Executing Dow Theory - 2 - Explained


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In the current day and age, a technical analyst can use different tools such as charts and graphs in order to analyse the market. His thought process and decision-making are based on different theories that have been developed over the years.

But if you go back in the history of technical analysis, the foundation of this branch of stock investing can be traced back to Charles Dow and his writings.

The concept of range is a natural extension to the double and triple formation. In a range, the stock attempts to hit the same upper and lower price level multiple times for an extended period of time. This is also referred to as the sideways market. As the price oscillates in a narrow range without forming a particular trend, it is called a sideways market or sideways drift. So, when both the buyers and sellers are not confident about the market direction, the price would typically move in a range, and hence typical long term investors would find the markets a bit frustrating during this period.

Stocks range breakout

Stocks do break out of the range after being in the range for a long time. Before we explore this, it is interesting to understand why stocks trade in the range in the first place.

Stocks can trade in the range for two reasons:

  1. When there are no meaningful fundamental triggers that can move the stock – These triggers are usually quarterly/ annual result announcements, new product launches, new geographic expansions, change in management, joint ventures, mergers, acquisitions etc. When there is nothing exciting or nothing bad about the company the stock tends to trade in a trading range. The range under these circumstances could be quite long lasting until a meaningful trigger occurs

  2. In anticipation of a big announcement – When the market anticipates a big corporate announcement the stock can swing in either direction based on the outcome of the announcement. Till the announcement is made both buyers and sellers would be hesitant to take action and hence the stock gets into the range. The range under such circumstances can be short-lived lasting until the announcement (event) is made.

The stock after being in the range can break out of the range. The range breakout more often than not indicates the start of a new trend. The direction in which the stock will breakout depends on the nature of the trigger or the outcome of the event. What is more important is the breakout itself, and the trading opportunity it provides.

A trader will take a long position when the stock price breaks the resistance levels and will go short after the stock price breaks the support level.

Think of the range as an enclosed compression chamber where the pressure builds up on each passing day. With a small vent, the pressure eases out with a great force. This is how the breakout happens. However, the trader needs to be aware of the concept of a ‘false breakout’.

A false breakout happens when the trigger is not strong enough to pull the stock in a particular direction. Loosely put, a false breakout happens when a ‘not so trigger friendly event’ occurs and impatient retail market participants react to it. Usually the volumes are low on false range breakouts indicating, there is no smart money involved in the move. After a false breakout, the stock usually falls back within the range.

A true breakout has two distinct characteristics:

  1. Volumes are high and
  2. After the breakout, the momentum (rate of change of price) is high

Have a look at the chart below:

The stock attempted to breakout of the range three times, however the first two attempts were false breakouts. The first 1st breakout (starting from left) was characterized by low volumes, and low momentum. The 2nd breakout was characterized by impressive volumes but lacked momentum.

However the 3rd breakout had the classic breakout attributes i.e high volumes and high momentum.


Trading the range breakout

Traders buy the stock as soon as the stock breaks out of the range on good volumes. Good volumes confirm just one of the prerequisites of the range breakout. However, there is no way for the trader to figure out if the momentum (second prerequisite) will continue to build. Hence, the trader should always have a stop loss for range breakout trades.

For example – Assume the stock is trading in a range between Rs.128 and Rs.165. The stock breaks out of the range and surges above Rs.165 and now trades at Rs.170. Then traders would be advised to go long 170 and place a stop loss at Rs.165.

Alternatively assume the stock breaks out at Rs.128 (also called the breakdown) and trades at Rs.123. The trader can initiate a short trade at Rs.123 and treat the level of Rs.128 as the stop loss level.

After initiating the trade, if the breakout is genuine then the trader can expect a move in the stock which is at least equivalent to the width of the range. For example with the breakout at Rs.168, the minimum target expectation would be 43 points since the width is 168 – 125 = 43. This translates to a price target of Rs.168+43 = 211.

Wrapping up

Now that you understand the basic know-how of The DOW theory, it’s only logical that we understand more about Executing DOW theory. To discover the answer, head to the next chapter.

A quick recap

  • A range is formed when the stock oscillates between the two price points
  • A trader can buy at the lower price point, and sell at the higher price point
  • The stock gets into a range for a specific reason such as the lack of fundamental triggers, or event expectation
  • The stock can break out of the range. A good breakout is characterized by above average volumes and sharp surge in prices

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