The importance of the Dow Theory in Trading

The Dow Theory is one of the most known and best approaches to the world of trading. It could be considered the mother of technical analysis.

This theory is based on the studies of Charles Dow, who wrote more than two hundred and fifty editorials on the Wall Street Journal. Those editorials were compiled later on, giving birth to the theory. The Dow Jones Index owes its name to that theory.

Dow Theory chart patterns

Dow Theory is a very important tool for anyone who loves studying the charts and price action. In my opinion, this theory has to key points: The trading style is a trend or swing trading strategy, and the fact that it concentrates on the price. So you avoid the mess of day trading and indicators.

The basic ideas of this theory are:

The stock market discounts all news.

The market has three major movements:

  • The primary trend, which may last from one to three years and is the main direction of the market.
  • The secondary trend, that may last between 3 weeks and three months. This would be the corrections of the primary trend.
  • The minor movement, which may last up to 3 weeks, which moves inside of the secondary trend and usually in the opposite direction.

It is an essential point because we can see that the most important fact is that we have to determine what the primary trend is. The minor movement is irrelevant, so this is not a theory for day traders, but more for those who do “week” or “month” trading.

Dow Theory movement

The moves have three phases. As for Dow every move has three phases and the last will be the “mania” one.

Stock indexes have to confirm each other. Dow used to use the Dow Jones industrial and the Dow transportation indexes. Both had to confirm the break of a major or primary trend. If one of them broke the trend, but the other did not, we would have a moment of “confusion”, and we should be neutral.

Trends have to be confirmed by volume. In every bull market there will be increasing volume when the market rises.

The trend will be valid till another trend takes place. By that we have to pay close attention to the moment the market ends its major move and starts the next and usually opposite one. In those cases, we have to get out or get in the markets.

Dow Theory Example

Here we have an example of this theory, although it is using a stock, not an index. In this case the stock is Bank of America.

Dow Theory Stocks

 

BOA had a previous primary bullish trend that ended in 2010. As we can see in 1, BOA made a top close to 20$ in April 2010. At that moment, we should be alert. If the price went below the previous bottom, 14$, we should get out, and even better be short.

 

The fact is that when the market went south 14$ it went down in a primary bearish trend of more than one year, in a 75% bear market.

In October 2011, BOA made a double bottom in which the second one was lower than the first. However, to have a better entrance point we should have waited till the next bottom, about summer of 2012. By that time, this bottom was significant higher than the bottoms of October 2011. Then we had a good double bottom signal to get long shortly afterwards, for instance, when the price went above 8$.

The primary trend that started in 2011 and 2012 still lasts today (3). Nowadays we have a congestion with a top of 18$ and a bottom of 14$ (the same bottom as 2010). If the market goes below 14$ then the chance for a new bearish primary trend is very high, and if the market goes higher than 18$, the bull market will still have some way to go.

In this case I have used the weekly chart, which is my favorite to analyze this kind of operations. There is no need of indicators, no 15 minutes charts, neither day trading. The only thing we need is to develop our trading strategy, which should be not complex.

Dow Theory trading systems

Even though Dow “designed” this theory thinking of indexes, we can use it with any financial instrument. Because once we understand the fundamentals of technical analysis and price action, we may easily identify the major trends and trade them accordingly.

Thanks for reading and sharing.