Theories

In general, any theory relating to analyzing and predicting market trends most likely relates to technical analysis. While several theories exist, you only need to be aware of a few of them for the exam.

Odd lot theory

The odd lot theory is a bit of a mean one, but is true from time to time. You may recall from your SIE studies that a round lot, which is a standardized unit of trading, is typically 100 shares for stock. Institutions and wealthier investors, who tend to have access to large amounts of capital (money) and are well-informed, usually trade in round lots. Instead of buying stock in small increments, these investors tend to trade in increments of hundreds or thousands of shares.

An odd lot is a denomination less than a round lot. If a round lot is usually 100, then an odd lot would be a purchase of stock in an amount less than 100. If you purchased 37 shares of a stock, you’re buying an odd lot of shares.

While there’s nothing inherently wrong with buying or selling stock in odd lots, investors with less skill and experience tend to trade in those increments. Uninformed investors are more likely to buy when the market is too high, and sell when the market is too low. If there’s an odd-lot trading trend identified, those investors are likely wrong about their assumptions (at least according to the odd lot theory).

If a technical analyst believes in the odd lot theory, they would keep an eye out for unique odd lot trading patterns. For example, if a chartist found a large influx of odd lot sales of a specific security, they would be bullish on that security and potentially consider making a purchase. To keep it simple, technical analysts identify odd lot trends and do the exact opposite.

Short interest theory

Investors can short sell securities to bet against a security. Short interest is the measurement of the percent of an issuer’s stock being sold short. For example, if ABC company’s short interest is 20%, then 20% of their outstanding shares have been borrowed and sold short.

You may think a high short interest level is a bearish indicator, but the short interest theory is somewhat counterintuitive. The theory states a high number of shares sold short is a bullish indicator. There actually is a good reason for this.

When investors sell short securities, they are obligated to buy them back at some point in the future (to return the borrowed shares to their financial firm). If a stock has a high short interest level, the influx of sales has already been factored into the market price. All of those short sellers must buy back the stock at some point, which will drive demand and the stock price upward.

The higher a stock’s short interest level, the more bullish technical analysts are on the stock. It also applies the other way. The lower a stock’s short interest level, the more bearish chartists tend to be.

Dow theory

You are probably aware of the Dow Jones averages. The Dow Jones Industrial Average (DJIA) is a commonly cited index in finance media. Made up of 30 prominent stocks from various sectors. Visa, Apple, and Verizon are all part of the DJIA (click here for the full list).

There are three primary Dow index averages:

Dow Jones Industrial Average (DJIA)

• 30 prominent stocks
• Various sectors

Dow Jones Transportation Average (DJTA)

• 20 prominent stocks
• Transportation sector

Dow Jones Utility Average (DJUA)

• 15 prominent stocks
• Utility sector

Like other indices, the Dow averages provide insight into the performance of the economy. The DJIA is broader than the other two, and is arguably the best Dow average to measure overall economic performance.

We need to establish some baseline assumptions to understand the big picture of this technical analysis theory. The Dow Theory assumes the market reacts to news very rapidly and it’s nearly impossible to make a trade based on publicly available knowledge. By the time an investor reads a newly published article on something related to the market, it’s very likely hundreds or thousands of investors have already placed trades based on that information. This is known as the efficient markets theory, which is assumed as true within Dow Theory.

The second assumption is the market has three types of trends:

Main (primary) trend

• Overall price trend
• Can last from a few months to several years
• Example: longest historical bull run (2009-2020)

Medium (secondary) trend

• Contrary reaction within a main trend
• Can last from 10 days - 3 months
• Example: Q4 2018 market downturn during historical bull market

Minor (short) trend

• Minor contrary reaction within a larger trend
• Can last hours - one month
• Example: Late November 2018 market rise

If you utilize the examples provided, you can gain an understanding of conflicting trends. Focusing on the last example, we had a short-term bull market, within a secondary bear market, which was part of a larger primary bull market. Sound confusing? This chart may help:

Technical analysts identify trends in the market with the ultimate goal of predicting market fluctuations in the future. The market can go up in a bear market, and vice versa. The point of identifying trends as main, medium, or short, is to help identify if today’s market activity is an indicator of an overall movement or a smaller contrary trend within a larger one.

The last and most important part of Dow Theory is understanding how data from the three Dow averages helps technical analysts determine the future direction and trend of the market. Depending on the circumstance, the three averages could move in different directions. For example, the DJIA could go up, the DJTA go down, and the DJUA stay flat. When this occurs, it’s an indicator that there’s uncertainty in the market. The primary price trend could continue, or potentially change.

A new primary trend is typically not accepted as legitimate until all three Dow averages move in the same direction for a prolonged period of time. If the market has been on a bull market for several years, but all three Dow averages suddenly go negative for more than 3 months, it’s a sign of a new bear market materializing.

These theories do not always result in the expected outcome, which is why they’re referred to as theories. For the exam, you’ll need to understand what each theory states and how technical analysts use them to predict future market movements.