Dow Theory is the oldest framework in technical analysis and the source of many of its basic ideas: trends, confirmation and the role of volume. It comes from the editorials Charles Dow wrote in The Wall Street Journal around 1900 to 1902. Dow never set it out as a system; William Peter Hamilton, a later editor of the Journal, and Robert Rhea organised his ideas into the theory known today. Dow also created the market averages it relies on, which became the Dow Jones Industrial Average and the Dow Jones Transportation Average (originally the Rail Average).
The six principles
- The averages discount everything. Prices already reflect what is known about the economy and companies, and quickly absorb new information.
- The market has three trends. The primary trend lasts from about a year to several years. Secondary reactions run against it for weeks to a few months and often retrace one-third to two-thirds of the prior move. Minor trends last days to a few weeks and are mostly noise.
- Primary trends have three phases. In a bull market: accumulation by informed buyers while news is still bad, a long middle phase as business improves and the public follows, then a speculative excess phase. Bear markets run in reverse: distribution, a sharp decline, and finally capitulation.
- The averages must confirm each other. A bull market signal needs both the Industrials and the Transports to make new highs; a bear signal needs both to make new lows. The logic was that goods made by industry must also be shipped.
- Volume confirms the trend. Volume should expand in the direction of the primary trend: rising on advances in a bull market, rising on declines in a bear market.
- A trend lasts until it clearly reverses. A primary trend is assumed to be in force until the averages give a definite signal that it has changed.
How to read it
Dow Theory defines a trend by its swings. An uptrend is a series of higher highs and higher lows; a downtrend is a series of lower highs and lower lows.
- Bull market signal. After a decline, both averages rally, pull back to a higher low, then break above their previous rally high. The signal is complete only when both averages have done it.
- Bear market signal. After an advance, both averages fall, bounce to a lower high, then break below their previous low.
- Non-confirmation. When one average makes a new high and the other does not, the move is suspect. A non-confirmation is a warning, not a reversal signal by itself.
Strengths and common mistakes
- Late signals. Dow Theory waits for confirmation, so it misses the first part of every new trend and gives back part of the gains before a sell signal. It is a tool for staying with the primary trend, not for catching tops and bottoms.
- Subjective swings. Analysts can disagree on which highs and lows count as significant. Decide your rules for a valid swing in advance.
- A changed economy. Railroads no longer dominate transport, and the industrial average now holds many service and technology companies. Many traders still watch the two averages together, but also look at broader measures such as market breadth.
- Using it as a forecast. Dow saw the averages as a barometer of business conditions. The theory describes the trend in place; it does not predict how far it will go.
Live chart: DIA (Dow Jones Industrial Average ETF), daily, with the 50-day and 200-day simple moving averages, a common modern stand-in for the primary trend. The chart updates every trading day.
Screen for it on MarketInOut
Our formula language can check an index or another ticker with the @ operator, so you can gate a screen on a Dow-style confirmation. This one finds stocks above their 200-day average at a new 63-bar (about three-month) high, but only when both the Dow Jones Industrial Average and the iShares Transportation ETF (IYT) are also above their 200-day averages:
exch(nyse,nasdaq) and type(stock) and price > 1 and advol(21) > 1
and (price > sma(200))@dow and (price > sma(200))@iyt
and price > sma(200) and price new_high 63
If either average is below its 200-day line, the screen returns nothing, which is the point: no confirmation, no signal.
Related: Moving averages, Trend lines, Support and resistance.
