DOW THEORY

Dow Jones???
DOW THEORY
Any attempt to trace the origins of technical analysis would inevitably
lead to Dow theory. While more than 100 years old, Dow theory remains the
foundation of much of what we know today as technical analysis.

Dow theory was formulated from a series of Wall Street Journal editorials
authored by Charles H. Dow from 1900 until the time of his death in 1902.

These editorials reflected Dow's beliefs on how the stock market behaved
and how the market could be used to measure the health of the business
environment.

Due to his death, Dow never published his complete theory on the
markets, but several followers and associates have published works that
have expanded on the editorials.

Some of the most important contributions to Dow theory were:

William P. Hamilton's "The Stock Market Barometer" (1922),
Robert Rhea's "The Dow Theory" (1932),
E. George Schaefer's "How I Helped More Than 10,000 Investors To
Profit In Stocks" (1960) and
DOW THEORY
The Dow theory is the oldest, and by far the most publicized, method of
identifying major trends in the stock market.

The basic principles of the Dow theory are used in other branches of
technical analysis.

The goal of the theory is to determine changes in the primary, or

major, movement of the market. Once a trend has been established, it
is assumed to exist until a reversal is proved.

Dow theory is concerned with the direction of a trend and has no

forecasting value as to the trend’s ultimate duration or size.

It should be recognized that the theory does not always keep pace with
events; it occasionally leaves the investor in doubt, and it is by no means
infallible, since losses, as with any other technical approach, are
occasionally incurred.
 DOW THEORY
The theory assumes that the majority of stocks
follow the underlying trend of the market most of the
time.

In order to measure “the market,” Dow constructed

two indexes, which are now called:
(1) the Dow Jones Industrial Average, which was
originally a combination of 12 (but now includes
30 bluechip stocks), and
(2) the Dow Jones Rail Average, comprising 12
railroad stocks.

Since the Rail Average was intended as a proxy for

transportation stocks, the evolution of aviation and
other forms of transportation has necessitated
modifying the old Rail Average in order to incorporate
additions to this industry.
https://www.aaii.com/journal/article/charles-dows-theory-still-valid-for-
Consequently, the name of this index has been the-21st-century
changed to Transportation Average.
 Big Picture Technical https://youtu.be/m1_Ms0inwwQ

• Indicators
The Dow Theory https://www.investopedia.com/terms/d/dowtheory.asp

• Dow theory is a technical approach based on https://youtu.be/fU2z0X58CHc

the idea that the stock market's behavior can
be best described by:
(1) the long-term price trend of the Dow Jones
Industrial Index and
(2) the Dow Jones Transportation Index.

• If the values of both indexes are rising, We

say that we are in a bull market.

• If the Dow Jones Industrial Average declines

and the Transportation index follows suit, we
say that the markets have entered into a
bearish period.

• An after-the-fact measure with no predictive

power.
Tenet no 6. The Averages Must
Confirm
One of the most important principles of
Dow theory is that the movement of the
Industrial Average and the Transportation
Average should always be considered
together; i.e., the two averages must
confirm each other.

The need for confirming action by both

averages would seem fundamentally
logical, for if the market is truly a
barometer of future business conditions,
investors should be bidding up the prices,
both of companies that produce goods and
of companies that transport them, in an
expanding economy.

It is not possible to have a healthy

economy in which goods are being
manufactured but not sold (i.e., shipped to
market). This principle of confirmation is
shown in Figure 3.4
 Interpreting the Theory:
The six basic tenets of the theory

1. The Averages Discount Everything

2. The Market Has Three Movements
3. Lines Indicate Movement
4. Price/Volume Relationships Provide
Background
5. Price Action Determines the Trend
6. The Averages Must Confirm
Interpreting the Theory:
The six basic tenets of the theory
1. The Averages Discount
Everything
The first basic premise of Dow theory suggests that
all information - past, current and even future - is
discounted into the markets and reflected in the
prices of stocks and indexes.
Changes in the daily closing prices reflect the
aggregate judgment and emotions of all stock market
participants, both current and potential.
It is, therefore, assumed that this process discounts
everything known and predictable that can affect the
demand/supply relationship of stocks.
That information includes everything from the
emotions of investors to inflation and interest-rate data,
along with pending earnings announcements to be
made by companies after the close. Based on this tenet,
the only information excluded is that which is
unknowable, such as a massive earthquake. But even
then the risks of such an event are priced into the
Like mainstream technical analysis, Dow theory is
market.
mainly focused on price. However, the two differ in
that Dow theory is concerned with the movements of
the broad markets, rather than specific securities.
 2. The Market Has Three Movements
There are simultaneously three movements in the stock
market.

Dow theory identifies three trends within the market:

primary, secondary and minor.

▪ A primary trend is the largest trend lasting for more

than a year, while

▪ a secondary trend is an intermediate trend that lasts

three weeks to three months and is often associated
with a movement against the primary trend.

▪ Finally, the minor trend often lasts less than three

weeks and is associated with the movements in the
intermediate trend.
2. The Market Has Three Movements

An upward trend is broken up into several rallies, where A downward trend is broken up into several sell-offs, in
each rally has a high and a low. which each sell-off also has a high and a low.
For a market to be considered in an uptrend, each peak in To be considered a downtrend in Dow terms, each new low in
the rally must reach a higher level than the previous rally's the sell-off must be lower than the previous sell-off's low and
peak, and each low in the rally must be higher than the the peak in the sell-off must be lower then the peak in the
previous rally's low. previous sell-off.
Now that we understand how Dow theory defines a trend, we can look at the finer points of trend analysis
 2. The Market Has Three Movements
(i) Primary Movement, (2) Secondary Reaction, (iii) Minor
Movement
(i) Primary Movement
The most important is the primary or major trend, more
generally known as a bull (rising) or bear (falling) market.

Such movements last from less than one year to several

years.

A primary bull market is a broad upward movement,

normally averaging at least 18 months, which is interrupted by
secondary reactions.

The Bull market stages:

▪ 1st: The bull market begins when the averages have
discounted the worst possible news and confidence about
the future begins to revive.
▪ 2nd: The second stage of the bull market is the response
of equities to known improvements in business
conditions, while
▪ 3rd: the third and final phase evolves from
overconfidence and speculation when stocks are
advanced on projections that usually prove to be
unfounded.
 2. The Market Has Three Movements
(i) Primary Movement, (2) Secondary Reaction, (iii) Minor
Movement
(i) Primary Movement
A primary bear market is a long decline interrupted
by important rallies.
It begins as the hopes on which the stocks were
first purchased are abandoned.
The second phase evolves as the levels of
business activity and profits decline.
In the third stage, the bear market reaches a
climax when stocks are liquidated, regardless of
their underlying value (because of the depressed
state of the news or because of forced liquidation
caused, for example, by margin calls).

Regardless of trend length, the primary trend

remains in effect until there is a confirmed reversal.

For example, if in an uptrend the price closes below

the low of a previously established trough, it could
be a sign that the market is headed lower, and not
higher.
 2. The Market Has Three Movements
(i) Primary Movement, (2) Secondary Reaction, (iii) Minor Movement
(ii) Secondary Reaction
In Dow theory, a primary trend is the main
direction in which the market is moving.
Conversely, a secondary trend moves in the
opposite direction of the primary trend, or as a
correction to the primary trend.

For example, an upward primary trend will be

composed of secondary downward trends. This is
the movement from a consecutively higher high to
a consecutively lower high. In a primary
downward trend the secondary trend will be an
upward move, or a rally. This is the movement
from a consecutively lower low to a consecutively
higher low.

Figure: Notice how the short-term highs (shown

by the horizontal lines) fail to create successively
higher peaks, suggesting that a short-term
downtrend is present. Since the retracement does
not fall below the February low, traders would use
this to confirm the validity of the correction within
a primary uptrend.
 2. The Market Has Three Movements
(i) Primary Movement, (2) Secondary Reaction, (iii) Minor Movement
(ii) Secondary Reactions
A secondary or intermediate reaction is
defined as “an important decline in a bull market
or advance in a bear market, usually lasting from
three weeks to as many months, during which
interval, the movement generally retraces from
33 to 66 percent of the primary price change
since the termination of the last preceding
secondary reaction.

This relationship is shown in Figure 3.1.

Occasionally, a secondary reaction can retrace
the whole of the previous primary movement,
but normally, the move falls in the onehalf to two
thirds area, often at the 50 percent mark.

As discussed in greater detail later, the correct

differentiation between the first leg of a new
primary trend and a secondary movement within
the existing trend provides Dow theorists with
their most difficult problem.
 2. The Market Has Three Movements
(i) Primary Movement, (2) Secondary Reaction, (iii) Minor Movement

(iii) Minor Movements

Defined as a market movement lasting less than
three weeks. The minor trend is generally the
corrective moves within a secondary move, or
those moves that go against the direction of the
secondary trend.

The minor movement lasts from a week or two

up to as long as six weeks. It is important only in
that it forms part of the primary or secondary
moves; it has no forecasting value for longer term
investors. This is especially important since short -
term movements can be manipulated to some
extent, unlike the secondary or primary trends.
Due to its short-term nature and the longer-
term focus of Dow theory, the minor trend is not
of major concern to Dow theory followers.
3. Lines Indicate Movement
Rhea defined a line as “a price movement two to
three weeks or longer, during which period, the price
variation of both averages moves within a range of
approximately 5 percent (of their mean average).

I see no reason why the 5 percent rule cannot be

exceeded. After all, it really represents a digestion of
gains or losses or a pause in the trend. Such a
movement indicates either accumulation stock
moving into strong and knowledgeable hands and
therefore bullish or distribution [stock moving into
weak hands and therefore bearish].”

An advance above the limits of the “line” indicates

accumulation and predicts higher prices, and vice
versa. When a line occurs in the middle of a primary
advance, it is really forming a horizontal secondary
movement and should be treated as such. My own
view is that the formation of a legitimate line should
probably take longer than 2 to 3 weeks. After all, a
line is really a substitute for an intermediate price
trend and 2 to 3 weeks is the time for a short term or
minor price movement.
4. Price/Volume Relationships Provide
Background
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 4. Price/Volume Relationships Provide
Background
The main signals for buying and selling are based on the price
movements of the indexes. Volume is also used as a secondary
indicator to help confirm what the price movement is suggesting.

Volume should increase when the price moves in the direction of

the trend and decrease when the price moves in the opposite
direction of the trend.
For example, in an uptrend, volume should increase when
the price rises and fall when the price falls. The reason for
this is that the uptrend shows strength when volume increases
because traders are more willing to buy an asset in the belief
that the upward momentum will continue.
5 Low volume during the corrective periods signals that most
traders are not willing to close their positions because they 4
believe the momentum of the primary trend will continue.
2 3
Conversely, if volume runs counter to the trend, it is a sign of 1 5
weakness in the existing trend.
For example, if the market is in an uptrend but volume is
weak on the up move, it is a signal that buying is starting to
dissipate.
If buyers start to leave the market or turn into sellers, there is
little chance that the market will continue its upward trend.
The same is true for increased volume on down days, which
is an indication that more and more participants are becoming
 4. Price/Volume Relationships Provide
Background
The main signals for buying and selling are based on the price
movements of the indexes. Volume is also used as a secondary
indicator to help confirm what the price movement is suggesting.

Volume should increase when the price moves in the direction of

the trend and decrease when the price moves in the opposite direction
of the trend.
For example, in an uptrend, volume should increase when the
price rises and fall when the price falls. The reason for this is
that the uptrend shows strength when volume increases
because traders are more willing to buy an asset in the belief
that the upward momentum will continue.
Low volume during the corrective periods signals that most
traders are not willing to close their positions because they
believe the momentum of the primary trend will continue.

Conversely, if volume runs counter to the trend, it is a sign of

weakness in the existing trend.
For example, if the market is in an uptrend but volume is According to Dow theory, once a trend has been confirmed by volume, the
weak on the up move, it is a signal that buying is starting to majority of money in the market should be moving with the trend and not
dissipate. against it.
If buyers start to leave the market or turn into sellers, there is
little chance that the market will continue its upward trend.
Volume and the technical indicators that are derived from it are undoubtedly
The same is true for increased volume on down days, which is
some of the most powerful tools at the disposal of proponents of Dow Theory.
an indication that more and more participants are becoming
 5. Price Action Determines the Trend
Bullish indications are given when successive rallies penetrate
peaks while the trough of an intervening decline is above the
preceding trough. Conversely, bearish indications come from a
series of declining peaks and troughs.

Figure 3.2 shows a theoretical bull trend interrupted by a

secondary reaction. In example a, the index makes a series of
three peaks and troughs, each higher than its respective
predecessor.

The index rallies following the third decline, but is unable to

surpass its third peak. The next decline takes the average below
its low point, confirming a bear market as it does so, at point X.

In example b, following the third peak in the bull market, a

bear market is indicated as the average falls below the previous
secondary trough. In this instance the preceding secondary was
part of a bull market, not the first trough in a bear market, as
shown in example a.

Many Dow theorists do not consider penetration at point X in

example b to be a sufficient indication of a bear market. They
prefer to take a more conservative position by waiting for a rally
 6. The Averages Must Confirm
One of the most important principles of
Dow theory is that the movement of the
Industrial Average and the Transportation
Average should always be considered
together; i.e., the two averages must
confirm each other.

The need for confirming action by both

averages would seem fundamentally
logical, for if the market is truly a
barometer of future business conditions,
investors should be bidding up the prices,
both of companies that produce goods and
of companies that transport them, in an
expanding economy.

It is not possible to have a healthy

economy in which goods are being
manufactured but not sold (i.e., shipped to
market). This principle of confirmation is
shown in Figure 3.4