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Understanding Dow Theory: Technical Primer

BALTIMORE ( Stockpickr) -- "Dow Theory" is a term that's thrown around quite a bit, in classrooms and on trading floors. But unlike many academic market studies, Dow Theory actually has real world trading implications.

Here's a look at how Dow Theory works, and why modern traders should be concerned with this century-old trading strategy.

While Charles Dow may be one of the most-storied names on Wall Street, many investors don't fully realize the contributions that the Wall Street Journal founder made to modern-day technical analysis. Around the turn of the century, Dow was the foremost expert on broad market movements, creating the first market indices -- the Dow Jones Transportation Average (then known as the "rails" index for its exposure to railroad stocks) and the ubiquitous Dow Jones Industrial Average.

Related: Does Technical Trading Really Work?

Over the course of his career, Charles Dow wrote hundreds of editorials that discussed his take on market structure and price behavior as well as the relationships between his averages. After his death, those editorials were compiled by Dow's successors at the Journal (namely William Peter Hamilton and Robert Rhea) to create Dow Theory as it stands today.

While not developed as an explicit trading system by Dow, that's exactly what it became in the years after its creation.

Basic Tenants of Dow Theory

While considerable work has been done on Dow Theory, it can be divided into a handful of core tenants. First off, the market is broken down into three different movements of either direction: primary trends, which last for years and are inviolate; secondary or intermediate trends, which last for weeks or months; and minor trends, which last for days or less, and are irrelevant for Dow Theorists.

Those trends are significant because they dictate which direction investors should be betting on the market. Along the way, those trends should be confirmed by volume, and each has its own lifecycle of accumulation, public participation, and distribution.

These trends manifest themselves in the averages, or the broad market. As an investor, the ideal trade is to buy into a primary trend and hold as the market bears out its direction. Keys to doing that include ensuring that the averages confirm each other (that is, a bottom in the Dow Jones Industrials coincides with a bottom in the Transportation Average), and realizing that the averages discount all external factors that could effect the market.

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