Dow theory explained: Your technical analysis guide

Dow theory is comprised of six tenets that dictate how to categorise and identify market trends. Learn everything you need to know about Dow theory here.

• What is Dow theory?
• Dow theory principles
• Dow theory and technical analysis
• Does Dow theory work?
• Dow theory stock markets
• Dow theory forex

What is Dow theory?

Dow theory is a set of principles outlined by Charles H. Dow, creator of the Dow Jones Industrial Average, in the late 19th century. It aims to dictate how market trends form, with a set of rules governing how to trade trends successfully. While some of it has been discounted, Dow theory forms the basis of much of modern technical analysis.

Charles Dow died before he published his theory, but it has been developed over the years extensively by other traders.

Dow theory consists chiefly of six principles (often called the six tenets). Let’s take a closer look at each one.

Dow theory principles

1. The efficient market hypothesis (EMH)

The first principle of Dow theory is that the financial markets will always take all factors into account when pricing an asset – including earnings, the wider economic picture, future potential and more.

This is the efficient market hypothesis, and it dictates that market prices are always correct – so you can’t find under or overvalued assets.

2. Three types of trends

Dow identified three types of trends in his theory:

• Primary (or major) trends are the overall direction of the market, lasting a year or longer. These are bull or bear markets
• Secondary trends can run counter to the primary price action, appearing as retracements on a chart. For example, a pullback within a bull market. These may last weeks or months
• Minor trends last days or weeks, and were considered as ‘market noise’ by Dow

3. Major trends come in three phases

In addition, there are three phases that each major trend follows. These are:

1. Accumulation phase (bull markets) or distribution (bear markets) phase. Here, volume starts to increase, price starts to move up or down and news of the trend starts to spread
2. Public participation phase. Retail investors join the action, either buying or selling en masse. This drives the longest, biggest portion of the trend
3. Excess phase (bull markets) or panic (bear markets) phase. This is where seasoned investors will exit their positions, but novices will continue to pile in, driving the trend yet further

4. Indices must confirm trends

One of the key tenets in Dow’s theory is that bull or bear markets should be confirmed across multiple indices. So, if you spot an accumulating uptrend in one index, you should always confirm it in another before opening a position.

Of course, Charles Dow was referring to his own set of indices when he proposed the theory – in fact, he helped create the Dow Jones Transportation Average partly to help confirm trends on the Dow Jones itself. However, today there are multiple indices you can check.

With City Index, for example, you can analyse and trade over 40 global indices.

5. Volume must confirm trends

You don’t only rely on other indices to confirm trends according to Dow Theory, though. You should also ensure that you are checking volume indicators, as a true trend needs to be backed by strong volume.

This tenet has carried through into much of technical analysis today, with the belief that momentum can be used to predict trends. Breakout traders will also pay close attention to volume, as a move that isn’t backed by an increase in volume is more likely to peter out.

6. Trade trends until they reverse

The final principle of Dow theory – and a general rule of trend trading today – is that you should keep positions open on markets in a primary trend until the movement has reversed.

Due to the presence of secondary trends, identifying reversals can be a difficult skill to master. According to Dow, you need a primary trend to be confirmed by another index and growing volume in the direction of the new trend – so high selling pressure if the new trend is down, and buying if it is up.

Dow theory and technical analysis

Some aspects of Dow theory have been abandoned today – but not all of them, and much of what Dow proposed has made its way into modern technical analysis. Indeed, two skills that are central to Dow theory are still crucial parts of technical trading today: identifying trends and identifying reversals.

Identifying trends with Dow theory

Two of Dow’s six tenets relate directly to identifying trends, and that’s not all the work he did on the topic. Dow proposed that peaks and troughs are the key building blocks of primary trends, noting that:

• Upward primary trends should see higher highs and higher lows
• Downward primary trends are the opposite, with lower highs and lows

Dow’s observation remains a core facet of reading charts using trendlines. To draw a trendline on an uptrending market, you connect the peaks – if the line points up, then the peaks are getting higher. On a downtrend, meanwhile, you can connect the troughs. If the line points down, the troughs are getting lower.

Identifying reversals with Dow theory

As we’ve noted, it can be difficult to tell the difference between a primary trend that’s reversed and a secondary countertrend. In his book, Dow urged caution, noting that it may be months into a new move before you can say for certain that it is a reversal, not a correction.

Today, technical traders have more tools at their disposal to detect when a trend is reversing. Candlestick patterns, for example, can offer hints of reversals when they appear on trading charts.

Does Dow theory work?

Dow theory can work as a means of categorising and identifying market trends. Many of the six tenets that Dow outlined are still applicable today, and you can generate buy and sell signals using his principles.

However, other aspects of Dow theory have been largely left behind, and new technical analysis principles – such as Elliott Wave theory – have enhanced our understanding of market movements.

Start trading with Dow theory

To start trading with Dow theory, follow these steps:

1. Open an account with a trading provider, such as City Index
2. Log in to our award-winning Web Trader platform, or download our mobile trading app
3. Add some funds
4. Look for markets that fit Dow’s definition of a primary trend, and open your position
5. Close your trade once the trend has reversed

Not sure if Dow trading is right for you? You can try out a range of theories and styles risk free using a City Index demo account. It comes with virtual funds to trade on our full range of live markets.

Finally, let’s examine a few key markets that can work with Dow theory.

Dow theory stock markets

When Dow first outlined his theory, his focus was solely on stocks and indices. Today, equities still provide a natural home for Dow’s tenets, for various reasons:

• Stocks and indices tend to be some of the strongest trending markets, generally exhibiting upward momentum with key periods of bear activity
• There are plenty of novice retail stock investors to drive the final phases of trends
• Stock indices and volume data are both easy to find and analyse, making it simpler to confirm trends

Dow theory forex

You don’t have to stick to stocks and indices when trading based on Dow’s principles, however – and lots of the framework of his theory also apply to the forex markets. Despite forex trading as we know it today being non-existent in Dow’s time, when currencies were still tied to gold prices.

Forex pairs can still move in primary, secondary and minor trends, and many forex traders use trend trading as their primary strategy. However, while currency indices (such as the DXY) do exist, it can be harder to confirm trends with them than on equity markets – which is why currency traders will often use other technical indicators instead.