How to Apply Dow Theory in Practice
This time, we will explain how to understand and apply Dow Theory, which is the foundation of the market.How to understand and use it in practiceDow Theory has been around for a very long time, so you might think it’s no longer usable. If you think that, please take a look.
Dow Theory is a theory devised by Charles Dow, and it is said to consist of six main points.
① All charts discount everything
② Trends are classified into three kinds: short-term, mid-term, and long-term
③ There are three stages of a major trend
④ Prices must be confirmed mutually
➄ Trends must also be confirmed by volume
⑥ Trends continue until a clear reversal signal appears
We will look at these in order.
① All charts discount everything
For example, if a stock’s earnings are good, or there is some negative news, these are thought to already be reflected in the chart.
Often, the chart moves first before a large drop occurs. For instance, let’s look at the COVID-19 shock. This is a chart of the Nikkei 225.
Source: https://jp.investing.com/
It may be a little hard to see, but the vertical line on the left marks the start of the decline on February 20, 2020. The line on the right marks the day Prime Minister Abe closed schools.
The closure of all schools was a major event, causing panic in society. However, the market actually declined first and then paused.
In this way,the chart often leads. In market terms, we say the chart is discounted into prices.
Of course, subsequent news led to a further decline, but remember that, to practice Dow Theory, the chart responds first.
② Trends are classified into short-term, mid-term, and long-term
This is about the time frame. Short-term trends are trends over short spans of time. For example, 15-minute, 30-minute, or 1-hour charts.
Mid-term trends are trends over moderate periods. 4-hour and daily trends. Long-term trends are weekly and monthly trends.
This sense of time frame is very important; for example, if all trends from 5 minutes to daily are in the same direction, entries that follow that direction tend to win more often.
In day trading, I commonly use 15-minute, 1-hour, and 4-hour charts. If the 15-minute is an uptrend, the 1-hour is a downtrend, and the 4-hour is an uptrend, I buy when the 1-hour turns up, aligning with the trend direction. This is the basic strategy I use called trend-following.
To use a trend-following strategy, these short-term, mid-term, and long-term trends are very important.
③ Major trends exist in three stages
In this diagram, ① is the impulsive phase, with a rise soon after a reversal. ② is the corrective phase, where profits tend to be maximized.
③ Profit-taking phase; when we reach this point, it’s time to consider securing profits. Those studying Elliott Wave will know, and Dow Theory says the same thing.
③ Prices must be confirmed mutually
In crypto assets, you would check Bitcoin’s movement against altcoins.
However, I only confirm this principle and do not use it for trading decisions. There are cases of independent highs or lows, so use it as a reference only.
The reason is that when you are trading a flagship stock within a benchmark (like Dow Jones or Bitcoin), other assets tend to follow later.
That said, if you are trading Nikkei 225 or other US indices, you will watch those indicators; if you trade Ethereum or Ripple, you will check Bitcoin.
➄ Trends are confirmed by volume
Please look at Bitcoin (BTC/JPY) chart from 2021.
Prices are rising, butvolume is decreasing in the red area. For a continuing uptrend, market momentum with volume is necessary to sustain it.
If you know Dow Theory, you can sense it’s near a profit-taking moment. It implies a bubble is forming.
That’s why Bitcoin didn’t crash. This is a highly important principle within Dow Theory.
⑥ Trends continue until a clear reversal signal appears
This is equally important as ⑤. If ⑤ can be used for near-term profit-taking,⑥ is used for entry signals.
Look at the Nikkei 225 chart below.
If you view it, you can see that after a substantial rise, the right edge is consolidating.
In this case, Dow Theory shows a lower high, but the lows are rising, so there is no clear trend reversal yet.
Thus, it can be judged that the uptrend is still intact. In other words,this consolidation is within an uptrend, so it’s likely to break upward.
Let’s check the actual chart.
Afterward, it fell, but initially it rose. The entry strategy here isconsolidation breakout strategy.
When judging which direction the consolidation will break, the Dow Theory ⑥ principle is extremely important. Now, which way the current trend’s consolidation is forming must be considered when entering. This is the basis for the consolidation breakout strategy.
Summary
If you actually want to see an explanation using Dow Theory in a video, please subscribe to the channel here. For now, I do Bitcoin and occasionally Nikkei technical analysis.
