Mon. Oct 19th, 2020

What is the Dow Theory? – What a new Trader Must Know

When I bought my first book on technical analysis six years ago (Technical Analysis of Stock Trends), I thought that the first chapter would dive right into juicy strategies that I can implement right away — it was pure investment incognizance on my part. So, I was surprised to see that up to chapter five of the book was still about theories, specifically the Dow Theory. Not really bummed out, I resisted opening my trading platform again which was a good idea considering how a loose cannon I was at trading back then. Ultimately, Mr. Dow piqued my curiosity, and the theory became a building block for my understanding of the financial markets.

The origins of the actual theorizing of the Dow Theory is intriguingly unattributable to Charles Dow himself. In fact, it was William Peter Hamilton followed by Robert Rhea who had built on Dow’s work, organized it and later on led to a more formalized subject. But what is the Dow Theory all about? Well, in some books I read, the theory is an antecedent to a comprehensive study of technical analysis. However, in this article, my objective is to explain what the theory is and what practical use a trader may find in immersing himself into its study.

Is there a need to learn the Dow Theory?


To the new trader, it may be difficult to comprehend that risk should receive greater thought than reward. Even to those who aren’t dabbling into trading for the first time, the potential profit would often outweigh the consideration for the possible loss.   

I think that successful trading is more risk-conscious meaning that the pursuance of profit has a degree of proportionality to its corresponding loss in that the estimated loss isn’t greater than the forecasted profit. It may sound very rudimentary to the ears of savvy traders, but other investors still commit this egregious mistake. Many times, trades are placed at random and without much concern about a specific entry and exit point; the only thing that matters is closing the trade on a positive note.

The newbie traders’ approach in the market is inherently blindsided due to how trading is often depicted in the promotional materials by some brokers. Most of these newbies never exercised a word of caution and perhaps even guilty of saying the phrase, “what could go wrong?”

They simply got into the market because a friend had all the nice things to say about a particular stock or they were captivated by some dubious ad on the internet and had opened a trading account straight away. But, a single trade can indeed take a turn for the worse, and without an understanding of how the market behaves is detrimental to a trader’s success.

The Dow Theory, more than anything else, is a guide or a precaution for a trader. And, if a trader wants to be in the market for the long haul, studying this theory has its benefits. With a firm grasp of the tenets of the theory (which I’ll discuss in the next paragraph), a trader will appreciate and become aware of specific characteristics of the market as well as some concepts of trend confirmation.

The 6 Tenets


Dow Theory has six tenets, and it may seem too much to bear for the new trader, but the sheer knowledge of these tenets is fundamental to the broader concept of technical analysis.

The averages discount everything


What this means is that everything that is to know or can be known about the market is factored into the prices. All the news and information available and even calamities as they struck are priced in immediately. The averages here originally pertain to the industrial and railroad average which were indexes that Charles Dow published in the Wall Street Journal.

A new trader must know that all the data that could affect the supply and demand in the market are already reflected in the price. Therefore, it may be more practical to understand the behavior of the market by analyzing the prices.

The market has three trends


The market has a primary, secondary and minor trend.

A crude depiction of market trends

The primary trend is the concern of the long-term investor according to Edwards and Magee. On the charts, the primary trend can easily be delineated because its course is very preeminent. A diagonal line connecting either higher (uptrend) or lower (downtrend) closing prices can be drawn to identify the primary trend. This major trend’s duration can last for a year or more.

The secondary trend is the retracement of about 50% of the primary trend’s move, and they are often called a correction, lasting for weeks to months.

Some new investors who luckily got into the early stages of a bull market may panic at the sight of a decline in their stocks’ market value and may abandon their exposure prematurely. Moreover, new traders who think that the only trajectory of an asset they bought is up are no different. Both unknowing traders can be enlightened by this tenet.

The minor trends are the day to day fluctuations in the market which can last for days to a few weeks and have very little significance to the predictability of future movements. But, to the new trader, this is still relevant as it makes up the bigger picture.

The major trends have three phases


Accumulation. Public participation. Distribution.

A roller coaster analogy would somewhat befit the phases of the major trends because of the ups and downs of the amusement ride: the slow anxiety-inducing climb and the breakneck drop from a great height.

In a bullish environment, the phase starts with a minor interest in the markets (possibly limited to religious Dow Theorist or contrarian investors). Then, it’s followed by improved general business conditions which stimulate public participation. Lastly, the unloading or profit-taking of seasoned investors which leaves the lesser informed or the riders of the market’s excess to scramble for willing buyers.

The new trader’s lesson here is to understand that just because everything about the market sounds rosy at a point in time, it doesn’t mean that it’ll last for eternity. When almost everyone buzzes about the stock market or even an innovative asset, like bitcoin, it could mean that the market is cruising at the participation phase and could almost be at the distribution phase; the new trader’s involvement, should he wish to partake, may perhaps be behindhand.

The averages must confirm each other


This again pertains to the rail and industrial averages, and it’s a measure for validating the market’s direction. Both averages should be in harmony. The time difference isn’t exactly on an hour to hour basis or even on a day to day basis, but the longer time frame should show a congruous relationship in order to “confirm” a trend.

The takeaway for a new trader in this tenet is that there are principles or a set of rules to confirm the direction of the market and one can’t be too sure of the signal derived from a single metric. Oft a trader should ask: what is my basis for my assumption?

The volume must confirm


Volume is another probative evidence for trend confirmation. When prices are up, they should be supported by an increase in volume to confirm an uptrend. Conversely, when prices fall, they should be supported by also an increase in volume to confirm a downtrend. What the new trader is to understand here is that volume is used as a supplementary metric to other principles for confirming a trend.

A trend is still in effect until there is a definite signal that it reversed


Just as confirming a predominant move in the market at its initial stage, the signal that it had reversed should be kept an eye on. Even if a primary uptrend is ongoing for years, but there’s no signal of a reversal, then the uptrend is assumed to continue.

To prevent a premature exit, many tools are at a trader’s disposal to spot signs of reversals as they occur. It’s in the hands of the trader to make certain that the market is about to turn the tide.

Conclusion


In essence, that’s the Dow Theory stated in simple terms. A more profound study of this theory could be undertaken by the new trader to further improve his ability to discern the market’s behavior. Should the new trader devote more time to the understanding of Dow’s principles, a bedrock for a better comprehension of technical analysis will be attained.


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