Dow Theory Buy and Sell Signal

By February 7, 2016 Newsletter No Comments

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This theory has been around for nearly one hundred years, and even in this modern, fast-paced, technology dependable market all of the basic rules that the Dow Theory has still have great value. The founder of the theory is Charles Dow, and Robert Rhea articulated it later on, while William Hamilton refined the whole theory. This theory focuses not only on price action and technical analysis, but it also looks back on market philosophy. Many thoughts, ideas and comments contributed by Hamilton and Dow slowly became the axioms of Wall Street. Even though there are many people who will disagree that these rules and trends still apply today, “The Dow Theory” proves them wrong and shows that the whole market acts similarly as it did over 100 years ago.

DJTA – Dow Jones Transportation Average

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The DJTA is one of the most recognized gauges used by the transportation sector. Furthermore, it is one of the oldest indexes which is still being used until this day. It is even older than its more popular brother the DJIA – Dow Jones Industrial Average. The Dow Jones Transportation Average is the first stock index ever and it was developed by Charles Dow during the year 1884.

Nowadays, a typical DJTA consists of twenty different stocks which are picked to represent the transportation industry. Similar to other Dow Jones Averages, DJTA is also a price-loaded index. This means that a certain firm’s relevant load in the index can be easily determined by the share price it has, and not by its capitalization on the market. Since 2010, some of the most famous companies which were tracked by this index include Union Pacific Corporations (UNP) , Southwest Airlines (LUV) and FedEx (FDX).

DJIA – Dow Jones Industrial Average

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The DJIA – Dow Jones Industrial Average, or simply the Dow theory, is one of the few most recognized stock market indices. The Dow Jones Industrial Average was also created by no other than Charles Dow in order to measure movements of daily stock prices for 30 large, public U.S. companies. It is also price-weighted, which means that all stock movements with higher prices have a greater effect on the Dow than on stocks which have lower prices.

The daily value of a Dow is not really the real average of all 30 stocks’ prices, and it is in fact the sum of all prices divided by the Dow divisor, which can be adjusted in case of stock splits, spin offs or some other structural changes. Even though the Dow is one of the most recognized market indices, it is commonly criticized for not accurately describing the whole picture when it comes to the market’s performance.

Both of these averages can be manipulated during their day to day movement. The secondary reactions can also be influenced but the primary trend for both averages can never be manipulated.

Three classification of Trends based on Dow Theory

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The averages have three different movements and all of them can be in progress at the same time.

  • Primary trends

The first, and definitively the most relevant is the primary trend. It has a wide downward and upward movement range which is also known as the bull market, and it can last for a couple of years. The determination of the exact direction of the movement is one of the most important factors for achieving a successful speculation. It is not possible to forecast the duration the primary trend will have. Once it starts, the trend will last until something stops it.

  • Secondary (Intermediate) trends

The secondary trend is very deceptive. This is an essential decline for the primary bull market or a certain rally which is in the primary bear market. They are also called recoveries or corrections and can be recognized by using smaller swing values.

  • Short-term trends

The third type are short term trends, and in most cases, they are unimportant. The reason why they are usually not relevant is because the inferences received from one day movement of averages are in most cases incorrect, misleading and hold no value.

Three Phases of Bull Market – Accumulation, Increasing Volume, Final Explosive Move

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Accumulation: in this phase, a careful investor chooses only the best valued and safest stock to buy, while considering the primary industries and services only.

  1. Increasing volume: due to the high investor participation volume increasing, causing prices to rise and enhancing the economic picture. Because of this, secondary stocks rise in popularity.
  2. Final explosive move: Due to the high general population and excessive amount of speculation, the final explosive move starts. People who never invested enter the market.

Three Phases of Bear Market – Distribution, Panic, Lack of buying interest

  1. Distribution: Professionals start selling while the whole public is still in the last stages of buying. Investors with less experience enter the market too late and pay high prices because of this.
  2. Panic: Prices fall drastically like never before and fail to rally. A sense of panic breaks out.
  3. Lack of buying interest: After serious losses, investors loose interest in buying even in high profile companies.

The Classic Buy Signal based on Dow Theory

A classic buy signal can develop like this: After the primary downtrend has reached its low trend in the bear market, a secondary uptrend will happen. After that, a certain pullback on some average will have to exceed 3%. This setback should hold higher than the prior lows on both transportation and industrial averages. In the end, a breakout higher than the previous rally high of both averages sends a clear buy signal for the certain bull market.

The Classic Sell Signal based on Dow Theory

A classic sell signal can be recognized with similar methods, but you will have to look in the opposite direction. When a market tops and gets set back after, followed up with a rally that goes back up again and falls short of reaching the past high while penetrating recent lows when the next decline happens, it’s a clear sign for sale.

Criticisms of Dow Theory

Even though the Dow Theory is the foundation for modern technical analysis, it’s not a perfect theory. The Dow Theory has an unavoidable lag that appears between the primary trend’s actual turn and the recognition in trend change. With this theory, you cannot predict the turn before it already happened and was confirmed. The second most common criticism of the Dow Theory is that the two different trends cannot be defined with utmost certainty. Usually the price swings cannot be interpreted so precisely that you can assign them to a certain trend type.

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