Many traders, especially beginners, try to apply technical analysis without a fully grasp of the field.

Before applying the Dow Theory in practice, Charles Dow made some assumptions that are the main tenets of his way of analyzing financial markets.

Those principles are essential in order to apply the theory successfully.

Before starting the discussion about the principles of the theory, we should note that Charles H. Dow never intended, through his editorials in Wall Street Journal, to become the Grandfather of technical analysis.

What we know about Dow’s theories of price movements we learn mainly from the writings of his contemporaries (William peter Hamilton, and Robert Rhea), and others who have taken up the work where they left off.

Why study the Dow Theory:

There are three primary reasons:

– It is one of the oldest theories of technical analysis.

– It is the most widely known and publicized theory of price action.

– The theory has proven that it involves principles, which are fundamental in price movement, and no trader can afford to be ignorant of them.

Charles H. Dow:

He was Born in New England in 1850, and served as a reporter on the Springfield republican in his early years. Later he became a member of the New York Stock Exchange. In 1882, he established the Dow jones financial news service and in 1889, he founded the wall street journal.

 He was fully respected, and gained confidence of his readers in his efforts to fairly report and interpret without bias the financial news of the day.

He created the Dow jones industrial and rail averages in 1884, and started writing about his theory in 1901-1902.

However, Dow didn’t put his theories into a book , and died leaving only a few editorials.

Principles of the Dow Theory.

Here is a summary of the main principles, and what you need to know about them:

1 – Manipulation:

Short term movements, from few minutes to few days, could be subject of manipulation by speculators and large institutions.

So, it is possible in daily movement and to a limited degree in secondary reaction. But the Primary trend can never be manipulated.

2 – Averages discount everything

Known also as “efficient market theory”. The market reflects all available information.

Everything there is to know is already reflected in the markets through the price.

You may notice sometimes that markets react negatively to good news. The reasoning behind that is that by the time the news hits the street, it is already reflected in the price, or what we call “priced in”.

This explains the old wall Street axiom “buy the rumor, sell the news”. As the rumor begins to filter down, buyers step in and bid the price up. By the time the news hits, the price has been bid up to fully reflect he news.

In stocks, the run up to earnings is a classic example.

3 – Successive highs and lows indicate the trend:

Rising tops and bottoms are bullish, declining tops and bottoms are bearish

4 – The three Market Movements

TIDE – WAVE – RIPPLES

There is a big wave (tide), known as the primary movement, that is made up of secondary waves of lesser amplitude and duration.

Similarly, the secondary wave is made up of minor waves of still smaller proportions.

Since it is by literally riding the wave that profits are made, the first task of a trader is to determine:

  1. the direction of the Tide.
  2. The stage of development of the wave.
  3. The direction of the minor ripple.

5 – Movements of the wave (major bull-bear market)

  1. Primary movement (Major bull /bear Market)
  2. Secondary movement(correction)
  3. Daily fluctuations (the ripples)

In 1900, Charles Dow wrote in a wall street journal editorial, “The market is always to be considered as having three movements, all going on at the same time. The first is the narrow movement from day to day. The second is the short swing, running from two weeks to a month or more; the third is the main movement, covering at least four years in its duration.” (stock market barometer, p30)

6 – Stages of Primary Movement

The primary movement is a long sustained directional move.

Primary Bull Market:

Accumulation

It is largely indistinguishable from last stage of the Bear Market. Price is undervalued (oversold) and starts to find a Bottom.

  • Big Move
  • Excess

Price is overvalued

Primary Bear Market:

Distribution

Market is overvalued, and smart money start taking profit

  • Big Move

The sell off starts, it is the longest Move.

  • Despair

The decline continues until all the bad news are fully priced in.

Trading ranges:

Charles Dow, in his writings, called the sideways movement in trading ranges “a line”.

 A line is formed when price hold within a narrow range for a certain period, indicating either accumulation or distribution. Breaking of the line on the up or down side signals the coming trend.

7 – Volume must confirm the trend

  Movements in volume should confirm price movement, otherwise we got false breakouts and fake signals.

In the Forex market, where there is no centralized markets, you can rely on currency futures volume as a proxy for forex volume.

8 – A trend is assumed to be continuous until Definite signals of its Reversal.

9 – The theory is not infallible.

Because of randomness in market movements, Charles Dow does not guarantee that his theory assumptions work 100% successfully every time.

As Robert Rhea stated: “the Dow Theory is not an infallible system for beating the market. Its successful use as an aid in speculation requires serious study, and the summing up of evidence must be impartial. The wish must never be allowed to father the thought.”

Conclusion:

When analyzing the market, make sure you are objective and see what is there, not what you want to see.

The goal of Dow Theory is to utilize what we do know, not to haphazardly guess about what we don’t know.

Through a set of guidelines, Dow theory enables traders to identify the primary trend and ride its way.