Dow theory

Dow theory says that the market moves in trends, that a trend has recognisable stages, and that it stays in force until there is clear evidence it has ended.

Charles Dow never published it as a theory. After his death in 1902 his ideas were collected and developed by William Hamilton and Robert Rhea, whose book The Dow Theory came out in 1932. Dow worked with two stock averages, Industrials and Railroads, but the principles are applied to any market.

• The market discounts everything – all known information is already in the price.
• The market has three trends – primary, secondary and minor.
• Primary trends have three phases – accumulation, public participation and distribution.
• The averages must confirm each other – a signal in one index counts only when a related index gives the same signal.
• Volume must confirm the trend – volume should grow in the direction of the primary trend.
• A trend stays in force until a clear reversal signal appears.

• Primary trend – the main direction, lasting from about a year to several years. This is the bull or bear market.
• Secondary trend – a move against the primary trend, lasting from about three weeks to three months. It often takes back one third to two thirds of the previous move.
• Minor trend – short swings of days up to about three weeks. Dow theory treats them as noise.

In a bear market the order is mirrored: distribution, public participation in selling, then panic. The same phases appear in Wyckoff accumulation and distribution, which grew from these ideas.

• Accumulation – after a decline, informed investors buy while the news is still bad. Price moves sideways.
• Public participation – the trend becomes visible, trend followers join, and price covers most of its distance.
• Distribution – the news is at its best and the public buys, while early buyers sell. Price stalls near the highs.

This is the same reading that is now called market structure, with the reversal described as a break of structure.

• Uptrend – each peak is higher than the last one and each trough is higher than the last one: higher highs and higher lows.
• Downtrend – lower highs and lower lows.
• Reversal – in an uptrend price fails to make a new high and then falls below the last trough. In a downtrend it fails to make a new low and then rises above the last peak.
• Dow used closing prices only and ignored moves inside the day.

Dow theory is the base for later methods such as Elliott wave theory and trend following with moving averages, including the golden cross.

• Direction – trade with the primary trend. Take longs in an uptrend and treat rallies in a downtrend as secondary moves.
• Entry – at the end of a secondary reaction, when price turns back in the direction of the primary trend.
• Stop – beyond the last trough in an uptrend or the last peak in a downtrend. A close beyond it is the reversal signal.
• Confirmation – check a related market: two stock indices, or bitcoin and the total crypto market.

• Expecting early signals – by definition the theory confirms a reversal after part of the move is gone.
• Mixing the three trends – a secondary reaction on the daily chart looks like a full downtrend on the hourly one. Decide first which trend you trade.
• Reading intraday spikes as signals – the classic rules use closing prices.
• Treating phases as exact – accumulation and distribution are clear mostly in hindsight.