Trading on Averages

Continued from...Dow's own application of his theory.

"There are those who trade on the theory of averages. It is true that in a considerable period of time the market has about as many days of advance as it has of decline. If there come a series of days of advance, there will almost surely come the balancing days of decline.

The trouble with this system is that the small swings are always part of the larger swings, and while the tendency of events equally liable to happen is always toward equality, it is also true that every combination possible is liable to occur, and there frequently come long swings, or, in the case of stock trading, an extraordinary number of days of advance or decline which fit properly into the theory when regarded on a long scale, but which are calculated to upset any operations based on the expectation of a series of short swings.

A much more practicable theory is that founded on the law of action and reaction. It seems to be a fact that a primary movement in the market will generally have a secondary movement in the opposite direction of at least three-eighths of the primary movement. If a stock advances ten points, it is very likely to have a relapse of four points or more. The law seems to hold good no matter how far the advance goes. A rise of twenty points will not infrequently bring a decline of eight points or more.

It is impossible to tell 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 succcssfully on that reaction.

A method employed by some operators of large experience is that of responses. The theory involved is this: The market is always under more or less manipulation. A large operator who is seeking to advance the market does not buy everything on the list, but puts up two or three leading stocks either by legitimate buying or by manipulation. He then watches the effect on the other stocks. If sentiment is bullish, and people are disposed to take hold, those who see this rise in two or three stocks immediately begin to buy other stocks and the market rises to a higher level. This is the public response, and is an indication that the leading stocks will be given another lift and that the general market will follow.

If, however, leading stocks are advanced and others do not follow, it is evidence that the public is not disposed to buy. As soon as this is clear the attempt to advance prices is generally discontinued. This method is employed more particularly by those who watch the tape. But it can be read at the close of the day in our record of transactions by seeing what stocks were put up within specified hours and whether the general market followed or not. The best way of reading the market is to read from the standpoint of values. The market is not like a balloon plunging hither and thither in the wind. As a whole, it represents a serious, well-considered effort on the part of far-sighted and well-informed men to adjust prices to such values as exist or which are expected to exist in the not too remote future. The thought with great operators is not. 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 ten to twenty points above present prices.

In reading the market, therefore, the main point is to discover what a stock can be expected to be worth three months hence and then to see whether manipulators or investors are advancing the price of that stock toward those figures. It is often possible to read movements in the market very clearly in this way. To know values is to comprehend the meaning of movements in the market."

There are assumptions here to which modifications might be offered, but there is no need. It would be impossible to show, except by the research of records covering at least half a century, that there are as many days of advance as of decline. The information would be valueless if obtained. It amounts to saying that heads and tails will equalize themselves if a coin is spun a sufficient number of times.

But what may be commended is Dow's clarity and sterling good sense. What he had to say was worth saying and he stopped when he had said it - a rare virtue in editorial writing. His feeling for the essential fact and for the underlying truth, without which the fact is bare and impertinent, will be readily remarked.  He dealt with speculation as a fact, and could still show forth its truth without profitless moralizing, or confusing it with gambling. It will be well to imitate his point of view in further discussion, both on his theory and on the immense and useful significance of the stock market generally.

Previous...Dow's own application of his theory. Next...Major Market Swings

From The Stock Market Barometer by William P. Hamilton, published in 1922

More in this chapter:
Dow's Theory, Applied to Speculation Bull and Bear Period Definition and Forecasts
Dow's own application of his Theory Trading on Averages

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