Dow Theory Explained
Updated: Nov 3
Dow Theory Explained offers a useful case study in turning market observations into repeatable trading rules. This updated guide preserves the original Financial Wisdom analysis while separating practical lessons from exceptional results and hindsight.
Dow Theory: In This Guide
Key lessons and practical rules
The original Financial Wisdom guide and media
Evidence, limitations and risk controls
Frequently asked questions
Related guides and authoritative sources
Key Takeaways
Translate the central idea into objective entry and exit rules.
Test the method across different market regimes and include costs.
Use price, volume and market context without treating any signal as certain.
Define invalidation and position size before entering.
Original Financial Wisdom Guide
Background and Core Ideas
What is it & how can it be applied to the stock market?
Hi, after numerous requests in the comments section, In this video we take a quick look at Dow Theory and how it can be helpful in identifying trends and reversals.
The Dow Theory was developed by Charles H. Dow, who was one of the co-developers of the DowJ ones Industrial Average in 1886. He published the theory through a series of articles in the Wall Street Journal, which he co-founded along with Edward Jones and Charles Bergstresser.
Unfortunately, Dow couldn’t complete the entire theory due to his death in 1902, and the theory was therefore expanded and completed by his associates and followers’ years after his death.
There are six main tenets of the Dow Theory
The first tenet of the Dow theory states that The market discounts everything.
The Dow Theory states that the market is efficient and discounts everything known to the general public. In a stricter interpretation of the theory, the markets even discount future events.
If Dow Theory is to be believed, it’s impossible to beat market returns, without exposing oneself to higher risk. As per the theory, all available information is already built into stock prices, and neither expert stock selection or market timing can help anyone outperform the market returns.
The second tenet of the Dow Theory states that there are Three kinds of market trends.
Practical Checkpoint
Define the setup, entry and invalidation level before acting.
Compare the potential payoff with risk-reward planning.
Set the trade size using consistent position-sizing rules.
Rules and Practical Application
The first is a primary trend that lasts a year or more, such as a bull or a bear market. Within the primary trend, there are intermediate, secondary trends that are formed against the primary trend like a pullback or short-term correction.
The duration of secondary trends can be between three weeks and
three months. Then there are minor trends that last less than three weeks and are considered noise.
The third tenet of Dow Theory states that the primary trends have three phases
The primary market trends go through three phases before they reverse. In an uptrend, the markets see an accumulation phase, a public participation phase, and an excess phase.
In a downtrend, the markets see a distribution phase, a public participation phase, and a despair phase.
As we enter this current period, we are certainly in or heading for the despair phase. For me however, this is a great time to be adding to long term positions, but only into well diversified funds, not singular stocks.
The fourth tenet of Dow Theory states that Indices Must Confirm Each Other
As per the Dow Theory, a trend gets established when all the major indices or market averages move in tandem. If the major indices point in opposite directions, the trend is not conclusive, and traders should be cautious.
Evidence Check
Is the sample broad enough to include difficult markets?
Do the results include spreads, fees, slippage and failed signals?
Could hindsight, survivorship or selective examples explain the result?
Evidence and Examples
Dow used two indices, namely, Dow Jones Industrial Average and Dow Jones Transportation Average to prove the tenet. The theory was, that if the economy was indeed healthy as indicated by the DJIA, the railroads should profit and the DJTA, which formed of railroad stocks should also move in tandem
with the DJIA.
For me, this part of the theory is now outdated.
The fifth tenet of Dow Theory is that Volume Must Confirm the Trend.
As per the Dow Theory, the trading volume should increase when the price is moving in the direction of the primary trend. So, for example, if the index is in an uptrend, the volume should be higher when the index is moving up and lower when it’s moving down.
If price moves in the direction of the primary trend with lower volumes, then it’s assumed that the trend is not strong, and a reversal might happen.
This part of the theory still holds true today, whether it is the direction of trend or a breakout trade, the volume should also be aligned to the move.
The sixth tenet of Dow Theory is that Trends Persist Until a Clear Reversal Occurs
As per the theory, a trend is considered to be in force until a clear reversal occurs. Investors and traders must understand how to identify reversals and how to differentiate them from secondary trends.
Risk and Limitations
Also referred to today as technical analysis, this part of the theory refers to the breaking of support or channel lines.
Let’s now understand how to interpret and implement Down Theory.
A follower of Dow Theory trades only in the direction of the trend, therefore it becomes necessary to understand how to determine which trend is in force and how to identify the reversal as it happens.
Dow suggested peak and trough analysis to determine the direction of the trend. In this analysis, price is said to be in an uptrend if it’s hitting higher highs and higher lows.
On the other hand, the trend is said to be reversed when the price fails to reach new highs and breaches previous low levels, making lower highs and lower lows.
The downtrend is deemed to be in place if the price keeps on hitting lower lows and making lower highs. The downtrend reverses when the price breaches the previous high and makes a lower low.
The theory can be used to identify the trends and reversals in individual securities as well as in broader markets. It gives a bird’s eye and microscopic view of the direction of the trend, which is of great help to a trend-chasing trader or investor.
Let’s now understand some limitations of the Dow Theory.
The Dow theory was formulated in the 1900s using the structure of the economy and the market indices at that time. It’s been more than a century since the theory was formulated and the structure of the market and underlying economy has completely changed over time. For example, the US market
Dow Theory Beyond Industrial Stocks
has moved away from industrials to technology companies, rendering the industrial indices like DJTA non-existent and unusable.
The other limitation of the theory is the emphasis on the efficient market hypothesis in its first tenet.
There have been many examples of active managers beating the market returns through expert stock selection and market timing, which is a complete contrast to the theory.
If you invest enough time and develop the right skills, it is indeed possible to beat the market returns in the long run.
Summing it up, the Dow theory, due to its simplicity, is a potent tool for traders and investors who need a simple theory to determine the direction of the trend. It’s easy to interpret and works well in all time frames.
I loosely use the theory, although prefer using moving averages to determine the trend.
Access Our Group Here - https://www.financialwisdomtv.com/service
My Breakout Scanner - https://bit.ly/3ea6sl8
My Forum - https://www.financialwisdomTV.com/forum
Applying Dow Theory Within a Trading Plan
My Strategy Blueprint - https://www.financialwisdomtv.com/plans-pricing
My Brokerage Account (Interactive Brokers) - https://bit.ly/3HVA1nc
Practical Limitations
Historical examples, book claims and indicator results are educational illustrations rather than forecasts. Outcomes depend on the market, timeframe, data, transaction costs, financing, taxes and execution assumptions. Test complete rules across varied conditions and define the maximum acceptable account risk before taking a position.
Put This Into Practice
These ideas become more useful when selection, entry, stop placement, position sizing and trade management form one repeatable process. The Financial Wisdom Trading Blueprint connects those decisions in a practical weekly framework.
Frequently Asked Questions
Does this strategy guarantee profitable trades?
No. It provides a framework with uncertain outcomes and must be tested with complete risk and execution rules.
What should be defined before an entry?
Specify the setup, trigger, invalidation level, position size and conditions for managing or exiting the trade.
Further Reading
References and Further Reading
Educational information only. Trading and investing involve risk, including the possible loss of capital. Examples are illustrative, not guarantees of future performance, and nothing in this article is personalised financial advice.
About the Author
Written by Gareth, MBA
Gareth, founder of Financial Wisdom, has more than 30 years of personal trading experience. He competes in the United States Investing Championship, creates award-winning trading content and has been featured in Technical Analysis of Stocks & Commodities.
A few questions to help me understand whether The Dow Theory has merit. Does this theory stack up? Is it reproducible? Which parts work and which don't? Has anyone tested it? My concern is that it has several tenets, a tenet is a principle or belief. If one tenet fails, then the theory fails. One point has already been highlighted that throws this into doubt. Does this point also needs thinking about? - "The duration of secondary trends can be between three weeks and three months. Then there are minor trends that last less than three weeks and are considered noise". How does one determine whether it's three weeks or up to three months? Presumably, this is more an art than a science, but where in…