DOW THEORY

Charles H Dow is considered by many to be the father of technical analysis & Dow theory
which is named after him is considered to be the granddaddy of all technical market
studies.

Dow is known for his invention of stock market averages, which are popularly these days
known as Indices.

Even before DOW it was quite well known to bankers and other people related to the stock
markets that stocks of established companies generally go up or down together. Though
there were stocks which moved against the general trend, such a move was generally not
possible for a longer period.

When the trend was up some stocks rose faster than others and when the trend was down
some stocks fell faster than others but it was generally seen that most of the stocks moved
up or down together or in a trend and they follow the same behavior even today.

He used two stock averages for his theory. Industrial average and rail average, rail average
was composed of 20 rail road companies and the industrial average which is today more
popularly known as Dow Jones Industrial average or just DOW which represented all other
types of businesses and had only 12 companies. (Today the Industrial average has 30
companies).

The basics of Dow Theory:

1. The averages discount everything (Except natural calamities)

2. The three trends:

Major or primary trends: These usually last for more than 9 months and less than 5
years. Characteristics of Primary Bear Market:

a) Primary bear market is represented by a big decline in the stock markets with some
important rallies in between.
b) It starts when expectations which led to lot of buying in the market are not met.
c) During the next stage the profit of the companies and economic activity declines.
d) The last stage reflects panic, the market players want to sell their holdings
irrespective of their fundamentals.

Characteristics of Primary Bull Market:

a) An upward movement of the market that generally lasts for more than a year with
small or corrections in between

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 b) The primary bull market starts when all the possible or sometimes the impossible
negative factors have been discounted and then there is some hope of revival for the
economy.
c) During the next stage there are signs of improvement in the economy and companies
also start reporting better earnings.
d) The last stage reflects overconfidence and speculation and the market players look
at only the positive side of the economy.

Secondary Reactions: Primary trends are interrupted from time to time by secondary
trends. (Secondary trends move in opposite direction to Primary trend). These last
generally for more than 4 weeks to many months. Note: The biggest difficulty faced by
Dow theorist is differentiating between the start of the primary trend and a secondary
reaction.

Minor Movements: They generally last for less than 4 weeks. Not significant as far as
Dow Theory is concerned. Some Dow theorists refer to them as crowd noises/random
movements which are to be ignored. WHY? Because they are easier to manipulate than
the secondary & primary trends.

3. Price determines the trend: The trend is said to be bullish when successive rallies
make higher highs and lower bottoms. Contrarily, the trend is considered to be bearish
when the price forms lower bottoms and lower highs i.e. if the primary trend is bullish
the correction comes in the form of secondary waves and if the primary trend is bearish
the intermediate rallies come in the form of secondary waves. (Refer Figure 1-A)

A trend once identified will be assumed to continue till trend reversal is confirmed with
the help of reversal signal:
Bullish to bearish Trend: When the price breaks the previous low the trend is
considered to have been changed from Bullish to bearish. (Refer Figure 1-B)

Similarly in a bearish trend if the price breaks the previous high formed by a secondary
wave the trend is considered to have been changed from bearish to bullish.

Note:
 If you are out of the market, you will buy if price goes above the recent top (i.e you
will only try to find new top & not bottom)
 If you are invested in the market, you will sell if the price goes below the recent
bottom (i.e you will only try to find new bottom & not top)
 The tops and bottoms referred to are the significant tops and bottoms that take more
than 4 weeks to form. Since any top or bottom formed that takes less than 4 weeks
is considered to be a tertiary wave and ignored for the application of Dow Theory.
 For a beginner it might be difficult to find and eliminate tertiary waves. Please refer
to our video “Dow Theory – Application” to get clear picture.

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 Secondary waves

Higher tops
Higher bottoms

Price

Primary trend bullish

Time

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 X

Change in trend : Bullish to bearish as

Price price breaches the previous low formed by
secondary wave

Time
Figure 1-B

4. Dow Theory should be applied on a weekly chart of an Index; one should resist the
temptation to apply it for individual stocks, since significant tops and bottoms can be
identified with ease on a weekly Index chart

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MOVING AVERAGES (MA)

Stock markets can be very volatile at times and it becomes very to difficult take a position.
Moving averages help us deal with this problem to some extent.

There are a number of variations of MAs. The most commonly used MA is a Simple MA.

Simple Moving Averages: Simple Average is calculated by adding and then dividing the total
by the number of data points.

For example we have a set of numbers: 10, 20, 50, 80, 100
Total= 10+20+50+80+100 = 260
Total / 5 = 260/5=52
So 52 is the average for the set (10, 20, 50, 80, 100)

To find a moving average a new number is added to the set and the first item is removed.

Example:

Date Day Price 3-Day MA

Monday, 29th March 2010 1 1000 -
Tuesday, 30th March 2 1010 -
Wednesday, 31st March 3 1050 1020
Thursday, 1st April 4 1000 1020
Friday, 2nd April 2010 5 990 1013.3
Sat
Sun
Monday 5th April 6 960 983.3
Tuesday, 6th April 7 990 980
Wednesday 7th April 8 1020 990

 Note: Generally speaking a rising MA line for a financial instrument indicates

that if we ignore the day to day fluctuations, the financial instrument is
performing well. Similarly a falling MA line indicates that the performance has
not been good.

Trading Strategy:

a) Go long when the price breaches the moving average on the upside and go short
when the price breaches the moving average line on the downside.
 Sometimes the volatility is so high that even MA’s create lot of confusion by
generating false calls. Unfortunately one can only reduce the no.of false signals
and not eliminate them by (1) increasing the time span for moving averages, (2)
Applying 20 week moving average with Dow Theory.
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  Ideal Time Span for Moving Averages:

 Unfortunately there is no ideal time span for moving averages. Very long time
span give pathetically slow signals whereas short time span results in a number
of false signals. The most popular MAs used are 20-50-100-200 day

 Application:
We use 20 Week
We Moving Average.
recommend 20 Week Moving Average should be used only
for long term investment.
So we have in all three tools for long term investment (90% of your portfolio
or the ETF portfolio) which are listed below in the order of their importance
a) PE Ratio
b) Dow Theory
c) 20 Week Moving Average

WESTERN TECHNICAL ANALYSIS – PRICE PATTERNS

1. Head and Shoulders Top: One of the most popular reversal pattern in WTA is H&S
Top. (Refer Figure 1-D) It is called head and shoulders for the obvious reason that the
pattern has head and shoulders like structure. Neckline is formed when you join points
A and B and extend this line through the shoulders.

Head

Price Shoulder 2
Shoulder 1 x

Neckline

Time

Volume

Time

Figure 1-D

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 Formation of H&S Top:

 Shoulder 1: During the first half of shoulder 1 there is a rise in price generally with
high volumes and in the 2nd half the price falls with significant fall in volumes.
 Head: Similar to Shoulder 1 during the first half there is a price rise with a
noticeable rise in volumes (ideally less than the volume during formation of first
half of shoulder 1) and in the 2nd half the price falls again with a noticeable fall in
volumes.
 Shoulder 2: Here again in the first half the price rises but the volumes do not
support the price rise, i.e. the volumes either remain same or decrease with the rise
in price. Generally the decline in the second half is supported by some rise in
volume. But Volumes are important when the price breaks the neckline. Breach of
neckline should be supported by high volumes.

Important points to remember:

 HS pattern should be spotted after a noticeable rally.

 2. HS pattern is significant only after formation of the last shoulder.
 Generally the volumes decrease as the pattern is formed and the traded volume is
high when the price breaks the neckline. This is the case with the ideal HS pattern,
you would see variations in real life.

Trading strategy:

 Sell / Short when the price breaches the neck line. It is also very important to keep a
watch on the volumes. When the price breaches the neckline with high volumes, the
probability that the price will go down further increases.
 The target for your short sell positions would be x, i.e. the maximum height of the
head.
 3 day – 3 % rule for daily and weekly charts : Many technical analyst follow the 3
D- 3% rule i.e. Unless the price breaches the NL by more than 3% or the price
remains below the NL for more than 3 days, they don’t trust the breach.
 Price back to the neck line might give you a second chance to short the stock.
 H&S top in weekly charts are very successful in spotting major reversals

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Dow Jones Industrial Average – Jun 2006 – Dec 2008
Head
Shoulder 1 Shoulder 2
x
Neckline
x

Source: stockcharts.com

Chart 1

BSE SENSEX Source: www.bseindia.comc

Head

Shoulder 2

Shoulder 1 X Neck line

Chart 2

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 RCOM Source:
www.bseindia.comc

Head

Shoulder 2
Shoulder 1 X
Neck line

Chart 3
RELCAP Source: www.bseindia.comc

Head

Shoulder 2
Shoulder 1 X Neck line

Chart 4

2. Head and Shoulders bottom:

The exact opposite of H&S top is H&S bottom (Refer Figure 1-E)

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 Figure 1-E

Price
x

Neckline

x
Shoulder 2
Shoulder 1

Head
Time

Volume

Time

Formation of HS bottom pattern:

 Shoulder 1: During the first half of shoulder 1 there is a fall in price generally with
high volumes and in the 2nd half the price rises with fall in volumes.
 Head: Prices fall below the bottom of the left shoulder, volumes show some
increase, but usually at a lower rate as compared to the left shoulder decline
 2nd half the price rises above the bottom level of the left shoulder , volumes may
pick up and exceed the rate as compared to the recovery from left shoulder
 Shoulder 2: Price falls with low volumes as compared to the volumes for the
Shoulder 1 and the head formation. Fall in price does not reach the lower level of
the head but is followed by a rally.
 Finally an increase in price accompanied with an increase in volume pushes past the
neckline and closes approximately 3% above the Neckline –This act as a
confirmation or breakout.

Important points to remember:

 HS bottom pattern should be spotted after a clear downtrend.

 HS bottom pattern is significant only after formation of the last shoulder.
 Volume price relation sometimes does not hold true for H&S bottom formed after
big recession or at the end of a long bearish trend

Trading strategy:

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  Buy / go long when the price breaches the neck line. It is also very important to
keep a watch on the volumes. When the price breaches the neckline with high
volumes, the probability that the price will go up increases.
 The target for your long position would be x, i.e. the maximum height of the head.
 3 day – 3 % rule for daily and weekly charts : Many technical analyst follow the 3
D- 3% rule i.e. Unless the price breaches the NL by more than 3% or the price
remains above the NL for more than 3 days, they don’t trust the breach.
 Price back to the neck line might give you a second chance to go long.

Dow Jones Industrial Average – Jun 2008 – Dec 2009

Necklin
e
x
Should Shoulde
er 1 r2
Hea
d

Source: stockcharts.com

Chart 5

3. Triangles:

There are two types of triangle patterns:

a) Symmetrical triangle
b) Right angled triangle.
They can act as continuation or reversal patterns

a) Symmetrical triangles: A symmetrical triangle is formed after a series of price

fluctuations, each fluctuation is smaller in comparison to the previous fluctuation,
i.e. the tops formed after a rally are unable to break the previous high (included in
the pattern) and the bottoms formed after correction are unable to break the
previous lows of the pattern. Hence Symmetrical patterns can be described as a
sideways movement with a contracting trading range. (Refer Figure 1-F)

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 Important points to remember:

 Generally the trading activity

diminishes as the pattern is formed and
there is a considerable rise in trading
activity when the price moves out of
the triangle.
 When the pattern is being formed it is
very difficult to predict the direction in
which the price will move out of the
triangle (volume and price movement
in other similar stocks might give an
idea).
 The market psychology reflected in this
pattern is similar to that of a Doji
(Japanese candlesticks) i.e. the market
is confused.
 Remember to draw a symmetrical
triangle one needs to have at least two
tops and two bottoms. If a symmetrical Figure 1-F
triangle is formed after an uptrend a
top will be formed first followed by Note: The upward& downward slanting
bottom then a second top that is lower line need not be of equal length
than the first top and at last a second
bottom which takes the price lower but not enough to take it lower than the
previous bottom. (The second bottom is said to be formed only when the price
moves up, away from the second bottom.
 The breach of the boundary lines should occur after price has traveled more than
half of the triangle but less than three-forth of the triangle (horizontal distance).
 It is generally observed when the price breaches the triangle very close to the apex
the movements in price on either sides post breach are quiet weak.
 The 3 day – 3% rule as discussed in the H&S Pattern will be applicable for
Symmetrical Triangles.
 The breach of the upper boundary of the triangle should generally be supported by
rise in volumes, but the breach of the lower boundary of the triangle does not
necessarily need to be supported by rise in volumes. (Price can fall by its own
weight).
 A pull back to the upward/downward boundary line after a break out could be
considered as a second buying/selling opportunity.
 Some analysts claim that statistically symmetrical triangles work more as
consolidation patterns than reversal patterns.

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 Trading Strategy

 If the price breaks the upward boundary line with rise in volumes go long and the
upward boundary line will act as your stop loss for the long position.
 In case the price breaks the downward boundary line with rise in volumes go
short/sell and the downward boundary line will act as your stop loss for the short
position.
 Target price

Britannia Chart 8 A

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 Britannia Chart 8 B

Tata Motors Chart 9 A

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 Tata Motors Chart 9 B

b) Right angle triangles: The right

angle triangles are differentiated
from the symmetrical triangles by
having one of their boundaries
parallel to the x-axis. Depending
upon whether the horizontal line is
upper side or lower side of the Figure 1-Gi
triangle these triangles are further
divided into :

i. Ascending Right Angle Triangle:

The horizontal line is the top line
and the bottom line slopes upward
(Refer Figure 1-Gi). The probability
that the price breaks the upward
boundary is higher (8/10).
ii. Descending Right angle Triangle:
The horizontal line is the bottom
line and the top line slopes
downward (Refer Figure 1-Gii). The
probability that the price breaks the
downward boundary is higher Figure 1-Gii
(8/10).

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 Important points to remember:

 Trading activity is similar to that of a symmetrical triangle i.e. activity decreases

as the pattern is being formed and the breach of boundary lines is supported by
rise in volumes.
 Sometimes (not a rule) in an ascending triangle one can see rise in volumes
during the rallies and decline in volume when the price falls.
 In a descending triangle one can see rise in volumes when the price falls and
rally is not supported by rise in volumes. (Not a rule)
 Similar to symmetrical triangles, the breakout after price has traveled more than
half of the triangle and less than three fourth of the triangle is much more
reliable.
 Pull back reactions towards the boundary line are fairly common in both
symmetrical and right angled triangles. One should take note of the general
market conditions when one spots the pull back towards the boundary line.
 Setting Targets.
 Triangles on daily, weekly and monthly charts.

Cipla Chart 10 A

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 Cipla Chart 10 B

Cipla Chart 10 C

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 OTHER PRICE PATTERNS

Generally the price cycle has three trends: Uptrend, Downtrend and Sideways trend.
Usually during a trend and during transition of one trend to other price moves in
sideways direction. Very rarely the price turns or continues to move in the same
direction without the sideways movement. This transition or consolidation period is of
utmost importance for a technical analyst. There are a number of patterns that are
formed on a chart which signal a consolidation or transition period (Eg. H&S and
Triangles)

A consolidation or transition pattern when formed before a downtrend is called

distribution pattern and a consolidation pattern formed before an uptrend is called
accumulation.

Accumulation: Accumulation represents a period in the market where the smart money
buys financial instruments from the common or uninformed investors, who are
generally willing to sell their holdings because of the prevailing bearish sentiment in
regards to the particular financial instrument.

Distribution: Distribution represents a period in the market where the smart money sells
financial instruments to the common or uninformed investors, who are generally
willing to buy because of the prevailing bullish sentiment in regards to the particular
financial instrument.

Important points to remember:

 When the pattern is under formation it is not wise to predict in advance the
direction in which the price will break out i.e. it can either be a continuation or a
reversal pattern.
 Generally one can observe a decline in trading activity as a pattern is being formed
and a breakout from the pattern is usually sported by rise in volumes. Though
volume during a downward breakout might be an exception.
 Confirmation of a valid breakout: There are times when the price breaks out of the
pattern by a very small margin which misleads the traders or investors. It is wise to
follow a criteria that minimizes the incidence of such false breakout. Many analysts
suggest to wait for 3% or 3 day breakout from the boundaries to confirm a breakout.
 The 3% rule holds good if you follow daily charts, the same might not hold true for
intraday charts where market players generally don’t aim for bigger profits. In such
cases the best approach would be to take a decision based on common sense &
experience. Taking note of Volume & volatility of the financial instrument also
helps)
 The principles of price patterns can be applied to any time frame from 1 minute
charts to weekly, monthly or annual charts.
 The significance of a pattern is directly proportional to its size and depth. A pattern
that takes longer time to complete and has greater fluctuations indicates a stronger
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 move after a breakout. Hence a pattern spotted on a monthly chart is more
significant than a pattern spotted on a intra-day chart.
 The existing trend is assumed to continue until a reversal has been proved.

Other Price Patterns:

1. Rectangle:
 When price moves in a horizontal or sideways direction for a while it is called a
rectangular pattern. Refer Figure 1-H

Rectangle as a continuation pattern

Rectangle as a reversal pattern
Figure 1-Gii

 Unlike the H&S or the triangle pattern the rectangle reflects an equal and opposite
strength of buyers and sellers until one outperforms the other.
 False move: Not as frequent as in Symmetrical triangles, as reliable as H&S though
not as powerful in its implications.
 Pullbacks: Takes place more frequently in rectangles as compared to Symmetrical
Triangles.
 Rectangles as reversal patterns are more frequent at the bottom than at tops.
 Measuring Implications: Width

2. Double Tops and Bottoms:

 A double top pattern is formed after an upside rally and is represented by two peaks
separated by a valley between them.
 Generally the second peak is formed with fall in volume.
 The 2 peaks are formed nearly at the same levels.
 Should be seen as a trading opportunity only after substantial uptrend or downtrend.

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 x x

x x

Double Top Double Bottom

Figure – 1-I

3. Triple Tops or Bottoms :

 Triple tops or bottoms are formed when the double patterns extend to form three
consecutive similar highs or lows. Can also be compared to rectangles.
 Refer Figure 1-J for various variations in these patterns.

x x

x x

Figure – 1-J

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RELATIVE STRENGTH INDICATOR (RSI):

Developed by Mr. Wilder and is measure of the strength in a financial Instrument.

Note: Beginners often confuse it with Comparative Relative Strength
Calculation for RSI:
RSI= 100 – ( 100 )
(1+RS)
Where RS = Average of n periods closes up/Average of n
periods closes down
Important points to remember:

a) The value of RSI varies from 0-100. Generally RSI value of less than 30 indicates
the stock is oversold and RSI above 70 indicates it is overbought.
b) The most effective way to use RSI would be to combine it with candlesticks.
 We would recommend to use RSI for individual stocks and daily charts,
since for long term and ETFs, PE ratio, Dow theory and 20 Week Moving
average are more effective
 To apply RSI follow the top down approach given below.
 Step 1: Look for the Sensex PE Ratio, if satisfactory, look for PE ratios of
different sectors
 Step 2: Identify the sectors that are relatively cheaper (For example:
Infrastructure Sector is cheap, make a list of stocks in the infrastructure
index.
 Step 3: Look for daily candlestick charts of stocks that have RSI below 30
 Step 4: Buy if you find a positive candlestick pattern or a positive gap in
these stocks with a stop loss (Stop loss of the candlestick pattern or

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