An Introduction to Dow Theory

Every trader is dependent upon Technical Analysis (TA) in one form or another. TA forms the backbone of many trading strategies and is used the world over as a market analysis tool.

Have you ever wondered what forms the basis of a TA?

A concept credited to Charles Dow and refined by William Hamilton, Robert Rhea, and George Schaefer, named aptly enough "Dow Theory" is one of the building blocks upon which Technical Analysis is built.

This article will provide the basic concept of Dow Theory in an effort to show traders and market analysts the root of modern-day, computer-driven TA.

At the very core, Dow Theory is a tool to determine the basic trend of the stock market. By trend, I am referring to the general movement, as shown on price charts, as either up or down. An uptrend is a series of higher highs and smart/big money begins to believe that the bull market is over, although the public still believes the uptrend will never end. They begin to sell stock to the public who readily buys all that can be thrown at them, oblivious to the obvious fact that the market is topping.

The market will start to go down, but most analysts and traders will refuse to believe the bull trend is over. This strong belief in the longevity of the bull trend will cause new money, sometimes a lot of it, to come into the market during these times. This new influx will result in sharp, severe rallies that will bring in even more capital into the market as it seems that the bull trend has resumed. This move will not take out the previous highs and is merely a reactionary rally. Then phase 2 begins.

2. The Big Move - The selling begins in earnest after the reactionary rally fails. The public starts to sell stocks, pushing the market down even faster. Bad news begins to sweep the news wires, what was once a rosy picture is filled with negativity and despair, leading us to the next and final phase of the bear trend.

3. Despair — This is when the public gives up on the stock market. There is no longer market chatter on the streets and hot tips are strangely absent from your E-mail inbox, around the office water cooler, and cocktail lounge. Once people start to believe that the market will stay down forever, a new uptrend will begin and the whole cycle starts again.

The next primary concept in Dow Theory is that the two Averages must confirm the trend together. Charles Dow used the Railroad Index to confirm the trend in the DJIA. Today, Dow theorists use the Transportation Index to confirm the trend in the DJIA.

The idea behind this confirmation is that the United States is connected via the transportation sector, or rail sector in Mr. Dow's day. Therefore, the transportation index should reflect booming or busting economic times.

If one of these Averages makes a new high or low, the other one needs to confirm soon after, for a Dow Theory buy/sell signal to be valid.

Volume is the final aspect of Dow theory. William Hamilton believed that volume is important, but price has the final say in trend determination. His idea was that volume should increase in the direction of the primary trends and decrease on corrections. Dow theory teaches that volume is a way to judge the strength of a trend, not the direction. However, extremely high volume readings can signal a reversal. Technical Analysts refer to these occurrences as "blow off tops".

The big question whenever traders and Technical Analyst's meet is whether or not Dow Theory is still valid in today's market. There are compelling arguments on both sides.

One of the primary criticisms of Dow Theory is that it's too conservative in identifying trends. This means that the trend is often finish or almost finish by the time Dow Theory gives a signal.

Another criticism is that the markets have changed since Dow's time, relying much more on the knowledge economy and less on the industrial economy and with that the transportation confirmation factor is no longer relevant.

Regardless of your point of view, Dow Theory is one of the building blocks to modern day Technical Analysis and thus, should be studied by every market aficionado.

David Goodboy is Vice President of Marketing for a New York City based multi-strategy fund.