I’m not really big on Dow Theory because its signals seem to be rather nebulous. Even the practitioners of the Theory cannot necessarily agree on when signals occur and when they don’t. Supposedly Dow Theory says that “the Dow Jones Industrials ($DJX) and the Dow Jones Transports ($DJT) should confirm each other in major moves. Trends persist until a clear reversal occurs.” Well, try figuring out what a reversal is. Is this one in Figure 8? It’s the current chart of $DJX and $DJT overlaid with each other. You can certainly see that $DJX is making new highs, while $DJT has stumbled badly. But I’ll wager that if you showed this chart to 10 Dow Theorists, you’d get 5 who thinks the bullish trend is still intact while 5 say a reversal is in the works. Systems that are that vague (and that long-term) are really of no use to us.
Rather, an intermarket spread trader might look at that chart and say that the two indices seem to converge rather frequently, but now they are rather far apart. Hence it might be a good time to buy $DJT while selling $DJX. Figure 9 is a longer-term look at that spread, dating back to the beginning of 2015. As the ratio rises, $DJX is outperforming $DJT. You can see that the ratio has peaked just above current levels twice before – both last year. Hence, it may be a convenient time to assume that ratio is going to move back towards the center of the chart.
However you view this, the same trade applies: Buy $DJT while selling $DJX. We would approach this with options, to limit the risk on the trade in case an outlier move occurs.
But before you think about loading up on this trade as a “sure thing,” look at the 17-year chart in Figure 10. Here you see that $DJT has been generally outperforming $DJX for 17 years…
This excerpt was taken from the 7/28/17 edition of The Option Strategist Newsletter. Read the full article by subscribing today.