How Dow Theory Might Help Improve Trading

Traders look at a variety of different factors when placing their positions, including financial metrics, corporate filings and financial commentary.

Many also use established trading theories, one of which is Dow Theory. The theory came about from a series of editorials in the Wall Street Journal by Charles Dow, the founder of the newspaper and Dow Jones and Company, which provided insight into his thoughts on how the markets worked. Following Dow’s death in the early 1900s, future editors and scholars expanded upon the original thoughts.

“Dow Theory is one of many tools that traders use,” said Brian Bachelier, vice president of active trader strategy at Scottrade. “Using the theory, along with many other important financial indicators, may help you manage your trading more effectively.”

What is Dow Theory?

Dow Theory is complex; as a result, many financial experts interpret it differently. Despite that, a few key points provide a general overview of how it works:  

  • Three trends are identified: The primary trend lasts anywhere from one year to several years. The secondary trend lasts from three weeks to three months, retracing anywhere from a third to two-thirds of the previous trend. The minor trend lasts anywhere from a week to six weeks. 
  • The Dow averages discount everything:  Dow Theory involves the performance of two major indices: the Dow Jones Industrial Average and the Dow Jones Transportation Average. The theory suggests that these averages provide an important bellwether for the stock market and the economy as a whole. The Dow Theory says that all relevant information is factored into the prices of the companies in those averages.
  • The averages must confirm: In order for a trend to exist, there must be a new high and/or new low in both Dow averages over a given period of time. The reasoning is that if goods makers are performing well, they will need to ship more products, boosting the fortunes of the transportation companies. Similarly, if a manufacturer is performing poorly, there will be less of a need for shipping. So, a new high in the Dow Industrials that is not confirmed by a new high in the Dow Transports (or vice versa) may be a warning sign for the market. The opposite is true also, where one average records a new low, but is not confirmed by the other. This may signal a coming improvement in stock prices.

Using Dow Theory in Your Trading Strategy

“For the typical non-professional investor and trader, perhaps the most important principle of Dow Theory is the recognition of the major or primary trend,” Bachelier said.

You may never have all the information available to the institutional investors and traders at larger financial institutions, which can make it harder to pinpoint smaller trends. But by following the larger trends, you may have a better idea of where the economy is heading, and, in return, you might be able to make more informed trading and investing decisions.

Read Next: Spotting the Trend Can Keep Your Trading on Track

The information and content provided in the Scottrade® Knowledge Center is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy. There can be no guarantee the strategies discussed in any presentation will be successful.

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