Dow Theory. The 6 basic tenets you need to know.

Charles Dow was the founder of the Wall Street Journal and, by trying to understand the market behaviour, he developed a series of 6 basic tenets which are now the basis of the technical analysis.

The Dow Theory is over 100 years old but, as you’re going to read, it still valid and it will certainly change the way you analyse the market.

The 6 basic tenets of the Dow Theory are:

  1. Charles Dow TheoryThe market has 3 main trends.
  2. Market trends have three phases.
  3. The Price discount all the news.
  4. Stock Market averages must confirm each other.
  5. Trends are confirmed by volume.
  6. Trends exist until definitive signals prove they have ended.

Let’s analyse them one by one, read until the end.

The Market Trends in the Dow Theory

Charles Dow identified 3 main trends:

  • The primary movement.
    It’s major trend and it can last from a year to several years.
    Nobody can really predict the duration and the length of this cycle, it can’t be manipulated.
  • The medium swing. 
    It’s a secondary movement and Charles Dow observed it usually retrace between the 0.33% and the 0.66%.
    The duration could be between one and 3 months.
  • The minor movements.
    They are the shortest and the more likely to be manipulated.
    The standard duration could be between from an hour to one month.

Here a practical example with the Eur/Aud Daily analysed with the Trend Detector. ⇐

Dow Theory Trends

The 3 phases of the Stock Market

Charles Dow notices that movement of a standard primary movement was characterize by 3 main phases:

  1. ACCUMULATION
    In this phase the market is moving slow and it's close to its minimum.
    In this moment the PANIC reign over the less informed market operators and the mass media.The Smart Money are secretly buying when the crowd is panic selling absorbing their short orders.
  2. TREND. ⇑
    This is the moment where all the markets participants are becoming aware of the bullish move and they're starting to buy.
    The general mood is hope and optimism.
  3. DISTRIBUTION.
    In this last phase the market it's overheating.
    The crowd, thanks to mass media, now know that the market is bullish and they can't wait to buy.The optimism turns into euphoria.

    The Smart Money, who bought the stock around the minimum during the accumulation phase, are distributing the stock to the less informed retail investors.
    (See how Wyckoff analysed this movement).
    The Dow Theory classify this movement as the CAPITULATION of the bullish trend.

Accumulation Distribution DOW THEORY

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The price discount all the news

In this principle, the Dow Theory says that the price instantly discounts all the news and possible news  by moving in advance (for example a rate hike).

Let's see the rate hike in December as example:

USDJPYH4

The conclusion is:

Don't trade the news thinking to be faster than the other, you are not.

Stock Market averages must confirm each other

It's the main principle of the Intermarket Analysis.

At that time the economy was lead by the industries and the transport sector was highly correlated.
(More production -> More good to be moved).

Now the leading sector is the finance industry and it's highly correlated with the risk.

This is an example between Gold (Xau/Usd) and the inverse of Usd/Jpy (1/UsdJpy).

dow theory intermarket analysis

Conclusion:

When two high-correlated markets don't confirm each other, a reversal is in place.

Trends are confirmed by volume

In this point, the Dow Theory explains a very important principle:

In a trend, the volume must increase in the direction of the main movement and decrease during the correction.

When this happens it means that the market movement is fuelled by new market participants and, so, by an increase in demand or supply.

Here an example of a trend confirmed by volume:

volumes

As you can see on all the lower high there is a lower volume.

You can find a different situation at the beginning of the trend shown above, where the volume started to do higher high on the bottom instead of on the tops and the trend turned bearish.

volume inversione

Trends exist until definitive signals prove they have ended

The last but not the least tenet of the Dow Theory regards the identification of a trend by the analysis of the tops and bottoms.

A bullish trend is characterised by a series of Higher Highs (HH) and Higher Lows (HL).

A trend reversal occurs when the price creates a lower low (LL).

Here an example of the Usd/Jpy Daily Chart analysed with the Min&Max Indicator. ⇐

USDJPYDaily

For a bearish trend is exactly the opposite:

It starts with a breakout of a higher low and it keeps its direction until there will be lower high.

bearish trend

- Conclusion -

With the Dow Theory, Charles Dow became one of the fathers of the Technical Analysis and his 6 principles are still the basis of each successful technical trader.

AND YOU? How are you using the Dow Theory?

Let me know in the comments below! ⇓

2 Comments

  • Gary Burton

    Reply Reply August 10, 2016

    Good summation –keep reading… Dow did not actually do any technical analysis work.. he wrote the “afternoon newsletter” to become the Wall Street Journal.. It was William Hamilton and Robert Reay after Dows death,that took Dows observations of the averages and Economic cycles and developed the basis of TA as we know it today. The transports are just as relevant today as 100 years ago, as the world as we know it,is still based on GDP, everything is still transported from the mines, oil rigs and fields to the factories to the shops to our homes.
    Currently the Transports are not at new highs because of the woeful 2% GDP growth in the US over the past 5 years. Elliott wave is based on Dow theory, Gann was a shame, just good with numbers.

    • Michele

      Reply Reply August 11, 2016

      Hello Gray!
      You could be right, but as you can see the economy is not going that good and the markets are keep doing new highs.
      This is because the markets are not following the real economy anymore.

      Maybe we are in a bubble (probably!), maybe the world is changing.

      The job of a technical trader is to spot a trend and to follow it until the reversal is confirmed (principle number 6).

      Thanks for the comment!

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