Dow Jones Theory Explained in Simple Words

While it’s crucial to develop new technical trading systems, it’s equally important to understand the core trading principles that have stood the test of time. These principles were introduced by Charles Dow in the beginning of the XX century.  

Before reading the article and writing your questions in the comments section, I recommend to watch this video. It’s not long but covers the biggest part of questions on the topic.

For most people, the stock market is indicative of the state of the national economy. If you ask a common American what, in their opinion, characterizes the national economy, the most popular answer will be: the Dow Jones Industrial Average Index. However, the Dow Jones is an outdated indicator that only measures the performance of 30 out of more than 10,000 publicly-owned companies listed on stock exchanges. Nonetheless, this is how the public sees the economy. This is why traders have no choice but to take DJIA into account as a barometer of public opinion.

The founder of the Dow theory and the Dow Jones index was Charles E. Dow (1851-1902). He was the first editor at The Wall Street Journal, where between 1900 and 1902 he published a series of editorials on the stock market. Later Robert Rhea assembled Dow’s articles in a book, The Dow Theory. According to some experts, with his book, Robert Rhea made a greater contribution to the Dow theory than Charles Dow himself.

Dow’s main interest was to develop a predictive economic indicator based on the stock prices of major publicly owned companies. Even today, DJIA tends to be ahead of the national economy by 6-9 months. Instead of going into graphic models or technical phenomena, Dow was concerned with inventing the index. Even nowadays, loyal advocates of the Dow theory are mainly focused on the larger market. The Dow theory provides a fundamental insight into the market structure. While Dow characterized intraday price action as being inconsequential, most of his principles for the larger market can be successfully applied to intraday price movements as well.

Knowing the Dow theory is a must for every trader. Listed below are its key principles:

• The price affects all information and emotions.
• Any market has three types of trends at the same time.
• Primary trends last months or even years.
• Secondary trends last weeks or months.
• Minor trends last several days or weeks.
• Trends are composed of three phases.

This last principle was later used by R. Elliott in his Wave Theory. The magic connotations surrounding number 3 date back to the times of Pythagoras and Ancient Egypt. Many technical experts believed that a trend makes three moves before making a reversal. For example, Edson Gould named such price action “Three Steps and a Stumble” and George Lindsay dubbed it “Three Peaks and a Domed House.”

Once they occur, the three phases described by Dow can be easily seen on a chart.

• Trends are frequently defined as secondary reactions.

Trends are an angular testing of two or more support/resistance levels. Trends are formed through a series of tests of higher highs with higher lows, and lower lows with lower highs. Testing of support/resistance levels is one of the most important building blocks of technical analysis.

• A reversing trend is the one that cannot beat the previous high or low. Failure of the larger market is the result of a failure of the primary trend.
• Sideway price fluctuations (5% or less) are usually a sign of accumulation or distribution.
• Only close prices are taken into account.

Even today, close prices are viewed as confirmation of market movement. Close prices are considered more important than extremes that occur throughout the day. Why? Because traders believe such positions are strong enough to be held overnight. If you follow this rule, you risk missing intraday highs and lows but Dow theory supporters view highs and lows as mere deviations that can be ignored.

• The longer the trend, the greater the secondary reaction will be.
• A breakout and/or exhaustion must be confirmed by volume.
• To be valid, an extreme of the Dow Jones Industrials Average Index must be confirmed by an extreme of the Dow Transportation Index.

In other words, for a dynamic trend to continue, the Dow Jones Industrials Average Index and the Dow Jones Transportation Index must move in the same direction and continue to make new highs/lows. Otherwise, a reversal is soon to be expected. There is a theoretical explanation for this statement. If you’re a manufacturer, you must ship your products. If you’re not shipping your products, you’re not selling them. And vice versa. If you’re shipping more than you’re manufacturing, you have a weak order portfolio. This is a fundamental rule applied to the overall economy.

According to the Dow theory, a string of higher highs or lower lows indicates that a dynamic trend has occurred and is going to continue. And vice versa. If the market fails to make a series of higher highs or lower lows, a dynamic trend is coming to an end.  Understanding this principle can be of great help even to intraday traders.

Note: It should be mentioned that the Dow theory of higher highs and lower lows generates lagging signals and shows highs and lows after they’ve already occurred.