What Is Dow Theory?

  • April 19, 2019

The Dow theory is another form of technical analysis. It deals in price movement coupled with some parts of sector rotation. The theory was compiled from the articles written by its namesake.

What Is Dow Theory?

  • What is the Dow theory? It's a theory which says the market is in an upward trend if one of its averages (industrial or transportation) advances above a previous important high and is accompanied or followed by a similar advance in the other average. In other words, if one average moves up in price then the other one will follow within a reasonable time frame. 

The stock market is a tug of war between buyers and sellers. That's one of the stock trading basics.

Charles H. Dow founded the Wall Street Journal, which he wrote for, and the Dow Jones and company. He had two other partners, Edward Jones and Charles Bergstresser.

Charles Dow never adopted the Dow theory while he was alive. Instead, after his death, his articles were organized and presented as the Dow theory.

As a result, the market trades in cycles. There will be pull backs and corrections. Those keep everything from becoming overvalued. Think about it; without corrections, the average trader wouldn't be to afford trading. Every stock would be too expensive.

So while bear markets or corrections can be painful to the investor, they're necessary. They also don't last as long as bull markets do. That's where you can implement the Dow theory.

If you want to know whether or not the market is in an uptrend, take a look at the industrial or transportation Dow averages. If one of those has a previous high that's broken to make a new one, look at the other average. There should be a similar advance as well.

As a result, the uptrend is confirmed. There are 6 components that make up the Dow theory. We'll take a look at those below.

dow theory

1. Discounts

The market discounts everything. As a result, the Dow theory uses something known as the efficient markets hypothesis. That means that stock prices incorporate all available information.

Even if the average trader doesn't know everything there is to know about a stock, a bunch of factors are accounted for and priced into the market. Things like earnings potential, competitive advantages as well as the competence of management.

In other words, fundamental analysis plays an important role into the price action of the market. Fundamental analysis is also something not every trader pays attention to.

There are fundamental traders and technical traders. One isn't better than the other and one way isn't right or wrong.

Our trading service offers both fundamental and technical trading. However, you do notice how potential earnings and management coupled with how competitive they are, moves stock prices. Hence where the Dow theory can help.

2. Market Trends

There are 3 kinds of market trends. The Dow theory is all about trend confirmation. There are the strong trends like the bull market and bear market. They're major because they can last a year or more. We can have a bull market or bear market last a long time.

In the big trends there are secondary ones as well. The secondary trends typically go opposite of the big trend in place. They can be pullbacks in a bull market or rally's in a bear market (find out how to use a stock loss vs stop limit order).

They can last a week up to a couple of months. As a result, make sure you're trading safely and watching the patterns. If you're going to invest long term, you don't want to buy stocks based off a short term trend.

Then there are the minor trends. These are just noise and don't last more than a couple weeks. These minor moves can be a reaction to a larger move that happens.

In other words, there are the large trends. Within those large trends are secondary trends that go against the primary trend. Then within those secondary trends are minor trends.

The Dow theory helps to confirm all types of trends. Take our online trading courses for the ability to make money in any style of trend.

dow theory

3. Phases and Confirmations of the Dow Theory

According to the Dow theory, there are three phases within a primary trend. They're not the same as the different trends within the primary trend. There's the accumulation phase, the public participation phase and the distribution phase.

The accumulation phase occurs when investors are actively buying or selling against the general outlook. As a result, price doesn't change much because these investors are in the minority.

What Is the Dow Theory Sell Signal?

  • What is the dow theory sell signal? As market sentiment catches up to them, phase 2 starts. Price changes quickly because technical analysis is changing along with the trend. Phase 3 starts when speculation beings and investors distribute their holdings to the market. Because the Dow theory is about trends, a trend must be confirmed. As a result, for a trend to be established, market indicators have to confirm each other. Hence the reason for the Dow Jones Industrial Average and the Dow Jones Transportation Average.

If one average is trending up but the other one doesn't follow, the trend is weak. In order for a trend to be strong, both averages must complement each other in the moves they make.

Volume is another conformation. Volume has to increase with the direction of the trend. If price is moving but volume is decreasing, then the trend is weak.

1. Reversal: Dow Theory 

The Dow theory is all about trends. Since there are three different types of trends in the Dow theory, strong reversal signals are needed to confirm the reversing of the trend.

As a result, look at at technical indicators, candlesticks and patterns to help get confirmation of a changing trend. In fact, our trade room look at every component that makes up a trend.

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