2023 – Technical Analysis of

Financial Markets
Module 2: Dow Theory and Trend
Analysis

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 Course Plan
Module Titles
Module 1 – Introduction to Technical Analysis, Charting Techniques, and Arithmetic
Scale vs. Ratio Scale
Current Focus: Module 2 – Dow Theory and Trend Analysis
Module 3 – Pattern Recognition and Financial Statistics
Module 4 – Quantitative Indicators I
Module 5 – Quantitative Indicators II
Module 6 – Lightning Round, Candlestick Chart Analysis, and Point and Figure
Chart Analysis
Module 7 – Breadth Analysis, Volume Analysis, Sentiment Analysis, Sector
Analysis, and Sensitivity Analysis
Module 8 – Performance Measurement, Risk Management Strategies, and Money
Management Techniques
Module 9 – Lessons Learned from Trading Exercises and Special Topics: Ichimoku
Charts and Financial Psychology 2
 Topics for this Module

• 2.1 Predictability of Stock Prices

• 2.2 Dow Theory and Trend Analysis
• 2.3 Trading Strategies with Support and Resistance

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Quote of the week
“The trend is your friend”
– Anon.

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 Module 2 – Section 1

Predictability of Stock Prices

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Flashback to the Future
• Let’s Watch an Exciting Technical Analysis Movie!
– Website: [Link]
– Stock: AAPL
– Start Date: Nov 1, 2021
– End Date: Mar 1, 2022
– Range: “Select Start/End”

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Module 2 – Section 2

Dow Theory

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The Million Dollar Question
• How much time does the market spend on moving up,
sideways and moving down?
• What are the implications of above question to our technical
trading strategies?

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What is a Trend?
• Definition: direction of the market action
• There are three types:
1. Uptrend = a series of successively higher highs and higher lows
2. Downtrend = a series of successively lower lows and lower highs
3. Trendless/Sideways = horizontal peaks and troughs

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 Group Exercise

• When the market is moving sideways, what should you

do?

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Dow Theory: Background
• Charles Dow
– Co-founder of Dow Jones & Company and editor of The Wall Street
Journal
– Published a series of Wall Street Journal editorials between 1900
and 1902 concerning market action
– Constructed the DJ Industrial Average and the DJ Transportation
Averages

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Six Tenets of Dow Theory
1. The Averages Discount Everything.
2. The Market Has Three Trends.
3. Major Trends Have Three Phases.
4. The Averages Must Confirm Each Other.
5. Volume Must Confirm The Trend.
6. A Trend Is Assumed To Be In Effect Until It Gives
Definite Signals That It Has Reversed.

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Insights into these Tenets
• #1: The Averages Discount Everything.
– Basically one of assumptions on which technical analysis
is based
• #2: The Market Has Three Trends.
– Primary Trend (tides)
• Lasts for at least a year
• Could be bullish or bearish
• Bullish trend: successive higher highs and higher lows
• Bearish trend: successive lower highs and lower lows

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Insights into these Tenets (cont’d)
– Secondary Trend (waves)
• Lasts between 4 weeks to 3 months
• Correction to the primary trend or retracement between 33% to 67% of
the previous primary uptrend or downtrend
– Minor Trend (ripples)
• Lasts for less than 4 weeks
• Considered statistical noise

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Insights into these Tenets (cont’d)
• #3: Primary Trends Have Three Phases.
– Example: Bull Trend
1. Accumulation phase (smart investors)
2. Participation phase (trend is your friend + linear trend + longest
phase)
3. Distribution phase (record prices + exponential trend + high volatility)

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Insights into these Tenets (cont’d)
• #4: The Averages Must Confirm Each Other.
– Both DJIA and DJTA must confirm each other to signify
a change in trend.
– Reason: The goods need to be distributed or shipped
to the market before a profit can be made
– DJIA gives you the signal but any trend or breakout
needs to be confirmed by DJTA
– The closer the confirmation, the stronger the breakout
is going to be.

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Example: When to Short Dow Jones?

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Insights into these Tenets
• #5: Volume Must Confirm The Trend Reason
– Uptrend:
• Price up, volume up/down
• Price down, volume up/down
– Downtrend:
• Price down, volume up/down
• Price up, volume up/down

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Insights into these Tenets (cont’d)
• #6: A Trend Is Assumed To Be In Effect Until It Gives
Definite Signals That It Has Reversed.
– Newton’s 1st law about inertia: a trend (once started) in motion will
remain in effect until an external force is exerted on the trend
– Technicians look for trend breakout or reversal patterns

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Example: Trend is Your Friend!

Get out if it
breaks below
the trend line

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Example: Don’t Catch a Falling Knife!

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Well-Known Trading Rule for Dow
• When the yield on DJIA falls to 3% or below => sell signal
(market tops)
• When the yield on DJIA increases to 6% or above => buy
signal (market bottoms)

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What was Dividend Yield of Dow Jones Industrial Average
at the Peak of the Stock Market in 1929?
• According to the Gold Eagle web site (see link below for more details), just prior
to the 1929 crash the numbers for the companies reflected in the Dow Jones
Industrial Average were:
– dividend yield around 2.9%
– price/earnings ratio around 16
– market/book ratio about 2
• [Link]
• What was that in the IT bubble?
– dividend yield around 1.3%
– price/earnings ratio around 28
– market/book ratio about 6
• What is it as of Jan 31, 2008)?
– dividend yield around 2.3%
– price/earnings ratio around 15
– market/book ratio about 2
• What is it now (as of Jan 29, 2017)?
– dividend yield around 2.4%
– price/earnings ratio around 21

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Update to Previous Slide
• What is it now (as of Jan 29, 2017)?
– dividend yield around 2.4%
– price/earnings ratio around 21

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 Module 2 – Section 3

Trading Strategies with Support

and Resistance

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Analysis of Support and Resistance Levels
Definitions
• Support: a price level where buying interest is strong
enough to overcome the selling pressure
• Resistance: a price level where the selling interest is strong
enough to overcome the buying pressure

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Analysis of Support and Resistance Levels
Characteristics
• A resistance that is penetrated will reverse its role as a support and vice
versa. They only reverse roles only after a significant penetration of 3%.
• The longer the period of time that prices trade in a support or resistance
area, the more significant that level becomes
• Volume is another way to measure the significance of support and
resistance
• The more recent the trading took place (at the support or resistance
levels), the more significant that level becomes

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Rules for Breakout
• How do we determine whether a trend line or
support/resistance is “decisively” broken?
1) 3% rule – the trend line or support/resistance level is penetrated
by more than 3%.
2) 2-day rule – the trend line or support/resistance level is penetrated
for more than 2 consecutive days.

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Example of a Breakout

2-day rule

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Analysis of Support and Resistance Levels

Current Resistance

Historical Support

Strong Support at 1.5

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Example: Where Were We in the Gold Rush One
Year Ago?

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Example: Where Were We in the Gold Rush Now?

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 Group Exercise 3

• Where should you put a stop loss when a stock is trading

above the strong support at $50?
a) 50.5
b) 50
c) 49.5
d) 49
e) 48.5

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Example of a Trend Line

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Penetrated Resistance Becomes a Support

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Example of 3% Rule

support at $1600

trading battle between $1648

and $1552 (plus & minus 3%)

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Example of Support Line

key support @
$33.5

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Trading Strategies with Support and Resistance

• Never buy or sell in the middle of nowhere!

• Buy above a key support after it has been
successfully tested!
• Sell just below a key resistance!
• Make sure that your RRR (return/risk ratio) is great
than 3!
– Return-Risk Ratio = (next resistance – current
price)/(current price – next support)

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Tim Fong’s 3-Step Price Action Analysis
1. Touching down or up
2. Fighting
3. Departing
– Reversing the trend if you win the battle in step 2
– Continuing the trend if you lose the battle in step 2

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Example – Step 1

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Example – Step 2

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Example – Step 3

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Analysis of Trend Lines and Trend Channels
• Uptrend Line: A line connecting ascending lows
with a positive slope
• Downtrend Line: A line connecting descending
highs with a negative slope

How do you draw a valid trend line?

• Need 2 points to draw the trend line
• Need the 3rd point to confirm the validity of the
trend line

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Analysis of Trend Lines and Trend Channels
(cont’d)
Other Characteristics of Trend Lines
• The longer it has been intact or the number of times it has
been tested, the more significant that level becomes.
• A close beyond the trend line is more significant than an
intraday penetration.
• An uptrend line will become a resistance line once it’s
decisively broken and vice versa.
• It is not necessary for a downside penetration to be
accompanied by high volume.

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Statistical Analysis of Trends
Review of Correlation
• Graphically: A scatterplot
• Mathematically: Correlation measures the linear relationship between
two random variables
• -1 ≤ correlation ≤ +1

Autocorrelation
• Defined as correlation between members of series of observations
ordered in time

Autocorrelation at lag j = Corr(Xt, Xt-j) = Cov(Xt, Xt-j)/Var(Xt)

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Example of Scatterplot and Positive Autocorrelation

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 Group Exercise

• Draw a time series chart where the autocorrelation would be

negative
• What is the implication of negative autocorrelation to
trading?
• How do we use autocorrelation in measuring your trading
performance?

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Any questions?

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Thank You
Thank you for choosing the University of Toronto
School of Continuing Studies

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