Understanding and Applying the Dow Theory to Trading

Traders benefit from technical analysis, which assists them in identifying trends occurring within the market. One concept of technical analysis is the Dow Theory. 

The Dow Theory was created by Charles H. Dow, who founded Dow Jones & Co, Inc., the DJIA, as well as the Wall Street Journal. Because Mr. Dow died in 1902, the theory was expanded upon by numerous other economists and market researchers. 

What is the Dow Theory?

According to the Dow Theory, if one of the averages, either industrial or transportation, advances significantly above a previous important average, with an advance of the other average, the market is declared to be in an upward trend. If the Dow Jones Industrial Average climbs to a milestone, the Dow Jones Transportation Average is expected to follow the upward trend. 

The 6 main components of the Dow Theory

 

  • The market is efficient and discounts all information: The Dow Theory follows the efficient market hypothesis, given that all relevant information is already inherently priced into a security. Whether individuals realize it or not, information such as free cash flow projections, earnings potential, and news regarding companies all are incorporated into the price of the stocks. 
  • Three market trends have effects: The market can be in two main states, a bear market when the market is clearly falling, or a bull market when it is steadily rising. There is also secondary trends that affect the markets, such as pullbacks or sudden spikes. These secondary trends typically represent minor fluxes in prices, and typically only last from a few weeks to a few months. 
  • There are three phases of market trends: According to the Dow Theory, the market encompasses three typical trends. The bull market typically consists of the accumulation phase, the public participation phase, where the big move happens, and the excess phase. In a bear market, there is the distribution phase, the public participation phase, and the panic phase, where the large sell-off occurs. 
  • The signals of both averages must match each other: In order for the trend to follow the Dow Theory, the Dow market averages must match each other’s direction. If both the DJIA and DJTA lead in the same direction, the market can have the potential to identify a trend. However, if, for example, the DJIA is up but the DJTA is down, a trend cannot be established. The two indices are theorized to be linked, where for example, if certain industrial companies are up, transportation companies, carrying the industrial production may be correlated. 
  • Volume typically follows trends: During periods of bull markets, the volume within the markets should be increasing to indicate a buying pressure. Conversely, during bear markets, the volume should be decreasing which indicates a weakness within the market. 
  • The trends are countered by reversals: The trends within the markets – either bear or bull – should be assumed to continue only until a significant reversal can be ascertained within the markets. Traders should ignore the effects of weaker secondary movements and should focus only on the larger market picture. 

 

Dow Theory Concerns:

The Dow Theory only is concerned with closing prices, rather than intraday movements within the markets. This helps traders filter out the ‘white noise’ and allow them to focus only on the relevant price movements. 

The Dow Theory is also a strong advocate of understanding line ranges, where traders should only trade after the security has broken out of the horizontal trading range and clearly identified a trend. 

The Dow Theory is a helpful technique trader can apply to increase profits and gain an edge on the markets. While this theory has been well developed, traders should continue to use their own analysis along with that of the Dow Theory. 

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