Dow Theory

The Dow theory is a financial theory founded on a set of ideas derived from Charles H. Dow's editorials. It fundamentally states that a significant shift between bear and bull sentiment in a stock market will occur when multiple indices confirm it.

The identified trend is accepted when it is backed by solid proof. The theory explains that if two indices move in the same direction, the identified primary trend is real. Whereas if the two indices do not match, then there is no clear trend. It focuses on price movements, trade volumes, capturing the trends with the help of pictorial representations and comparison of indices.

• Dow theory trading strategy is primarily based on the ideas about stock price movement put forth by Charles H. Dow through his editorials in the Wall Street Journal back in the 19th century.
• It mainly states that multiple indices should provide the same signal to confirm a trend.
• It lists a set of fundamental tenets. Identifying and following a trend should be in line with these tenets.
• It is the core principle of modern technical analysis. Traders use the Dow theory forecast to confirm between uptrend and downtrend.

The Dow theory developed from the market price action analysis, views on speculation, etc., put forth by Charles H. Dow formed a foundational step for technical analysis when the software's aided technical analysis like today didn't exist. Its evolution and usefulness in speculation are well portrayed by Robert Rhea in his book "The Dow Theory" by meticulously examining the Wall Street Journal editorials by Charles H. Dow and William Peter Hamilton in the 19th century. It was among the earliest attempts to understand the market by using fundamentals that indicated future trends.

The original version of the theory focused on comparing the closing prices of two averages: the Dow Jones Rail (or Transportation) (DJT) and the Dow Jones Industrial (DJI). The argument was that if one rose above a certain threshold, the other would follow it.  To illustrate it, Dow's compared the market to the ocean. According to the economist, if you are on one side of the beach and the waves go up until a point, waves in another part of the beach will eventually reach the same point. The same happens with markets because they're also a part of a whole.

The Paradigms of Dow Theory

To explain the theory, understanding the several rules devised by Dow is vital. These paradigms are generally known as the tenets or principles of Dow theory.

• Three significant market trends: They are primary, secondary, and minor trends defined by their duration. Primary trends can be uptrend or downtrend lasting months to years, while secondary one moving opposite to the primary will last weeks or a few months. Minor trends are treated as insignificant variations lasting from a few hours to weeks, and they are not as important as the others.
• Primary trends have three distinct phases: The different phases in bear markets are distribution, public participation, and panic. Bull markets, on the other, have accumulation, public participation, and excess phase.
• Stock market discount everything: The market indexes react quickly to all forms of information. It can be related to the entity or economy as a whole. For instance, any economic shock or issues in the company management will affect stocks and move the indices upward or downward.
• Volume confirms the trend: Trading volume increases during an uptrend and decrease during depressions. 
• Indices confirm each other: Multiple indices moving in an identical pattern reveal a trend since they give the same signal. Whereas if two indices move in the opposite direction, it is difficult to deduct a trend.
• Trends continue until solid clues imply the reversal: Traders should be aware of trend reversals. It’s easy to confuse them with secondary trends, so Dow cautions the investor to be careful and confirm trends with several sources before believing it’s a reversal.

The Dow theory was fundamental to technical stock market analysis and acted as the underlying principle for its continued advancement. The technical framework of the analysis emphasizes the need to pay close attention to market data to discern trends, reversals and determine when to buy or sell an asset for maximum profit since the market is the indicator of future performance. In this way, technical analysis in accordance with theory assists investors in making profitable trading decisions by detecting established long, mid, or short-term trends.

The concept is explained better with the help of a suitable chart from TradingView, as given below. In the chart of Apple Inc., the Dow Factor has been combined with the Stochastic Relative Strength Index (RSI) to get better visibility. The Dow shows the relationship between the price of the stock and the volume, which means the trader can use this indicator to keep monitoring the stock and, therefore, determine the entry and exit level along with any possible trend reversals. The trader can, thus, identify excellent and profitable trades using the indicator.

Source

The technical analysis in line with the theory confirms a particular trend and validates the buy or sell signal if both averages confirm each other. If one average is moving towards a new high or low, then the other must soon follow. To further illustrate how Dow's theory work, check the following chart that shows the relationship between the industrial and transports indices and what would constitute clear buy and sell signals in this model.

Source- Stockcharts.com

According to the above chart, both the DJIA and the DJTA set new highs in April as part of the core bullish trend. However, when the DJIA set a new high in July, the DJTA failed to do so. It served as a warning sign but did not confirm the trend reversal. At the end of July, the DJTA recorded a new low. Subsequently, the DJIA also recorded a new low and confirmed a change in the primary trend from bullish to bearish. Following this, both averages signaled to continue the downtrend.

In October, the DJIA formed a higher low while the DJTA recorded a new low.  After the higher low, the DJIA followed through with higher lows and highs, indicating an overall upward momentum. It essentially resulted in an upward trend. By early November, the DJTA had begun to confirm with the DJIA, and the primary trend had shifted from bearish to bullish.

This has been a Guide to Dow theory and its meaning. Here we explain how does Dow theory works in technical analysis and paradigms, along with an example. You can learn more from the following articles -

• Fundamental Analysis vs Technical Analysis
• Security Analysis
• Trend Trading