So far, we have discussed a lot of the ideas behind Dow theory along with its main tenets. In this section, we'll take a look at the technical approach behind Dow theory, such as how to identify trend reversals.
Closing Prices and <?xml:namespace prefix = st1 />Line Ranges
Charles Dow relied solely on closing prices and was not concerned about the intraday movements of the index. For a trend signal to be formed, the closing price has to signal the trend, not an intraday price movement.
Another feature in Dow theory is the idea of line ranges, also referred to as trading ranges in other areas of technical analysis. These periods of sideways (or horizontal) price movements are seen as a period of consolidation, and traders should wait for the price movement to break the trend line before coming to a conclusion on which way the market is headed. For example, if the price were to move above the line, it's likely that the market will trend up.
Signals and Identification of Trends
One difficult aspect of implementing Dow theory is the accurate identification of trend reversals. Remember, a follower of Dow theory trades with the overall direction of the market, so it is vital that he or she identifies the points at which this direction shifts. (For related reading, see Retracement Or Reversal: Know The Difference.)
One of the main techniques used to identify trend reversals in Dow theory is peak-and-trough analysis. A peak is defined as the highest price of a market movement, while a trough is seen as lowest price of a market movement. Note that Dow theory assumes that the market doesn't move in a straight line but from highs (peaks) to lows (troughs), with the overall moves of the market trending in a direction. (For more on this topic, read Peak-And-Trough Analysis and The Ups And Downs Of Investing In Cyclical Stocks.)
An upward trend in Dow theory is a series of successively higher peaks and higher troughs.
|Figure 1: Upward Trend|
A downward trend is a series of successively lower peaks and lower troughs.
|Figure 2: Downward Trend|
The sixth tenet of Dow theory contends that a trend remains in effect until there is a clear sign that the trend has reversed. Much like Newton's first law of motion, an object in motion tends to move in a single direction until a force disrupts that movement. Similarly, the market will continue to move in a primary direction until a force, such as a change in business conditions, is strong enough to change the direction of this primary move.
A reversal in the primary trend is signaled when the market is unable to create another successive peak and trough in the direction of the primary trend. For an uptrend, a reversal would be signaled by an inability to reach a new high followed by the inability to reach a higher low. In this situation, the market has gone from a period of successively higher highs and lows to successively lower highs and lows, which are the components of a downward primary trend.
|Figure 3: Upward Trend Reversal|
The reversal of a downward primary trend occurs when the market no longer falls to lower lows and highs. This happens when the market establishes a peak that is higher than the previous peak followed by a trough that is higher than the previous trough, which are the components of an upward trend.
|Figure 4: Downward Trend Reversal|