DOW

THEORY
TABLE OF
CONTENTS
• Describe the history of Dow Theory
• Discuss the basic principles of Dow Theory
• Identify the three basic types of trends identified in Dow Theory as defined by time:
primary, secondary, and minor.
• Identify the three basic trend patterns of all prices: upward, downward, and sideways.
• Describe the “ideal power picture” according to Dow Theory.
• Express the concept of confirmation in Dow Theory
• Explain the role of volume in Dow Theory
 CHARLES
DOW
• Father of Technical Analysis.
• First recorded creation of an Index to measure the
market.
• His writings from the Wall St Journal were later
formalized into “Dow Theory” by William Hamilton
and Robert Rhea.
• Rhea organized the writings into hypotheses and
theorems.
 Dow Theory Hypothesis
• The primary trend is inviolate

• The primary trend is inviolate.

• The averages discount everything
• Lots of manipulation was going on.
• Dow theorized that the effect was in the shorter terms. • Investors only studied individual stocks.
• Primary trends could not be manipulated. • Dow suggested that the Indices foretold the shape of the industry.
• This was beneficial in understanding the health of the economy.
• Dow Theory is not infallible • All of Wall St’s knowledge is represented in the price of the
• Dow, Hamilton & Rhea knew that this was not a “magic”
averages.
formula.
• From this the Dow Theory Tenets were derived.
• They believed that study of the indices
• would reveal the probability of the market continuing or
reversing
Dow’s Ideal
Market
Picture

• The ideal market consists of

• Bottom (Accumulation)
• Uptrend
• Top (Distribution)
• Downtrend
 Dow Theory Tenets
1. Trends

• The market has three movements (waves).

• The Primary Trend Months to Years.
• The Secondary Trend Ten days to three months.
• The Minor or Short-Term Trend Hours to a month.
• Dow suggested traders avoid trying to predict the
secondary trend.

Trade with the Trend!

Dow Theory Tenets
1. Trends
• Primary trends develop in three phases.

• Bull market Phases 2. Bull market Phases

• Accumulation • Distribution
Investors “In the Know” are actively buying Investors “In the Know” are actively buying
against public opinion. against public opinion.
• Participation (Absorption) • Panic
Increasing Volume Prices decline faster than anytime in the
More investors get involved. Bull
Secondary stocks become popular market rise. Everyone wants to liquidate.
• Final explosive move • Borrowers have no options but to sell.
Lack of Interest
Excessive speculation and public elation. Investors do not want to experience that again.
Buying becomes indiscriminate. All stocks are undervalued. All news is negative
Investors borrow to buy stocks and pessimism prevails.
SCHABACKER’S RULES
HOW TO IDENTIFY THE END OF A PRIMARY TREND

End of a Bull Market End of a Bear Market

Trading volume increases sharply Trading volume is low

Popular stocks advance while others collapse Commodity prices have declined

Interest rates are high. Interest rates have declined

Stocks become a popular topic of conversation Corporate earnings are low

Stock prices have been steadily declining and bad news is

Warnings about an overheated market appear on the news
everywhere
 Characteristic of Secondary
Reaction
• The most difficult thing is to determine if a
retracement is a secondary reaction or a change
in the primary trend Characteristics:

• Secondary reactions have some characteristics • There are a number of clear downswings (in a bull market).
that we can identify • The movement is more rapid in the reversal than in the
primary move.

• The reaction is over once prices reach new highs. • The reactions last from 3 weeks to 3 months.
• If the volume during the reaction is equal (or greater) than
the volume prior to the reaction, then a bear market is likely.
• Lower volume confirms it is a reaction.
• If there has been a lot of speculation, a bear market is likely
 Dow Theory Tenets
2. Discounts News
• There are two common variants of this tenant:

• The stock market discounts all news.

• Stock prices reflect all known knowledge.

• New information (News) is quickly reflected in
the stock price.

• The averages discount everything

• Dow’s era was rife with manipulation.

• By using averages (indices), Dow was able to
minimize the effect of a single stock move.
 Dow Theory Tenets
3. Confirmation
• Stock market averages must confirm

• Wanted to see confirmation between Industrials

and Railroads. • Primary upward trend was only established when both
averages posted higher peaks.
• Industry could not bring products to market
without rail. Growth in Industrials was not
• Conclusions based on the movement of one average,
sustainable without growth in Railroads.
unconfirmed by the other, are almost certain to prove
misleading.” (Rhea 1932)
• Primary downward trend was only established
when both averages posted lower troughs.
• Today we can use S&P 500 and Russell 2000 as they
better represent the Industrials and the high growth
segments
CONFIRMATION – INDUSTRIALS &
TRANSPORTATION
CONFIRMATION – S&P 500 & RUSSELL 2000
 Dow Theory Tenets
4. Volume
• Trends are confirmed by volume.

• Price moves on low volume could be an over-

zealous buyer and not reflect the sentiment of
the market.

• Price moves accompanied by strong volume

reflect the “True” market view.
Dow Theory Tenets
5. Only use Closes
• Dow believed that only the closing price of the day
should be used.

• Intra - day traders have liquidated positions.

• Large funds typically executed at the end of the day.

• Today we still see higher volume at the end of a

trading day.
Dow Theory Tenets
6. Trends Persist

Trends exist until definitive signals prove they have ended

• Dow believed that trends existed despite "market noise".

• Counter - moves are expected and do not signal a change in trend.

• The trend should be given the benefit of the doubt until the change is obvious.

• Technical Analysis tries to solve this.

Criticisms of Dow Theory

Signals lag changes in trend

• Reduced profits
• Reduced risk

Trends are not strictly defined.

DOW THEORY Describe the history of Dow
1 Theory

Discuss the basic principles

of Dow Theory 2
Identify the three basic types of
trends identified in Dow Theory as
3 defined by time: primary, secondary,
and minor.
Identify the three basic trend
patterns of all prices: upward, 4
downward, and sideways.
Describe the “ideal power
5 picture” according to Dow
Theory
Express the concept of
confirmation in Dow Theory. 6
Explain the role of volume in
7 Dow Theory
Thank you
For listening
HISTORY &
CONSTRUCTION
CHARTS
TABLE OF
CONTENTS
• List advantages of reviewing price information in chart format.
• Review the data points required to construct line, bar, and candlestick charts.
• Describe how to construct line, bar, and candlestick charts.
• Explain the differences between arithmetic and logarithmic scales and their uses.
BENEFITS OF USING CHARTS
Jack Schwager, Technical Analysis(1996)

01 Charts provide a concise history

02 Give a sense of volatility

03 Used as a Timing Tool

04 Used to set Stops for Money Management

05 Highlight Patterns
CHART CONSTRUCTION

• Many ways of viewing price data have been created.

• Over the years they evolved to show us more information.
• Each evolution has allowed us to explore new ways to analyze the
data, identify correlations, and create forecasts.

Joshua M Brown, The Reformed Broker Jan 18, 2016

“Price lies all the time. Facebook can be valued at $40 billion and
then $20 billion and then $200 illion inside of a four-year period of
time. Which of these prices is the truth? None of them. But all of
them were momentarily true, until they were rendered a lie, and a
new truth was forged in the fires of the marketplace.”
 Line Chart

• The most simple is a Line Chart.

• All the historical closing prices for a security are joined.

• In this case the last prices posted for every Friday are
joined to create the chart.

• Early charts were always lines as it was easiest to

create.
 Bar Chart
• People started recording the first price of the period
and comparing the last to the first

• Over time the highest price and the lowest price of the
period were also stored.

• These became known as the:

• Open -First price
• High - Highest price
• Low -Lowest price
• Close -Last price
 Bar Chart

• From these, a bar was drawn on the chart for each period.

• Each bar represents all the price action for that period.
 Candlestick Chart

• Developed in Japan mid 1600s to trade rice futures.

• Candles use the same Open, High, Low, & Close

(OHLC) as the Bar Chart.

• The Body being Solid or Hollow denotes if the Close

is Higher or Lower than the Open.
 Candlestick Chart
• The box between the Open and the Close is called
the “Body” or “Real Body” of the Candle.

• The line above and beneath the body is the

“Shadow” (sometimes called whiskers).

• Rule of Thumb:

• A Solid Body is heavy and will sink. Close is

below Open.

• A Hollow Body is light and will rise. Close is

above Open.
 Swing Charts
• Remove Time and just look at the rise and fall of
prices.

• Many types available:

• Price Swings
• Percent Swings
• Volatility Swings
• Gann Swings

• Each have different rules to determine when the

swing should turn.

• Great for identifying trends.

2-Day Gann Swing Charts

• Gann called his Swings his Master Trend Detector.

They were his rules for identifying trend direction.

• Gann would classify bars into:

• Higher
• Lower
• Outside (higher and lower)
• Inside

• A downward 2-day swing requires two higher bars

for the swing to turn up.
Price Scales
• All charts so far have been Arithmetic.

• Gives an unrealistic display when comparing to

history.

• Changes in Value are more important than changes

in price.

• 10,000 - 1,000 == 10%

• 2,000 - 1,000 == 50%

• What Great Depression?

• Arithmetic is not suitable for long -term charts.
Price Scales

• We solve this by using a Logarithmic Price Scale.

• Sometimes called a semi-log scale as we are not

using log on the time scale.

• 2001 & 2008 do not compare to 1929.

 Point & Figure

• Similar to Swings because they take time out of the picture.

• Most like a Point Swing Chart

• Define the Box Size and the number of boxes needed to start a
new column.

• In P&F we handle Logarithmic by defining a Percentage box size

• P&F will be covered in more detail later

HISTORY & CONSTRUCTION
1 OF CHARTS
List advantages of reviewing
1 price information in chart
format.
Review the data points
required to construct line, 2
bar, and candlestick charts.
Describe how to construct line, bar,
3 and candlestick charts.

Explain the differences

between arithmetic and 4
logarithmic scales and their
uses.
Thank you
For listening