Module 01. Technical Analysis of financial markets

Charles Dow analysed the The DJ Industrial Average and DJ Rail Index and semi-published his papers on Dow Theory suggesting stock markets move in similar ways over time. He is thought of as the founder of Technical Analysis (TA), although Japanese rice traders were using a form of TA to predict future price action in the 1500's (See the module on price action). Dow's basics on Dow Theory still hold good today and are the basic assumptions chartists use in their TA to this day. It's important to note that while Dow theory itself is focused on price movements and index trends, implementation can also incorporate elements of fundamental analysis, including value and fundamental oriented strategies. TA focuses mainly on the technical's of the chart, but will still have a handle on the broader fundamental activity. Having said that, Dow theory is much more suited to technical analysis.

He died prior to publishing all his theories, but his works were completed by his associates and published in financial journals around the world. He believed that the stock markets were a good measure of business conditions and by analysis one could identify trends and predict future price movements. All traders using TA should get to know Dow's 6 Tenets (beliefs) and keep them in mind when using TA to form your trading strategies.

Tenet 1. Markets have 3 Trends

Primary Trend

The Primary Trend is the background trend of a stock or other security, shown on our Apple Chart below. Dow indicates that the Primary Trend will last between 1 and 3 years, but may vary in some circumstances (5 years in our Apple example). Today's analysts may think of the primary trend as Dow did, or he/she may shorten it - It all depends on your trading horizon. I.e. If you're a day trader, this primary trend may only last a few months to a year. As we go through the course, you'll grow to realise that Dow's Theories, although valid, can be interpreted differently to benefit modern trading.

Anyway, this Primary Trend is the major trend in the market and will affect The Secondary and Minor market trends. One of the most basic rules of TA is trade with the trend (within your trading horizon) and not against the trend, so it's always prudent to look at the long term Primary Trend first when making trading decisions. You'll see in the Apple Inc chart below the primary trend is an up trend, lasting around 60 months. We are using a weekly chart, capturing the closing prices every Friday night. You can just as easily use a daily chart, capturing the closing price on a daily basis.

It's important to note that trends aren't straight, but tend to go up and down in a zigzag motion making peaks and troughs along the way. Dow used Peak and Trough Analysis to identify these trends. We'll talk about this further in Module 1. The definition of an up trend is a trend making higher highs (higher peaks) and higher lows (higher troughs) and a down trend makes lower highs and lower lows. The zigzag nature of the trend can again be seen in the below chart of Apple, where the general primary trend is up (or bullish), but not exactly straight. This Primary Trend will stay in place until there is a trend reversal. This reversal is confirmed when the current price starts closing below a previous established trough in the last primary trend (if we have been in an up trend & vice-versa for a down trend). In our example Apple's price starts to reverse at the start of 2008 and the trend reversal is confirmed when the price makes lower lows and lower highs.

Secondary Trend

The Secondary Trend, or intermediate trend as it's often called, moves in the opposite direction to The Primary Trend, before the Primary Trend resumes - It's a correction to the Primary Trend. If the Secondary Trend takes place in a Primary Up Trend then the secondary trend will be down consisting of lower highs and lower lows. The secondary trend ends when the trend resumes to higher highs and higher lows.

Charles Dow observed The secondary trend generally lasting up to 3 months and it's retracement generally between 33% and 66% of the primary trends latest move. The length of the secondary trend does vary and can be longer than 3 months, especially if we observe a long primary trend. Dow also observed that volatility was found to be greater than the primary trend. In our Apple example the secondary trend lasts 6 months against a 6 year primary trend and the secondary trend low in Jul 06 retraces 66% back to the last trough of the primary trend (May 05).

Minor Trend

A minor trend typically lasts less than 3 weeks and is generally the corrective moves to the secondary trend. Dow suggests traders and investors should concentrate on the primary and secondary trends as these minor trends are generally period of volatility and must be treated with the long term picture in view. They are in effect continuing the long term primary trend, but are brief and volatile. But they shouldn't be dismissed out of hand as they can provide trading opportunities. In our Apple example our minor trend lasts 4 weeks, which is a little longer than Dow suggests, but given the long length of the primary trend this is not unexpected.

Tenet 2. Trends have 3 Phases

Charles Dow's second Tenet is "The market trend has 3 phases". These are called the Accumulation, Public Participation and Excess Phases in an up trend (or bull market) and The Distribution, Public Participation and Panic Phase in a down trend (or bear market).

The Accumulation Phase (Bull Market)

The Accumulation Phase is where the up trend start, which is usually at the bottom of a down trend (but not always). This is the point where the savvy, professional traders/investors enters the market at the best prices when the market is under valued. It is also the hardest phase of the up trend to spot, as it may look like the market is ranging and not trending. Technical Analysis can indicate entry into the accumulation phase, as this phase is often preceded by a consolidation phase from the previous down trend. We'll go on to talk about this in our Module on Chart Patterns where reversals can be anticipated. You may also want to read the section on Retracement or Reversal - know the difference. Again we'll use Apple Inc to highlight these 3 phases to a trend. On our chart below the accumulation phase is seen between May 03 and Aug 04. For a more in depth analysis of Accumulation please see the section at the top of the right hand side bar.

The Public Participation Phase (Bull Market)

The Public Participation Phase happens after the good news starts to be taken on board by the general population. The Public then start buying sending prices ever higher. This phase doesn't necessarily have to be steeper than the Accumulation Phase, but it is generally the longer lasting where prices moves the most. In our Apple example The Public participation Phase starts Aug 04 and lasts until the end of 2007.

The Excess Phase (Bull Market)

In our Apple example the excess phase is seen between the start of 2007 and the end of 2007. This is the last part of the 3 phases within the primary trend and is where the market is gripped by a scramble to get on board before they miss the boat. Interestingly, this is where the savvy traders start to reduce their exposure and begin to take some profits. This is the part of the trend that traders should start looking for signs of upward momentum weakness. In our Apple example we can see some signs of weakness when large downside moves take place in the excess phase. Eventually a major sell-off results at the start of 2008. The excess phase is generally seen in a bubble market.