Dow Theory

What is Dow Theory?

Any efforts to track down the beginnings of technical analysis will lead the reader to an introduction to Dow Theory.  In principle, it is a set of general principles to help you take action on different price action data in the market. Charles H. Dow founded Dow Theory in the 19th century and initially used it to describe stock price movement. But, because Dow Theory helps establish the direction of a financial market, it makes for a universal tool that can be applied to other asset classes like CFDs. Dow Theory compares the Dow Jones Industrial Average to the Dow Jones Transportation Average. It can identify if we’re in a technical bull market or a technical bear market. To confirm if the market is a technical bullish or bearish phase, the trend for the DJIA should match that of the DJTA. Dow Theory serves as an indicator of the general health of a financial market. For traders, Dow Theory is an excellent introduction to the way the market moves, and thus, gives traders ideas of where to find trading opportunities, according to a set of basic principles.

The 6 Principles of Dow Theory

The six principles of the Dow theory are:

1. The price discounts everything.
2. The market has three trends.
3. Trends have three phases.
4. The averages must confirm each other.
5. The volume must confirm the trend.
6. A trend is assumed to be in effect until it has given a definite signal that it has reversed.

Price discounts everything

Dow theory states that all information that can be known has already been factored into the price. So the news has been discounted, and the only remaining influence on the price is our human emotion. Dow Theory would imply that we are then only studying human emotion and not the statistical data. Because considering price action is merely a reflection of human emotion.

A Market has three trends

Dow Theory stipulates that there are three important trends in a market. An uptrend is defined as successive higher lows followed by successive higher highs while a downtrend is successive lower lows followed by successive lower highs.

1. The primary trend.
2. The secondary trend or Intermediate trend
3. The minor trend or daily fluctuation.

The primary trend generally lasts between one and three years. The primary trend is the most critical trend because it will impact the secondary and minor trend as well. The secondary trend generally lasts between three weeks and three months and moves in the opposite direction of the primary trend. The minor trend generally lasts less than three weeks. The minor trend will remain relative to the secondary trend in the same way that the intermediate trend remains relative to the primary trend.

GBP/USD Daily Chart

Three Phases of a Trend

A trend has three phases as follows:

1. Accumulation Phase.
2. Public Participation Phase
3. Distribution Phase.

EUR/USD Chart

The accumulation phase is the first stage of a bull market and represents smart buying by the most informed traders. Generally, the accumulation phase appears at the end of a bearish trend and is characterised by extreme negative sentiment. On a price chart, the accumulation phase is characterised by a period of consolidation in the market. The public participation phase occurs when the price starts to change rapidly. This public participation phase is where most trend followers begin to take part, and it is the phase that lasts the longest and has the most significant price movement. The distribution phase is the first stage of a bear market and represents smart selling by the most informed traders. The distribution phase is characterised by positive sentiment and fundamental data that looks better than ever.

Averages Must Confirm Each Other

This principle states that the overall direction of the trend must be confirmed by a correlated pair, thus confirming each other. If for example, the EUR/USD is moving in an uptrend, we should also see the primary GBP/USD trend moving upward. But if the GBP/USD doesn’t confirm the EUR/USD trend, we have divergence, and something is not right. This could signal that there can be a significant change in the trend coming soon.

EUR/USD vs GBP/USD Daily Chart

Volume Must Confirm the Trend

According to Dow Theory, volume should move in the direction of the primary trend. If there is a bullish trend, we should see an increase in buying volume and, if we have a bearish trend, we should see an increase in selling volume. Weak volume indicates a possible weak trend.

A Trend is Assumed to Continue Until it Has Given A Definite Signal that it Has Reversed

According to Dow Theory, a trend is expected to remain in effect until a major event takes place that would cause a reversal. As with the law of physics, we assume that an object in motion will continue in motion until an external force causes it to change direction. Traders should keep trading in the general direction of the trend until it’s given certain signals that the trend has reversed.

Conclusion

Understanding Dow Theory will give you a better grasp of technical analysis and make you a better trader. The principles are fundamental but give any trader a strong foundation for how to trade the markets. These principles give traders rules to follow, so helping a new trader remove emotion from their trades.