how the dow theory works
there are six main components to the dow theory the dow theory operates on the efficient market hypothesis emh which states that asset prices incorporate all available information earnings potential competitive advantage management competence all these factors and more are priced into the market even if not everyone knows all or any of these details in more strict readings of this theory even future events are discounted in the form of risk markets experience primary trends which can last a year or more such as a bull or bear market within the broader trends secondary trends make smaller movements such as a pullback within a bull market or a rally within a bear market these secondary trends can last a few weeks to a few months finally minor trends can last a few days to a few weeks these small fluctuations are considered market noise according to the dow theory the primary bull and bear trends pass through three phases a bull market s phases are the a bear market s phases are the for a trend to be established dow postulated indices or market averages must confirm each other this means that the signals that occur on one index must match or correspond with the signals on the other if one index such as the dow jones industrial average shows a new primary uptrend but another remains in a primary downward trend traders should not assume that a new trend has begun dow used the two indices that he and his partners invented the dow jones industrial average djia and the dow jones transportation average djta on the assumption that if business conditions were healthy as a rise in the djia might suggest the railroads would be profiting from moving the freight this business activity required thus the djta would also be rising trading volume generally increases if the price moves in the direction of the primary trend and decreases if it moves against it low volume signals a weakness in the trend for example in a bull market buying volume should increase as the price rises and falls during secondary pullbacks because traders still believe in the primary bullish trend if selling volume picks up during a pullback it could be a sign that more market participants are turning bearish reversals in primary trends can be confused with secondary trends it is difficult to determine whether an upswing in a bear market is a reversal or a short lived rally followed by still lower lows the dow theory advocates caution insisting that a possible reversal be confirmed by comparing indexes special considerationshere are some additional points to consider about the dow theory charles dow relied solely on closing prices and was not concerned about the intraday movements of the index another feature in dow theory is the idea of line ranges also referred to as trading ranges in other areas of technical analysis these periods of sideways or horizontal price movements are seen as a period of consolidation therefore traders should wait for the price movement to break the trend line before coming to a conclusion on which way the market is headed for example if the price were to move above the line it s likely that the market would trend up one challenging aspect of implementing dow theory is accurately identifying trend reversals remember a follower of dow theory trades with the overall direction of the market so it is vital that they recognize the points at which this direction shifts one of the main techniques used to identify trend reversals in dow theory is peak and trough analysis a peak is defined as the highest price of a market movement in a period while a trough is seen as the lowest price of a market movement in a period note that dow theory assumes that the market doesn t move in a straight line but from highs peaks to lows troughs with the overall moves of the market trending in a direction an upward trend in dow theory is a series of successively higher peaks and troughs a downward trend is a series of successively lower peaks and troughs the sixth tenet of dow theory contends that a trend remains in effect until there is a clear sign that the trend has reversed similarly the market will continue to move in a primary direction until a force such as a change in business conditions is strong enough to change the direction of this primary move a reversal in the primary trend is signaled when the market cannot create successive peaks and troughs in the direction of the primary trend during an uptrend a reversal occurs when the index consecutively fails to reach higher highs and higher lows over a long period instead the index moves in a series of lower highs followed by lower lows the reversal of a downward primary trend occurs when the market no longer falls to lower lows and highs consecutively higher highs and higher lows in a downward trending market demonstrate a possible reversal to an upward trend it s vital to remember that primary trend reversals can take months to present themselves a change in price direction over a one month two month or even three month period might only be a market correction 