The Dow Theory

Dow Theory, technical analysis, trading, Dow Jones

Dow Theory, technical analysis, trading, Dow JonesThe Dow Theory is the basis of technical analysis, so fundamental for anyone who approaches the graphical analysis of financial markets. Before concentrating on the fundamental points of the theory I want to briefly tell you the story that led to its creation.

On July 3, 1884, Dow published the first market index consisting of closing prices of 11 securities, 9 related to transport and 2 for assessing the conditions of the national economy.

In 1897 he split the index into 2 parts, the first consisting of 12 securities of industrial companies (the current Dow Jones Industrials Average) and the second of 20 railway company securities (the current Dow Jones Transportation Average).

In 1928 there were 30 securities in the first index. The Dow Jones 30 was born.

The "Dow Theory" was the result of a series of articles published by Charles Dow in the Wall Street Journal at the beginning of 1900. Until his death, they were William P. Hamilton and Robert Rhea to resume the theories by reorganizing them in the orderly and structured way we know today.

Dow realized that the prices of the securities of the most important companies tended to move very similar with delays of a few days or a maximum of a few weeks. This led him to calculate the average price of a limited number of securities, for using equity behaviour as an index of the overall economic development. 

The main points of Dow Theory are:

1. The market discounts everything. The theory states that every index reflects everything that market participants know. Similarly, the price of a share suits all the information that is known about it.

“The sum and tendency of the transactions of the Stock Exchange represent the sum of all Wall Street's knowledge of the past, immediate and remote, applied to the discounting of the future. There is no need to add to the averages, as some statisticians do, elaborate compilations of commodity price index numbers, bank clearings, fluctuations in exchange, the volume of domestic and foreign trades or anything else. Wall Street considers all these things.”

 2. There are three kinds of market trends. Dow considered a trend to have three parts: Primary, Secondary, and Minor. The Primary trend usually lasts at least a year, but can continue for several years, and can be an uptrend or a downtrend. An uptrend has a pattern of rising highs and lows. The opposite situation, with successively lower lows and highs, defines a downtrend.

The Secondary, or intermediate, trend represents corrections in the primary trend and usually lasts three weeks to three months. These Secondary corrections generally retrace between one-third and two-thirds of the previous trend movement and most frequently half, or 50%, of the previous move.

The Minor (or near-term) trend usually lasts less than three weeks. This Minor trend represents fluctuations in the Secondary trend.

3. Primary trends have three phases. The first phase of the bullish primary movement is characterized by a situation where "strong hands" start to buy at very low prices. The general sentiment at this stage is mistrust, but they have access to privileged information and they realize that the worst is over and that a turnaround is inevitable. Aggressive purchases begin, progressively increasing as the sales volume tends to decrease.

In the second phase, the buying pressure increases with the entry into the market of the small investors, which produces an increase both in price and volume of trade. Ultimately comes to the final phase, the general euphoria leads to a sudden increase of the securities purchased. Being a phase dominated by emotion, it does not lead to good results, in fact, big investors know now that the trend is over and they begin to liquidate positions by anticipating the reversal of the trend.

The primary bearish trend is also distinguished by three distinct phases: the first is called distribution. Strong hands sell their securities, while trend-follower still affected from the previous uptrend. The second phase begins when uncertainty turns into pessimism, fear and then panic. In the third stage, the fall in prices continues to accelerate and volumes reach high levels. Finally, once the market has taken off all the causes of its downturn, the bearish trend may be considered over, and a new cycle can begin.

 4. Indices must confirm each other. Dow used the two indices he created, the Industrial and the Rail, comparing them simultaneously. Both indices must exceed a previous Secondary high (low) to confirm the inception or continuation of a bull (bear) market. Signals must not occur at the same time, but they must be in a limited time.

 5. The volume must confirm the trend. Dow recognized volume as a secondary but important factor in confirming price signals. Simply, volume should expand or increase in the direction of the primary trend. In a primary uptrend, volume should increase as prices move higher, and decline as prices fall. In a primary downtrend, volume should increase as prices drop and reduce as prices rise.

 6. Trends persist until a clear reversal occurs. We have seen that rising highs and lows define a bullish trend. In order to talk about a reversal trend, there must be at least a high and a low lower than the previous. The opposite of a bearish trend. When a reversal in the primary trend is confirmed by the Industrials and the Transports Index, the chances that the new trend continues are very high. In any case, the longer a trend continues, the less chance there is that the trend continues for a long time.

 7. Closing prices are important. The Dow Theory takes no account of the daily top and bottom, but only the closing prices.

Some criticisms of Dow Theory. Many traders share the idea that the Dow Theory miss out too many occasions (on average, Dow Theory misses 20 to 25% of a move before generating a signal) but it is good to remember that Dow Theory does not intend to predict the beginning of a trend, but confirm it. We are faced with a clear trend-follow theory that gives the most fruits in the second phase of the trend movement.


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