Price Indicators

Dow Theory, Advances and Declines, New Highs and Lows, Circuit Filters

Core Concept: Price indicators are technical analysis tools that use price data to provide insights into market trends and potential future price movements. These indicators help traders and investors gauge market sentiment, identify potential entry and exit points, and manage risk.

1. Dow Theory

• Definition: The Dow Theory is one of the oldest and most influential technical analysis theories. Developed by Charles Dow in the late 19th century, it provides a framework for understanding and interpreting market trends.

• Key Principles:

  • a) The Averages Discount Everything:
    • Similar to the assumption in technical analysis, the Dow Theory posits that the market price reflects all available information, including past, present, and future events.
    • This means that analyzing price movements alone can provide insights into market sentiment.
  • b) Three Types of Market Trends:
    • Primary Trend: The major, long-term trend of the market, lasting from several months to several years. It can be either upward (bull market) or downward (bear market).
    • Secondary Trend: Intermediate-term corrections or rallies within the primary trend, lasting from a few weeks to a few months. These trends move against the primary trend.
    • Minor Trend: Short-term fluctuations lasting from a few days to a few weeks. These trends are considered noise and are generally ignored by Dow theorists.
  • c) Primary Trends Have Three Phases:
    • Accumulation Phase (Bull Market): Informed investors begin buying as they recognize value in the market. The general public is still skeptical.
    • Public Participation Phase (Bull Market): As the market rises, more investors begin to participate. News is positive, and earnings are improving.
    • Distribution Phase (Bull Market): Informed investors begin selling as they believe the market is overvalued. The general public is still enthusiastic.
    • Distribution Phase (Bear Market): Informed investors begin selling as they recognize the market is overvalued.
    • Panic Phase (Bear Market): Prices decline rapidly as more investors sell in response to negative news and fear.
    • Accumulation Phase (Bear Market): Discriminating investors start buying again, believing assets are undervalued.
  • d) The Averages Must Confirm Each Other:
    • A key principle of the Dow Theory is that a signal of a trend change must be confirmed by both the Industrial Average and the Transportation Average (in the original Dow Theory, now often replaced by a broader market index like the S&P 500 or NIFTY 50 alongside a sector-specific index).
    • For example, a new uptrend is not considered established until both averages break above their previous highs.
  • e) Volume Confirms the Trend:
    • Volume should increase in the direction of the primary trend. For example, in a bull market, volume should increase on rallies and decrease on corrections.
  • f) A Trend is Assumed to be in Effect Until it Gives Definite Signals that it Has Reversed:
    • The burden of proof is on demonstrating a reversal rather than assuming one.

• Application:

  • Identify the primary trend of the market and trade in the direction of that trend.
  • Use the confirmation principle to avoid false signals.
  • Pay attention to volume to confirm the strength of the trend.

• Limitations:

  • The Dow Theory is a lagging indicator, meaning that it often signals trend changes after they have already begun.
  • The theory is subjective and open to interpretation.
  • It may not be suitable for short-term trading strategies.

2. Advances and Declines

• Definition: Advances and declines (A/D) is a breadth indicator that measures the number of stocks that have increased in price (advances) and the number of stocks that have decreased in price (declines) over a given period.
• Calculation:
  • A/D Line = (Number of Advancing Stocks - Number of Declining Stocks) + Previous A/D Line Value
• Interpretation:
  • A/D Line Rising: Suggests that the market is broadening, with more stocks participating in the rally. This is a bullish signal.
  • A/D Line Falling: Suggests that the market is narrowing, with fewer stocks participating in the rally. This is a bearish signal.
  • Divergence: When the A/D line diverges from the price index, it can signal a potential trend reversal. For example, if the price index is making new highs, but the A/D line is not, it may indicate that the rally is losing momentum.
• Application:
  • Confirm the strength of a market trend.
  • Identify potential trend reversals.

3. New Highs and Lows

• Definition: New highs and lows is a breadth indicator that measures the number of stocks reaching new 52-week highs and the number of stocks reaching new 52-week lows.
• Interpretation:
  • Increasing New Highs: Suggests that the market is strong and that the uptrend is likely to continue.
  • Increasing New Lows: Suggests that the market is weak and that the downtrend is likely to continue.
  • Divergence: When the number of new highs or new lows diverges from the price index, it can signal a potential trend reversal.
• Application:
  • Confirm the strength of a market trend.
  • Identify potential overbought or oversold conditions.

4. Circuit Filters

• Definition: Circuit filters (also known as circuit breakers) are mechanisms implemented by stock exchanges to temporarily halt trading in the event of a significant market decline.
• Purpose:
  • Prevent panic selling and excessive volatility.
  • Provide investors with a cooling-off period to reassess the market situation.
  • Maintain market stability and integrity.
• Mechanism:
  • Circuit filters are triggered when a market index (e.g., NIFTY 50, SENSEX) declines by a certain percentage from its previous closing level.
  • The halt in trading can last for a specified period (e.g., 15 minutes, 1 hour) or until the end of the trading day, depending on the severity of the decline.
• Example (Indian Context): * As of my knowledge cut-off date, Indian stock exchanges typically have circuit filters at different levels (e.g., 10%, 15%, and 20% declines). If the NIFTY 50 or SENSEX falls by 10%, trading may be halted for a short period. Further declines may trigger additional halts.
• Impact on Technical Analysis:
  • Circuit filters can disrupt technical analysis patterns and indicators.
  • Traders need to be aware of the potential for circuit filters to be triggered and adjust their strategies accordingly.
  • The triggering of a circuit filter can be a strong signal of market stress and potential further declines.

Conclusion:

Price indicators, such as the Dow Theory, advances and declines, new highs and lows, and circuit filters, provide valuable insights into market trends and potential future price movements. These tools help technical analysts gauge market sentiment, identify potential entry and exit points, and manage risk. However, it's essential to use these indicators in conjunction with other technical analysis techniques and to consider their limitations.