Dow Theory is a fundamental concept in the technical analysis used to analyze and predict stock market trends. It is named after Charles H. Dow, who, along with Edward Jones and Charles Bergstresser, co-founded Dow Jones & Company and The Wall Street Journal. Dow Theory was developed based on the editorials written by Charles Dow in the late 1800s.
The principles of Dow Theory are as follows:
- The Dow Jones Industrial Average (DJIA): The Dow Jones Industrial Average (DJIA), one of the world’s oldest and most extensively followed stock market indices, is the primary subject of the theory. The DJIA is a basket of 30 big, publicly traded corporations in the United States that is used to gauge overall market performance.
- The Trend: Dow Theory suggests that the stock market moves in primary trends: uptrends (bull markets), downtrends (bear markets), and sideways trends (consolidation periods). These trends can last for extended periods and provide valuable information about the market’s direction.
- The Three Movements: Dow Theory identifies three movements within the primary trends:
- a) Primary Movements: These are the major long-term patterns that might endure for months or years.
- b) Secondary Movements: Also known as reactions or corrections, these are short-term movements that go against the primary trend but do not reverse it entirely.
- c) Minor Movements: These are short-term market movements that are frequently caused by daily news and events.
- Confirmation: Dow Theory emphasizes the importance of confirming signals between the Dow Jones Industrial Average and the Dow Jones Transportation Average (DJTA). The strength of the trend is ensured if both averages move in the same direction. If they move in opposite directions, it may signal a potential reversal or market indecision.
- Volume: Dow Theory considers trading volume as an essential component of confirming trends. Increasing volume during an uptrend or downtrend can signify market conviction, while decreasing volume may indicate a weakening trend.
Dow Theory remains a foundational principle in technical analysis and is used by traders and analysts to interpret market movements, identify potential entry and exit points, and make informed trading decisions. Dow’s Theory, like every analytical technique, has limitations and should be used in conjunction with other types of analysis and risk management methods.
How to use Dow theory in trading?
Using Dow Theory in trading involves analysing the Dow Jones Industrial Average (DJIA) and applying its principles to make trading decisions.
Here are some steps on how to use Dow Theory in trading:
- 1. Identify the Primary Trend: The first stage is to identify the market’s primary trend. Search for an order of higher highs and higher lows in an uptrend (bull market); in a downtrend (bear market), seek a series of lower highs and lower lows. It’s essential to focus on longer-term charts to identify the primary trend accurately.
- 2. Confirm the Trend with DJTA: Use the Dow Jones Transportation Average (DJTA) to confirm the trend seen in the DJIA. The strength of this trend validates when both of the trends move in the same direction. For example, if the DJIA is in an uptrend and the DJTA is also rising, it validates the bullish trend.
- 3. Spot Reversals with Secondary Movements: Look for secondary movements or corrections that go against the primary trend. These temporary reversals can provide opportunities for traders to enter or exit positions. For example, during an uptrend, a pullback or correction can be seen as a buying opportunity.
- 4. Analyse Volume: Pay attention to trading volume when assessing the strength of a trend. Increasing volume during an uptrend or downtrend can indicate a market conviction. On the other hand, decreasing volume during a trend may suggest a potential trend weakening.
- 5. Use Multiple Timeframes: Dow Theory can be applied to different timeframes, from daily to weekly and monthly charts. Analyzing trends and confirming signals across multiple timeframes can provide a more comprehensive view of the market.
- 6. Combine with Other Analysis: Dow Theory should not be used in isolation. To acquire a more thorough knowledge of market circumstances, it is best to combine it with other technical indicators, chart patterns, and fundamental analysis.
7. Set Stop Loss and Take Profit Levels: When using Dow Theory to make trading decisions, managing risk effectively is essential. Set stop-loss orders to protect your positions in case the market moves against your trade, and set take-profit levels to secure profits when the market moves in your Favor.
Remember that no trading method is perfect and that there are inherent threats in the financial markets. It’s essential to practice sound risk management, trade with discipline, and continuously educate yourself to improve your trading skills. Additionally, seeking guidance from experienced traders or financial advisors can be beneficial, especially for those new to using Dow Theory in their trading approach.