RECENT POSTS
latest

728x90

468x60

Dow Theory



dow theory


The Dow theory

It is perfectly evident, from the statements made by the contemporaries of Charles H. Dow, that he never intended, in the brief paragraphs which appeared in his Wall Street Journal editorials, to become the grandparent of technical studies. Perhaps if he had lived a little longer, the urging of his friends would have resulted in a more systematic presentation of his theories, from his own mind. As it is, what we know about Dow’s theories of stock price movements we learn chiefly from the writings of his contemporaries, and others who have taken up the work where they left off.”   
By H.M GARTLEY, Profits in The Stock Market.


Dow theory is the basis theory of technical analysis of financial markets first observed and developed by Charles H Dow through over 250 editorial in the wall street journal. Through a set of guidelines, Dow theory enables traders to identify the primary trend and ride its way.


Why we study the Dow Theory:

     - It is one of the oldest theories of technical analysis.
- The most widely publicized and followed theory of stock price movements.
- This theory, as shown by market action over many years, involves principles which are absolutely fundamental in price movement, and no trader can afford to be ignorant of them.  

Brief history

Before taking up the theory in detail, let us review briefly some general history of the men who have been responsible for bringing Dow’s theory to us.

CHARLES H. DOW:

He was born in New England in 1850. He served as a reporter on the Springfield Republican in his early years. Later he became a member of New York Stock Exchange, in partnership with Robert Goodbody.
In time, the partnership was dissolved and Dow returned to newspaper work. In 1889 he founded the Wall Street journal, and gained confidence of his readers in his efforts to report fairly and interpret without bias the financial news of the day. In his editorials Dow was always cautious in the extreme, and because of his reticence he never came out with a flat statement of his principles of technical market action.
Although he began keeping averages in 1884, he wrote practically nothing about his theory until 1901 and the first half of 1902, and then his discussions started in editorials devoted to general business conditions. Nevertheless, he was the first technical analyst of note.

S. A. Nelson:

He was the first person to speak of “Dow’s theory”. In 1903 he published a book called The A B C of stock speculation. Nelson had been a member of the Wall street Journal staff when William Peter Hamilton was a young reporter thereon.
 Nelson said in his preface that many requests had been received for a book giving the principles governing stock speculation, and if any man was qualified to write such a volume, that man was Charles H. Dow.
 But Dow died leaving only a few editorials. However, Nelson says that Dow’s theories are given in The A B C  of Stock Speculation, and acknowledges the assistance of Dow’s colleagues and contemporaries in preparing the book.
 Apparently, Nelson was on excellent terms with Dow and the book may be regarded as a reasonably authoritative summary of Dow’s theory as it was originally formulated.

William Peter Hamilton:

Hamilton was the editor of the Wall Street Journal from 1908 until his death in 1929. An Englishman by birth, he served in his early boyhood as a page on the floor of the London Stock Exchange. But he had a strong sense of adventure, and when Gold was discovered in south Africa, he joined the rush to these regions. 
After sometime spent as a trader in gold and diamonds in South Africa, Hamilton migrated to Australia and New Zealand, and then to The United States. Here he joined the staff of the Wall Street Journal, and was closely associated with Charles H. Dow during the closing years of the latter’s life. 
Beginning in 1903, Hamilton wrote editorials for the Wall Street Journal until his death in 1929. Some of these were on the subject of “the price movement”, and comprise most of his writings on the Dow Theory. These editorials aggregating some 260 in all. Have been collected by Robert Rhea and published as an appendix to his book The Dow Theory. Hamilton also published a Book entitled The Stock Market Barometer in 1922.
In fact, The Dow theory as generally understood was almost entirely the joint work of Dow and Hamilton. Dow had been reticent and cautious in his statements about price movements, but Hamilton became an ardent interpreter and exponent of the founder’s precepts. While he referred constantly to Dow’s methods, there is little question that Hamilton was constantly developing the Theory in his own mind.
Hamilton’s characteristics may best be summed up by saying that he was a journalist, not an analyst. His method of observation was impressionistic, not systematic.

Robert Rhea:

 The most prominent contemporary Dow Theorist, first became interested in the Dow Theory in 1910. He had a small retail automobile tire store in Colorado. His father, believing that good business men should keep themselves informed on economic conditions, subscribed to the wall Street Journal for him, and urged his son to read it thoroughly, especially the editorial column by William Peter Hamilton.
Rhea became interested in in Hamilton’s discussions of the price movement, and finally, in 1914 he started trading. His first venture in the market resulted in substantial profits, but he was soon to learn that he did not know enough about Dow’s Theory, for when the first bear market came, he lost a large part of his previous earnings. He promptly withdrew from the market, and started to study the theory.  After that, he rejoined the market, made handsome profits and became an ardent follower of Dow’s theory.  
In the summer of 1932, he began writing articles on the theory for Barron’s, and then he published his book The Dow Theory, in the same year.


   

Little background on averages:

It was not until May 26, 1886, that Dow Jones Industrial Average (DJIA) was born with 12 companies’ stocks. A year later, a separate average was started to keep track of the rail road stocks, DowJones transportation average. The Dowjones Utilities (DJUA) did not exist until 1929; the standard and poor’s 500 (S&P 500), not until 1957.



Principles of the DOW Theory.

Many traders, especially beginners, try to apply technical analysis without a fully grasp of the field.
Before applying the Dow Theory in practice, Charles Dow made some assumptions that are the main tenets of his way of analyzing financial markets.
Those principles are essential in order to apply the theory successfully.
Here is a summary of those principles, and what you need to know about them

1 - Manipulation:

Short term movements, from few minutes to few days, could be subject of manipulation by speculators and large institutions.
So, it is possible in daily movement and to a limited degree in secondary reaction. But the Primary trend can never be manipulated.

2 - Averages discount everything

Known also as “efficient market theory”. The market reflects all available information.
Everything there is to know is already reflected in the markets through the price.
You may notice sometimes that markets react negatively to good news. The reasoning behind that is by the time the news hits the street, it is already reflected in the price “priced in”.
This explains the old wall Street axiom “buy the rumor, sell the news”. As the rumor begins to filter down, buyers step in and bid the price up. By the time the news hits, the price has been bid up to fully reflect he news.
In stocks, the run up to earnings is a classic example.
In the Dow theory, the daily price fluctuations of the DowJones averages afford a composite view of all the hopes, disappointments and knowledge of every one who knows anything of financial matters. For the reason, the effects of coming events (excluding acts of God) are always properly anticipated in the dowjones index movement.



3 - Market Movements


A) – The three Market Movements

a-      Primary movement (Major bull /bear Market)
b-      Secondary movement(correction)
c-       Daily fluctuations (the ripples)


dow theory market movements



 Dow defined three types of price movements: Primary movement, secondary movements and daily fluctuations.
Primary moves last from a few months to many years and represent the broad underlying trend of the market; it is a long sustained directional move.
Secondary (or reaction) movements last from a few weeks to a few months and move counter the primary trend.
Daily fluctuations can move with or against the primary trend and last from a few hours to a few days.

TIDE – WAVE – RIPPLES

Charles H Dow compared those market movements to movements of the ocean where there is a tide, waves, and minor ripples.
On January 31, 1991, he wrote in the Wall Street Journal:
“ A person watching the tide coming in and who wishes to know the exact spot which marks the high tide, sets a stick in the sand at the points reached by the incoming waves until the stick reaches a position where the waves do not come up to it, and finally recede enough to show that the tide has turned. This method holds good in watching and determining the flood tide of the stock market.”
There is a big wave (tide), known as the primary movement, that is made up of secondary waves of lesser amplitude and duration.
Similarly, the secondary wave is made up of minor waves of still smaller proportions.
Since it is by literally riding the wave that profits are made, the first task of a trader is to determine:

 a-       The direction of the Tide.
      b-      The stage of development of the wave.
 d-      The direction of the minor ripple.

B) Stages of Primary Movement

There are three stages to both primary bull and bear markets.
A primary bull market in stocks is defined as a long sustained advance marked by improving business conditions that elicit increased speculation and demand for stocks.
A primary bear market is defined as a long sustained decline marked by deteriorating business conditions and subsequent decrease in demand for stocks.
In both primary markets, there will be secondary movements that run counter the major trend.

Primary Bull Market:

Stage 1: accumulation

The first stage of a bull market is largely indistinguishable from the last reaction rally of a bear market. Pessimism, which was excessive at the end of the bear market, still reigns at the beginning of a bull market.
It is a period when the public is out of stocks, and the news are bad.
However, it is at this stage that smart money begins to accumulate stocks. Stocks are cheap, but nobody seems to want them.
In the first stage of a bull market, Price is undervalued (oversold) and starts to find a Bottom. When the market starts to rise, there is a widespread disbelief that a bull market has begun.
After the first leg peaks and starts to head back down, the bears come out proclaiming that the bear market is not over. It is at this stage that carful analysis is warranted to determine if the decline is a secondary movement ( a correction of the first leg up). If it is a secondary move, then the low forms above the previous low, a quiet period will ensue as the market firms and then an advance will begin. When the previous peak is surpassed, the beginning of the second leg and a primary bull market will be confirmed.

Stage 2: Big Move

The second stage of a primary bull market is usually the longest, and sees the largest advance in prices. It is a period marked by improving business conditions and increased valuations in stocks. Participation is broad and the trend followers begin to participate.

Stage 3: Excess

This stage is marked by excessive speculation and the appearance of inflationary pressures. The public is fully involved in the market, valuations are excessive and confidence is extraordinarily high.

Primary Bear Market:

Stage 1: Distribution

Distribution marks the beginning of a bear market. Market is overvalued, as the smart money begins to realize that business conditions are not quite good as once thought, they start to sell stocks.
Most investors and speculators are still involved in the market at this stage. There is little in the headlines to indicate a bear market is at hand, and general business conditions remain good.
However, stocks begin to lose a bit of their lusts and the decline begins to take hold.
When the market declines, there is little belief that a bear market has started and most forecasters remain bullish.
After a moderate decline, there is a reaction rally (secondary move) retraces a portion of the decline.
However, the reaction high of the secondary move would form and be lower than the previous high. After making a lower high, a break below the previous low would confirm that this was the second stage of a bear market.

Stage 2: Big Move

It provides the largest move. This is when the trend has been identified as down and business conditions begin to deteriorate. Earnings estimates are reduced, short falls occur, profit margins shrink and revenues fall. As business conditions worsen, the sell-off continues.

Stage 3: Despair

By the final stage of a bear market, all hope is lost and stocks are frowned upon. Valuations are low, but the selling continues as participants seek to sell no matter what. The news are bad, the economic outlook bleak and not a buyer is to be found. The market will continue to decline until all bad news is fully priced into stocks. Once stocks fully reflect the worst possible outcome, the cycle begins again.


dow theory accumulation and distribution movements

4 – Volume must confirm the trend

  Movements in volume should confirm price movement, otherwise we got false breakouts and fake signals.
In the Forex market, where there are no centralized markets, you can rely on currency futures volume as a proxy for forex volume.

5 - Averages must confirm each other:

The two averages that were emphasized in this rule were the Dowjones industrial average and the Dowjones transportation average. In nowadays as we have more popular averages and largely reflective of the economy, we can apply the same rule for the Dowjones industrial average with the S&P 500, and empirically they give the same desired results. 
As Hamilton stated, one of the shortest ways of going wrong is to accept an indication by one average which has not been clearly confirmed by the other.
Sometimes, while the two averages may vary in strength they will not materially vary in direction, especially in a major movement.
In fact, this rule does very well help traders confirming their views using intermarket analysis, especially where markets now are very interrelated each other.
For example, in forex we can relay on the DXY (U.S Dollar index) to confirm trades on the USD pairs. 

6 – A trend is assumed to be continuous until Definite signals of its Reversal.

Talking about trends and signals, Robert Rhea identified some separate theorems, based on Charles Dow and Hamilton writings.

Trend identification:

Hamilton used peak and trough analysis in order to ascertain the identity of the trend. An uptrend is defined by prices that form a series of rising peaks and troughs, higher highs and higher lows. A downtrend is defined by prices that form a series of declining peaks and troughs, lower highs and lower lows.
Once the trend has been identified, it is assumed valid until proved otherwise. A downtrend is considered valid until a higher low forms and the ensuing advance off of the higher low surpasses the previous reaction high.
Here comes the idea of trend lines. Drawing a line helps emphasize the direction of the trend.
An uptrend is considered in place until a lower low forms and the ensuing decline exceeds the previous low.

Volume:

Volume should increase in the direction of the primary trend and decrease on corrections.

Trading ranges(lines):

Trading ranges indicate either accumulation or distribution, but it is impossible to tell which until there was a break to the upside or the downside. If there were a break to the upside, then the trading range would be considered an area of accumulation. If there were a break to the downside, then the trading range would be considered an area of distribution.
Hamilton considered the trading range neutral until a breakout occurred. He also warned against attempting to anticipate the breakout.


7 – The theory is not infallible.

Charles Dow, and the Dow Theory theorists, do not guarantee that the theory works 100% successfully every time. That is because of randomness in market movements.
The Dow Theory in not an infallible system for beating the Market. Its successful use as an aid in trading requires serious study, and combination with other analysis tools and elements.

Charles Dow quote:

-          If people with either large or small capital would look upon trading in stocks as an attempt to get 12% per annum on they money instead of 50% weekly, they would come out a good deal better in the long run.”


Conclusion:

When analyzing the market, make sure you are objective and see what is there, not what you want to see.
The goal of Dow Theory is to utilize what we do know, not to haphazardly guess about what we don’t know.
Through a set of guidelines, Dow Theory enables traders to identify the primary trend and ride its way.
Finally keep in mind:

      1-      The averages express the sum of all pertinent information.
      2-      The market as a whole has a trend
      3-      The trend is interpreted by reversals
      4-      A signal is made only by confirmation 
      5-      A signal, once given, remains in force until a countersignal is given
      6-      Signals made in third phases have diminishing authority.
      7-      Manipulation and short-selling have no lasting influence on              the trend.
      8-     Conditions that bring about bull markets and bear markets                change slowly.


Sources:

-          Chartschool.com
-          H.M GARTLEY, Profits in The Stock Market.
-          William Peter Hamilton, the stock market Barometer



« PREV
NEXT »

Facebook Comments APPID