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Dow Theory Special Issue: Putting The Dow Theory Under Stress-Test (IV)

|Includes: DIA, IYT, SPDR S&P 500 Trust ETF (SPY)

What happens to the Dow Theory when the market enters into "fibrillation" (Narrow ranges)?

We continue our saga of looking at the Dow Theory from all possible angles (specially the stressful ones).

Narrow ranges are the plague to trend followers. While the Dow Theory by integrating the time and extent element is less prone than breakout systems or moving averages to false signals, small losses are likely to occur when ranges occur. It the lack of any meaningful trend (be it up or down) persists for a long time (i.e. 4 years) it is likely (not a certainty, though) that a succession of small losing trades will occur. Would this unusual market situation result in the proverbial death by one thousand cuts? Would a succession of small (or not so small) losing trades result in a drawdown exceeding 50% (as buy and hold is used to). In 110 years of Dow Theory history this situation has never occurred, and the occasional periods of narrow ranging have not lasted enough to decimate Dow Theorists. In other words, as far as I have been able to observe, the draw downs caused by the cumulative effect of losing trades has never been worse than those of buy and hold. More specifically, it is far from even 50%. If my observations don't betray me, the largest cumulative loss underwent by Schannep's Dow Theory amounted to ca.18.5% due to two consecutive losing trades on June 20, 2008 and January 30, 2009. It is worth noting that the largest cumulative loss was caused not by "narrow ranging" environments but by a powerful cyclical (or even secular) primary bear market. It is also worth stressing that under Schannep's DowTheory, the largest losing trade amounted to -10.45% (Jan 30, 2009), which is far from being lethal to the investor. Once again, it bears repeating that the largest losing trade was not caused by a trading range.

Thus, it is unlikely that a persistent narrow range condition would result in deep drawdowns. Historically seen narrow ranges have not lasted enough to cause a high number of losing trades resulting in deep drawdowns. However, the market might not be so lenient for us in the future, and hence, we've to imagine scenarios of protracted trading ranges.

How "narrow" is a narrow range to be harmful? Answer: At least a 3% range from closing lows to closing highs confirmed by at least two indices. Less than this does not generate signals, as the minimum threshold of 3% is not reached. On the other hand, swings exceeding 15- 16% between confirmed closing highs and lows are likely to result in profits or, at least, very well contained and sparse losses.

Thus, we can put some tentative figures to the market environment which is detrimental to the Dow Theory: Narrow ranges between 3% and 15-16%. Less than 3% results in no change of trend (and hence no signal, no trade), and more than 16% is a swing of sufficient magnitude to lock in profits in most instances. We have to add the time element to the extent (percentage) element. Narrow ranges of very short duration will not develop secondary reactions, and hence will not lead to the set up for bull/bear market signals. Our likely loss is not linear, and is not proportional to the magnitude of the narrow range. This is a vital point. In other words, a narrow range of 3% per definition is not likely result in losses exceeding that range (unless a sudden event results in a macro down day with a close well below the lows of the secondary reaction). The same applies to a range of 4 or 5% where our likely loss is contained by the confines of the ranges. However, things change as we approach the 7-8% range level. Ranges exceeding 7-8% are likely to result in smaller losses. Thus, a range of 11% is likely to result in a smaller loss than a range of 6%. This is good news, since, even under general adverse market conditions (ranges from 3% to ca. 15-16%) most of the ranges are marginally harmful. If they were too narrow because the loss would be small in direct proportion to its "narrowness", if they were broader, because we'd begin to have sufficient magnitude for the Dow Theory to extract some profits (or have very small losses). Please now follow me and take your time to digest.

We know (see here why) that ca. 7-8% is lost when buying and a similar figure when exiting. The Dow Theory (no trend following system for this matter) is not able to catch the absolute top or bottom. Thus, from a given "swing", we "lose" ca.- 15-16%. Accordingly, our minimum swing from closing high to low, containing a buy and a sell signal, just to break even, should be ca. 16%. A larger price advance between bottom and top is likely to result in profits and a smaller one is likely to cause losses. Why I say likely? Because, we know that our entries and exits are at ca. (ca. "circa" means approximately, around, from this Latin word comes the word "circle"), and hence "ca.", "around", imply no certainty. We have seen instances where the buy or sell signal were signaled very close to the top or bottom (i.e. at 5%) whereas in others it has been signaled at 11%. Thus, I am not talking about mathematical certainties. The market will do what it wants to do. However, I try to provide myself and my readers with a framework to properly appraise what is a "worst case" scenario under listless markets.

Thus, very narrow ranges of 3-4% which manage (a very rare occurrence) to flash buy and sell signals, will result in losses in the vicinity of 3-4%. If our range approaches 6-7% our likely loss will be nearing 6-7%.

Look at the table below.

Or look at the chart below. The horizontal axis displays the extent of the swing from bottom to top. If the range does not exceed 3%, there is no secondary reaction, no signal, and hence no loss (as not trades are taken). Once we exceed the 3% threshold, you can see that the larger the range the larger the likely loss until the range reaches enough magnitude to first reduce the amount of the likely loss and finally result in profits.

Profit and Loss profile of Dow Theory trades according to the extent of the range (swing)

While reality should not match my model, "on average" it is clear that the extent of each range tends to favor a determined risk and loss profile. The specific profit or loss of each trade will depend on the extent of the secondary reaction which led to the setup of the buy/sell signal.

On the other hand, once the ranges exceed 7-8% and given that we know than on average the buy and sell signals tend to "eat up" 7-8% when entering and exiting. We know that it is likely that broader ranges will result in smaller losses. Thus, a 12% range with an average entry and exit implies that ca. 15% is going to be lost when entering and exiting the trade. However, 15%-12% equals 3% which is the loss likely to be made on the trade, which is less than the loss made with a range of just 6%.

When we talk about narrow ranges, we should clarify what we mean by "narrow range". Thus the last 1 ½ year can be characterized as a narrow range, and it certainly affects the outcomes of our Dow Theory trades. However, we should be more specific. We should zero in on the specific range pertaining to each "buy/sell" pair. On any given Dow Theory trade (buy/sell signal) the success or failure of our trade will be largely influenced by the amplitude of the swing which contains the bottom of the preceding bear market and the top of the bull market. By "swing" I mean a movement not interrupted by a secondary reaction. The larger the swing, the more likely we will lock in profits. The narrower the swing (trading range), the more likely our trades will result in losses.

As an aside, Classical/Rhea Dow Theory is less prone to such whipsaws as it is less predisposed to signaling secondary reactions, and hence less prone to setups and signals (but then, it has a larger average losing trade. Everything comes at a price). However, in past experience, (see here) the slightly higher number of trades resulting from Schannep'S Dow Theory did not result in degrading performance; not even the number of losing trades. Just on the contrary: ca. +2% p.a. outperformance versus the classical Dow Theory and drastically reducing average and largest losing trades. However, the price structure of the past (aka: the shape of the charts) may be different in the future.

(to be continued in next post where we will draw specific conclusions as to what to expect under narrow ranges, and more specifically "fibrillation" -repeated narrow ranges in succession-)

Sincerely,

The Dow Theorist