Dow Theory

To understand not just technical analysis, but market analysis in general, we need to find the source. And we have to dig far back. We have to go back more than 100 years, when the Dow Theory was created. It is this theory which defines technical analysis and fundamental analysis as we know and use it today.

Dow’s theory, as such, was formulated by Charles Dow in his editorial column that appeared in the Wall Street Journal he founded from 1900 to 1902. Dow was a brilliant journalist. He described the structure of the stock market and how it could be used to determine the health of the entire economy.

Dow died young, in 1902. His theory, in its completed form, was never published. It was the work of Doe’s followers, who framed it in several of their works. Among them were William P. Hamilton, Robert Rhea, George Schaefer and Richard Russell.

Charles Dow’s own personality is interesting. The founder of Dow Jones and The Wall Street Journal, he was born into a simple… farming family. With no special education, Doe worked for several years as a reporter and editor in provincial newspapers and magazines.

At a newspaper, Doe was assigned to write about various historical events. So, gradually, he began to study various economic phenomena of the past that influenced the present.

Doe’s research was striking in its depth and detail. Bosses noticed his work and Doe began to work closely with bankers and stock traders to write increasingly significant investigative journalism. That’s how Doe got to know the underside of the financial world. The bankers and industrialists were very frank over a glass of whiskey and shared their secrets, and Dow was careful to write it all down.

Then he moved to New York and met Edward Davis Jones, another journalist. Thus was born the Dow Jones Company, and from there came the now world-famous Dow Jones Index. In 1889, the first edition of the famous Wall Street Journal was born.

Charles Dow walked the path that has always inspired me personally. From the very bottom, as an ordinary provincial reporter who wrote about housewives, he founded the world’s most famous financial magazine, and his theory formed the basis of modern technical analysis, used by traders all over the planet. I want to do that too, and who knows, maybe someday I’ll create my own trader’s project that will go down in the ages, or at least in the history of my floor. And bingoore is for warming up (there’s no harm in dreaming, I know).

In short, almost the entire basis of technical analysis is the Dow Theory. It is what absolutely all traders study before they get to Wall Street. Every trader, banker and investment manager in the world knows it, without exception. This is the basis.

The market takes into account all

This is the first thing to learn. According to Dow, the price of an asset already contains all the necessary information about the past, present, and even the future.

Emotions, inflation, discount rate data, it’s all already built into prices, in advance. Except, of course, for even theoretically inaccessible data like the exact date of a new earthquake. But even the risk of this extraordinary event is also built into market prices

All this does not mean that market participants can be guaranteed to predict future events. In fact, market prices simply encapsulate all the factors that affect them and may affect them in the future. As the situation and market risks change, so does the market itself, responding to new information.

Now every trader knows that the market takes everything into account. However, in Dow’s time, such an idea was revolutionary. The very idea that you only need… a chart to analyze a chart was a real breakthrough.

AAPL Dow Jones

The theory is based on price, but Dow talked about the market in general, not about the prices of specific assets, be they stocks or currency pairs. The theory was adapted to them by his followers.

As for the whole market, according to Dow theory, you should watch the movements of the main market indices. If they are trending, they affect the mood of investors. The theory also includes some fundamental concepts that take into account the assessment of the financial condition of companies, which is important when trading stocks.

So, the first conclusion – the market takes into account everything and gives plenty of clues by which you can understand its further movement.

Three trends

Trend analysis is the next stage of Dow theory. When the market moves in a certain direction, it never makes it a straight beautiful line.

The market always moves this way:

• a new pinnacle;
• rollback;
• a new pinnacle.

A pullback is followed by a new maximum, a new pullback and so on until the trend changes.

As a result, any trend can be decomposed into several stages. Each stage will have its own maximum and minimum value.

If the trend is going upward, each maximum value will be greater than the previous one. Similarly for a downtrend, where each minimum updates the previous minimum value.

According to Dow theory, there are three types of trends:

• main;
• secondary;

The main trend lasts more than a year. A secondary trend lasts from 3 weeks to 3 months, and it can often go against the general trend. Minor trend lasts up to three weeks and, as a rule, goes within the general trend.

The main trend

This is the key market movement. To determine it, it is necessary to open a larger timeframe on the chart, say, a monthly or weekly timeframe. This global trend ultimately affects everything, including secondary and minor trends.

According to Dow theory, the global trend lasts 1-3 years, which, however, can change. For the screenshot below, we move to the 1-month TF and draw a trend line.

A major trend remains in effect until there are clear indications that it is ending. One such indication could be, for example, a market closing below the previous high.

Secondary trend

The market moves in the direction of the main trend. The secondary trend, as a rule, goes against the main trend or as a correction to it.

This is how the main trend can go up and the secondary trends can go down. In this case, we go to the 1-day TF and draw secondary trend lines. As you can see, exactly according to the theory they go against the main trend.

According to Dow theory, secondary trends last from 3 weeks to 3 months, and the pullback against the main trend lasts from 30 to 60% of its movement.

Also, a secondary trend is usually much more volatile than the primary trend.

Slight trend

In theory, it is a market movement of up to 3 weeks duration. As a rule, it represents a correction to a secondary trend. For the screenshot below, we use the 1 hour TF.

Dow trends in short-term – intraday – trades

The theory is designed, as you have understood, first of all for the stock market (there were no others in the time of the Dow). Hence the long periods: 1-3 years, 1-3 months, etc.

However, in the same binary and other contracts, as well as in e traders, mostly work with expirations up to 1 hour, no one likes to wait (for long periods there are stocks).

So we can use principle number 1 – the market takes into account everything – to adapt these timeframes for intraday. Such adaptation has already been done in the screenshots above, where we used “smaller” timeframes.

For example:

1. main trend: 1-month TF;
2. secondary trend: 1-day TF;
3. slight trend: 1-hour TF.

Another option:

1. main trend: 1-day TF;
2. secondary trend: 1-hour TF;
3. slight trend: 15 or 5 minute TF.

This is how analysis is done on the chart. You open a chart on a 1-day TF, draw a trend line or channel. Then at 1 hour, repeat it, and at 15 minutes. Done – 3 cycles of price movement.

3 phases of the market trend

According to Dow theory, each major trend has 3 key phases:

• accumulation (distribution) phase;
• public participation phase;
• panic phase (realization).

Let’s look at them with a very clear example of a bull (upward) market for Apple stock.

Accumulation phase

This is the first phase, the beginning of an uptrend. It is at this stage that investors enter the market. As a rule, this phase begins when the downtrend is over. By this point, most of the negative news has already been taken into account by the market, due to which investors, despite low prices, begin to see a prospect in the asset.

Of course, it is not easy to detect the accumulation phase. It often comes after a downtrend. And it can be, in turn, just a secondary trend in a general downtrend. As a result, instead of a new trend we get only a temporary pullback.

 

From a technical point of view, the beginning of a new trend is always accompanied by a period of consolidation. This is when the market moves into a sideways movement and then begins to show an upward trend.

Confirm a new trend when the market has not updated the previous lows.

Participation Phase

“Advanced” investors enter the market in the accumulation phase. In their opinion, the worst is over. When the trend really reverses, the public participation phase begins.

Economic data is improving, the market is saturated with good news (say, Apple showed good growth in quarterly earnings). The more such news, the more investors get involved in this phase.

This phase is the longest of all, and it is also characterized by the most active movement. The highs are constantly updating, which is exactly what investors have been waiting for.

Implementation phase (panic)

In this phase, investors who entered in the first phase of accumulation leave the market. And the market begins to demonstrate completely illogical behavior.

A lot of investors, fascinated by the strongest trend, begin to think that it will always be there and rush to take part in it. At the same time, the main participants are leaving it or have already left it.

As a result, such investors in excitement buy at the very peak of the trend, just before its impressive fall.

In order to determine this phase, it is necessary to carefully study the signs that the market growth is over. In this case, the more active the market growth, the stronger the subsequent decline will be.

We have seen this recently in the Chinese stock market – just look at the drama with the Shanghai Stock Exchange composite index. Millions of uneducated Chinese housewives inflated the stock bubble, which then spectacularly burst and bankrupted many of them.

Shanghai Composite Index

But if housewives had bothered to study Dow theory, they would have figured out what was going on during the panic phase of the sale and saved their hard-earned money by selling stocks well before the market crashed.

It is a similar story when the main trend is bearish and going down. The situation repeats itself in a mirror image, and at the realization stage there is often a very real panic, when many investors dump their assets and the price gets the last downward impulse before rising.

Market indices should confirm each other

Two indices developed by the Dow are relevant to the stock market:

1. Dow Jones Industrial Average (Dow Industrials);
2. Dow Jones Transportation Index (Dow Transportations).

These indices can be thought of as averages of the stock prices that comprise them. Let’s say the Dow Jones Transportation Index takes into account the stock prices of 20 companies.

According to Dow theory, the general mood of the market should be confirmed by the coinciding directions of both indices. This is certainly true for the stock market. But it also plays a role for the currency market. In this case, if indices diverge, it means there is no clear trend.

The correlation between the Dow Jones Industrial and Transportation indices is used to determine the health of the entire U.S. stock market. As we can see, he is doing quite well.

Unlike currency pairs, where there are no real volumes, the stock market has complete information on them. Therefore, in order to forecast stocks, you need to consider both the financials of the companies that issued them and the volume data.

According to Dow theory, there is nothing complicated here. If the trend is up, volumes should go up as well. If the price is going against the trend, the volumes should go down.

Volumes are increasing because traders are actively buying shares during the accumulation and participation phases. Small volumes during the correction phases indicate that most traders do not close their positions because they believe in the strength of the general trend.

If the volumes do not coincide with the trend, it is an indication that it is ending. Let’s say the market is going up and volumes are decreasing – the bears are starting to pull the market in their direction. If buyers leave the market or they become sellers, the chances of the market continuing its upward movement are not good at all.

 

According to Dow’s theory, if the trend is confirmed by volumes, then market liquidity (money that rotates in the market) will follow the trend, not against it.

Recall that there are no reliable volumes for currency pairs. However, we can get indirect data – open interest in currency futures. About this later in the University.

The trend is working, until there is an indication of its reversal

The trend allows you to determine the general direction of the market – the trend it follows. The golden rule is “don’t work against the trend” and it is absolutely true.

According to Dow’s theory, a trend works until there is convincing evidence of its end.

It is important not to confuse a minor or insignificant movement with a real reversal. As a rule, trading against a trend is very risky.

Dow himself pointed out how you can determine the strength of a trend and anticipate its reversal. The same idea can be studied in the works of Martin Pring. The main method of how you can confirm a trend reversal is the analysis of maximum and minimum price values.

As we remember, according to the Dow theory, there must be specific indications of a trend reversal. What might they be? When the market fails to update the maximum or minimum of the price – this is an indication of a trend reversal

The Legacy of the Dow Theory

Technical analysis began with Dow Theory and is still the basis of it. Many others are based on this theory as well, say, Elliott waves. As the years went by, the market changed, the basic Dow index was renamed and became a “transport” index, while it used to be a railroad index.

Like any theory, in practice you will face a lot of peculiarities. For example, indications of a trend reversal are very conservative and often occur when the market has already turned steadily and traveled a considerable distance in a new direction.

The indices have also changed. In the Dow era, railroads were king, and now information technology is king. But these are all details. Have the indices changed? You just have to learn new ones. For example, if you work with high-tech stocks, you need a new generation of indices for them (the NASDAQ indices to help).

Theory adapts, it lives and changes with the market. Trends, index correlations, price values, updates of highs and lows – all this is the basis of technical analysis. This is the foundation for working with the market with already detailed methods, which we will move on to.