What is the Dow Theory?

The identified trend is accepted when it is backed by solid proof. The theory explains that if two indices move in the same direction, the identified primary trend is real. Whereas if the two indices do not match, then there is no clear trend. It focuses on price movements, trade volumesTrade VolumesThe volume of trade is the overall measure of the number of securities, shares or contracts traded during a particular trading day. read more, capturing the trends with the help of pictorial representations and comparison of indices.

Key Takeaways

  • Dow theory trading strategy is primarily based on the ideas about stock price movement put forth by Charles H. Dow through his editorials in the Wall Street Journal back in the 19th century.It mainly states that multiple indices should provide the same signal to confirm a trend.It lists a set of fundamental tenets. Identifying and following a trend should be in line with these tenets.It is the core principle of modern technical analysis. Traders use the Dow theory forecast to confirm between uptrend and downtrend.

Dow Theory Explained

The Dow theory developed from the market price action analysis, views on speculation, etc., put forth by Charles H. Dow formed a foundational step for technical analysis when the software’s aided technical analysis like today didn’t exist. Its evolution and usefulness in speculationSpeculationA speculator is an individual or financial institution that places short-term bets on securities based on speculations. For example, rather than focusing on the long-term growth prospects of a particular company, they would take calculated risks on a stock with the potential of yielding a higher return.read more are well portrayed by Robert Rhea in his book “The Dow Theory” by meticulously examining the Wall Street Journal editorials by Charles H. Dow and William Peter Hamilton in the 19th century. It was among the earliest attempts to understand the market by using fundamentals that indicated future trends.

The original version of the theory focused on comparing the closing prices of two averages: the Dow Jones Rail (or Transportation) (DJT) and the Dow Jones Industrial (DJI). The argument was that if one rose above a certain threshold, the other would follow it.  To illustrate it, Dow’s compared the market to the ocean. According to the economist, if you are on one side of the beach and the waves go up until a point, waves in another part of the beach will eventually reach the same point. The same happens with markets because they’re also a part of a whole.

The Paradigms of Dow Theory

To explain the theory, understanding the several rules devised by Dow is vital. These paradigms are generally known as the tenets or principles of Dow theory.

  • Three significant market trends: They are primary, secondary, and minor trends defined by their duration. Primary trends can be uptrend or downtrend lasting months to years, while secondary one moving opposite to the primary will last weeks or a few months. Minor trends are treated as insignificant variations lasting from a few hours to weeks, and they are not as important as the others.Primary trends have three distinct phases: The different phases in bear markets are distribution, public participation, and panic. Bull marketsBull MarketsA bull market occurs when many stock prices rise 20% from a recent low, with the price climb spanning for an extended period.read more, on the other, have accumulation, public participation, and excess phase.Stock market discount everything: The market indexesMarket IndexesA market index tracks the performance of a diverse selection of securities that make up a significant part of the financial market. It serves as an indicator of the overall financial market condition by listing the historical and real-time trends in different market segments.
  • read more react quickly to all forms of information. It can be related to the entity or economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more as a whole. For instance, any economic shock or issues in the company management will affect stocks and move the indices upward or downward.Volume confirms the trend: Trading volume increases during an uptrend and decrease during depressions. Indices confirm each other: Multiple indices moving in an identical pattern reveal a trend since they give the same signal. Whereas if two indices move in the opposite direction, it is difficult to deduct a trend.Trends continue until solid clues imply the reversal: Traders should be aware of trend reversals. It’s easy to confuse them with secondary trends, so Dow cautions the investor to be careful and confirm trends with several sources before believing it’s a reversal.

How Does Dow Theory Work in Technical Analysis?

The Dow theory was fundamental to technical stock market analysis and acted as the underlying principle for its continued advancement. The technical framework of the analysis emphasizes the need to pay close attention to market data to discern trends, reversals and determine when to buy or sell an asset for maximum profit since the market is the indicator of future performance. In this way, technical analysis in accordance with theory assists investors in making profitable trading decisions by detecting established long, mid, or short-term trends.

Example

The technical analysis in line with the theory confirms a particular trend and validates the buy or sell signal if both averages confirm each other. If one average is moving towards a new high or low, then the other must soon follow. To further illustrate how Dow’s theory work, check the following chart that shows the relationship between the industrial and transports indices and what would constitute clear buy and sell signals in this model.

Source- Stockcharts.com

According to the above chart, both the DJIA and the DJTA set new highs in April as part of the core bullish trend. However, when the DJIA set a new high in July, the DJTA failed to do so. It served as a warning sign but did not confirm the trend reversal. At the end of July, the DJTA recorded a new low. Subsequently, the DJIA also recorded a new low and confirmed a change in the primary trend from bullish to bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more. Following this, both averages signaled to continue the downtrend.

This has been a Guide to Dow theory and its meaning. Here we explain how does Dow theory works in technical analysis and paradigms, along with an example. You can learn more from the following articles –

The theory is based on a list of essential principles. For instance, the trading volume and multiple indices must confirm the trend, the categorization of trend into primary, secondary, and minor ones, primary trends exhibit three distinct phases, etc.

The goal of the theory is to identify the primary trend in the financial market backed by solid proof. Once a trend is recognized, it is considered to continue until a turnaround is evident. It tells us that minor trends act as noises and do not imply trend reversal. The theory is concerned with movement direction and has little predictive value for the trend’s eventual duration or magnitude.

According to the theory, asset prices reflect the health of the economy and business circumstances. Therefore, by evaluating these variables and events, one may determine the trajectory of fundamental market movements in Forex and other forms of investment such as stocks and commodities.

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