HD1L2 Dow Theory : Part One
Dow Theory has been around for almost 100 years, yet even in today’s volatile and technology-driven markets, the basic components still remains valid.
Developed by Charles Dow and updated by William Hamilton, Dow Theory addresses technical analysis and price action but also market philosophy.
Dow Theory helps you see the market with the biggest picture possible.
Many ideas shared by Dow and Hamilton became the soul of trading.
While most people may think that the market behaves differently nowadays, the actual truth is that Dow Theory confirms that financial markets still behave the same way today as they did centuries ago.
Dow Theory at a high level describes market trends and how they behave.
At a more granular level, it provides signals that can be used to identify the primary market trend and/or indicate a change in that trend.
If both Dow Jones averages are trending in the same direction, then the entire market can be said to be trending in that direction as well.
Traders use these signals to identify market trends and trade accordingly.
Background
Charles Dow developed Dow Theory from his analysis of market price action in the late 19th century.
Until his death in 1902, Dow was part-owner of The Wall Street Journal.
Although he never wrote a book on these theories, he did write several editorials that reflected his views on speculation..
William Hamilton later refined the theory into what it is today.
Nelson wrote ABC of Stock Speculation and coined the term “Dow Theory”.
Application
According to Dow Theory, a market is made of many a market is made up of several trends that get entangled and evolve simultaneously over different time units.
There are usually three trend units :
- Main (long-term) trend which is the movement of the market over a period of several years or months
- Average (medium-term) or intermediate trend which often corrects the main trend, in general over several months
- Short (short-term) trend that reflects short-term market fluctuations over a few weeks
Bullish/Bearish Trend
We will compare an uptrend to climbing a mountaineer.
If the climb is long, the mountaineer will need, for security and endurance reasons, to stop regularly, every night, to rest a bit.
It will go up several hundred meters, then take a break of several hours, before going back to reach a higher level, and so on to the top.
Sometimes, he will have to go down a little, to find a more suitable and safe bivouac place, but never, if he wants to continue his progress, he will not go lower than the level of his bivouac the day before.
When an action goes up, it also feels the need to blow, it stops its progress, and even often it loses a little of the road traveled, without exceeding the lowest level above.
If this trend is healthy, when it has finished its break, called a consolidation or correction (if the withdrawal is more important), it should start again and, like the mountaineer, reach a level of course even higher.
It is this ability to form new highs with each advance, without ever breaking down the previous consolidation lows, which sets a bullish trend.
It is the opposite for a bearish trend.
Assumptions
Before one can begin to accept Dow Theory, there are a number of assumptions that must be accepted.
Manipulation
The first assumption is : Manipulation of the primary trend is not possible.
Hamilton did not argue against the possibility that speculators, specialists or anyone else involved in the markets could manipulate the prices.
But he qualified his assumption by asserting that it was not possible to manipulate the primary trend.
Short movements, from a few minutes to few hours could be subject to manipulation by large institutions, speculators, breaking news or rumors.
While these shares were manipulated over the short term, the long-term trends prevailed after about a month.
Hamilton also pointed out that even if individual financial assets were being manipulated, it would be impossible to manipulate the market as a whole.
The market is simply too big for this to occur.
that’s why one needs to see the bigger picture and have a open minded reading of financial markets.
Averages Discount Everything
The second assumption is: the market reflects all available information.
Everything there is to know is fully reflected in the markets through price.
Prices represent the total sum of all the hopes, fears and expectations of all participants. Interest rate movements, earnings expectations, revenue projections, presidential elections, product initiatives and all else are already priced into the market.
The unexpected can occur but usually this will only affect short-term trends.
The primary trend will remain unaffected.
Coca-Cola (KO) is a recent example of the primary trend remaining intact.
The downtrend for Coca-Cola began with the sharp fall from above 90.
The stock rallied with the market in October and November, but by December started to decline again.
According to Dow Theory, the October/November rally would be called a secondary move against the primary trend.
However, when the major indices were hitting new highs in December, Coca-Cola was starting to resume its primary trend.
Hamilton noted that the market would react negatively to good news.
For Hamilton, the reasoning was simple: the market looks ahead.
By the time the news is delivered, it is already reflected in the price.
This explains this old Wall Street quote : “Buy the rumor, sell the news”.
As the rumor begins to filter down, buyers step in and bid the price up.
By the time the news hits, the price has been bid up to fully reflect the news.
Let’s look at Yahoo (YHOO) market trend on earnings.
For the first three quarters , Yahoo had been in an uptrend while delivering negative earning reports but thhe main trend kept alive on each of those quarters.
Because the trend was persistent Quarter-Over-Quarter (QoQ), the stock price showed no consolidation. It was just running sideways, thus ranging R[30,50]
Dow Theory Is Not Perfect
The third assumption is: the theory is not infallible.
As with anything in trading, there is never a 100 % absolute truth for any scenario as nobody can predict the markets, but can only try to at best.
As with anything in trading, Dow Theory is just a set of guidelines and principles that assist investors and traders with their own study of the market.
One needs to set his own trading system and strategy in order to follow Dow Jones Theory guideline. There is no conservatism here.
Dow Theory provides a mechanism for traders to use that will help remove some of the emotion.
Resist Emotions
The fourth assumption is: the theory always resists to emotions.
When a traders spots the main trend, he will not feel uncomfortable when the short-term trend is incurring him losses, since he knows a major pullback will come and shutdown the short-term trend.
When trading with less emotion and less focus on the money lost, a trader becomes emotionally and technically efficient.
Hamilton warns that investors should not be influenced by their own wishes.
There is no wish or hope to have. Only stoicism is to adopt.
That philosophy is one of the hardest thing to perform on earth.
But once emotions about money are controlled, there is no limit to success.
90 % day traders fail at this.
Money is too important to their eyes, and becomes less relevant when all capital is burnt through emotional trading.
That’s why tere is a saying : Never trade with money that you need.
Meaning, your deposited capital doesnt matter much to you, it should only be a mere percentage of your whole financial assets.
That way you cannot mind it.
When analyzing the market, make sure you are objective and see what is there, not what you want to see.
If an investor is long (buying), he or she may want to see only the bullish signs and ignore any bearish signals.
If an investor is short (selling), he may be able to focus on the negative aspects of the price action and ignore any bullish developments.
Dow Theory provides a mechanism to help make objective decisions.
The methods for identifying the primary trend are clear and not open to interpretation.
No matter what your timeframe, Dow Theory always helps to be able to identify the primary trend.
However, it is not advised to use timeframes smaller than Eagle Eye to spot Dow-compatible main trends.
Pushing further, according to Hamilton, those Dow Theory purists rarely trade more than four or five days a year.
Remember that scalping, intraday, and day-to-day can be prone to manipulation, but the primary trend is immune from manipulation.
Hamilton and Dow sought a means to filter out the noise associated with daily fluctuations. They were not worried about a couple of points, or getting the exact top or bottom.
Their main concern was catching the large moves.
Both Hamilton and Dow recommended close study of the markets on a daily basis, but they also sought to minimize the effects of random movements and concentrate on the primary long-term trend.
Market Movements
Dow and Hamilton identified three types of price movements :
- Primary movement
- secondary movement
- Daily fluctuations
Primary movements last from a few months to many years and represent the broad underlying trend of the market.
Secondary (or reaction) movements last from a few weeks to a few months and move counter to the primary trend.
Daily fluctuations can move with or against the primary trend and last from a few hours to a few days, but usually not more than a week.
Hamilton characterized secondary moves as a necessary phenomenon to combat excessive speculation.
Corrections and counter moves kept speculators in check and added a healthy dose of guesswork to market movements.
Because of their complexity and deceptive nature, secondary movements require extra careful study and analysis. Investors often mistake a secondary move for the beginning of a new primary trend.
How far a secondary move have to go before the primary trend is affected ?
This issue will be addressed in Dow Theory : Part Two, when we analyze the various signals based on Dow Theory.
After reading this course, you have gained +1 experience level points.
Current Experience Level Points : 3
