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Which Way is Up?



It's all right if you love me
It's all right if you don't
I'm not afraid of you runnin' away
Honey, I get the feelin' you won't
Tom Petty - "Breakdown"

So let me get this straight. We broke out at 10,600 on the Dow, then a few days later we broke down at 10,425 on the Dow. Which way is up, Richard Pryor?

Point and figure indicators, the bullish percent indices and shorter-term indicators I use, provide a context for my decision-making process when trading. When the context is positive, as it is now, the market (generally) supports higher prices, and downside action is (generally) constructive. Since markets do not move up or down in a straight line, the context of specific moves helps sort out whether a down move is "helpful" or damaging. But timeframe is critical in making those judgments as well.

For example, let's look at several different scales of the Dow Jones Industrial Average, sort of the point and figure equivalent of a monthly, weekly, daily, hourly, bar chart. I am frequently asked which scale is appropriate for looking at a point & figure chart of a stock or index. The answer is the one that matches up most closely with your timeframe.

On the 50x3 scale chart below, more of a longer-term investment view of the Dow, the breakout occurred at 10,600, a spread triple top. Yesterday's action was enough to reverse the chart down, but not generate a sell signal on this chart.

Dow Jones Industrial Average 50x3 scale

(Chart courtesy Dorsey, Wright)

Yesterday morning I mentioned that I do not buy breakouts or sell breakdowns. This is an excellent illustration of why I believe that strategy is difficult to make money with. Anybody who bought, say, the Dow Diamonds ETF on the breakout is now underwater in his or her position. By being patient, risk/reward can be improved by waiting for a pullback on a breakout, or retracement of a breakdown. Sure, sometimes things can move away from you, but if the goal is to make money under advantageous risk/reward conditions then the absolute price at which one buys or sells is irrelevant. A 10% move is a 10% move whether it occurs at 10,600 or 7,500.

Yesterday's breakdown on the Dow occurred on a smaller scale than the 50x3 scale we looked at above. The breakdown shows up on a 25x3 scale.

Dow Jones Industrial Average 25x3 scale

(Chart courtesy Dorsey, Wright)

When we look at the smaller 25x3 scale we get a closer view of the action on the Dow. A move to 10,375 violates the trendline from the April lows.

So which is more important, the still existent breakout at 10,600 that remains in effect on the 50x3 scale, or the new breakdown that occurred on the 25x3 scale? The answer is, naturally, a question: are you an investor or a trader? The process one uses should offer a game plan for engaging the market.

Organized according to a hierarchical chart, it might look something like this, where the decisions flow from top down. This is not an advice, just one way to develop a process for mapping out your specific decisions.

The top tier, the macro view, or broad thesis, might be used to determine overall exposure. The second tier, a contextual determination, might be used to determine the specific strategies that are employed; long only, short bias, pairs trade, etc.
The third tier based on the various scales helps organize the specific weapons to be deployed to achieve the strategic objectives. The timing decisions are the final step to implementing the plan.

This is the way one view of that scale might look according to the tools I use:

As with all things, there are no "right" answers. That is why people from all walks of life implementing a tremendous array of differing methodologies are successful engaging financial markets. The paths are many.

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No positions in stocks mentioned.

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