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DOW THEORY


About That Breakdown, Dow Transports Division

11/07/05 02:30:21 PM
by David Penn

The transports signaled the possibility of a breakdown in late October, but a retreat from shooting star candlesticks turned into a reversal to the upside.

Security:   $TRAN
Position:   N/A

What did I miss? That was the first question I asked myself in the days leading up to Halloween, when the Dow transports -- which looked ripe for a rollover -- instead surged higher.

Let's go back to the tape, as they say on Sunday afternoons this time of year.


The case against the transports had a number of pillars. Negative divergences in both the stochastic and the moving average convergence/divergence (MACD) histogram suggested that there was a strong chance that the transports would continue lower. And while not at the top of an extended rally, the shooting star-like candlesticks late in October added a further bearish cast to the market's movement (Figure 1). And certainly, had the transports in fact broken down, all of these pillars would have been considered almost obvious signposts of relative doom.

FIGURE 1: DAILY DOW JONES TRANSPORTATION AVERAGE. Breaking out above and finding support on its 10- and 50-day exponential moving averages, the DJTA defies the bearishness of negative divergences in both the stochastic and MACD histogram.
Graphic provided by: Prophet Financial, Inc.
 
So what happened to the doom? The transports never flipped the switch. Consider how the MACD histogram reacted -- and how prices did and did not react in late October. There were negative divergences in the stochastic and MACD histogram as of October 27. As of the close of that date, the MACDH has made a lower high vis-a-vis the early October MACD histogram high. In addition, the 7,10 stochastic had completed a lower high vis-a-vis the early October stochastic high. The transports were making a higher high, and thus, a negative divergence had been created.

How to trade that negative divergence? The approaches I have mentioned in the past both rely on the histogram reversal day. In this case, that day was October 27. On that date, the histogram, which had crossed over to the positive (blue), dipped back down. In the context of a negative divergence, that is sufficient grounds to posit a short entry somewhere below that reversal day (or "session," if you prefer).

There are two ways of doing that. The first is simply to wait for the first close below the low of the reversal day, and to use that closing level as the entry level. The second is to take half the range of the reversal day and to subtract that amount from the low of the reversal day. In the first case, we would have looked for a close after October 27 lower than 3675.32. In the second case, we would have had a short entry target bit lower lower at 3643.28.

Suffice it to say that there was no short entry from either method. The market opened up the following day and never looked back.

So what did I miss? Tune in next time for more on divergences and the three-bull-closes rule.




David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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