THE DOW THEORY

Posted by on Dec 27, 2012

By Fabiano Trevisiol


the economic theory of Dow

THE ECONOMIC THEORY OF DOW

The theory of Charles Dow, one of the most important and necessary that a trader, mainly technical, should possess.

Before delving into the actual theory, let’s see the story, definitely interesting involving this man to make him famous.

In 1982 Charles Dow was an associate of Edward Jones, together they founded a company called Dow Jones & Company. Most scholars contend that markets what today is define worldwide as “technical analysis” comes from theories first proposed by Dow in the period between the late 1800 and early 1900. Concepts that were included in the Dow was a series of articles written for the Wall Street Journal. Today, 100 years later, most traders and financial analysts acknowledge and does own the Dow theory, sometimes even unaware of its origin. The Dow theory is still a century one vital tool for studying technical analysis, although today, despite many years apart, are at your disposal powerful computer technology available to get from market movements theoretically more precise indications, however this does not happen, because the Dow theory encompasses in itself a series of concepts and basic fundamentals and that discretionary no computer will ever achieve in their processing.

On 3rd of July 1884 Dow published the first index composed of the market closing prices of 11 stocks, nine transport and two related to assessment tool of the conditions of the national economy.

In 1897 he separated the index in 2 parts, the first consisting of 12 titles of industrial society and the second to twenty titles of railway companies.

In 1928 the first index included already 30 industrial stocks, which is also the current number.

In subsequent years, the editors of the Wall Street Journal recently updated the list several times, in 1929 was added an index of usefulness. In 1984 at the centenary of the first publication of the Dow, the market technicians Association offered a premium to Dow Jones and co. for permanent contribution made by Charlses Dow annual industry and investment. In particular this index is still today, 110 years after its death one vital tool for technical analysts. Unfortunately Dow VI never made a systematic form his thoughts, but the ideas expressed on the stock market in a number of articles appeared in the wall street journal. When, after his death were collected and reprinted, it was realized, as the existence of a real economic theory whose value for the stock market was to some authors compared to what was the theory of Freudian psychiatry.

Dow’s work was applied to stock market indices, which he had created, namely the industrial and railway, however most of the concepts of analysis he formulated are estendibli in all indexes. This article will be fleshed out the 6 priciples of the theory, and at the same time, it will be shown how these ideas are suitable for modern study of technical analysis. The implications related to these ideas were partly covered in previous articles and are also filming later in future articles of FOREX GUIDE.

 

The basics of Dow theory

 

The indexes are all

“The sum and the tendency of stock transactions represent the sum of knowledge of the past, remote, and applied to future discount. It is not necessary, as do some statisticians, add elaborate builds indexes of wholesale price indices, Bank compensation, stock market fluctuations, the volume of domestic or foreign trade. Wall Street takes into account all these aspects “.This principle is also repeated on the indexes. The theory States that every possible factor concerning supply and demand, must be reflected in the index, excluding of course, everything is not predictable, as, for example, earthquakes, or natural disasters. Basically everything that cannot be anticipated by the market, is granted and almost immediately assimilated in the prices.

 

The market has three trend

Before analysing the behavior is important to clarify the definition of trend given by Dow. It stated that an uptrend, could be in place as long as each rally (bullish movement) to rise to new highs, and every correction ended up as little more than before.

In other words, an uptrend should grow according to a formation with Higher Highs and Higher Lows. A downtrend is going to be the exact opposite, with Lower Highs and Lower lows decreasing. This definition has withstood the test of time and still is the foundation of the analysis of the trend.

 

Example of a DownTrend

downtrend market

 

Exsample of an  UpTrend

uptrend market

 

Dow believed that the law of action and reaction is applicable to markets and not only to the physical universe. He wrote: “trading records show that in many cases when a stock reaches its peak will undergo a moderate decline and then back to approach the higher figures. If, after this motion, the price is further down, this happens most consistent measure “

Dow divided the trend into three categories: primary trends, secondary trends and minor trend. Dow compared these three phases to the tide, the waves and wave breakers. The primary trend was like the tide. The secondary trend or middle period was compared to the waves that travel with the tide. The minor trend is comparable to the situations of the waves. Placing signals to indicate the highest point on the beach reached by each wave, you could measure the direction of the tide; If each wave stretched beyond the point previously marked, the tide was still ongoing. Only when the waves began to recede from the highest points you could understand that the tide was about to change. Dow believed that the waves of the market lasted for more than a year, perhaps for several years.

The secondary or intermediate trend therefore represents only the primary trend correction with an average duration of three weeks to three months. These intermediate corrections are usually from 1/3 to 2/3 of the total width of the previous trend. Often the retracement is approximately 50% of the main movement.

The minor trend or short period usually lasts less than three weeks and represents the shortest fluctuations of the intermediate trend.

 

The primary trend has three stages

Dow concentrated his focus mainly on primary or main trend, which he divided into three distinct phases: an accumulation phase, the phase of public participation and the distribution phase. The first, by accumulation, is created by investor buying smarter and informed when they feel that all the negative news are now been assimilated into the market. In the second stage, public participation, most of trend followers takes place, prices begin to rise rapidly and the economic news are increasingly positive. The third and last phase, that of distribution, when newspapers reported increasingly positive corporate news and speculative volume accelerates. It is during this last phase that most knowledgeable investors, who had begun to accumulate just when no one else wanted to buy, they begin to distribute titles when nobody seems willing to sell.

Scholars of the Elliott wave theory, recognize certainly the primary uptrend, which was divided by Elliott in three main movements. In one of the following lessons concerning the theory of Elliott, will be highlighted the similarities between the three phases of Dow in the bull market and the theory of five waves of Elliott.

 

The indexes they must confirm each other

In formulating this rule, the Dow industrial index was referred to and railways and argued that no bullish or bearish of some importance could occur if both indexes do not provide the same indication giving mutual confirmation. In other words, both indexes had to overcome the previous maximum to confirm the start or continuation of a bull market. The signals don’t have to occur simultaneously, but a close temporal proximity is much desired. When the two indices are confirmed, the primary trend is believed to be still in force.

However, unlike the Dow, Elliott’s theory requires the signals on a single index. The principles of confirmation and divergence will be treated in future lessons.

 

The volume must confirm the trend

Dow acknowledged to a secondary value, but neverless extremely important for confirmation of price signals. More simply, one can say that the volume must expand in the direction of the primary trend. If the primary trend is upward, the volume should expand and increase when prices soar while, conversely, the volume should decrease when prices drop. In a down trend, the opposite occurs. The volume should increase the price decline and should decrease when prices bounce within a downtrend.

In his theory, the signals of buying or selling are based solely on closing prices. Later in a future lesson we will see the issue much more volume detail. Today, sophisticated volume indicators help to understand if this is increasing or decreasing. Then traders experts compare this information with the prices to see if the two values are confirmed.

However it must be clear that the volume is only a secondary indicator and can hardly get in forex a reliable volume value, because each broker will provide that relative to its market, however exists on forexfactory site the ability to display a volume composed of the volume averages provided by leading brokers.

 

A trend is in place until there is a definitive sign of turnaround

This concept represents a solid pillar for those who follow the trend.

Relates the market movement to physical law according to which a moving object (in this case a trend) tends to remain in that condition until an external force makes it change direction. Of course it’s not so easy to recognize the signs of reversal. The study of support and resistance levels, figures, trendlines and moving averages, is one of the technical tools available, indicating when a trend into existence could be undergoing reversal. Some indicators help to predict ahead of time worrying signs of losing momentum. Neverless, the chances are greater for the continuity of the trend. The biggest difficulty for those who follow the Dow theory or any other theory, exists in a normal minor correction distinguish a trend into existence by the first step of a new trend in the opposite direction: there is some difference of views on the theory that allows you to locate an effective reverse signal. In fact the discernment between a retracement and the actual change in trend is a skill that takes practice.

Figure 1 shows this divergence. In Figure 1 we note how to rebound to the point C can’t touch the up earlier than before under point b. In this case, the fact that there are two Maximun and two minimun are lower can give a clear sell signal at the point where 3 is broken (point 3). This figure is called inversion swing bills.

In Figure 1b, we notice how the upside until C exceeds the previous maximum, before heading down under point b. Although there is no clear support drilling at S1, some advocates of Dow theory won’t recognize a decisive signal, because there are only increasing minimum and maximum decreasing. Would prefer to see a rebound until well, very close to C, then another new low point D. As a result, you would sell signal at point S2, where there are two Maxima and two minima decreasing. Reverse schema of Figure 1 b is defined as no failure swing. A failure swing (shown in Figure 1) is a much weaker configuration of failure swing not present in Figure 1 b figure 2 shows the same scenario on the bottom of the market.

 

Figure 1 a-b Failure swing. The inability of top C to overcome A, followed by minimal breakage ‘s, constitutes a sell signal s. b.-failure Not swing. Notice how C exceeds to before falling under (B). Some advocates of Dow would like to see a sell signal S1, while others would like to see a maximum of less than and before becoming bearish S2.


 

Figura 2 a – b Fatture swing botlom. Il segnale d’acquisto appare al punto B1 o B2. b. – Non failure swing. Il segnale d’acquisto prende posto quando il punto S viene superato.

 

Closing prices and side lines

Dow noted only the closing price, then the indexes were to have a closure over the previous minimum or maximum. Intraday breaks were not considered valid. Index lines refer to horizontal movements between two extreme bands that you are creating in the graphs. These horizontal movements often occur instead of correction phases and are defined as the consolidation phases. In more modern terms, we can define these lateral figures as “rectangles”.

 

Some criticisms of the Dow theory

Although the Dow theory has identified in the major markets to rise and fall, it subtracts some criticisms. On average, approximately 20% -25% of the movements is lost before the signal was given and this, for many operators, is an indication of lack of timeliness by signals. Usually a buying signal of Dow theory takes place only during the second phase of an uptrend, when a previous interim maximum is exceeded. This also happens, incidentally, when most of those who follow technical systems begin to identify and participate in ongoing trends.

But we must remember that the Dow theory has never wanted to anticipate trends. Its purpose was to signal the emergence of major markets to rise and fall and capture a large slice of the important market movements. There is well-documented evidence showing its good functionalities: between 1920 and 1975 the Dow theory signals have captured 68% of the industrial index movements and transport and 67% of those of Stan-dard & Poor ‘s. Anyone who criticizes the Dow theory as inadequate to capture the maximum or the minimum of time demonstrates a poor understanding of the theory of trend-following.

 

Actions such as economic indicators

Dow has never purported to use his theory to predict the direction of the bag. He realized that his real value was to use the stock market as a barometer of the State of the economy. One can only admire the fact that Dow, thanks to his intuition, he managed not only to formulate many of the principles of those techniques, which even today are used in stock market forecasts, but also have been able to recognize function indexes of economic indicators.

 

The Dow theory applied to futures trading and forex

Dow‘s work took into account the behavior of market indices. Though most of his original work was significant application in the futures market and the spot forex, it is important to note the distinction between futures trading and forex and trading on the shares. First Dow supposed most investors follow major trends and only used intermediate corrections solely for purposes of timing; considered negligible minor trends or short-term. Of course this concept does not apply to futures trading in which traders tend to follow the trend and not the main one; for reasons of timing must pay great attention to minor fluctuations. If the expectation of a trader is an intermediate uptrend lasting a couple of months for the purchase of mild downturns will in the short term; in the case of intermediate downtrend will use minor bounces to sell shortly. The minor trend, therefore, is extremely important in futures trading and forex spot.

 

Conclusions

In this article were presented in a succinct way the most important aspects of Dow theory; It will become clear that the full understanding of this theory can provide a solid foundation for the study of technical analysis and that many of the topics to be discussed, are simply variants of theses already present in the Dow theory: the standard definition of trend, its classification into three categories and stages, the principles of confirmations and divergencesthe interpretation of the volumes, the use of percentages or retracement retracement, just to name a few, are principles derived in one way or another by the comments made by Dow.

 

Source: John Murphy –  Technical Analysis of The Financial Markets

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