2 Dow Theory Trading Strategies: (Setup, rules, backtest, example, and performance) – What Is It?
Last Updated on May 19, 2023
The Dow Theory is widely considered one of the earliest forms of technical analysis in the western world and has always been a very integral part of technical analysis since then. But what is the theory about?
The Dow Theory strategy is a technical analysis model that states the U.S. market is in an upward trend if one of its averages (say, the Dow Jones Industrial Average) advances above a previous important high and is accompanied or followed by a similar advance in the other average (Dow Jones Transportation Average) within a suitable period of time.
In this article, we make two backtests of Dow Theory strategies. Overall, the Dow Theory strategy seems to be mediocre.
Let’s take a look at the theory.
What is the Dow theory?
The Dow theory is a technical analysis model that says the U.S. market is in an upward trend if one of its averages climbs higher than a previous important high and is accompanied or followed by a similar advance in the other average.
For instance, when the Dow Jones Industrial Average (DJIA) advances above an intermediate high, it is expected that the Dow Jones Transportation Average (DJTA) would follow suit within a reasonable period.
The Dow Theory is a result of a series of articles published by Charles Dow in The Wall Street Journal between 1900 and 1902, where he documented his observations that stocks tended to move up or down in trends, and they tend to move together at a variable extent.
Meanwhile, Charles Dow created the Dow Jones Industrial Index and the Dow Jones Rail Index (now known as the Transportation Index) for the Wall Street Journal to provide an accurate reflection of the economic and financial conditions of companies in two major economic sectors — the industrial and the railway (transportation) sectors.
The Dow Theory strategy is based on the common belief that an asset price and its resulting movements on a trading chart already factored in all necessary information available that can affect it. It teaches investors to read a trading chart to understand what is happening with any asset at any given moment. The analysis of maximum and minimum market fluctuations is used to predict the direction of the market. With this simple analysis, even the most inexperienced can identify the context in which a stock or an index is evolving. According to Charles Dow, the importance of these upward and downward movements is their position in relation to previous fluctuations.
Who invented the Dow theory?
The Dow theory was developed by Charles H. Dow who noticed that stocks tended to move up or down in trends, and they tend to move together, although the extent of their movements could vary.
In 1896, Charles Dow and Edward Jones founded Dow Jones & Company, Inc. and developed the Dow Jones Industrial Average, which included 12 blue-chip stocks. They also created the “Rail Average” that comprised 20 railroad enterprises then — now called the Dow Jones Transportation Average.
Dow fleshed out the theory in a series of editorials in the Wall Street Journal between 1900 and 1902. Although Charles Dow never published his complete theory on the markets before his death in 1902, several followers and associates have published works that have expanded on the editorials.
For example, William Hamilton refined the theory in his 1922 publication, The Stock Market Barometer. But it was Robert Rhea who in his 1932 book, The Dow Theory, articulated all the points into a market theory. Many of the ideas and comments put forth by Dow and Hamilton became axioms of Wall Street.
Some other important contributions to Dow theory include the following:
- E. George Schaefer’s How I Helped More Than 10,000 Investors to Profit in Stocks (1960)
- Richard Russell’s The Dow Theory Today (1961)
While some aspects of the theory have lost ground, for example, its emphasis on the transportation sector (or railroads, in its original form), the Dow Theory approach still forms the core of modern technical analysis more than 100 years after Charles Dow’s death.
The basic principle of the Dow Theory
The Dow Theory comprises six assumptions:
- The market discounts everything: A stock’s price reflects everything that is known about the stock.
- The market is comprised of three trends: It’s a primary trend, a secondary trend, and a minor trend.
- Primary trends have three phases: For an uptrend, they are the accumulation, public participation, and excess phases. In a downtrend, they are the distribution, public participation, and panic phases.
- The averages must confirm each other: The Industrials and Transports must confirm each other for a change of trend to be valid. If that is not the case, traders should not assume that a new trend has begun.
- The volume confirms the trend: When the price is moving in the direction of the primary trend, the volume should increase, otherwise, the trend is weak.
- A trend remains intact until it gives a definite reversal signal: An uptrend is defined by a series of higher highs and higher lows. For a trend reversal, prices must have at least one lower high and one lower low.
What is the Dow theory buy signal?
This refers to how to use the theory to know when to buy or sell a stock or an ETF (exchange-traded fund). It is important to note that the Dow Theory has been improved over the years and different traders apply it differently. However, a typical Dow theory buy signal would follow the below sequence:
- After the low point of a downtrend in a bear market is established, a secondary uptrend bounce will occur.
- A pullback on one of the averages must exceed 3% and then ideally hold above the prior lows on both the Industrial and the Transportation averages.
- A breakout above the previous rally high would generate a buy signal for the developing bull market.
In addition to the buy signal, there is also a Dow Theory sell signal. As with the buy signal, a typical Dow theory sell signal would follow the below sequence:
- A bull market tops and sets back.
- A subsequent rally goes back up over 3% and falls short of reaching the previous high.
- A bear market sell signal is triggered when the rally penetrates the recent lows on the next fall, as measured by both the Industrial and Transportation averages.
However, very few backtests exist to back up the theory. In addition, the Dow Theory is very old and is based on the “old economy”. It might work in theory, but does it work in practice? Let’s go on to do some backtesting:
Dow Theory trading strategy
The Dow Theory is not easy to backtest and can be done in many different ways.
However, in this article, we test two simple hypotheses by using two ETFs: DIA (Dow Jones Industrial) and IYT (Dow Jones Transport).
Dow Theory trading strategy 1
In plain English we test the following strategy:
If Dow Jones Transport sets a new 20-day high of the close (and Dow Jones Industrial does not), what is the return of the Dow Jones Industrial over the next 2-20 days? We don’t use any stop loss or profit target. We can argue this is some kind of a breakout strategy.
To do this backtest we need to do strategy optimization: we measure the performance of holding the ETF 2-20 days by using intervals of 2 days in between.
Here is the backtest report:
The first column shows (in the rows) the strategy performance when exiting after N-days. Perhaps as expected, the best results are after 18 and 20 days. This is because of the tailwind in stocks (the longer you hold, the more you make – on average).
The profit factor, though, is a bit lower than what we’d like. Below is the equity curve of DIA when we exit after 20 days:
As you can see, this is not a strategy you’d like to use.
Let’s go on to our second backtest:
Dow Theory trading strategy 2
If Dow Jones Industrial sets a new 20-day high of the close (and Dow Jones Transport does not), what is the return of the Dow Jones Transport for the next 2-20 days?
The results are slightly better than for DIA in the first strategy and backtest, although the profit factor is more or less the same.
Let’s look at the equity curve of IYT when we hold for 20 days after a buy signal:
The strategy performed well for many years, but seems to have broken down lately.
Does the strategy work better if we use a breakout with a different number of days? We tried many versions but overall the results are much the same as the backtests above.
Trading Rules in plain English (+Amibroker code for backtesting)
The backtests done in this article is done in Amibroker. You can get access to the code plus the code for over 100 other ideas if you order this product:
Dow Theory strategy – ending remarks
Many trading theories are exactly that – theories. We like to employ strategies that at least have worked in the past and that can be put into 100% testable hypotheses. The Dow Theory is a bit vague, and the two trading strategies we backtested in this article didn’t perform well. Thus, we believe that the Dow Theory strategy is not a viable strategy.