How to Use Dow Theory in Technical Analysis
6 minutes for reading
There is an opinion that modern tech analysis is based on the Dow theory, and today we will speak about this unique Charles Dow’s theory that still remains quite efficient. Also, we will discuss how this approach can be used in trading.
What is Dow theory
A series of Dow’s articles in the Wall Street Journal helped William P. Hamilton, Robert Rhea, and George Schaefer design a market research theory.
The Dow theory is an approach to trading based on six principles. The main focus is on price highs and lows that help detect the current trend. Also, each outer factor, such as news or random events, is supposed to be already incorporated in the price. The Dow theory in technical analysis remains topical these days as well.
Initially, the principles were used for the railway and industrial indices only that were included in the Dow Jones Industrial Average. However, some research proves the efficacy of the principles for the stock market as well.
For example, Martin Pring in his book Technical Analysis Explained wrote that the stocks from the Dow Jones index bought in 1987 for 44 USD could have yielded about 2,500 USD of profit if sold in 1990.
Charles Dow theory principles
As said above, the whole of the Dow theory is based on six principles. Let us take a look at each of them in a more detail.
Market cares for everything
All events and factors have already been taken account of by the market and included in the price. Absolutely any event that might happen, even a disaster or an earthquake, is valid. The principle is also known as “Market depreciates everything”.
For example, if a company is getting ready to present a great report, the market is likely to account for it even before the report appears. In other words, the demand for the shares of the company will grow in advance, and after the report is published, the growth might stop.
Moreover, the quotes might fall when a strong report is published because the report might turn not as great as expected.
There are three types of trend
Charles Dow defined the trend but never made a focus on uptrends, downtrends, and flats as in classical tech analysis. Nonetheless, his definition of the trend remains efficient. It says that in an uptrend, each next high and low is higher than the previous one. In this principle of the Dow theory the length of trends is estimated:
- A primary trend lasts for longer than a year, sometimes for several years. It is supposed that the main mass of investors in the stock market looks for a primary trend chiefly.
- A secondary trend, a.k.a. intermediate trend, lasts from three weeks to three months. It might reach up to 50% of correction of the primary trend.
- A small trend lasts for no more than three weeks. It consists of minor fluctuations inside a secondary trend. In modern trading, it is mostly called a short-term trend.
Trend has three phases
In the primary trend, the Dow theory singles out three phases based on the info background and investors' behaviour:
- Accumulation begins when more informed and experienced investors start to buy. All the negative information has been cared for by the market, but the sentiment of most market players remains negative.
- Participation starts when traders who use tech analysis engage in buying. Prices continue going up and indicators show strong bullish trends. The info background becomes more positive, and the general sentiment improves.
- Distribution begins when most market players actively enter the market, news is all bullish, forecasts are too optimistic, and trade volumes hit records. At this moment informed investors who were buying during the first phase start to distribute their assets. However, the majority only feel the urge to buy.
Indices must prove one the other
The Dow theory comparrs the railway and industrial indices to see to what extent the current trend has progressed. Any movement of one index must be proved by the other one. Moreover, the time that passes between these movements must be minimal: the smaller it is, the stronger is the signal.
For example, we can suspect that the market is bullish when both indices renew previous highs. And if just the industrial index hits the high while the railway index never confirms the movement, this means it is too early to make forecasts by the Dow theory.
Trade volume must confirm trend
Trade volume is expected to grow in the direction of the prevailing trend. In a bullish trend, trade volume must grow alongside the growing price, and in a downtrend it must fall while the price is falling.
However, Dow never considered this signal to be the main one: he first looked at the price chart behaviour and then searched for volume confirmations.
Trend develops until clear reversal
In the Dow theory, a market reversal is considered hard to find: a new trend aims in this direction. However, there is a view that a bullish trend reverses when the price cannot renew the previous high and demonstrates a low below the previous one. This might be a trend slowdown or a reversal because the sequence of new highs and lows has stopped, and there is a risk of going in the opposite direction.
Dow theory in technical analysis
Charles Dow theory is quite easy to adapt to modern markets. Jesse Livermore said that markets are moved by the psychology of market players. Though there have appeared new markets, psychology has never changed; hence, the patterns and laws discovered by Charles Dow on charts will be working in the future as well.
What do you think about the Dow theory plus Forex? Indeed, these days it is used in Forex as well. For example, we trade the trend and combine different timeframes for signal search.
Trend reversals that appear when the price cannot renew the previous high often lead to the appearance of such patterns as the Head and Shoulders and Double Top.
And if we trade a bullish trend, some traders who use tech analysis think that one should buy when the price breaks through a high or nears the preceding low. If the trend is strong, a breakaway of the high can push the price further up and will not let the price fall below the previous low.
There might be no direct correlation between the Dow theory and Forex, but most often the ideas of price behaviour described above coincide with the analysis practises by modern traders. With graphic patterns, forecasts by the Dow theory can be made.
Closing thoughts
The Dow theory describes market behaviour very well. While initially it was designed for index analysis, today traders successfully use it in tech analysis.
The emphasis is not only on price movements but also on the behaviour of market players at different stages of trend development. The theory might contain a psychological part.
Obviously, certain principles are outdated but no one will dare deny the importance of the Dow theory for modern trading.
