Dow Theory Explained

The stock market seems to move in a highly chaotic way, but on closer observation, you will notice that the movements follow a certain repeating pattern over the long term, as suggested by the Dow Theory. What do you know about the Dow Theory?

The Dow Theory is a financial market theory that tries to use the situation of current price action relative to the previous market movements to predict future price movement. Although it focuses on the collective market (benchmark index), the theory provides the basis for understanding market trends and price swings. It is widely considered the origin of technical analysis in the Western world.

In this post, we will take a look at most of the questions you may have about the Dow Theory: what it is, how it works, and how you can use it to improve your trading strategies. Keep reading!

Key takeaways

• The Dow Theory is a financial market theory that aims to predict future price movements by analyzing current price action relative to previous market movements.
• It is widely regarded as the origin of technical analysis in the Western world.
• It was developed by Charles H. Dow, who co-founded The Wall Street Journal and Dow Jones and Company. He used the Dow Jones Industrial Average (created in 1896) and the Rail Average (now Transportation Average) to study market trends.
• Dow’s theory was an accumulation of editorials published in The Wall Street Journal between 1896 and 1902. His work was further developed by associates like William P. Hamilton and Robert Rhea after his death.
• Core Concepts – Market Trends:
• The theory posits that the market moves in trends, which can be analyzed to anticipate future movements.
• It classifies market trends into three types:
• Primary trend:
• The long-term direction of the market, lasting several years.
• Secondary trend: Impulse and pullback waves within the primary trend, lasting several weeks to several months.
• Minor trend: Short-term fluctuations within the secondary trend, lasting only a few days.
• Phases of the Primary Trend:
• A primary trend typically goes through three self-repeating phases based on “smart money” activities:
• Bullish Market:
• Accumulation phase: Smart money quietly accumulates long positions.
• Public participation phase: The significant price move occurs.
• Climax phase (or mania): Retail traders rush in due to FOMO (Fear Of Missing Out).
• Bearish Market:
• Distribution phase: Smart money offloads buy positions and takes sell positions.
• Public participation phase: Prices fall significantly.
• Panic (or capitulation) phase: Most previous buyers dump their positions out of fear.
• Main Principles of Dow Theory:
• The market discounts everything: All available information affecting the market is reflected in stock prices.
• The market consists of three trends: Primary, secondary, and minor.
• The primary trend has three phases: As described above.
• Volume must confirm the primary trends: Rising prices with high volume confirm bullishness, while falling prices on high volume suggest bearishness.
• Trends in major indices must confirm each other: For a trend to be valid, other major indices (e.g., Dow Jones Industrial Average and Transportation Average) must confirm it by making higher highs and lows (for a bull market) or lower lows and highs (for a bear market).
• The primary trend persists until proven to have reversed: A trend remains in effect until the market structure changes, for example, an uptrend making lower lows and highs.
• Market Analysis and Prediction:
• Dow Theory analyzes trends by observing higher highs and higher lows for bullish markets, and lower lows and lower highs for bearish markets.
• Market reversals are recognized only after the market structure has shifted in the direction of the reversal (e.g., higher highs for an uptrend reversal).
• It helps identify the market phase and the phase to anticipate next, guiding traders to look for opportunities in the direction of the trend.
• Limitations and Application:
• Limitations: The theory does not provide direct entry and exit signals and cannot be used as a standalone trading strategy. It can be subjective to interpret and places too much emphasis on market indices.
• Application in Modern Trading: It is primarily a tool for market analysis to decipher trend direction and identify market phases.
• It can be used for short-term trading by applying its principles to lower timeframes (e.g., identifying a primary trend on a daily timeframe and looking for shifts on an hourly timeframe).
• Tools like candlestick patterns and support/resistance levels can complement Dow Theory to create specific entry and exit strategies.
• Related reading: A list of technical trading indicators.

What is Dow Theory?

The Dow Theory is a financial market theory that tries to use the situation of current price action relative to the previous market movements to predict future price movement. Developed by Charles Dow in the late 19^th century, the Dow Theory is widely considered the origin of technical analysis in the Western world.

Although it focuses on the collective market (benchmark index), the theory provides the basis for understanding how the market behaves — the overall trends and internal price swings. It introduced the idea that the market moves in trends, which, when analyzed, can be used to anticipate future market movements.

The theory classifies market trends into primary, secondary, and minor fluctuations. The primary trend is the long-term direction of the market, which can last for several years. Within this long-term trend are secondary trends, which are the impulse and pullback waves that last for several weeks to several months. Then, there are minor trends that consist of short-term fluctuations within the secondary trend, and these last only for a few days. While Dow worked on the higher timeframes, these classifications can also be done to the trends on lower timeframes.

For the primary trend, the market usually goes through three self-repeating phases based on smart money activities. In a bullish market, the market goes through the accumulation phase where smart money accumulates their long positions, the public participation phase where the big move happens, and the climax phase or mania where the retail traders rush in due to FOMO. In a bear market, there is the distribution phase where the smart money offloads their buy positions and takes sell positions, the public participation phase, and the panic or capitulation phase.

Who developed Dow Theory?

The Dow Theory was developed by Charles H. Dow, who co-founded The Wall Street Journal and Dow Jones and Company. Together with Edward Jones and Charles Bergstresser, he created the Dow Jones Industrial Average in 1896 and the Rail Average (now Transportation Average), which he used to study market trends. The theory is an accumulation of a series of editorials he published in the Wall Street Journal between 1896 and 1902 when he died.

Dow did not complete his theory before he died, but many of his associates and students followed up on his work to produce what is known today as the Dow Theory. Two important contributors include:

• William P. Hamilton, who succeeded Charles Dow as the Editor of The Wall Street Journal, — aggregated Dow’s writings into a theory in his book titled, “The Stock Market Barometer: A Study of Its Forecast Value of 1922“
• Robert Rhea, who, in his book, “The Dow Theory of 1932“, developed the work further to create the Dow Theory we know today.

What are the main principles of Dow Theory?

The main principles of Dow Theory are as follows:

1. The market discounts everything: The theory posits that the stock market reflects all the available information that can affect the market. This is in line with the Efficient Market Hypothesis (EMH). The performance is a reliable measure of overall business conditions within the economy, so analyzing past market movements is enough to know the future direction of the market.
2. The market consists of three trends: They are the primary, secondary, and minor trends. The primary trend is the long-term direction of the market and can last for several years. Within this primary trend are secondary trends, which are the impulse and pullback waves that last for several weeks to several months. Then, there are minor trends that consist of short-term fluctuations within the secondary trend.
3. The primary trend has three phases: The market usually goes through three self-repeating phases. In a bullish market, they are the accumulation phase (where smart money accumulates their long positions), the public participation phase where the big move happens, and the climax phase or mania when the retail traders rush in due to FOMO. In a bear market, there is the distribution phase (where the smart money offloads their buy positions and takes sell positions), the public participation phase, and the panic or capitulation phase.
4. The volume must confirm the primary trends: The Dow Theory highlights the need to use volume to confirm price movements. Prices rising with high volume indicate a bullish market, while prices falling on high volume suggests a bearish market.
5. Trends in major indices must confirm each other: For a trend in one major stock index to be considered valid, other major indices must confirm the trend. To Dow, a bull market occurs if both the Dow Jones Average and Transport indices are bullish — that is, making higher highs and lows. The opposite is true for a bear market.
6. The primary trend persists until proven to have reversed: The primary trend remains in effect until the market structure changes. For instance, an uptrend persists until the primary trend starts making lower lows and highs that characterize a downtrend rather than the higher highs and lows that characterize an uptrend.

How does Dow Theory analyze market trends?

The Dow Theory analyzes market trends by showing whether the market is making higher highs or lower lows. If the market is making higher highs, the market trend is bullish. On the other hand, if the price is making lower lows, the market trend is bearish.

The same principle applies to all three types of trends. For example, the market can have a primary uptrend and a secondary downtrend if the primary trend is making new highs while the secondary trend is making new internal lows during a pullback.

What are the primary trends in Dow Theory?

The primary trend is the long-term direction of the market. This trend can last for several years and consists of secondary trends, which are the impulse and pullback waves of the trend. The primary trend usually goes through three self-repeating phases based on smart money activities.

In a bullish market, we have the accumulation phase where smart money accumulates their long positions, which is followed by the public participation phase where the big move happens, and finally, there is the climax phase or mania when the retail traders rush in due to FOMO.

In a bear market, there is the distribution phase where the smart money offloads their buy positions and takes sell positions, the public participation phase, and the panic or capitulation phase — where most previous buyers dump their position out of fear.

How does Dow Theory define bullish markets?

The Dow Theory defines bullish markets as markets where prices are making higher highs and higher lows. That is, the market is bullish if the primary trend is making higher highs and the secondary trends (pullbacks) are making higher lows.

In such markets, there can be an accumulation phase where the smart money quietly builds their long positions, a markup phase where prices advance significantly on huge volumes, and a manic or climax phase where there further advances but on low volume.

How does Dow Theory define bearish markets?

The Dow Theory defines bearish markets as markets where prices are making lower lows and lower highs. In other words, the market is bearish if the primary trend is making lower lows and the secondary trends (pullbacks) are making lower highs.

In such markets, there can be a distribution phase where the smart money quietly disposes of their long positions or takes short positions, a markdown phase where prices fall significantly on huge volumes, and a panic or capitulation phase where there further declines but on low volume.

What role does volume play in Dow Theory?

The role volume plays in Dow Theory is that of a confirmation signal. The volume data can be used to confirm whether a trend is healthy or not. In an uptrend, the price should be rising on huge volumes — if that is not happening, the uptrend is unhealthy, probably in the manic phase where retail traders are the only ones pushing the market higher.

Likewise, in a downtrend, the price should be falling on huge volumes — if that is not happening, the downtrend is unhealthy or nearing its end.

How can Dow Theory predict market movements?

The Dow Theory predicts market movements using past and present price actions to forecast how the market could move in the future. It compares the present price movement to past price movements to establish whether the market is trending and in which direction. If the market is making higher highs and higher lows, it is trending upwards and will likely continue rising.

On the other hand, if it is making lower lows and lower highs, the trend is to the downside and that is likely to continue. When the highs stay around the same level and the lows stay around the same level, the market is range-bound or moving sideways.

What are the limitations of Dow Theory?

The limitations of the Dow Theory include:

• The Dow Theory does provide entry and exit signals
• It cannot be used as a trading strategy on its own
• Its use of volume makes it ineffective in certain markets where volume data is not available
• The three-trend approach doesn’t always apply in the market

How is the Dow Theory applied in modern trading?

How you apply the Dow Theory in modern trading will depend on your approach to trading — whether you are a price action trader or an indicator user. The theory is more suitable for price action trading where it can help in market analysis to decipher the direction of the trend and identify the market phase.

A price action trader can use the Dow Theory to interpret the market structure to decide the direction to trade and then use their specific entry method to know when to enter the market.

What are Dow Theory’s signals for buying?

There are no Dow Theory’s signals for buying as the theory is not designed to be a trading strategy but rather as a way to analyze the market conditions. However, some traders apply its principles in their technical analysis, especially the use of higher highs to identify an uptrend.

They may further use the same principle on lower timeframes to identify when a pullback trend on a higher timeframe is shifting to start a new bullish impulse wave by creating a higher high on the lower timeframe. This bullish market structure shift on the lower timeframe can be a buy signal for them.

What are Dow Theory’s signals for selling?

There are no Dow Theory’s signals for selling since the theory is not designed to be a trading strategy but rather as a way to analyze the market conditions. However, some traders apply its principles in their technical analysis — using lower lows to identify downtrends.

Some use the same principle on lower timeframes to identify when a pullback trend on a higher timeframe is shifting to start a new bearish impulse wave by creating a lower low on the lower timeframe. That is a lower low on a lower timeframe after a pullback in a downtrend can be considered a sell signal.

How does Dow Theory compare to other technical indicators?

Compared to other technical indicators, the Dow Theory is not a technical indicator. Instead, it is a way of analyzing past and present price action to decipher the condition of the market. Unlike indicators which use mathematical formulas to plot lines that show what the market might be doing, the Dow Theory uses price movements to ascertain the trend and market phases.

Can Dow Theory be used for short-term trading?

Yes, the Dow Theory can be used for short-term trading if the principles are applied on lower timeframes. For instance, you may look for your primary trend on the daily timeframe and step down to the 1-hour timeframe after a pullback to look for a market structure shift in the direction of the primary trend.

If the primary trend on the daily timeframe is an uptrend, look for a higher swing high on the hourly timeframe after a pullback to a support level.

What are the criticisms of Dow Theory?

The criticisms of Dow Theory are many. These are some of them:

• Interpreting the theory can be very subjective
• The theory does not consider fundamental analysis
• It places too much emphasis on market indices
• It does not have a clear entry and exit strategy

How does Dow Theory incorporate market averages?

The Dow Theory incorporates market averages by using them to analyze the direction of the entire market. It works on the assumption that the direction of the market averages determines the direction of individual stocks. So, when a market average is making higher highs, the market is assumed to be in an uptrend, especially if another market average is doing the same and volume data supports that.

What is the significance of confirmation in Dow Theory?

The significance of confirmation in the Dow Theory is that it validates the direction of the market trend. There are two confirmations in the theory — a related major market index and the volume data. For a trend to be valid, another major market index should also be trending in that direction and the trend should be on huge volumes.

How does Dow Theory address market reversals?

The Dow Theory addresses market reversals by recognizing a reversal only after the market structure has shifted in the direction of the reversal. For instance, a reversal from a downtrend to an uptrend is recognized only after the price starts making higher highs.

Likewise, a downward reversal is recognized after the market starts making lower lows.

What tools complement Dow Theory in trading?

The tools that complement Dow Theory in trading are candlestick patterns and support/resistance levels. Such tools can be used to create entry and exit strategies with the Dow Theory.

For instance, if the Dow Theory identifies an uptrend, a bullish reversal candlestick pattern after a pullback to a support level can be an entry signal while the nearest resistance level can be the exit target.

How to implement Dow Theory in a trading strategy?

To implement the Dow Theory in a trading strategy, you need to understand what the theory tells you about the market condition so you trade accordingly. When the price is making higher highs, the trend is to the upside, so you look for only buy setups. On the other hand, when the price is making lower lows, the trend is to the downside, so you look for only sell setups.

What are common mistakes when using Dow Theory?

The common mistakes when using Dow Theory are as follows:

• Using the theory to find entry setups without creating an entry strategy
• Not combining the theory with other analysis tools to create a robust trading strategy
• Trading without a proper risk management plan

How does Dow Theory handle market volatility?

How the Dow Theory handles market volatility will depend on whether the market is trending or not. If the market is trending, higher market volatility will make the trend clearer. In a sideways market, higher volatility might lead to poor interpretation from false breakouts of an established price range.

What resources are available to learn Dow Theory?

There are many resources available for learning Dow Theory. These are some of them:

• The ABC of Stock Speculation by Samuel A. Nelson (1903)
• The Stock Market Barometer by William P. Hamilton (1922)
• The Dow Theory by Robert Rhea (1932)
• How I Helped More Than 10,000 Investors to Profit in Stocks by E. George Schaefer (1960)
• The Dow Theory Today by Richard Russell (1961)

Why choose Dow Theory for your trading strategy?

You choose Dow Theory for your trading strategy because it helps identify the direction of the market trend so you can look for trading opportunities in that direction. It also helps you to know the market phase and the phase to anticipate next.