Dow Theory

Back in 1889 when the stock market was beginning to really pick up steam, Charles Dow founded the Wall Street Journal. In this, he published ground breaking analysis of stock prices through a series of editorials which formed the foundations of what we now term technical analysis. While Charles unfortunately popped his clogs in 1902, his work was continued by William Hamilton until 1929. The efforts of both men were then consolidated down into the Dow Theory, being published in 1932.

While some aspects of the theory now only have limited application, such as the proposal that "the two averages must confirm". The averages being referred to here are the "Rails" and the "Industrials" such that Industrials produce goods which are transported by Rails and so there must be alignment between the two for a valid signal to be generated. Today we have many more aspects to consider, with rail freight not being the monolith it once was and the variety of manufacture being substantially broader as industries become increasingly complex.

However, the core tenets of Dow Theory are still worth holding in the back of your head as you progress along your trading journey.

The price has already discounted all information and rumours in the public domain.

This includes fundamental factors (crop yields), economic conditions, and investor psychology (e.g. if a key resistance price is coming up).

The market has three trends:

• The primary trend acting as the dominant long-term trend, setting the direction of the market, usually lasting months or years.

• The secondary trend accounts for shorter-term corrections or counter-trends against the primary trend, lasting weeks or months.

• The minor trend being the daily fluctuations within the secondary trend.

Major trends go through three phases:

• Accumulating - This is the initiation of a trend and is formed of the most informed traders making early moves.

• Trending - This can be referred to as the "public participation" phase where most technical trend followers begin to join in, building strength.

• Distribution - The most informed traders begin to unwind their positions recognising the trend is coming to an end. This is typically aligned with the time that major media outlets begin talking about the strength of the trend.

Price action determines the trend, while Volume confirms it.

Trading volume is often an underappreciated indicator, but Dow believed that it plays a critical role in confirming trends, with volume increasing as the price rises and decreasing during corrective periods of a dominant upward trend. Conversely, during a downward trend, the volume should increase during price declines and decrease during temporary rallies.

The averages must confirm each other.

As highlighted above, in our opinion, this aspect has less relevance today unless you are trading in niche aspects. If we took natural gas for example, then the averages would be production volume and shipping vessels, both of which are widely reported via open source means. So you can still apply this theory but it requires a little thought.

Trends remain in action until proven otherwise

This operates in a manner not dissimilar to momentum in the real world, and is where many trading methodologies draw their nomenclature from. Momentum trading is a wide field so we won't get into it today but the basic compromise is that if your reversal signals are too sensitive then you may mistake the secondary trend (correction) as the break of the primary trend and close your positions too early. Meanwhile, if the signal is too coarse, then you will remain in positions after a trend has broken, resulting in losses. There appears to be little consensus as to what is definitively a market reversal signal.