Lesson 2 – Dow Theory – An Introduction

Topic Progress:

In the last lesson on technical analysis we talked a bit about the different ways that traders analyze the markets. In this lesson we will look at the history of technical analysis and something known as Dow Theory.

Most consider the father of technical analysis to be Charles Dow, the founder of Dow Jones and Company which publishes the Wall Street Journal. Around 1900 he wrote a series of papers which looked at the way prices of the Dow Jones Industrial Average and the Dow Jones Transportation Index moved. After analyzing the Indexes he outlined his belief that markets tend to move in similar ways over time. These papers, which were expanded on by other traders in the years that followed, became known as “Dow Theory”.

Although Dow Theory was written over 100 years ago most of its points are still relevant today. Dow focused on stock indexes in his writings but the basic principles are relevant to any market.

Dow Theory is broken down into 6 basic tenets. In this lesson we are going to take a look at the first 3 and then finish up our conversation of Dow Theory in the next lesson by looking at the last three.

The first tenet of Dow Theory is that The Markets Have 3 Trends.

  • Up Trends which are defined as a time when successive rallies in a security price close at levels higher than those achieved in previous rallies and when lows occur at levels higher than previous lows.
  • Down Trends which are defined as when the market makes successive lower lows and lower highs.
  • Corrections which are defined as a move after the market makes a move sharply in one direction where the market recedes in the opposite direction before continuing in its original direction.

To help better understand each trend lets look at an example of each:

A Price Chart Showing an Up Trend:

A Price Chart Showing a Down Trend:

A Price Chart Showing a Correction:

The second tenet of Dow Theory is that Trends Have 3 Phases:

The accumulation phase which is when the “expert” traders are actively taking positions which are against the majority of people in the market. Price does not change much during this phase as the “experts” are in the minority so they are not a large enough group to move the market.
The public participation phase which is when the public at large catches on to what the “experts” know and begin to trade in the same direction. Rapid price change can occur during this phase as everyone piles onto one side of a trade.
The Excess Phase where rampant speculation occurs and the “smart money” starts to exit their positions.

Here you can start to see how the psychology of investors and traders comes into play an important concept which we will delver deeper into in later lessons.

One of the best examples which shows these three phases occurring in an uptrend that most people are familiar with is the run-up up the NASDAQ into 2000:

Chart of the NASDAQ Showing the 3 Phases of a Trend:

The third tenet of Dow Theory is that The Markets Discount All News, meaning that once news is released it is quickly reflected in the price of an asset. On this point Dow Theory is in line with the efficient market hypothesis which states that:

“the efficient market hypothesis (EMH) asserts that financial markets are “informationally efficient”, or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information and therefore are unbiased in the sense that they reflect the collective beliefs of all investors about future prospects.”

Source: Wikipedia

This concept that the markets discount all news is one that is sited in arguments in favor of using technical analysis as a tool to profit from the markets as if it is true that markets already discount all fundamental factors then the only way to beat the market would be through technical analysis.

So now you should have a good understanding of the first three tenets of Dow Theory including the different types of trends, the different phases of trends, and Dow’s concept that the price of an asset already reflects all known news. In our next lesson on Dow theory we are going to look at the second three tenents.