What is Dow Theory?

Last Updated on Thursday, 8 September 2011 05:47 Written by FxTT Content Department Thursday, 8 September 2011 04:58

Dow Theory is a very basic and oldest (over 100 years) approach to technical analysis. Peter Hamilton, Robert Rhea and E. George Schaefer collectively derived the theory from 255 Wall Street Journal editorials written by Charles H. Dow (1851–1902). Charles Dow is considered as the father of technical analysis.

The Dow Theory is made up of six basic principles. The theory helps us identify the primary trend and catch the big moves. The Dow Theory addresses not only technical analysis and price action, but also market philosophy.

Let’s understand the principles of Dow Theory.

First Principle: The Averages Discount Everything

Any price chart reflects everything that is known about a market instrument or asset. Price represents the sum total of all the hopes, fears and expectations of all participants. Interest rate movements, macroeconomic data, central bank decisions and all else are already priced into the asset. As new information arrives, market participants quickly disseminate the information and the price adjusts accordingly. Likewise, the market averages discount and reflect everything known by all stock market participants.

Second Principle: Market consists of three trends

Dow Theory says market is made up of three trends: the Primary trend, Secondary trend, and Minor trend.

The Primary trend can either be a bullish (rising) market or a bearish (falling) market. As we can see in figure 1 the Primary trend usually lasts more than one year and may last for several years. The figure shows that the pair is making successive higher-highs and higher-lows so the primary trend is up.

Secondary trends are intermediate, corrective reactions to the Primary trend. These reactions typically last from one to three months (secondary trend in figure 1 lasts from October to December).

Figure 1. Market Trends

Minor trends are short-term movements lasting from one day to three weeks (minor trend in figure lasts from late January to mid February). Secondary trends are typically comprised of a number of Minor trends. The Dow Theory says minor trends are unimportant and can be misleading.

Third Principle: Primary trends have three phases

The Dow Theory says that the First phase (Accumulation Phase) is made up of aggressive buying by small number of smart traders who think stocks are undervalued.

The Second phase is characterized by improving fundamentals and improving public sentiment. Traders will begin to participate in market now.

The Third phase is characterized by robust fundamentals and positive sentiments. The general public now feels comfortable participating in the market; fully convinced that the stock market is headed for the moon. They now buy even more stock, creating a buying frenzy. It is during this phase that those few investors who did the aggressive buying during the First phase begin to liquidate their holdings in anticipation of a downturn.

Fourth Principle: The Averages must confirm each other

Dow Theory says that both the indexes (the Dow Industrial and Rail averages) would need to be in agreement with each other.  The reason why Dow considered these two averages only was, because In Dow’s time, the US was a growing industrial power. The US had population centers but factories were scattered throughout the country. Factories had to ship their goods to market, usually by rail. Dow’s first stock averages were an index of industrial (manufacturing) companies and rail companies. To Dow, a bull market in industrials could not occur unless the railway average rallied as well, usually first.

According to this logic, if manufacturers’ profits are rising, it follows that they are producing more. If they produce more, then they have to ship more goods to consumers. Hence, if an investor is looking for signs of health in manufacturers, he or she should look at the performance of the companies that ship the output of them to market, the railroads.

The two averages should be moving in the same direction. When the performance of the averages diverges, it is a warning that change is in the air.

Fifth Principle:  The volume confirms the trend

The Dow Theory focuses primarily on price action. Volume is only used to confirm uncertain situations. Volume should expand in the direction of the primary trend. If the primary trend is down, volume should increase during market declines. If the primary trend is up, volume should increase during market advances.

Figure 2. Trend confirmation with volume

Figure 2 shows expanding volume during an uptrend, confirming the primary trend.

Sixth Principle:  A trend remains intact until it gives a definite reversal signal

Dow believed that trends existed despite “market noise”. Markets might temporarily move in the direction opposite to the trend, but they will soon resume the prior move. The trend should be given the benefit of the doubt during these reversals. Determining whether a reversal is the start of a new trend or a temporary movement in the current trend is not easy.

Figure 3. An illustration of Dow Theory

The trend shall continue unless a reversal in the primary trend is confirmed by more than one signal.

So how can Dow Theory help in forex trading?

Now after learning six principles of Dow Theory we understand that a trend is long term and until it is proven that the trend is going in the other direction, we should follow the trend even in forex.

We also understand that the secondary trends can be places to make a lot of money. If we know that the primary trend is moving upwards, it would be safe to assume that the secondary trend might be a series of rallies and sell-offs, but in the end the primary trend rules.

Dow Theory addresses not only technical analysis and price action, but also market philosophy which is not an exception for forex markets. However we should all know that Dow Theory helps us identify facts, not make assumptions or forecasts.

The Dow Theory has been around for almost 100 years, yet even in todays volatile and technology-driven markets, the basic components of Dow Theory still remain valid. For more technical analysis related articles keep visiting fxtechnicaltrade.com.