The Dow Theory is considered one of the oldest and most highly regarded technical theories.
As always, it is important to give credit where its due. This was developed by Charles Dow, refined by William Hamilton and articulated by Robert Rhea, in her book The Dow Theory.
So what exactly is this theory?
The basic premise is that a buy signal is given when the Dow Industrial and Transportation averages close above a prior rally peak.
The opposite is true.
A sell signal is given when both averages close below a prior reaction low. The strength of this theory is that it addresses not only technical analysis and price action, but also market philosophy.
To further clarify and explain this theory, Dow and Hamilton identified three types of price movements: primary movements, secondary movements and daily fluctuations.
Primary moves last from a few months to many years and represent the broad underlying trend of the market.
These movements are typically referred to as bull and bear markets. Once the primary trend has been identified, it will remain in effect until proved otherwise.
The objective of the theory is not so much to use price and fluctuations but using a set of guidelines, identify the primary trend,invest accordingly, and stay with it.
Dow and Hamilton felt that it was a futile exercise to attempt to predict the length and the duration of the trend.
Secondary(or reaction) movements last from a few weeks to a few months and they run counter to the primary trend. These trends are therefore reactionary in nature!
An example is - In a bull market a secondary move is considered a correction. In a bear market, secondary moves are sometimes called reaction rallies.
Below is a chart illustrating a correction within the confines of a primary bull trend.
Daily fluctuations can move with or against the primary trend and last from a few hours to a few days, but usually not more than a week.
Daily fluctuations are difficult to forecast. They are random and will occur day to day - when using this theory - do not focus on them -except to expect them.
Keep the big picture in mind! Don't make a hasty decision or base an action like say selling your stock on a day or two's volatility. Wait for a couple of days to get a better picture.
And as always - do your research!