Dow Theory: What It Is, and How Does It Work?

Did you know that many investors and traders are looking for various ways or systems, both fundamental and technical, to make a profit in the market?

You may wonder, where should someone start looking for this strategy? What to learn first?

If you are a trader, you should know that there is one theory known as the Dow Theory; this theory is known as the basic theory of trading strategies.

Therefore, as a novice trader, you should try to understand this theory as a starting point before studying other trading strategies out there.

Curious about the dow theory? Check out the full discussion in this article.

What is the Dow Theory?

Dow Theory is a theory that became the forerunner of modern technical analysis. This theory explains that there is a pattern or trend in a market. There are three trends, namely, a bullish trend (uptrend), a bearish trend (downtrend), and a sideways trend (consolidation). Within the trend, there are more sections called the major trend, secondary trend, and minor trend.

Dow Theory also explains that the trend in the market can be confirmed through volume. The trend will also generally continue until a reversal signal appears in the market.

Simply put, this theory explains that the movement of asset prices in a chart already contains all the information needed for an investor or trader to predict and make the right decisions.

Did you know that it turns out that some think that this dow theory existed long before candlesticks were discovered? Even today, dow theory is still widely used for technical analysis. Traders combine modern analytical strategies with the principles of dow theory.

History of the Dow Theory

Dow Theory is the result of the thoughts of Charles H Dow (1851 - 1902) with Edward Jones, published in the Wall Street newspaper. At that time, Dow was a journalist and editor of the Wall Street Journal and an economist from the United States.

In 1868, Charles H. Dow made a new development, namely the Jones Industrial Average, which is a stock market index that measures the performance of the United States stock market industry. From there, he also developed several other theories, which were re-published in a series of editorials in the Wall Street Journal. He later gave the name Dow Theory, also known as the Down Theory.

After that, in 1880, Charles H. Dow moved to New York. To be precise, Dow moved to work for the Kiernan news agency and met his partner Edward Jones who was also a Dow fan.

They then developed two indices, the Dow Jones Industrial Index and the Dow Jones Transportation Index, originally developed for the Wall Street Journal.

The two created the Dow Jones stock index because they believed it could provide an accurate picture of the economic and financial conditions of the two main sectors at that time, namely the industrial sector and transportation.

But unfortunately, in 1902, Charles H. Dow died, and William P. Hamilton replaced his position.

Hamilton then continued the knowledge left by Dow and then published a book entitled "The Market Barometer". After that, the theory was further developed by Robert Rea in a book published by Barron in 1932 entitled "The Dow Theory."

Charles H. Dow's legacy theory has evolved over the past century and continues to form the basis of all modern technical analysis today.

How the Dow Theory Works

In general, there are 6 basic principles or main components of how Dow Theory works; the following is a complete discussion.

1. The Market Has Three Types of Movement

Main Movement/Primary Movement/Major Trend

Dow Theory states that a major trend is a major trend that occurs in the financial market. This major trend is very important for a trader to identify because this major trend will significantly affect the current or future price movements In the market.

This major trend will also impact two other types of movement, namely the secondary and minor trends, which will be explained later.

This major trend does not have a time benchmark for how long it lasts. The major trend or primary trend will continue as long as there are no signs of a reversal in price movements.

You need to remember that the trend is a friend of a trader; when you trade, always check the major trend. Whether he will continue or will there be a reversal, which actually determines that is a difficult thing.

Medium Swing / Secondary Movement / Intermediate Reaction

If the major trend is the main movement of a price in the market, then the secondary trend is different from the primary trend. The secondary trend is a trend whose direction is always opposite from the primary trend, so this secondary trend traders also call a correction trend from the primary trend that occurs.

For example, suppose the primary trend is currently experiencing an increase. In that case, the secondary trend is the price that has decreased for a moment and formed a lower point (support) that is higher than the previous correction or support.

This secondary trend does need to occur in a price movement in the market because if there is no secondary trend, it usually means that the price is no longer able to continue the primary trend that is happening and make a reversal.

Generally, this secondary trend or correction will last for three weeks or even three months. While the exact length is not as long as the entire primary trend, the secondary trend is only one-third or two-thirds of the length of the primary trend.

In addition to the characteristics already mentioned, the primary trend also has other characteristics. Namely, the price that occurred at that time was very volatile, and uncertain what price movements would look like, which we all know is moving in the opposite direction than the direction of the primary trend.

Short Swing / Minor Movement

According to the Dow theory, the last type of movement is a minor trend. This trend will generally last less than three weeks, this minor trend is actually a general movement of the secondary trend.

Usually, those who use Dow Theory in trading or investing do not pay too much attention to minor trends. This is because the Dow Theory is not very relevant to the minor trend which as we know Dow Theory is more focused on the long term not the momentary movement of a price.

However, this minor trend is still part of the primary and secondary trends; the three cannot be separated.

2. Market Trend Has Three Phases

Major Upward Trend (Bullish Market)

Accumulation

Phase The accumulation phase is the beginning of a bullish trend forming in the market. This phase is a point where investors are aware and consider that it is the right time to enter the market.

You can find this accumulation phase at the end of a downtrend, which is when you and probably most investors see that the market is in bad shape. But make no mistake, when circumstances like that are the most interesting times.

However, the accumulation phase is still a very difficult phase to identify because it is generally in a downtrend which as we know, could be just a rebound, aka a secondary trend, and not a new trend is created.

From a technical point of view, you will find this accumulation phase when price consolidation appears in the market. Things like that happen when selling pressure has begun to decrease and prices start to move flat.

And when the price has not made a new valley or lower low, a trend can be said to have entered the initial phase of an uptrend (bullish)

Public Participation Phase

When a lot of market information has entered the accumulation phase, investors generally think that the storm has passed, the situation has improved, and prices will recover. Then when the price has started to rise, the primary trend begins to form, and that's when the public participation phase also begins.

In this phase, most of the negative sentiments that used to appear during the downtrend have decreased a lot. Then when the market has been entered with good news then from there investors enter the market again.

This phase is the longest phase and is followed by very large price movements. Therefore those who enter during the accumulation can usually take the maximum benefit possible in this public participation phase.

Exceeding Phase

Along with very large price increases, market or business conditions are getting better, and the number of market participants is increasing every time. So this is the phase where investors with large capital start to exit the market, marking the final phase of the bullish trend.

In this phase, market participants think that the conditions are good and will get better in the future, and it is also in this phase, many new buyers or investors will enter the market even though the trend is a bit more at the end increase.

When this phase exceeds, you will need to pay attention to any signs of weakness that may appear in the market because then you can identify the end of the current bullish trend.

Primary Trend Down (Bearish Market)

Distribution

The initial phase of a bearish trend is the distribution phase. This phase is a condition in which market participants, especially those with large capital, begin to relinquish all positions they have previously taken as holders.

In contrast to the accumulation phase, where sentiment has a negative perspective, in this distribution phase, market sentiment thinks that prices will continue to rise and there is no potential for a decline, even though the trend has begun to break and has changed direction.

This distribution phase was successfully confirmed when the price could no longer form a higher high or a higher peak than the previous peak.

Public Participation Phase

Actually, the same as during a bull market, many investors have taken action in this phase. The difference is that in the public phase in the bullish market, many people buy, in the public participation phase during the bear market, most of the market participants have started to let go of their positions and leave the market.

Panic

Phase This phase is actually also similar to the phase of transcendence. Here, market participants panic to sell their shares or positions and secure the remaining funds that may still be saved them.

In the sell-off phase, market participants will be very high. They will continue to increase in just a short time, not to mention that the market is already filled with negative sentiments, be it from bad economic or business news.

In short, in this phase, people will panic and sell what they have in the market. But you need to know that usually at times like this, those with large capital will start to enter back little by little and start an accumulation phase and the beginning of a bullish primary trend.

3. Any news that counts in the stock market

What does this principle mean? Why does news count in the market according to Dow Theory?

So, according to Dow Theory, the stock price already represents all the information contained in the financial market. If there is new information at that time, the price will immediately adjust to that information.

So it can be said that the price does represent everything that happens in the stock market, it reflects all the information that stock traders know.

4. Exchange Indices Share Information

Dow Theory also states that indices in a related sector will confirm each other. In Dow Theory itself, the sector is represented by two indexes: industry and transportation.

The point is, according to Dow Theory, the trend will be considered valid if the two sectors confirm each other's trends. Each index is required to pass the previous trend to validate the current trend.

Even though the market conditions in each country are different, you can still use this Dow Theory principle. You only need to look for a reference index or sector that is crucial for your country's economic conditions.

5. Trading Volume Confirming Trends

Dow Theory is basically a theory that discusses price movements. So it's clear that "Volume" is only a confirmation tool. By utilizing volume you can confirm whether a trend is valid or not.

So it can be said that Dow Theory uses volume to create certainty when determining a trend that is starting to increase.

Dow Theory states a trend will be considered valid if it is followed by an increasing volume when the trend starts.

In simple terms, when an increase simultaneously follows the price decreases and in transaction volume, it can be confirmed that the market is experiencing a downtrend and vice versa if the market is increasing or bullish.

6. The Trend Will Continue Until Various Signs Appear Clearly If The Trend Has Ended

According to Dow Theory, a trend will continue to experience until various signs give signals that the trend will reverse direction.

You may already understand this, in this theory a bullish trend is marked by prices that continue to increase consistency and create new highs. And vice versa, a bearish trend will be considered valid if the decline occurs consistently and creates new lows continuously.

So if there is no signal, for example when in an uptrend, unable to create new highs and a decrease in volume, or in a downtrend, prices are unable to form new lows, then both of them can be said to be experiencing a trend change direction or reversal.

Trading Strategy with the Dow Theory

"Trend is a friend" Maybe you've heard a phrase like this, this is because trading by relying on trends is a very powerful strategy and it is the basis of the Dow Theory. After getting to know the principles of Dow Theory, you also need to know the trading strategy using the theory:

1. Entry a position according to volume

When you want to take a buy position on a stock, it means you are speculating that the price will increase. So by utilizing your Dow Theory, you can enter a buy position when the transaction volume also increases, whereas you can enter a position when the market is having low volume, aka when it is undergoing consolidation, and this is called a buy-on weakness.

If you want a sell entry, the principle is the same, you wait for the trend to go down and the volume to increase, but you can still enter when the price is consolidating to enter the initial position.

2. Entry positions when you are at the beginning of the participation phase.

If you are a retail trader, aka a trader with a capital that is not large enough, it is highly recommended not to force yourself to enter the accumulation phase. For example, when the trend is currently experiencing a decline and then there is a consolidation where you can assume it is the end of the trend and also an accumulation phase, don't take long positions at that time.

You should let it go first to see confirmation because you need to know that during this accumulation phase, the price has the potential to continue and not reverse direction. So it's a good idea to wait until the primary trend has really happened, then you can enter the participation phase.

3. Enter when a price swing occurs

. When a primary trend occurs, there will always be a secondary trend that follows it. The trend cannot continue to increase just like that; as a consequence, the trend will not last long and will break.

You can take advantage of the secondary trend that occurred at that time, namely when the price swing occurred. For example, when the price increases, it will not always continue to rise. There will be a time when the price swing down occurs and creates support, which is called a retracement. According to Dow Theory, this is also the best time for you to enter the market.

Advantages and Disadvantages of the Dow Theory

Advantages of the Dow Theory

• Helps in determining price trends in the market
• Very easy for beginners to use
• It helps in finding the best and safest entry points.
• Can be the foundation of all existing modern technical analysis so that the potential can be even greater.

Disadvantages of the Dow Theory

• Its accuracy is not always 100% accurate.
• Not suitable for current market conditions.
• Not suitable for those who trade with daily timeframes or below.

FAQ - Frequently Ask Questions

Does the Dow Theory apply to all types of financial instruments?

Although Charles H. Dow first published a theory to analyze stock price movements, you can still use it in other investment instruments such as forex and cryptocurrencies.

Is the Dow Theory still relevant to today's modern market conditions?

This theory is indeed a century old, but you can still use it as the basis for your technical analysis. By combining Dow Theory with modern technical analysis, you can find greater opportunities in the market.

Conclusion

Dow Theory is the basis of technical analysis, which has been around for centuries. Although over time, market conditions have changed, the Dow Theory can still be used as a foundation or basis for technical analysis that we have to combine with other modern technical analyses.

However, you should not make this Dow Theory the main reference in your trading because its accuracy is not always correct. You must combine it with other technical analyses to make the best trading decisions.