The Dow Theory Explained

  • By Noah Schumacher

  • July 26, 2021
  • 7:14 pm BST

Technical analysis is a base barometer for many traders, and rightly so as technical indicators can help you reach higher profits. Although it has evolved into its own field, it remains anchored in Dow Theory. If you’re a trader who is serious about understanding the fundamentals of what you’re doing in order to deepen your understanding of technical analysis, you must get to grips with the theory first postulated by Charles Dow, one of the fathers of the Dow Jones Industrial Average Index. Here are the basic pillars.

Everything is already factored into the price

 The central concept here is that the market is not dumb. Any circumstances that could affect the price, such as social or political change, psychological factors or economic data, has already been factored into the price.

A trio of trends informs the market

 Trends can be short, long or intermediate in terms of how long they last. They are nothing more than the general direction in which a market is moving. There are three of them to keep in mind:

  • Primary or major trend: This is the one of most consequence to you when trading CFDs, stocks, forex pairs or any commodity. Because it is a long-term trend, it can last for over a year. It is also the dominant trend, as it is able to influence the other two trends. Dow called this trend “the tides in the sea” as you should trade in the direction of this trend.
  • Secondary trend: This is viewed as a correction of the primary trend, and it can go for three weeks to three months. Dow saw these as the waves in the sea. In a bullish market, the trend will be downward, and the opposite is true in a bearish market. It can last from three weeks to three months.
  • Minor trend: This is also known as a short swing, and it can last from several hours to several weeks. It represents a pullback from the secondary trend. This period is seen as cluttered with noise, which is usually the reaction to the slightest change in market sentiment and can therefore lead to wildly speculative and irrational trading decisions. It is definitely one to avoid when you learn to trade CFDs.

Three phases characterize market trends: 

  • Accumulation phase: This is a good but risky entry period as the market is hesitant, prices are consolidating, and a previous trend has just run its course.
  • Absorption phase: This is the mark-up phase. The direction is approved, the price adjusts more than in any other phase, and it is also the longest phase.
  • Distribution phase: This is when most traders start closing their positions as the volatility disappears.

Volume must confirm the trend

Dow’s position was that volume should grow in the direction of the main trend. If the trend is upward, the volume should grow, along with an increase in price. The volume will expand with a fall in price if the market goes down.

A trend remains in place until there is a reversal

 Dow says that a trend remains in place until a reversal is clear, and not before then. An upward trend forms when every peak and low is higher than before, while a downward trend has decreasing peaks and dips. The logic behind this says that an obvious sign of an impending reversal is when a lower minimum within an upward movement forms. When there is a downward trend, the opposite is true.

Today, Dow theory still has a huge influence on technical analysis. It also still has an effect on general market theory and Elliott Wave Theory draws on Dow Theory. As a result, it can be argued that at its heart, Dow theory remains as relevant as it’s ever been.