Dow Theory

Dow never actually wrote his observations down in one manuscript, so the principles of Dow theory gathered together here have come from several different locations, not from one comprehensive source. You will find different interpretations of what Dow theory is. Here, though, are the six key principles in what I believe to be the most convenient grouping of Dow's thoughts.

1. The market indexes cover the whole market and discount all market information.
2. Markets have three time horizons for trends: primary, secondary, and tertiary.
3. Each trend goes through three phases.
4. For a trend to be in effect, it must be confirmed by volume.
5. For an overall market trend to be confirmed, the market indexes must agree with each other.
6. A trend is in effect until a clear signal is given that it has reversed.

The first point to note when looking at Dow's theory and applying it to today's markets is that he was working in a world where the industrial average (referred to as the Dow these days) and the transportation average covered all listed securities. There was no NASDAQ. The aspects of Dow theory that refer to market indexes are only relevant when assessing the overall direction of the market, which we do as day traders to give us a bias on the direction in which we prefer to trade. In other words, those aspects of Dow theory are presented mainly for the sake of thoroughness. Let's examine each principle in turn and see how it relates to trading today.

1. The market indexes cover the whole market and discount all market information. Dow's industrial and transportation indexes covered the whole market at the time, and he believed that their prices reflected the sum total of knowledge and opinion at any give time of how those indexes should be priced. All factors related to the supply and demand of securities are assumed to be represented by the movement of the indexes. Dow also asserted that any significant information gets quickly assimilated into the price, things like wars, unexpected interest rate changes, and the like. Dow was therefore able to reduce his market study to keeping up with the two averages and drawing his conclusions about market direction on the basis of their movement.
2. Markets have three time horizons for trends: primary, secondary, and tertiary. This is a general rule that can still be seen today. At the time of Dow's study, he determined that the primary trends that represented the overall direction of the market lasted between one and two years. A secondary trend occurred as a temporary interruption of the primary trend and acted as a temporary correction. (When we examine them later in this chapter, secondary trends will be seen as continuation patterns.) At that time, Dow considered that such corrections took between three weeks and three months to complete, and he viewed them as temporary as long as they corrected no more than 66 percent of the primary trend.
   
   Tertiary trends were identified as fluctuations within secondary trends and could last for up to three weeks. They could be in the direction of either the primary or secondary trends. These classifications are useful in terms of placing short-term movements within the context of an overall trend. This concept is essential to proper trading when the market is in the Phase 2 stage identified in Chapter 1. As a means of analyzing the overall market, however, the time scales for each trend are not applicable any more. It is much more useful simply to be aware of the fact that countertrends exist within the overall trend, often identifying themselves as pullbacks to areas of support in the main trend.
3. Each trend goes through three phases. His description of the three phases is probably the most important Dow rule for day trading. Dow's explanation of these phases almost exactly describes how trends exist in the intraday movements that day traders can profit from. This is not surprising. In Dow's day, the flow of information was remarkably slow compared to today's speed of information delivery. What we see, therefore, is a concatenation of time scales for what happened in the past. In other words, what Dow described as taking place over the course of days or weeks, we can see taking place in the markets within minutes or hours. Here, then, are three phases, first for an uptrend, or bull move, then for a downtrend, or bear move. In a bull move, the first move up is caused by those with superior information or those with superior insight as to the market's appetite for the security. During this stage, the majority are selling the stock, believing worse is to come, which allows those better informed to purchase the security. Since as day traders we merely react to trends that exist, the first phase is of no interest in terms of attracting our capital. The second phase is where the day trader hopes to identify and take advantage of the trend. Price accelerates out of the initial trend and the trend becomes established for everyone to see. The final stage is characterized by rampant speculation following up the significant price rise that professional traders have enjoyed. This is when the professionals sell into what are referred to as „weak hands,“ those who do not follow the market as closely as the professionals and therefore only get in on the end of the trend. The price falls when there are no more weak hands left to buy the stock. The professionals have sold out and the weak hands are driving the price down in their urgency to get out and limit their losses.
   
   This is what I mean when I advise getting out of a winning position when you can, rather than when you have to. If you have a positive position, sell when there are still plenty of buyers. You will miss out on catching the top and, therefore, the most gain, but over time you will do better by not having to execute a trade when there are next to no buyers.
   
   Bear market moves are similar in concept, but, of course, in the opposite direction to bull runs. Bear declines start when the professionals sell, either as a result of taking profits, or, in anticipation of a decline, selling short. The second move is typified by investors selling out their positions as they realize they have made a mistake with that investment. The last gasp is when the overly optimistic or those who say they are in it for the long term finally lose faith and take big losses.
   
   These observations by Dow are critical for the day trader to internalize, because they really nail the notion of when a trend should be entered and exited. By the last gasp run, whether in the upward or downward direction, the professional should already be out, or for sure making an immediate exit.
4. For a trend to be in effect, it must be confirmed by volume. This is best illustrated with reference to the below figure.
   
   
   
   Here we see an uptrend, always the easiest to trade, especially in this case, since it is clear that the volumes are confirming the direction of price movement. As price moves up, volume picks up, indicating that the market is in agreement with the price movement. When the price moves down, volume falls, indicating that the market as a whole does not agree with the downward direction in the price movement and that more people are waiting for the price to turn up again before buying in.
   
   This point of Dow theory is less directly relevant to day trading than the last. It does, however, bear consideration as a secondary indicator. Most commonly, you will see this illustrated on intraday charts as a significant move in the security coinciding with heightened volume. It is not much of a predictor for the day trader because the price movement itself is telling you all you need to know. That volume is confirming it is nice, but not essential. Where a day trader can get value from this Dow point is that you tend to see an increase in trades, i.e., an increase in volume, when a security is starting to run up, which is better seen by judging the pace of trades through a time-of-sales screen than by looking at the volume bars on the chart.
5. For an overall market trend to be confirmed, the market indexes must agree with each other. This Dow point is really only of value to the day trader when assessing overall market health. It places a bias on the direction that day trades should be made in. In Charles Dow's day, the industrial average and the transportation average covered all securities in the market, and Dow thought that both had to be trending in the same direction for it to be said that the market was in a confirmed trend. These days, those indexes clearly do not represent the market. They do not include any of the NASDAQ securities we will be trading, so as it stands, this Dow point is useless. We can, however, update it a bit by saying that perhaps the market is best represented by the S&P 500, which must be trending for the market to be considered in a trend. In my own experience, the S&P and the S&P futures have not provided much help in terms of deciding how to trade an individual security. There are some market gurus who will advise closely watching the S&P futures, the price of oil, and a whole bunch of other indicators in order to decide how to trade an individual security. I have not seen reliable enough signals from these indicators to make them part of my decision to put capital at risk, or more accurately.
6. A trend is in effect until a clear signal is given that it has reversed. This is a very important Dow point for the day trader to know and appreciate. During Phase 2 trading, when we are looking for trends, this point should be paramount in our minds. If you see a trend that has pulled back to support a couple of times, it is definitely worth entering that trend the next time support is reached. If, however, that turns out to be the point at which the trendline breaks, a swift exit should be made. Time and again, I have seen traders convince themselves that the market would turn in their favor and watch their losses mount as they wait for the bounce back. Occurrences like the break of a trendline should be seen as signals that the existing trend is no longer in effect. The astute day trader waits for the next trend to be established. This Dow point also helps to stop us from prematurely entering a short in the market just because we believe the market is too high. If, indeed, a strong bull run has pushed a security to all-time highs, it is probable that a pullback will happen, but we don't know when that pullback will occur until something definite signals it, like a reversal pattern. This Dow point should also stop people from buying a favorite security that is in a confirmed downtrend just because they believe it is too cheap.
   
   This is not to say that as day traders we should wait for a signal that the trend has finished before exiting a winning position. It is always better to protect your profits and get out while you can, when there are plenty of buyers, even if it means missing out on some further appreciation. I myself prefer to wait for a sign of weakness, rather than a complete signal, before selling out. This thinking is covered in more detail in the next section, which discusses trend more fully.