Monday, March 26, 2012

Charles Dow on Trading and Speculation - Dow Theory

Security Analysis Article Series
Charles H Dow was the founder editor of Wall Street Journal. Very interesting observations, explanations and comments were made by Dow on trading and speculation in his editorials.

Charles Dow

Charles H Dow was the founder editor of Wall Street Journal.

While many people tried to use the word "investor" instead of speculator, Dow openly used the word speculation and wrote about it his editorials. Probably many of his editorials are not available to us today.

One of the persons/writers of that time S.A. Nelson included 16 of those editorials in a book 'The ABC of Stock Speculation.' The book was published 1903 by S.A. Nelson. Fraser Publishing Company, Burlington, published it in 1964. The fifth reprint of the book was made in 1999.  

Very interesting observations, explanations and comments were made by Dow on trading and speculation in those 16 Editorials.

On speculation

It is, however, part of almost every manufacturer's business or of every merchant's business to speculate in raw materials or goods, and nobody thinks of finding fault with either for doing so. In Wall Street speculation stands alone, without any business disguise, for all men to see. There is no difference between one kind of speculation and another so far as essence is concerned; the only difference is that one is disguised and the other is not.

Scientific Speculation

Dow made very pertinent observations in this editorial on the topic of speculation.

He wrote, the maxim "buy cheap and sell dear" to make profits in trading is ok, but it leaves unsolved the question of when a security or a commodity is cheap and when it is dear. He did hit upon the right issue with this comment.

He quotes the elder Rothschilds' principle that it was well to buy a property of known value when others wanted to sell and to sell when others wanted to buy. This brings into consideration the concept of value.

There is also the belief in professional traders that public as a whole buys at the wrong time and sells at the wrong time. The reason given is that public buys on manipulated advances and after they are well along. It buys at a time when manipulators wish to sell and sells when manipulators wish to buy.

Dow quotes Daniel Drew to bring another idea of speculation. "Cut your losses short, but let your profits run." It means that if a stock has been purchased and it goes up, it is well to wait; but if it goes down, it is well to stop the loss quickly on the ground that the theory on which the purchase was made was wrong.

When a trader finds in his accounts that his profits in profitable trades have been relatively large and his losses in losing trades relatively small, he can pat himself that he learning how to trade.

Dow quotes Jay Gould that his policy was to endeavor to foresee future conditions in a property and then, having made his commitments carefully, to exercise great patience in awaiting results. "Patience" is the important word here. Many find great difficulties in using this method for speculation. Dow provides encouragement to this method also by writing, "The present is always tending toward the future and there are always in existing conditions signals of danger or encouragement for those who read with care."

Thus in one of the editorials Dow quoted three persons and brought out ideas of value, keeping losses to small amounts and patience to be used in speculation.

The Two General Methods of Trading

One is technical and the other is fundamental.

In this editorial Dow mentioned that there were two general methods of trading.

One is to deal in active stocks relying for protection upon stop orders. Active stocks mean there is enough liquidity at various price points so as to permit the execution of the stop order at the point selected. The importance stop order is very high in this method. The trader need not know much about the value of stock under consideration. But he must have a basis to guess which way the stock will move. After taking a position, if his guess turns out right, he lets his profits run. If his guess turns out to be wrong, he squares up the transaction with the stop order. If he can guess right as many times as he can guess wrong, he can expect profits. This system is based on a rule or logic for guessing the direction of the market and then using stop losses to take small losses in case of adverse moves in the market.
The second system of trading is based on values. The value estimation is based on fundamental analysis. The trader has to feel sure of the value for at least months to come. Dow mentioned that values are related to earnings available for dividends. The trader also has to consider the general trend or tendency of the market, relative moves of the stock with respect to the market. Based on this information, the trader buys the stock at a price below the value and if the price goes down, he will buy an equal amount at the every decline by 1 percent. Dow wrote that stocks on their downward move can go down by 20 to 30 points. So there should be enough capital to buy on the downside and profit when the stock comes up. Traders have to commit capital to trading conservatively rather than taking big positions at a single point of time.
Dow mentioned the saying in Wall Street, "The man who begins to speculate in stocks with the intention to make a fortune, usually goes broke, whereas the man who trades with a view of getting good interest on his money sometimes get rich." It is probably another way of saying a few lucky ones make a lot of money.
Dow cautioned traders using value based method to pay attention to the following points.

1. Bull and bear markets run four and five years at a full time. Use the average prices (implying Dow Jones Averages), to determine which one is underway.
2. In a bull market, it is better to always work on the bull side. In a bear market, work on bear side.
3. In bull market buy on declines and in bear markets sell on rallies.
4. Stick to the stock bought until a fair profit is realized or until there is good reason for deciding that the first estimate of value was wrong.
5. Have enough capital to do trading. Dow advised an initial capital of $2500 for accumulating shares starting with 10 share lots.

Three General Lines of Reasoning

Dow mentioned in this editorial that three points were made in earlier pieces.

1. The surface appearance of the market is apt to be deceptive.
2. In trading losses are to be cut short and profits are to be allowed to run.
3. Discounting correctly the future is a sure way to wealth.

The third point shows that Dow supported fundamental analysis based trading also apart trading based on technicals. Many will give credit to Dow only for technicals based trading.

Why the surface appearance of the market is deceptive: The market has to be analyzed as the market is to be considered as having three movements all going at the same time. The first is the narrow movement from day to day. The second is the short wing, running from two weeks to a month or more; the third is the main movement covering at least four years in its duration. This description of three movements is considered to be the essential part of Dow Theory.

The day to day movement should be disregarded by everybody, except traders who pay no commissions. With that statement Dow gave the opinion that extreme short term trading is to be left to persons having brokerage seats and arrangement with brokers to pay flat payments. Now that more and more people are paying flat brokerage payments day trading is increasing.

The medium swing is the one for ordinary consideration. In describing Dow Theory many people say that Dow Theory recommends only main trend trading. But in the editorial Dow clearly said medium trend is the one for ordinary consideration. The outside trader should not attempt to deal in more than two or three stocks at a time. He should keep a chart of price movements of these for months or years so that he can identify the swings.

In charts, apart from price, a record of volumes and any special and interesting facts about the company are to be noted. The trader should also keep a chart of average as they tell about the market more clearly.

The average thirty day swing could be 5 points. So Dow recommends buying a stock which has a value above the price whenever it declines by 4 points from a previous peak in bull market. He recommends buying half of lot at the first instance so that if it declines further remaining quantity can be bought.

Swings within Swings

In this editorial, Dow describes the three swings mentioned above once again and points out the method for taking profits from the market.

The first swing is day-to-day movement which is due to local causes and the balance of buying and selling on that day. The second is the secondary movement that covers a period ranging from ten to sixty days with an average of thirty to forty days. The third swing is the main trend covering from four to six years.

If the main move is up, relapses are speculators' opportunities, but if the main move is down, rallies furnish opportunities. The movement of averages defines the main trend. As long as the average of one high point exceeds that of previous high point, the main trend is up. It is difficult to judge the reversal before hand, as it can be an unusually pronounced secondary trend.

In this editorial, Dow talks of speculation or trading using fundamental values. A value based speculator has to buy when the price declines in the market.

In the example given, Dow talks of 10 point decline of a good stock from 108 to 98 in a bull market. The value based speculator can buy it, because the 10-point decline in the bull market would be almost certain to bring in bull market more than 5 points recovery and full 10 points would not be unreasonable. Dow advises even this investor to put a stop order after the 5 point rally from 98 and allow the profits to accumulate. This is techno fundamental trading. The trader uses fundamental value to enter the trade and then uses stop orders to continue the trade.

Methods of Reading the Market

Dow gives the following methods of making some judgments on the market. He says it is doubtful if any have been or can be wholly satisfactory. But many are in practical use and give some suggestions for action in the market.

The first is the book method. In this method price changes are noted by 1 point sizes. The price moves up or down are shown by diagonals and small price changes will be captured in horizontal lines. A long horizontal line indicates accumulation or distribution. This description resembles somehow point and figure charting. But not exactly.

The second method is mentioned is that of double top. Dow gives the caution once again that there will good many exceptions and many times without this signal market goes down.

The third method says some people trade on the logic over a period of time up days will equal down days.

The fourth one, described as more practicable by Dow is the theory that a primary movement will have a secondary movement in opposite direction. The opposing move can be at least three-eighths of the primary movement. If a stock advances 10 points, it is very likely to have a relapse of 4 points or more. The law seems to hold irrespective of the size of the advance.

Dow comments that it is impossible to predict in advance the length of any primary movement, but the further it goes, the greater the reaction when it comes, hence the more certainty of being able to trade successfully on that reaction.

Dow makes a point about great operators. The thought with great operators is not whether a price can be advanced, but whether the value of property which they propose to buy will lead investors and speculators six months hence to take stock at figures from 10 to 20 points above present prices.

Dow concludes this editorial with the statement 'To know values is to comprehend the meanings of movements in the market."

Dow is normally thought to be the advocate of technical trading. But these editorials seem to indicate that Dow is equally a strong advocate of trading based on fundamentals.

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