The Basics of Dow Theory for Traders

The Dow theory, developed in the late 19th century by Charles Dow, the founder of The Wall Street Journal and Dow Jones & Co., describes the relationship between broader trends and micro-movements in the financial markets. Although it was primarily developed for technical analysis of the equity markets, it is widely used today for a variety of financial instruments. Understanding the Dow theory can help traders consider long-term market movements while making short and medium-term trading decisions.

What is the Dow Theory

According to Nasdaq, the Dow theory states: “A major trend in the stock market must be confirmed by simultaneous movement of the Dow Jones Industrial Average and the Dow Jones Transportation Average to new highs or lows.”

Applying the theory requires traders to analyse the largest and smallest price movements to accurately predict market direction in the short, medium, and long term.

Principles of Dow Theory

Dow theory answers the question – “What’s happening in the market” for the asset under consideration. To use this theory for trading decisions, you must first understand the six tenets underpinning the theory.

1. The Market Discounts Everything The first principle is based on the efficient market hypothesis (EMH). The hypothesis states that all factors affecting an asset are incorporated into the price. In simpler words, the asset price reflects all known information, including past, present and future events. So, if an unexpected event leads to volatility, the impact will be short-lived. The tenet reinforces the principle that you should not argue with the markets. If it moves in a certain direction, identify what you missed in your speculation to improve your trading strategy.
2. Three Types of Trends The Dow theory states that markets experience three kinds of trends, based on duration:
   1. Primary Trend: These are long-term trends that last for over a year, defining whether the market is in a bull or bear run.
   2. Secondary Trends: These are corrective moves within primary trends that last from a few weeks to a few months. These include price corrections during a bull run and rallies during a bear run.
   3. Minor Trends: These are tiny fluctuations in price during a trading day or over a week. These are more unpredictable than primary and secondary trends. These small movements are also called market noise.
   The tenet guides traders to use their trading strategy taking into account the wider markets. For instance, while scalpers take advantage of tiny price movements (minor trends), keeping an eye on the secondary and tertiary trends can show them the bigger picture to make informed trading decisions. 
3. Primary Trends Occur in Phases A primary trend undergoes fluctuations before a reversal. There can be many secondary and minor trends within a primary trend. Phases of a Bull Market
   • Accumulation: Price increases alongside volume. This is when analysts identify potential and enter the market.
   • Big Move: The longest phase, where the number of participants and the move is the highest.
   • Excess: The saturation point, where larger players, such as experienced investors and analysts start exiting their positions while trend riders hold on.
   Phases of a Bear Market
   • Distribution: Price starts to decline with the entire investing community experiencing a change in market direction.
   • Bulk Move: This is where retail traders and average investors start selling their positions. This is the longest with the largest move.
   • Panic: Large-scale selling where investors are convinced that the market will not correct anytime soon and selling happens on a large scale.
   The tenet states that a clear long-term reversal happens only after the three phases of a primary trend are completed.
4. Indices Must Confirm with Each Other As the Dow theory was primarily developed for equities, Charles Dow emphasised that the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) must confirm with one another. However, on a broader level, it indicates that primary trends across the global markets reflect trends in global economies. For traders, this means that broader indices worldwide move in similar ways in the long term.
5. A Trend Reversal Shows Clear Signs Primary trends across major indices reverse only after completing all three phases, usually around the same time. This highlights that there will always be clear signs of a reversal when a primary trend changes. The tenet cautions traders against confusing reversals in minor trends or a pause in a secondary trend as a sign of reversal in the primary trend. These are evident as double-top (or bottom) and triple-top (or bottom) reversal patterns on candlestick charts.
6. Volume Must Confirm the Trend In the last tenet, the Dow theory posits that trading volume increases in the direction of the trend and decreases when the price moves against the primary trend. This means in a bull market, volume will increase when the price rises and decrease during a correction. This is because traders still believe that the market has unrealised upward potential. This can be tricky to use but applies equally to secondary and minor trends. Traders can use volume indicators to determine whether a price move confirms or defies the broader trend and take positions accordingly. 

Trading with the Dow Theory

The Dow theory can add value to your technical analysis with the following sequential signals indicating entry to a reversal:

Buy Signal

• A primary bear market has a secondary rally after establishing a support level.
• Indices involving the asset hold above prior lows while the pullback in the asset should be above 3%.
• The price breaks out above the previous rally.

Sell Signal

• Price registers a resistance level while it is pulling back.
• The market declines at least 3% and does not reach the previously registered high.
• The price breaks below the last established low.

A good practice is to confirm the signals with modern mathematical indicators to trade more confidently.

To Sum Up

• The Dow theory explains how short-term and long-term market trends are related.
• The theory is governed by 6 principles that guide technical analysis and trading strategies.
• Dow theory can be used to get clear buy and sell signals for traders to take positions.
• Confirming signals with other technical indicators helps traders make confident trading decisions.

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