signals, which, as far as I have tested (unpublished studies with precious metals and interest rates) is, at least, as good as the classical application of the Dow Theory.


By having two alternative ways of appraising secondary reactions, we will, in many instances (not all), generate alternative Buy and Sell signals. Sometimes, both “versions” will be winners, sometimes one will be a winner and the other a loser, and rarely will the two of them be losers. The net result will be smoothing out our results. And “smoothing out” is crucial because it will tend to reduce drawdowns, calm our nerves, and help us stay the course.


A final word about shortening the time requirement for a secondary reaction. One might be concerned that by being too flexible with the time requirement, one can end up with suboptimal trades. In other words, a lesser performance than that made with the “classical” Dow Theory. However, this seems not to be the case. As far as US stocks are concerned, Schannep’s Dow Theory has outperformed the “classical” Dow Theory by about 2% p.a. while cutting drawdowns. Go to this post to convince yourself. More performance with fewer drawdowns is evidence of more efficiency. So, at least as far as Schannep’s Dow Theory (which is more reactive than the “classical” one) is concerned, shortening the time requirement for a secondary reaction resulted in better trading results, not worse.


My own experience with precious metals and interest rates seems to validate the claim that requiring a little bit less time for a secondary reaction to be appraised (especially when we have had an ample enough swing) does not result in worse performance or deeper drawdowns. Rather the contrary. However, since I look for diversification, one can continue to use both ways of determining secondary reactions. When one fails, the other will, probably, pick up the slack. The objective is not to trade the best strategy but, rather, to have two reasonable good ones to act in tandem.


By the way, this is what Schannep actually does in his publicized track record. He commits 50% of the trading capital to the Dow Theory for the 21st Century (what I call “Schannep’s Dow Theory”), the other 50% is invested in the so-called “timing indicator” (based on momentum and monetary policy). Both trading strategies tend to have similar performance over the long run, albeit in specific trades, they may diverge (i.e. the timing indicator says “hold” whereas the Schannep’s Dow Theory says “sell”). The two strategies' composite is a smoother performance with less “ups” and “downs”. More about Schannep’s timing indicator, here.


Well, having explained why I am fond of displaying two alternative ways of appraising secondary reaction, it’s time to sign off. I know I still owe my readers the post explaining all the entrails of the current secondary reactions in precious metals.



One Dow Theorist

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