Is Charles Dow’s “Market Breadth” Indicator Effective?

The publications of Charles Dow form the basis of the technical analysis of financial markets. In one of his articles for the Wall Street Journal, Dow explored the market reaction to the individual securities' growth. Dow concluded that the movement of individual securities must be confirmed by a broader movement that involves a significant part of the entire market. The initial movement is considered plausible only in this case. This pattern has led to the emergence of the concept of “market breadth”.

The statistical indicator "market breadth" confirms or refutes the price movement of individual securities. The price movement of an instrument is considered confirmed if at least 2/3 of the entire market moves in the same direction and at a similar pace. In the event of a discrepancy between the movement of the share price and the market index, a conclusion is made about the speculative nature of price dynamics. In this case, there may be a good opportunity to short a stock that has significantly outperformed the market.

Strategy

The daily price change is calculated:

Price change (D), % = (Close1 – Close0) / Close0 * 100

Close1 – closing price on the first day

Close0 – closing price on day zero

Price changes are calculated for individual stocks and for the S&P 500 index.

The signal to open a position is the ratio:

(Ds / Dm) ≥ K when Ds > 0, Dm > 0

Ds – price change of a stock

Dm – change of S&P 500 index

K is a value indicating how many times the price of a stock exceeds the S&P 500 growth 

K = 2, 3, 4, 5 (changeable criterion of signal quality)

Opening a position – selling a stock on the open of next daily candlestick after the signal

Closing a position – buying a stock on the close of 1st, 2nd, 3d, 4th, 5th daily candlesticks after the signal

We will evaluate the results according to the following criteria:

• The rate of return reflects the relative change in the quotations of financial instruments in percentage. A positive value of the rate of return indicates the profitability of the strategy, negative - about the loss. 

The rate of return (D) of a financial instrument is calculated using the formula:

D = Σ P (%) / n,

where:

n is the number of transactions;

P (%) = ((position opening price - position closing price) / position opening price) * 100%

• The average rate of return of profitable transactions (Dp) includes the rate of return of only profitable transactions, as a percentage:

Dp = Σ D (+) / n,

n is the number of profitable transactions;

D (+) – rate of return of profitable transactions.

• Average drawdown (AD) reflects the average loss when closing losing transactions for the entire trading period, as a percentage. The lower the value of the average drawdown, the lower the losses, and the better the trading signal works.

AD = | Σ D (-) / n |

where:

n is the number of losing transactions;

D (-) – rate of return of losing transactions.

• Maximum rate of return (MaxD) is the maximum profit from closing successful transactions for the entire trading period, as a percentage. The higher the maximum rate of return value, the better the trading signal works.

MaxD = max (D)

• Max drawdown (MD) is the maximum of losses when closing unsuccessful transactions for the entire trading period, in percent (minimum profitability). The lower the value of the maximum drawdown, the better the trading signal works.

MD = | min (D) |

Analysis of the obtained results 

For changeable parameters, the following notation is used:

D: 1,2,3,4,5 - daily candlestick on which the position is closed

K: 2,3,4,5 - a value indicating how many times the growth of the stock price exceeds the growth of the S&P 500 index

Example: D1 K2 means that the parameter is calculated under the conditions of closing a position on the 1st daily candlestick and exceeding the growth of the stock price over the growth of the S&P 500 index by 2 or more times.

When analyzing all 30 stocks from the Dow Jones index, the signal has shown a positive average rate of return only in two cases: with a combination of D1 K2 and D2 K3 parameters. 



There is a noticeable trend: with an increase in the values of the parameters D and K, the strategy, on average, shows a deterioration in the result.

The average rate of return of profitable transactions fluctuates slightly when the parameter K changes. A change in the moment of exiting a position leads to a growth of average rate of return from 0.83% at D1 to 2.19% at D5.

The average drawdown also changes slightly when the K parameter changes. A change in the moment of exiting a position leads to an increase in the average drawdown from 0.82% at D1 to 2.15% at D5.

The maximum rate of return of the signal increases with the D parameter growth and decreases with the K parameter growth.

The maximum drawdown is similar to the maximum rate of return: it increases with the growth of the D parameter and decreases with the K parameter growth.

At the level of individual instruments, only 3 of the 30 stocks under consideration have shown significant rate of return of 0.3% and more: Walmart, Verizon and JP Morgan. However, the combination of the best parameters D and K for them differs sharply from the average values for all stocks from the Dow Jones index. If, on average, the strategy with D1 K2 parameters has shown the highest rate of return, then for Walmart, Verizon and JP Morgan, the D4 K5 parameters strategy has turned out to be better than the others.

Detailed results are shown in the Appendix:

XLSX (0.13 MB)Is Charles Dow’s market breadth indicator effective.xlsx