What is the Dow Theory in technical analysis?
The oldest and most fundamental theory of technical analysis is the Dow Theory. In 1884 Charles H. Dow invented a stock index: the Dow Jones Industrial.
Dow never wrote a book on technical analysis but expressed his ideas on the stock market in numerous articles in the Wall Street Journal.
All these articles were collected and published by Robert Rhea in the book Dow Theory.
The six fundamental principles of this theory are set out in this volume.
Indexes discount everything
Any possible supply and demand factors are reflected in stock exchange indices.
In practice, everything that cannot be anticipated by the market is assimilated and discounted in prices.
When new information arrives, the participants adapt instantly, and the price moves accordingly.
Similarly, market averages also discount and reflect what operators are aware of.
Prices thus represent the aggregate sum of all operators’ hopes and expectations.
This means that the market often discounts information that the individual does not have at his disposal and also that it is complicated, if not impossible, to get information that the mass of market participants does not have.
We will elaborate on this concept in the next paragraph.
The market has three trends
According to Dow’s theory, an uptrend is formed by a sequence of increasing highs and lows.
A downtrend is composed of a succession of decreasing highs and lows.
Dow argued that we could consider an upward trend as long as each upward phase leads to new highs, and each correction ends at a higher minimum than the previous one.
This statement is critical to understanding the swing trading developed by Livermore and others.
The exact opposite is true of the downward trend.
Dow then divided the trend into three categories: the primary, the secondary, and the minor.
The primary trend reflects the attitude of investors towards the evolution of fundamentals related to the business cycle and has an annual duration.
The secondary trend represents a correction of the primary trend and has an average duration of between three weeks and three months.
These intermediate corrections usually go back 50% of the total length of the previous movement.
The lowest trend usually lasts less than three weeks and represents short-term fluctuations.
The primary trend can be upward or downward
If prices draw increasing highs and lows, the primary trend is upward. On the other hand, prices show decreasing highs and lows; the primary trend is downward.
- When the primary trend is upward, a secondary movement consists of a correction or a side consolidation phase.
- If the primary trend is downward, a secondary movement consists of a rebound or a lateral settling pause.
It should be noted that the time frames indicated by Dow to identify the various trends must be adapted to the increasingly rapid behavior of financial markets.
Using this principle, some analysts construct multi-timeframe operational strategies.
The trader operates on the smallest time frame, taking advantage of the primary trend in the upper time frame.
The primary trend
The primary trend usually lasts from one to several years and is the most important, as it captures the attention and action of most investors.
Dow argued that the primary trend is like the tide, the secondary to the waves in the flow, and we could see the minor as the breakwaters of the waves.
The similarity did not have a simple artistic value but made it clear what the mentality with which you observe swings, or price fluctuations, must be.
In fact, according to this model, if observing the movement of water on a beach, you notice that each wave extends beyond the point previously marked; the tide is still in progress and is unfolding.
But if the waves recede, the tide may be changing.
The intermediate secondary trend
Therefore, the intermediate secondary trend represents only the correction of the primary one and, according to Dow, has an average duration from three weeks to three months.
Also, we define a measure of these corrections, which can usually reach an amplitude of 1/3 or even 2/3 of the previous trend. Still, often the retraction is equal to 50% of the main movement.
A minor trend usually lasts less than three weeks and represents a simple retracement of the intermediate trend.
The primary trend has three phases
- The first phase is accumulation, develops with the purchases of the most informed investors, and occurs when the market already discounts all negative news.
- The second, in which so-called follower trends take a stand, is the phase during which prices begin to rise rapidly, and economic news signals a continuous improvement in the fundamentals of the economy.
- The third phase occurs when corporate news becomes increasingly positive, and the bulk of small investors enter the market, resulting in exponential growth in both stock prices and speculative volume.
During the latter phase, when no one seems willing to sell, more informed investors instead begin to distribute the securities they had previously accumulated.
The first Phase
The first, called accumulation, see the purchases of the most experienced and informed investors, which take place when they believe that we now discount all negative news in the market.
Most potential investors, however, are still discouraged, to where this can we can call this a phase of mistrust.
The second Phase
In the second phase, experienced investors increase their positions because the economy improves. Even less experienced investors are entering the market because prices now show that they can grow for an extended period.
The simultaneity between the rise of the stock market and the economic recovery means that we can define this as a phase of coherence.
The third Phase
The third and final stage is the entry into the markets of the mass of investors (the so-called ox park) when the stock price race is now reported in the newspapers.
Precisely the echo given to the sharp rises attracts more and more people in the stock market, with the illusion of being able to get rich quickly.
At this stage, more informed investors are at least partially liquidating positions, partly because the economy is increasingly struggling to grow, as physical markets are becoming saturated.
We are, therefore, in the phase of excess. The downside scenario begins when the economy provides the first signs of difficulty and slowdown, with not all operators and economists acknowledging the start of a significant downturn.
The downside scenario, therefore, also begins with the phase of mistrust.
The deterioration of the economy and the decline in stock prices continue, convincing more and more people that things are going wrong.
Businesses are firing massively; traders see their sales fall; investors are experiencing the first significant losses.
This is, once again, the phase of coherence.
The last phase of a long downward trend is catastrophic because companies and banks fail.
Investors can no longer sell because they are now suffering losses that are too strong to hope to recover.
Pessimism feeds itself quickly, because now even what has always gone well goes wrong. We’re in the excess phase.
Indexes must confirm each other
Dow, referring to the industrial index (Dow Jones Industrial) and the railway index, argued that no substantial change in the primary trend could occur if both indices had not given the same indication.
If, on the contrary, one index moves upwards and the other weakens, a divergence of behavior occurs, signaling how the internal depth of the market is declining.
When Dow planned this principle, he referred to the Dow Jones Industrial and Dow Jones Transportation indices. He meant that no upward or downward signal of any importance could be reliable if both indices do not point in the same direction.
Therefore, to have a real signal, both indices must exceed the previous maximum or fall below a minimum prior.
The two signals don’t have to manifest themselves, but it must not take too long for them to agree.
When the two indices are confirmed, we still consider the trend strength.
Volume must confirm the trend
The general rule is that the volume must expand in the direction of the primary trend.
- If the primary trend is upwards, the volume should be high when prices accelerate upwards and decrease when prices are being corrected.
- If the primary trend is downward, the volume should be high when prices accelerate downwards and decrease when prices are being corrected.
The higher the volumes on the purchasing side, the more substantial and rapid the rise in prices will be.
Similarly, the higher the volumes on the sales side, the more substantial and sharp the fall in prices will be.
The first stage is called accumulation.
When the market has already discounted all the negative news, there is an increase in volumes on the demand side that initially stops the fall in prices.
In the second phase, prices start to rise rapidly. The upward pressure increases substantially, with volumes recording a sharp increase.
The market is controlled by buyers, whose size is significantly larger than that of sellers.
The third phase, called distribution, occurs instead at the end of an upward movement.
When the market has already discounted all the positive news, there is an increase in volumes on the supply side that blocks the rise in prices.
In the fourth stage, prices fall sharply.
The downward pressure increases substantially, with volumes recording a sharp increase.
Prices are falling and establishing a downward trend.
According to Dow, the volume has a secondary value, but it is still relevant as a confirmation of the trend.
For Dow, the volume must expand toward the primary trend. We expect volume to expand and increase when prices rise, whereas, on the contrary, we expect it to decrease when prices fall.
In a downward trend, according to Dow, the opposite should happen, i.e., volumes should increase downwards and decrease when they recover.
What is the rationale behind this principle?
Buyers vs Sellers
The logic of mass participation. Most savers can only operate upwards.
Therefore, in a bullish market, a sharp increase in volumes means that increasingly less experienced people are entering the stock market, who will pay little attention to the price at which they buy.
All this favors the continuation of the upward market, precisely because buyers continue to arrive who buy mainly without price limits.
During the downturn, the volume works in reverse, I.e., panicked sales are mainly made by the unprepared. They sell without regard to the price, for fear of not being able to do so, but in this way, they increasingly stimulate a rapid fall in prices.
Conversely, only slightly more experienced and wise people dare to buy after a sharp decline, and this explains why, according to Dow, volumes should decrease during upward reactions along with a downward trend.
A trend is in place until a definitive trend reversal signal arrives.
This is one of the most important concepts of technical analysis.
No matter how high and even absurd, the price achieved by security or the value of an index may seem.
Until a reversal signal arrives, the trend has yet to be considered. This Dow rule defines the correct approach to the matter.
The trend is your friend
A pattern is in place until a definitive signal of trend reversal occurs.
The objective must be to exploit impulsive movements that develop in the same direction as the primary trend followed by the market.
These movements have a much higher extension than physiological corrections and offer the best opportunities in terms of risk/return.
From an operational point of view, therefore, priority should be given to trend-following operations, based on which:
- If the primary trend is upward, it is especially important to look for opportunities for a long entry.
- If the primary trend is downward, it is especially necessary to look for opportunities for a short entry.
THE PSYCHOLOGICAL CYCLE OF MARKETS
The different psychological phases that develop within a medium-term economic/financial cycle can be summarized as follows:
It starts from a situation in which the stock market is in a dominant downward trend. The macroeconomic situation is very harmful, and there is widespread pessimism among operators.
At the end of this decline, the market will reach a necessary minimum, characterized by a generalized sell-off. A depletion gap-down may also occur.
When the downward pressure has reached its extreme peak, the market, a technical rebound will begin, fueled in particular by the coverage of short positions.
The majority of investors do not participate in this first phase of the rise.
Economic fundamentals have not yet shown any signs of improvement, and technical indicators still indicate a downward trend.
Volumes are usually small, as many institutional investors remain on standby, awaiting a signal from the market.
After this first recovery, a dangerous bending occurs very often. At this stage, many trader trend followers try to re-enter shorts, but have been misled and will suffer losses.
This decline has a lower intensity than the previous downward impulses.
The market, drawing an increasing minimum compared to that achieved during phases A and B.
From a graphical point of view, in particular, the sequence of decreasing highs and lows that technically identifies a downward trend has been interrupted.
At this stage, a process of accumulation begins on the part of institutional investors who begin to open new long positions.
At this stage, volumes increase substantially as upward pressure grows steadily as prices continue to grow.
During this positive movement, some corrections occur, probably caused by profit-taking.
These breaks do not damage the technical framework of the market, but I provide an opportunity to enter the market.
For this reason, rather than actual corrections, these are short side consolidation phases, where prices move sideways.
The upward movement, which was initially of a linear type, undergoes a sharp acceleration and can become exponential.
This behavior pushes prices to new highs (highs) in a climate of euphoria and excitement, with economic fundamentals improving markedly.
In this climate, the market reaches the end of its climb, very often designing an exhaustion gap-up that creates, in technical and psychological terms, the conditions for the subsequent downward reversal.
Institutional investors, taking advantage of the market entry of small operators, start a process of distributing long positions.
There is, therefore, a strengthening of the downward pressure that triggers a bending of a sure consistency.
Most operators cannot explain this decline, as the macroeconomic situation remains positive, and the technical indicators are all bullish.
Few realize that the market has reached a significant top, and many trades this decline as an opportunity to open up new long positions.
At this point, we are witnessing an attempt at recovery on the part of the market, which is developing at a lower intensity than previous bullish impulses.
The market, drawing a maximum decreasing compared to the one reached during the last extension, indicates that the technical framework is getting worse.
The downward pressure increases and causes a sharp bending that causes the breaking of critical graphic supports and establishes a primary downward trend.
This decline is fuelled by a worsening of the macroeconomic situation and the short market entry by those institutional operators that use trend following methodologies.
At this stage, the volumes increase substantially, as the downward pressure grows continuously.
The negative trend, therefore, undergoes a sharp acceleration, even if occasionally technical rebounds occur.
We arrive in a climate of extreme tension and pessimism at the final stage of the descent, when the market creates the conditions, in technical and psychological terms, for achieving a medium-term bottom.
NEWTON AND THE FINANCIAL MARKETS
The behavior of financial markets can be analyzed, even with the basic principles of physics.
In particular, following the laws designed by Isaac Newton, it is possible to verify how price trends follow three standard rules.
The first law is that of inertia.
Prices remain at rest (stationary) until a force acts on them.
Similarly, motorcycle prices tend to stay in motion until some other force acts on them.
If we analyze the behavior of many stocks, we can see that very often, prices move in a narrow trading range, before making a sudden directional movement.
The latter is generated because one of the two forces that face each other on the market takes over.
Thus, the Prices then continue in their trend, bullish or bearish, as long as they remain in an imbalance between the strength of the buyers and that of the sellers.
The second law is linked to momentum/impulse.
A moving price accelerates in proportion to the force acting on it.
In particular, the force is equal to the mass multiplied by the acceleration, i.e., f = m × (a).
The second law of physics can be passed on to the financial markets considering the volumes.
The latter expresses the strength of buyers and sellers and are therefore likely to accelerate, upwards or downwards, the trend followed by prices.
The higher the volumes, the stronger and more substantial the upward or downward movement that develops on the market.
The third law may be called an action/reaction.
Each action corresponds to an equal and opposite reaction.
This last rule regards the possibility that, at the end of a bullish trend, a reverse bearish trend occurs, capable of bringing the prices back to their starting point.
On the contrary, after a long downward movement, prices can turn upwards and start an up-trend that, from a theoretical point of view, could bring them back to the highs previously reached.