The Dow Theory

You will hear a lot about the Dow Theory as you travel through your trading career. Dow himself never actually used the phrase. That came later as analysts began to use the term.

I should back up here slightly and mention that in 1884 Dow published his first stock market average of 11 stocks. From the original 11 stocks there were some changes and rearrangements of the average until finally in 1928 he settled on 30 stocks which are now know as the industrial average and that is where we get the term the 'Dow Jones Industrial Average'.

The actual theory is fairly straightforward to explain and sensible if you take the time to think about it. I shall simplify it slightly, as we have not covered some of the terms yet.

1. The market discounts everything. The price you see is the true value of the market. If you are following a particular stock and it is trading at $10 then that is a fair value of that stock. It assumes that all the known information about that stock has been taken into consideration by the market and is reflected in the price. If new information was introduced it would change the price of the stock but it would still be reflected in the price.

2. The Market Has Three main Trends. We are starting to get into some technical expressions here but just bear with me, as we will explain all these terms as we progress. Dow interpretation of a trend was that each rally high be higher than the previous rally high and each rally low be higher than the previous rally low.

The three trend where a primary, secondary and minor trends. Now this is important because later on as we discuss this it will play a major roll in our analysis.

The primary trend is the main force behind the trend and is like a river flowing in a particular direction. The secondary trend is like tributary to the main trend. It may diverge for a time but eventually it will come back in line with the main river. The minor trend is like a small stream, which runs this way and that but is headed, in the general direction of the river.

The primary trend may take years to come to an end and develops over time. The secondary trend can take anywhere from a few weeks to a few months in duration and the minor trend may be in the opposite direction of the primary trend. Minor trends such as daily trend last a few days or so and are of little significance.

3. In addition to the three types of trends, Dow then went on to further qualify the trend by saying that the trend has three phases. An accumulation stage, the public participation stage and finally the distribution stage.

4. As the original Dow average was composed of shares from different sectors the next part of the Dow theory was that the average of the different sectors must confirm each other.

5. Dow also considered the effect of volume on a trend. He stated that volume should expand in the same direction of the trend.

6. The last major part of the theory is the trend should be assumed to still be in force until there is a definite indication that the direction has in fact changed.

My interpretation of the Dow theory above is very brief as it is to delve to deeply into any one particular subject. It is also not necessary for what I am trying to achieve and that is to give you a broad idea of how the markets work and some way to trade them.

The main point I want you to take away from the Dow theory is that there are three types of trends, a primary trend, a secondary trend and minor trends. We can use this in our approach.

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