Understanding Dow Theory

Chapter 1

Understanding Dow Theory

As we studied about variety of derivative datasets, its about time to give slight attention to price action and a pictorial study of this is termed as Technical Analysis.

Technical Analysis

Technical analysis in the financial markets refers to the study of time series data, like price, volume open interest, strike prices. In comparison to fundamental analysis which is dependent on parameters and data sets like P/E, P/B or Quarterly results/profitability ratios, operating margins etc., technical analysis is a study of data sets put forth preferably in the form of charts. As picture is worth a thousand words. It is a field of recognising price patterns by technical analysts, sentimental analysis using price is an approach followed by most in technical analysis to gauge the demand-supply scenario for an asset and charts depict the shifts in these scenarios. Dow theory in technical analysis has been some profound work done by Charles Dow.

What is Dow theory?

Charles Dow, father of technical analysis, also the founder of Dow Jones financial news service in New York, first editor of the Wall Street Journal never formally specifically formulated what has come to be known as the “Dow theory”. The term “Dow theory” was first used by Dow’s friend A.C. Nelson, who wrote in 1902, an analysis of Dow’s Wall Street Journal editorials called The A B C of Stock Speculation. Peter Hamilton was the successor at The Wall Street Journal, as its editor, after Dow’s death. There have been several authors, who wrote about Dow’s research. Robert Rhea in 1932, further refined
what has become known as Dow Theory.
Rhea prescribed three hypothesis:
1. The primary trend is inviolate.
2. The averages discount everything.
3. Dow Theory is not infallible.
We shall now discuss the principles or six tenets of Dow Theory in technical analysis:

1. The Averages Discount Everything:

The averages of stocks helped in gauging the health of industry and hence the strength of the economy. The concept that prices discount everything, every factor that influences the demand and supply equation gets discounted almost instantaneously in the markets. The tendency of most investors was to look at individual stock prices and studied individual companies, until the approach of averages was brought forth by Dow. While the markets cannot pre-empt or forecast events such as earthquakes, epidemics and various other unknown events/calamities, they quickly discount such occurrences, and almost instantaneously assimilate their effects on the price action. The averages are a metric of the markets under study, as per Dow.

2. The market Has Three Trends:

The three trends that Dow discussed about were:
1. Primary Trend
2. Secondary trend
3. Minor trend
Dow compared the three trends, stated above to the tide, waves, and ripples of the sea. The primary trend represents the tide, the secondary or intermediate trend represents the waves that make up the tide, and the minor trends behave like ripples on the waves. Dow defined an uptrend, when the prices rally high and each successive rally moves the price higher. Also, the low of the successive rally is higher than the previous rally low. Briefly, as they say, uptrend is equivalent to higher tops and higher bottoms. While the downtrend was characterised by lower tops and lower bottoms. Dow’s definition of trends has withstood the test of time and still is practised by trend followers. Unlike actual ocean tides, which last a matter of hours, Dow conceived of market tides (primary trend) as lasting for more than a year, and possible for several years. The secondary, or intermediate, trend represents the corrective phase in the primary trend and usually lasts three weeks to three months. These intermediate corrections generally retrace between one-third and two-thirds of the previous trend movement and most frequently about half, or 50%, of the previous move.


According to Dow, the minor trend usually lasts less than three weeks. This minor trend represents fluctuations in the intermediate trend. The primary focus of all investors/speculators should be the primary trend of the stock prices which couldn’t be manipulated, as per Dow theory.

Nifty chart highlighting the 3 trends.

3. Major Trends Have Three Phases:

Dow focused his attention on primary or major trends, which he felt usually take place in three distinct phases:


1. accumulation phase

2. a public participation phase,

3. A distribution phase.


The accumulation phase represents informed buying by the most astute investors. If the previous trend was down, then at this point these astute investors recognize that the market has discounted most of the negative news; all the so-called “bad” news. The public participation phase, where most technical trend-followers begin to participate, occurs when prices begin to advance rapidly and business news improves (response to improved corporate earnings)


The distribution phase takes place when newspapers begin to print increasingly euphoric stories; when economic news is better than ever; and when speculative volume and public participation increase.


Similarly, three phases exist in bear markets, too. Firstly being, abandonment of hopes. Secondly being, decreased corporate earnings and selling due to trend followers. Lastly, distress selling, where expectations hit rock-bottom and some believe the worst D-day is yet to come.

4. The Averages Must Confirm Each Other:

Dow theory, in referring to the Dow Jones Industrial Average and Dow Jones Rail Averages, meant that no important bull or bear market signal could take place unless both averages gave the same signal, thus confirming each other (Concept of Confirmation).


Dow felt that when one average exceeded a previous secondary peak, a similar nuance, or price action should be witnessed in the other average too, to confirm a bull trend.


He did not believe that the signals had to occur simultaneously, but recognized that a shorter length of time between the two signals provided stronger confirmation.


When the two averages diverged from one another, Dow theory mentions that the failure of the two averages to reach new highs almost simultaneously, may be suggestive of primary trend reversing to a bearish nuance. These are called nonconfirmations.

5.  Volume Must Confirm the Trend:

Dow recognized volume as a secondary but an important factor in confirming price signals. Volume, by itself, cannot signal a trend reversal, but it should expand or increase in the direction of the major trend.


In a major uptrend, volume would then increase as price move higher, and diminish as prices fall.


In a downtrend, volume should increase as prices drop and taper off, as they rally.


When excessively high market prices persist, it is important to see volume as a secondary indicator, if accompanied by less volumes on rallies and more activity on declines, suggest a possibility of the trend being overbought.

6. A Trend Is Assumed to Be in Effect Until It Gives Definite Signals That It Has Reversed:

This principle/tenet relates a physical law to market movement, which states that an object in motion (in this case a trend) tends to continue in motion until some external forces causes it to change direction (law of inertia).


A number of technical analysis tools are available to traders to assist in the difficult task of spotting reversal signals, including the study of pivotal technical levels, price patterns, trendlines, and moving averages. Some indicators can provide even earlier warning signals of loss of momentum.


The most difficult task for a Dow theorist, or any trend-follower for that matter, is being able to decipher when a trend reversal has occurred or when the move is actually a secondary trend i.e. just a normal correction.


After having discussed Dow theory, we proceed in the next chapter to discuss about application of a Japanese technique of candlesticks and candle stick patterns.


Can you use technical analysis in option trading?

Yes, options trading is a concept of gaining or amassing wealth through buying low and selling high, the option premium, taking advantage of wavering prices, which are influenced by demand and supply of that instrument at different junctures. This shift in demand and supply is depicted by charts and technical analysis can be effectively deployed to study them.

How do you analyze data for options trading?

The importance of options trading is to analyze underlying, price and derivative data, to form a bias on the underlying asset and then prudently selecting the strikes in which option traders are supposed to be active, especially to know when short covering or option unwinding is occurring (to spot breakouts or breakdowns). The underlying asset may be an index like Nifty, BankNifty or NSE F&O stocks. The Dow theory lays down certain tenets/principles for technical analysts to follow.

What Are the 3 Trends of the Dow Theory?

The 3 trends that Dow Theory discusses are listed ahead:


1.Primary trend: Dow conceived of primary trend as lasting for more than a year, and possible for several years.

2.Secondary trend: The secondary, or intermediate, trend represents the corrective phase in the primary trend and usually lasts three weeks to three months.

3.Minor trend: According to Dow theory, the minor trend usually lasts less than three weeks.

What Is the Goal of Dow Theory?

The goal of Dow theory was to put forth certain basic tenets in technical analysis. Charles Dow, father of technical analysis, also the founder of Dow Jones financial news service in New York, never formally specifically formulated what has come to be known as the “Dow theory”. But it is a very useful work on Technical analysis, more of it can be found in the article above.

What are the 3 phases of the major trends in Dow Theory?

Dow focused his attention on primary or major trends, which usually take place in three distinct phases, as mentioned by him:

1. Accumulation phase

2. A public participation phase,

3. A distribution phase.