Technical Analysis Topic 1 Dow's Editorials

Dow on Speculation - Dow Theory


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

While man 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 editorias 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. I read the fifth reprint (1999) of it.

I provide the interesting observations, explanations and comments made by Dow in his 16 Editorials.

The names of the chapters having these editorials are:

IV. Morality of Wall Steet
V. Scientific Speculation
VI. Thwe Two General Methods of Trading
VII. Three General Lines of Reasoning
VIII. Swings within Swings
IX. Methods of Reading the Market
X. The Operation of Stop Orders
XI. Outting Losses Short
XII. The Danger in Overtrading
XIII. Methods of Trading
XIV. The Out of Town Trader
XV. The Short Side of the Market
XVI. Speculation for the Decline
XVII. Concerning Dicretionary Accounts
XVIII. The Liability of Loss
XIX. The Recurrence of Crises
XX. Financial Criticism

On speculation

It is, however, part of almost every manucturer'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's priniciple 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 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 endeavour to foress future conditions in a property and then, having made his commitments carefully, to exercise great patience in awating 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 this editorial 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 technical and the other 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 whso 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 clealy said medium trendis the one 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 recommeds 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 thity to forty days. The third swing is the main trend covering from four to six years. (Remember in India currently people are talking of bull markets for next 10 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 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 advise even this investor to put a stop order after the 5 point rally from 98 and allow the profits to accumulate. This is technofundamental 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 judgements 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 chages 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 methods 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 of 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 (Is Dow hinting the short sale?)

Dow makes a point about great operators. The thought with great operators isnot 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.

The Operation of Stop Orders

With value based trading, wherein the stock is bought to carry it till it reaches its intrinsic value, a stop order is a folly.

But for the trader, who wants to trade in and out of stocks without regard to values, but being governed by a sense of what the general market is going to do, stop orders are beneficial.

The practice of letting losses run infrequently makes a loss so large that trading come to an end because the speculator has no more money.

Cutting Losses Short

Dows says experience says that "either cut losses short, or take an investment position."

The general rule is to stop losses within a range of two or three points from the purchase price. all purchases on points, tendencies and rumours should be regarded as guesses and protected by stop orders.

The stop order is of primary importance when a purchase is first made and when its wisdom is in doubt. It is also use when a stock has had its normal swing for the purpose of saving most of the profit if a reaction comes.

The Danger in Overtrading

It is very important to note this statement of Dow in this editorial

Making money in stocks for most people resolves itself into a series of transactions in which we may say there are six profits and four losses, resulting in net gain.

The experience of good traders shows that the operating expenses of trading, that is to say, the ratio of losses to profits, run from 50 to 65 per cent of the total profits.


Methods of Trading

The more a man really knows about speculation, the less certain he becomes in regard to any market movement, except as the result of general conditions.

Dow in this editorial makes the statement that it is possible to derive fairly accurate knowledge of the value of a speculative investment stock. The value estimation should be considered essentially with reference to its ability ot maintain or increase its dividends. If the stock seems likely to continue a current rate of dividend, and the return on the cost is such as to make it fairly satisfactory as an investment, it is a good stock to buy when, in sympathy with decline in the general market, it has fallen below its normal price.

The stock bought as investment should be held without regard to current fluctuations, until it showed a satisfactory profit. Then it should be sold and the operator should wait weeks or months if necessary for an opportunity to take it or some other stock back upon favourable terms. The operator who selects investment properties carefully and buys after the market has had general declines, and who exercises a good deal of patience both in waiting for the time to buy and for the time to sell-who in short, treats his speculation as an investment, will be likely to make money in stocks.

While the first method that described was the speculative investment method by using values as basis, the second method advocated was the method of cutting losses and allowing the profits to run. This method now has the name of technical analysis. Dow was more straight in describing it.

Dow cautions at the end of this piece, that there is no sure way of making money in stocks, but the principle of buying after a period of steadiness in prices, stopping losses and letting profits run will, as a matter of statistical record, beat most people's guessing at what is going to occur.

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The Out of Town Trader