What is Dow Theory? | Using the 6 Tenets for Day Trading

Dow Theory can be used in short-term trading as well as long-term investing. Learn about the 6 tenets, how they work and how they can be applied to day trading.

Contents: Dow Theory

  • What is Dow Theory?
  • Why is Dow Theory important?
  • The Six Tenets of Dow Theory
  • Dow Theory Charts
  • Dow Theory for Day Traders

What is Dow Theory?

Dow Theory is really a collection of theories about how financial markets move over time. There are six Dow Theory tenets, which were put forward by Charles Dow in a collection of editorials he wrote between 1900-1902. Dow also invented the Dow Jones industrial average with Edward Jones and co-founded the Wall Street Journal newspaper.

 

Charles Dow Theory

Why is Dow Theory important?

At it’s core Dow Theory is a theory about how price trends and over one hundred years later, it forms the basis of most technical analysis used in day trading and investing today. Ideas like uptrends, downtrends, support and resistance got their start from Dow Theory.

The 6 Tenets of Dow Theory

The 6 tenets or principles that would be applied to a Dow theory portfolio are as follows:

  1. The market discounts everything
  2. There are 3 kinds of market trends
  3. Primary trends are split into 3 phases
  4. Indices must confirm each other
  5. Volume should confirm the price
  6. Trends persist until there is a clear reversal

 

These are quite self-explanatory but let’s explore each one a bit deeper before we move on to how to apply them.

The Market discounts everything

This Dow theory principle has been taken from the efficient market hypothesis. It says that all available information is already reflected by the current price from company earnings to macro economics. This is also the philosophy of technical analysis but is the antithesis of fundamental analysis and behavioural economics.

There are 3 kinds of market trends

These three types of trend are split by the length of time they occupy.

Primary trends last a year or more and are the major market trends. They can be bull markets (price travelling up), bear markets (price trending down) or sideways ranges.

Secondary trends last a few weeks or perhaps months and usually counter-trend corrections, where the price moves in the opposite direction to the primary trend.

Minor trends last less than three weeks are the hunting grounds for day traders but considered noise by long-term investors.

Dow Theory chart 1

3 trend lengths dow theory

Primary trends have three phases

The three phases are dictated by what the price did previously and the role of the ‘smart money’ and the general public. The three phases are given slightly different names depending on whether it is a bull or bear market.

Dow Theory chart 2

the-dow-theory-phases

A bull market will start with an accumulation, then move to a public participation phases and finishes with an ‘excess’ phases. A bear market starts with a distribution phases, then a public participation phases and then a panic phase.

It is always the smart money buying (accumulating) assets after a big decline, ready for the next bull market or selling (distributing) assets after a big move up ready for the next bear market. Once the price reverses, the general public follow the momentum and after a big move, those buying in greed at the top or selling in fear at the bottom are left ‘holding the bag’.

Indices must confirm each other

Charles Dow created the Dow Jones Industrial Average and the Dow Jones Transportation Average and would use these two indices to confirm each other. These days investors will apply the same concept to different national stock indices like the Dow Jones (DJIA), the S&P 500 and the Nasdaq 100.

Dow Theory Chart 3

indices confirmation dow theory

 

For example, if one index moves up to a new 52-week high, but the other index remains below that high, then the bullish breakout in the first index is deemed not as strong and susceptible to reverse. Once the second index makes a new 52-week high, then the price action is seemed to have wider breadth and more likely to continue upwards. Vice versa for a move to new 52-week lows.

Volume must confirm the trend

This is still the main way that volume data is used today. As a reminder, volume is how many trades took place or the value of the trades that took place over a certain period of time. Volume on a price chart will normally be plotted as a bar chart beneath the price plotted as a line or Japanese candlesticks.

Dow Theory Chart 4

volume to confirm price dow theory

 

The most volume comes from the smart money that controls billions of dollars so the idea is that if the volume is rising with the price trend, then it means that the smart money is buying into the trend. However if the price is rising but the big volume happens in the declines, then it shows the smart money are selling into the uptrend in expectation that it will reverse.

Trends persist until there is a clear reversal

This if you like is the original ‘the trend is your friend until it ends’. The thing the Charles Dow taught us to keep in mind is that the trend will always last longer than you think. So you need to be very clear that the trend has turned before you start trading against it.

Dow Theory Chart 5

uptrend vs downtrend dow theory

This brings about the need to explain ‘How to identify a trend’ and ‘how to identify a trend reversal’. Dow does this via the idea of peaks & troughs. The idea is very simple but can be hard to implement without extensive practise trading.

Dow observed, as have we all, that market prices do not go up or down in a straight line – the trend is curvy. The top and the bottom of these curves are called peaks and troughs. A peak can also be termed a high and a trough can also be called a low. The thing to do is compare how each high compares to the previous high and how each low compares to the previous low. Is it higher or lower in price?

Dow Theory for Day Traders

So how do we put all this information about Dow Theory into a checklist for day traders?

  1. The market discounts everything

Day trading lesson 1: Let economists forecast the economy and investment analysts forecast company earnings; neither of them are of concern for day traders

  1. There are 3 kinds of market trends

Day trading lesson 2: Look at three timeframes of charts (multi-timeframe analysis)- the chart you are trading, a longer timeframe chart and a shorter timeframe chart. This will help you know which phase of the market the current trend falls within.

  1. Primary trends are split into 3 phases

Day trading lesson 3: Keep the bigger picture (which part of the major trend) in mind so that you’re day trading is in line with what the smart money are doing. Tried-and-true trend trading methodologies can be used by any day trader.

  1. Indices must confirm each other

Day trading lesson 4: Look for equivalent assets to confirm each other. If you’re trading forex looks for the dollar to make a move versus two or major currencies. If you’re trading indices, look at one or more stock index that measures the same stocks. If day trading stocks, look for similar companies to perform in the same manner – for example General Motors to confirm a price move in Ford Motor Company.

  1. Volume should confirm the price

Day trading lesson 5: Volume data in forex markets is almost impossible to find accept for dealer banks. Stock traders and futures traders can use volume to good effects to confirm price moves with convergence or divergence.

  1. Trends persist until there is a clear reversal

Day trading lesson 6: Wait for reversal price patterns like double tops and head and shoulders patterns to occur before you trade in a new direction. Otherwise assume every counter-trend move is a correction and an opportunity to enter the market at a discount.

 

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