Dow Jones Theory Strategy Guide
Market trends are such complex forex concepts in technical analysis that the Dow Jones Theory details them. Among many market trends theories, the “Dow Jones theory” also known as the “Dow Theory” is believed to be the most accurate trading strategy in forex. Dow Jones or more precisely the Dow Jones & Company is a financial news company considered one of the biggest businesses in the United States of America in the 19th century.
Dow Jones Theory FAQ
What is the “Dow Theory”?
The Dow theory is a technical analysis financial strategy that we can use in trend analysis and forex trading. It addresses technical analysis, the price of the stock, and market philosophy. The main idea of the Dow theory in technical analysis is that it proves that the stock market behaves the same way today as it did more than 100 years ago. The Dow theory studies market trends and how the market behaves and it provides signals that we can use in forex trading. In other words, it provides Dow Theory buy or sell forex signals.
Furthermore, the Dow theory strategy is based on the analysis of 2 trading indexes. First, the Dow Jones Industrial Average(DJIA). Second, the Dow Jones Transportation Average (DJTA).
The theory in general is quite simple. It is based on 1 fundamental concept: a comparison between the 2 indexes (DJIA) and (DJTA) to figure out the current trend and take action or trade on this basis. Note that the volume of daily transactions also is an important key element of the theory.
Dow believes that these 2 indexes, as they are the averages of the stocks, project the shape of the industry. Thus, they are both valuable in understanding the current situation of the economy in general.
Hence, we can say that the Dow theory in technical analysis is a general view of the stock or forex market. A general ideal shape that we can’t ever reach. We can describe it as follows:
Assumptions of the Dow theory in technical analysis
Manipulating the Primary Trend is completely impossible!
Dow theory states that manipulating the long-term trend is impossible as we judge the market to be “Too big to be played with” in technical analysis. However, manipulations could occur in intraday trading, day-to-day trading, or secondary market trends. Dow believes that there are 2 types of possible manipulations:
- Price manipulations: by purchasing or selling stock with a price much higher or lower than the current market price. Usually done by large institutions or speculators.
- Market sentiment manipulations: usually done by inaccurate breaking news or rumors.
However, we can manipulate some individual shares. The stock price goes up or down depending on the manipulator’s objective. Eventually, the price will go back to continue the primary trend as manipulation could only be temporary.
The indexes show everything !
Dow believes that even if a stock manipulation could occur, the index will reflect any available information through prices because as we stated earlier. It’s possible to manipulate an individual stock but never the market as a whole.
However, unexpected events could occur (Events that aren’t manipulations). Which could influence the price of a certain asset or a group of assets. Therefore, these events would only affect the short-term trend. The primary trend remains unaffected.
As follows, is an example of an unexpected event that occurred. Tesla’s Shanghai Gigafactory work suspension due to the Covid-19 crisis.
As we observe, the stock price made a pullback during the period when Tesla’s administration decided to shut down Shanghai’s factory, one of the most productive factories of the company due to the Covid-19 excessive spreading in China. The stock price decreased for a short period, approximately less than 3 months, going down from almost 900$ per share to 540$ per share. A decrease of almost 40% in the share’s value. Yet, we can consider this price movement as a secondary movement because it didn’t last long. Also, the price came back to its previous level and continued rising as the primary trend is Bullish.
The Dow Jones Theory isn’t “error-free”
As we stated earlier, the Dow theory is an illustration of what’s considered a “Perfect Reality”. Thus, it’s looked upon as guidelines that assist investors and traders in their market study, a mechanism to help remove emotions while investing.
However, William Peter Hamilton (one of the 3 experts that published the Dow jones theory in technical analysis) warned investors. He stated that When analyzing the market, investors should make sure that they are objective and that they should see what there is, not what they’re craving to see.
Furthermore, the theory wasn’t meant for short-term trading. Yet, it is useful for all market participants (Traders/speculators/investors) as it helps identify the primary trend.
Peter Hamilton explicitly said: “Those who successfully applied the Dow Jones theory, rarely traded more than 4 to 5 times a year!”. Because it’s almost impossible to detect the start of a primary trend. (We’re going to explain the primary and secondary trends in detail in the next section).
What are the Dow Theory 3 rules?
The primary market trend is in simple words, the long-term trend, it’s either Bearish or bullish, and it can’t be a sideways trend. Thus, it’s referred to as “Bull and Bear Markets”.
Once we identify the primary market trend and validate it, it stays active until proven otherwise. Thus, its length and duration are indeterminable.
Note that “NOBODY knows where or when the primary market trend will end”. So it’s useless to apply previous trends’ length and duration for forecasting upcoming primary trends.
The primary market movement contains 3 phases depending on the trend (Bullish or Bearish).
Phases of the Bullish Primary Market
A bullish primary trend means that the market value of stocks is increasing. In other words, the price of the asset is in a long-term uptrend. The Bullish Primary Market trend contains 3 phases:
Phase 1: Accumulation
It’s a Phase that is indistinguishable from a “Rally” of a Bearish Market. (A rally is a short-term increase in prices that isn’t significant considering the volume of transactions during the period). During the accumulation phase, bad news about companies starts to spread, and a lot of people are selling their stocks, but there is no one willing to buy and they expect prices to fall even more. Furthermore, as the supply is much more than the demand, the price would fall as the investors thought they will, but lucky those who sensed a potential trend reversal. They bought at cheap prices and will sell at much higher prices.
During the accumulation phase, the stock price hits the bottom and bounces announcing the start of a Bullish trend.
Unfortunately, people would consider it as a simple rally that will disappear shortly after and they won’t buy. And those who already own the stock would see to minimize losses.
Furthermore, prices would fall slightly after what was thought of as a “Rally”. Thus, people would think that the bearish primary trend isn’t over yet. But it’s in reality a secondary market movement than follows the primary market trend reversal.
At this stage, analysts will try to determine if the price movements belong to a potential bullish primary trend or a simple secondary movement that is considered a correction of the increase in prices during the bearish trend.
At this point, there will be 2 possible scenarios:
The first scenario is supposing that it’s truly a secondary move, where the low forms below the previous low.
The second scenario supposes that it’s the start of a Bullish primary trend. Therefore, a quiet period will follow then prices will start to advance where the current high surpasses the previous high.
The primary Bullish Trend is Confirmed and Validated.
Phase 2: Big Bullish Move
The “big move” is the second phase of a Bullish primary trend. This phase is the longest phase of the primary trend; no one can predict how much it is going to last. It could be months or even years.
However, this phase is characterized by the highest possible advances in prices, with many shape peaks.
During the big move, the good news about companies starts to spread, and the values of stocks increase significantly. Thus earnings start to increase as the market becomes ready to absorb more and more of the final products of each company.
Therefore, as investors start trusting companies, they become willing to buy more and more of their stocks.
Professionals consider this the easiest phase to make a fortune.
As follows, is an example of a Primary Bullish trend of the “PayPal” stock over 2 years.
The stock is in a bullish primary trend as prices are significantly increasing over time. Yet, the market reacted to the primary trend by making some secondary movements, a pullback in our case.
The price of the asset went up from almost 80$ per share in April 2020 to almost 300$ per share by the middle of 2021.
The Pullbacks that occurred were temporary and weren’t significant.
Phase 3: Excess
The 3rd and final phase of the Bullish Primary Trend is the “Excess Phase”. This phase is characterized by excessive speculation of stock. In other words, traders buy and sell stocks in a really short period. Thus, inflationary pressures start to appear as the confidence in companies is extremely high.
This phase is in simple words: a mirror image of the accumulation phase.
The chart below describes the movements of the price of the PayPal stock over 1 year. As observed, the stock has been through a period of high speculation where traders buy and sell in the hope to realize the highest possible profit margin.
However, the Excess phase didn’t last long as the prices started to fall continuously. People thought that it was a pullback and price will go back to normal soon enough. But, the prices broke the minimum trading limit, announcing the start of a Bearish Primary Trend.
Phases of the Bearish primary market
A Bearish primary trend means that the market value of stocks is decreasing continuously. In other words, the price of the asset is in a long-term downtrend. The Bearish Primary Market trend contains 3 phases:
Phase 1: Distribution
The Distribution phase is the 1st step of the start of a Primary Bearish Trend of the Dow theory trading strategy. It simply marks the start of a long-term downtrend.
During the distribution phase, business conditions start to deteriorate, and only experts could realize it. Thus, they start selling immediately.
On the other hand, the public is happy to buy more and more of the stock, thinking they could realize much profit from selling the asset later. This reaction is perfectly normal because they can’t detect any indication of a potential Bearish primary trend. Furthermore, business conditions seem to be well going for now. And the decrease in stock price is thought to be a simple pullback that will vanish soon. This is when the Primary Bearish Trend starts.
However, prices are still falling continuously and no one is believing that a downtrend is coming, at least, that’s what they want to believe. Thus, everyone keeps buying more and more thinking they would make a huge profit.
Furthermore, after this decrease in price, a rally begins, it is thought to be the continuation of a primary bullish trend.
During this rally, we can recover a large portion of losses (which could last a few days up to a few weeks).
In this case, the public spreads rumors that the Bull market is still going, even though a reaction to the rally would form, where the current high will be lower than the previous high.
On the other hand, after making a lower high, the price would fall below the previous low, clearly indicating that a Bearish primary trend has already started. Hence, it is also a confirmation that the 2nd phase of the Bear market is starting.
The chart below represents the price of the Disney company stock over 2 years.
From a general viewpoint, both the Bearish and Bullish primary market trends are visible. However, the Start of a Bearish trend was thought of as a pullback, as it was followed by a rally.
People thought that it was a simple market reaction and that prices would go back to their bullish trend. Thus, they have started buying a huge quantity of stocks which is going to cause them catastrophic losses.
Phase 2: Big Bearish Move
Similar to the big move of the Bullish Primary Trend of the Dow theory displayed on the forex trading, the 2nd phase of a Bearish primary trend is called the same. They both almost have almost the same characteristics.
It’s the largest phase of the whole trend. Experts may identify the Bearish primary trend once the business conditions start to deteriorate. In other words, earnings are continuously falling and companies experience a shortfall. (They start borrowing a lot of money to cover their expenses).
Furthermore, revenues start to drop off, as well as profits. That’s when experts start a massive sell-off.
As we observe in the chart below, the Bullish Primary Trend is clear and easy to identify. However, it ended when the prices broke through the dotted line in the chart. Prices kept falling then a rally takes place. People thought that the rally was a continuation of the Bullish Primary Trend. Thus, they bought more and more stocks in the hope that they might make a huge profit. Unfortunately, it was truly the start of a Bearish primary trend. Those who bought at the start of the rally and sold at the end of it made some profit. The others are going to suffer catastrophic losses.
Phase 3: Despair (Panic)
The 3rd and final phase of the Bearish primary trend of the dow theory in technical analysis is called the despair period. It’s a phase where hope is equal to 0. Everyone is pessimistic about the future of the market. The valuation of companies is continuously deteriorating.
Everyone is selling the stocks they own to minimize losses. Thus, the selling volume is high, and the prices are continuously falling as investors are willing to sell at any price. But there are almost no buyers, everyone is scared that the prices would fall even more.
On the other hand, bad news about companies keeps spreading as the economic situation keeps deteriorating.
And prices keep falling more and more as news is spreading.
The Market Movements Based on the Dow Jones Theory
The Dow Jones Theory stipulates that secondary market movements, also known as “secondary market trends” or “market reactions”, are a fluctuation in forex prices that occur in the opposite direction of the primary trend.
We can classify these fluctuations into 2 sub-categories: Pullback and rally that last between 3 weeks and 3 months. And some minor trends that are less than 3 weeks.
Dow Theory states that these forex fluctuations must occur in every primary trend but they are not to be feared as they are insignificant and temporary.
Is a small decrease in prices that occurs within a Bullish primary trend. During a pullback, prices fall to a certain level and then they go up back to pursue the primary trend. Also, the volume of transactions is typically low during secondary movements.
Is a short period characterized by an unusual increase in the price of the stock. It occurs during a Bearish Primary trend, where prices are continuously falling. People may mistake it for a potential primary trend reversal. Furthermore, the volume of transactions in this period is typically low compared to the volume that we detect during the primary trend movement.
These are fluctuations in price that occur during an extremely short period, typically less than 3 weeks. During this period, prices increase or decrease slightly. In the majority of cases, speculation is impossible during these trends as the potential benefit is so small and the risk could be high.
How to build a Trading Strategy With The Dow Theory ?
The Dow Jones theory is a famous trading strategy constructed based on 3 principal axes that are:
This is the most important part of the whole theory. It is based on identifying the individual trend of each index: the DJIA and the DJTA.
DJIA (Dow Jones Industrial Averages): is the base of the United States economy. It is constructed using a combination of the strongest 30 companies in the US. The trading strategy of the Dow theory believes that tracking this average could tell approximatively the health of the economy.
DJTA (Dow Jones Transportation Averages): this index represents a complementary to the DJIA, because as you know, after producing a good, it must be shipped to the retail stores or the consumers. The DJTA contains 20 of the biggest transportation companies in the US. The 20 companies are divided into railroad companies, airlines, trucking, marine transportation, delivery services, and logistics companies.
The Dow Jones theory identified only 2 possible trends:
A period in which prices are continuously falling. During this period, the 1st peak is lower than the 2nd peak and the 2nd peak is lower than the 3rd peak, and so on. Thus, the 1st trough is lower than the 2nd trough and the 2nd is lower than the 3rd, and so on.
A period in which prices are continuously rising. During the downtrend, the 1 peak is always higher than the 2nd peak and the 2nd peak is higher than the 3rd one, and, so on. In the same way, the 1st trough is higher than the 2nd trough and the 2nd is higher than the 3rd, and so on.
- An uptrend is valid until the current highest high is lower than the previous highest high.
- A downtrend is valid until the current highest low is higher than the previous highest low.
Hamilton said that it’s hard to distinguish between a change in trend and a simple correction. Thus, he thinks about eliminating moves less than 3%, during trend analysis. Therefore, this theory focuses mainly on catching only the big moves.
However, to detect a primary trend both indexes should confirm each other. In other words, the DJIA and DJTA should move in the same direction. Therefore, if one index records a new high or a new low, the other must do the same.
The chart below shows to movements of both the Dow Jones industrial averages (DJIA) and the Dow Jones transportation Averages (DJTA) from the last quarter of 2017 to almost half of 2022.
Both indexes move in the same direction generally. For example, a Sharp downtrend occurred approximately from February to almost the end of April 2020 (the red box). Both indexes confirm the trend. Following the Dow theory trading strategy, we can consider it the primary market trend as it lasted less than 3 months, which in turn makes it classified as a secondary market movement. Furthermore, we can observe that after that sharp downtrend, a towering uptrend occurs, it lasted long so we can consider it as a primary Bullish market trend. In other words, it’s a continuation of the Bullish primary trend that started before the last quarter of 2017.
However, the 2 indexes experienced a downtrend by the start of 2022. It is probably a primary Bearish market trend because it lasted more than 3 months and it’s continuing until now. Also, we can observe that during this downtrend, both indexes have recorded a new low that broke the previous low.
Even though the trading strategy of the Dow theory considers the price as the principal determinant of the trend based on the smart money concept also. It has given great importance to volume. Thus, we can consider the volume as the second most important factor when analyzing the strength of the trend and the direction.
Dow theory notes that volume would typically increase in the direction of the primary trend of the forex chart, and decrease during the secondary market movement or market reactions.
Thus, we can conclude the following:
During a Bullish Primary Market:
Volume tends to be heavier during the primary trend movement, during price increase in the case of a Bull primary trend.
However, volume declines remarkably during a correction, as there is less participation. In other words, during a “Dull market”.
During a Bearish Primary Trend:
Volume tends also to be heavier during a Bearish Primary trend. Thus, rallies experience a huge decrease in volume, which we consider it a “Dull Market”.
On the other hand, high volume levels could be an indication of a close potential trend reversal.
In other words, after a long advance, a huge volume in one day could be the signal of a potential trend reversal. Watch out for a reaction that may form soon enough.
Trading ranges also refer to the “2 lines” are a limit to the highest level and the lowest level prices could reach during the trend.
These 2 lines indicate the 1st phase of a Bearish or a Bullish primary trend. In other words, they either indicate accumulation or distribution.
However, it is impossible to tell which phase is forgoing until a break occurs.
Furthermore, the dow theory considers the trading range “Neutral” in technical analysis, until a break occurs which will determine the upcoming trend.
Also, the dow theory warns that trying to anticipate the trend may cause forex disastrous losses.
The Dow Theory represents a general viewpoint of the whole market trend in the technical analysis field. The forex theory focuses on 3 main aspects given by Dow Jones. Which are trend identification, trading volume, and trading ranges. Note that primary trends are long-term trends whereas secondary trends are fluctuations that occur during and go against the primary trend. The 1st step of the primary trend of the Dow Jones trading strategy is almost impossible to identify using the theory. Thus, only the lucky ones could benefit from it.
Institutional investors and experts have a better look at the market, thus they can detect any signal of a trend reversal. High volume during a 1day trading could mean a possible trend reversal. Once the price breaks through the trading range like in Darvas Box Strategy, it’s an indication of a downtrend or an uptrend, depending on which line the price break.