The goal of the Dow Theory is to identify the primary trend and catch the big moves. Charles Dow and his predecessors understood that the market was influenced by emotion and prone to overreaction, both up and down. Dow Theory helps investors identify facts, not make assumptions or forecasts.
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What is the Dow Theory
The Dow theory is a financial markets theory developed by Charles H. Dow that rests on six basic "theorems” that were a precursor to modern-day technical analysis. At a high level, the Dow Theory describes market trends and how they typically behave. At a more granular level, it provides signals that can be used to identify and subsequently trade with the primary market trend.
Dow Theory is founded on a set of ideas derived from Charles H. Dow's editorials that address not only technical analysis and price action but also market philosophy. Many of the ideas and comments put forth by Dow and his predecessors became axioms of Wall Street. While there are those who may think that the market is different now, the Dow Theory attests that the stock market behaves the same today as it did almost 100 years ago.
Who is Charles Dow
Charles Dow developed the Dow Theory from his analysis of market price action in the late 19th century. Until his death in 1902, Dow was part-owner as well as editor of The Wall Street Journal. Although he never wrote a book on these theories, he did write several editorials that reflected his views on speculation and the role of the rail and industrial averages.
Even though Charles Dow is credited with developing the Dow Theory, it was S.A. Nelson and William Hamilton who later refined the theory into what it is today. In 1932, Robert Rhea further refined the analysis of Dow and Hamilton in his book, The Dow Theory. Rhea read, studied, and deciphered some 252 editorials through which Dow (1900-1902) and Hamilton (1902-1929) conveyed their thoughts on the market.
Dow Theory Explained
The Dow theory is based on the analysis of maximum and minimum market fluctuations to make accurate predictions on the direction of the market.
According to the Dow Theory, the importance of these upward and downward movements is their position in relation to previous fluctuations. This method teaches investors to read a trading chart and to better understand what is happening with any asset at any given moment. With this simple analysis, even the most inexperienced can identify the context in which a financial instrument is evolving.
Furthermore, Charles Dow supported the common belief among all traders and technical analysts that an asset price and its resulting movements on a trading chart already have all necessary information already available and forecasted in order to make accurate predictions.
The six “theorems” of Dow Theory
Most trading strategies used today hinge on one key concept, the "trend". This was a novel idea when Charles H. Dow published his writings at the end of the 19th century. However, more than a century later, the Dow Jones index, created by the American journalist to illustrate his theory, is probably now the most followed stock index on the planet.
For a better understanding of Charles H. Dow's writings and their implications, here are the six basic "theorems" that underpin Dow's Theory.
#1: The market discounts everything
The first assumption is that the market reflects all available information. Everything there is to know is already reflected in the markets through the price. Prices represent the sum total of all the hopes, fears, and expectations of all participants. Interest rate movements, earnings expectations, revenue projections, presidential elections, product initiatives, and all else are already priced into the market. The unexpected will occur, but usually, this will only affect the short-term trend. The primary trend will remain unaffected.
Hamilton noted that sometimes the market would react negatively to the good news. For Hamilton, the reasoning was simple: the market looks ahead. By the time the news hits the street, it is already reflected in the price. This explains the old Wall Street axiom, “Buy the rumor, sell the news”. As the rumor begins to filter down, buyers step in and bid the price up. By the time the news hits, the price has been bid up to fully reflect the news.
#2: The three-trend market
Dow Theory highlights that there are three trends in the stock averages and in any market: the short-term trend, lasting from days to weeks; the intermediate-term trend, lasting from weeks to months; and the long-term trend, lasting from months to years. All three trends are active all the time and may be moving in opposing directions.
- The long-term trend is by far the most important trend and the easiest to identify, classify, and understand. It is of primary concern to the investor and, to a lesser extent, the speculator. The intermediate- and short-term trends are subsidiary components of the long-term trend and can only be understood and fully taken advantage of through recognition of their status within the long term.
- The intermediate-term trend is of secondary importance to the investor and of primary importance to the speculator (learn more about swing trading). It can move with the long-term trend or against it. If the intermediate-term trend significantly retraces the long-term trend, it is characterized as a secondary reaction or a correction. The characteristics of a secondary reaction must be closely evaluated to avoid confusing it with a change in the long-term trend.
- The short-term trend is the least predictable and is of primary concern only to the short-term trader (learn more about day trading and scalping). The speculator and investor's interest in the short-term trend should consist almost solely in optimizing profits and minimizing losses by the timing of buys and sells within the short-term movement. Secondary reactions should not be confused with minor reactions that occur frequently within primary and secondary price movements. Minor reactions move in opposition to the intermediate trend and last less than two weeks (14 calendar days) 98.7% of the time. They have virtually no impact on the intermediate or long-term trends.
Classifying price movements in terms of the three trends isn't just a mental exercise. The investor who is aware of the three trends focuses on the long-term trend, but depending on how hard he wants to work, he can use intermediate- and short-term movements that run contrary to the primary trend aiming to optimize profits in several ways.
- First, if the long-term trend is up, he may choose to ride a secondary reaction by selling short throughout the correction and then using the potential profits to pyramid his long position somewhere near the turning point of the correction.
- Second, he may do the same thing by buying puts or selling calls.
- Third, he may ride through the contra-move with confidence, knowing that it is an intermediate, not a long-term, move.
Finally, he may use short-term movements to time buys and sells for a profit maximization objective. For the speculator, the same kind of thinking applies, except that he is not interested in holding positions through secondary reactions that move against him; his object is to move with the intermediate-term trend in either direction. The speculator can use the short-term trend to look for signs that the intermediate-term trend is changing. The mindset (learn more about trading psychology) is different from that of the investor, but the basic principles used to identify change are very similar.
The main focus of the prudent investor should be on the intermediate-term trend. But to accurately focus on the intermediate-term trend, you have to understand it in relation to the long-term, or primary trend.
#3: Primary trends remain in effect until a clear reversal occurs
This is one of the more controversial elements of Dow Theory, that the market reflects all available information. Everything there is to know is already reflected in the markets through the price. Prices represent the sum of all the hopes, fears, and expectations of all participants. Interest rate movements, earnings expectations, revenue projections, presidential elections, product initiatives, and all else are already priced into the market which reacts faster to any change in sentiment. The unexpected will occur, but usually, this will only affect the short-term trend. The primary trend will remain unaffected.
#4: The three phases of primary trends
The first phase of primary trends determines that informed investors profit from an accumulation phase (before a bull market) or a distribution phase (before a bear market). Traders then move towards a second public participation phase, which is when the largest price movement occurs. Finally, the market experiences a third excess phase, characterized by a period of euphoria (at the end of a bull market), or panic/despair (at the end of a bear market).
A primary bear market is a long downward movement interrupted by important rallies. It is caused by various economic ills and does not terminate until stock prices have thoroughly discounted the worst that is apt to occur.
There are three principal phases of a bear market:
- The first represents the abandonment of hopes upon which stocks were purchased at inflated prices;
- The second reflects selling due to decreased business and earnings
- The third is caused by the distressed selling of sound securities, regardless of their value, by those who must find a cash market for at least a portion of their assets.
A primary bull market is a broad upward movement, interrupted by secondary reactions, and averaging longer than two years. During this time, stock prices advanced because of a demand created by both share investment and speculative buying caused by improving business conditions and increased speculative activity.
There are three phases of a bull period:
- The first is represented by reviving confidence in the future of business;
- The second is the response of stock prices to the known improvement in corporations' earnings
- The third is the period when speculation is rampant and inflation [of stock prices] apparent period when stocks are advanced on hopes and expectations.
#5: Volume must confirm the primary trends
Volume should increase in the direction of the trend in order to give confirmation. It is only a secondary indication, but Dow realized that if volume didn't increase in the direction of the trend, this is a red flag. This means that the trend may not be valid.
#6: Primary trends must confirm each other across market indices
This last tenet, that two opposing primary trends cannot coexist on two different market indices, was doubtless the most important to Charles H. Dow. In other words, the primary trend discovered on a stock market index must always be confirmed by a similar trend on another market index and vice versa.
It was in response to this final tenet that Charles H. Dow did not stop at creating the USA 30 Index. He also contributed to the development of another market index, the Dow Jones Transportation Average.
Does Dow's theory work?
Dow Theory alone is by no means the comprehensive way to forecast market behavior, but it is an invaluable component of knowledge that no prudent trader should ignore. Many of the principles of Dow Theory are implicit in the language of Wall Street and the vocabulary of market participants without them even knowing it.
By reviewing the basic tenets of Dow Theory, you have learned a general method of gauging the future of market price movements by studying both current and historical price movements.
Although a lot has changed over the past 100 years, the Dow theory and its tenets are still applicable today and are considered a valid trading strategy by many traders. Much of what we currently know about technical analysis has its roots in the Dow theory. Therefore, all financial operators using technical analysis should be familiar with the basic principles of Dow Theory.
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