Dow theory explained: what is it and what are its principles?

Charles Dow is one of the forefathers of technical analysis, and with his Dow theory analysts have a whole set of tenets which have been guiding trading theory for decades. Dow theory was generated through the 255 Wall Street Journal editorials penned by Charles Dow through the 1851-1902 period.

While these rules were never viewed as one set by Dow, they can richly enhance an analyst’s way of viewing markets. Given that they were written over a century ago, it is common that traders will provide their own modern interpretation of these rules.

Dow theory principles

1. The market has three movements

Trend followers will know that there can be trends within different timeframes, where an hourly uptrend would be discounted by a downtrend on the weekly chart. That ability to differentiate between different timeframe ‘movements’ is key. Dow states that there are three movements:

• Primary movement/major trend – long-term. Dow states that this could be anything from less than a year to several years. However, it could be worthwhile thinking of this as relating to the long-term trend as seen through the weekly or monthly chart.
• Secondary reaction/medium swing/intermediate reaction – medium-term. This could be anything from ten days to three months. It makes sense to think of this as the view taken with the daily and four-hour charts.
• Short swing/minor movement – short-term. This is the view taken over the space of hours, up to a month. This would use the hourly chart and lower timeframes.

2. Trends have three phases

• Accumulation phase – ‘in-the-know’ investors are actively building or exiting positions against the general market opinion at the time. The stock price does not change much at this time given that this opinion is against the grain and thus there are sufficient buyers to make up for any selling, and vice versa.
• Participation - once the market catches on to the opinion of those ‘in-the-know’ investors, we see a sharp reversal for the market, with technical traders also taking part.
• Panic - once we see rampant speculation take hold, those ‘in-the-know’ investors will begin to reverse their positions as we come to end of the trend.

3. The stock market discounts all news

This rule states that a stock price will fully reflect the underlying economics and financials from the moment that they are available to the public.

4. Stock market averages must confirm each other

Given the importance of the US rail network in shipping goods throughout the country at the highly industrialsed time of Dow Jones, the Dow Transportation Index was seen as a key gauge of economic activity. With factories dotted throughout the country, the rise or fall of rail use was more important than it is today.

Nevertheless, Dow’s idea of seeing confirmation between two stock indices still holds value. Taking those two indices as an example, Dow said that when both were moving in the same direction, it provided greater confidence compared to times where there is a divergence between the two. It makes sense to look for confirmation utilising the case of whether both create higher highs and higher lows for an uptrend. Nowadays traders may wish to look for alternate markets, yet the notion of using correlated and related markets to find confirmation remains valuable.

5. Trends are confirmed by volume

Dow saw volume as a crucial tool for confirming or refuting a market move. When a market moves on low volume, this is thought to mean a number of possible things.

One such reason could be that there is one overly aggressive buyer or seller who is attempting to move the market. However, when significant price movements occurred with high volume, Dow believed that this gave a ‘true’ market view.

6. Trends exist unless proved otherwise

Markets do not move in a straight line, and with fundamental events providing volatility, there will be times that the trend seems to come under pressure.

However, Dow believed that the trend will typically remain in play despite such ‘market noise’. The trend should thus be given the benefit of the doubt during such retracements. Dow does not provide a specific means to determine whether a trend has reversed or if it is simply in retracement move.

To conclude, there are a whole host of rules which can be extended to fit a plethora of different trading scenarios for the modern trader. From correlated markets, to news-based trading and the recognition of trends, Dow’s theories help form the backbone of most technical analysis courses worldwide. Ensuring that a trader has a strong knowledge of these rules will help ensure that future learning is influenced by Dow’s principles.