Dow Theory         

Dow Theory

Dow Theory, developed from the writings of Charles Dow, the first editor of the Wall Street Journal, formed the foundation of the technical analysis used today. Charles Dow created the Industrial Average consisting of top blue chip stocks, and the Transport Average (at that time it consisted of railroad stocks). He observed behavior patterns in these averages and published articles in the Wall Street Journal from 1900 to 1902 that formed the basis for technical analysis.

Important assumptions of Dow Theory are still relevant and important today, and are summarized below.

The market is efficient. The price of securities reflects everything known about the security. This, in turn, applies to the market indexes made up of large baskets of securities.

The market moves in three important trends. The Primary trend may last from several months to several years. Secondary trends may last from several weeks to several months. Minor trends may last from several days to several weeks. Dow Theory holds that Minor trends may be subject to manipulation, but Primary and Secondary trends are not.

Primary trends are initiated with a phase of aggressive buying by smart money in anticipation of stronger economic times while the majority of invesors are still bearish. As economic conditions and earnings improve, more investors begin to accumulate securities. The general public starts buying securities when economic conditions are very strong and companies are making record earnings. The smart money begins to liquidate their holdings by selling to the general public at this time to take large profits, anticipating weaker economic times ahead.

A bull market is a broad upward movement of the market with a duration that may last several years, interrupted by corrections that may retrace from one third to two thirds of the primary trend during a period of several weeks to several months. A bull market is marked by price action resulting in higher highs and higher lows. Volume is used to confirm the trend. During a bull market, volume should increase on market advances.

A bear market is a broad downward movement of the market with a duration that may last several years, interrupted by rallies that may retrace from one third to two thirds of the primary trend during a period of several weeks to several months. A bear market is marked by price action resulting in lower highs and lower lows. During a bear market, volume should increase on market declines.

A trend remains intact until basic assumptions of the trend are broken. A bull trend would need a lower high and a lower low to initiate a bearish trend. Similarly, a bear trend would need a higher low and a higher high to initiate a bullish trend. A new bull market is confirmed when a bull trend on one of the indexes (Industrials or Transportation) is confirmed by the start of a bull trend on the other index. Similarly, a new bear market is confirmed when a bear trend on one of these indexes is confirmed by the start of a bear trend on the other index.

When you are analyzing potential option positions, it helps to have a computer program like Option-Aid that swiftly calculates volatility impacts, probabilities, statistics, and other parameters of interest. These programs can pay for themselves with the first trade that they help you with.

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