The Dow Theory works on the fundamental principle that markets do not operate independent of one another. Like orbiting bodies in physics, markets influence one another in direct proportion to distance from another. In the case of the Dow Theory, the intermarket “distance” between the DJIA and DJTA is close, so the influence is greater. Unlike orbiting bodies in physics, though, the intermarket relationship is not totally obedient to the Laws of Physics. Market participants have no influence over the sun or moon, yet, when it comes to this, or any other intermarket relationship, we have plenty of influence, which means inconsistency is part of the equation.
Since the correlation between the DJIA and the DJTA is not a perfect trade, we need tools to translate what we know (data) into what we “think” will occur. Those tools are, as I said on Friday, the three basic, tenets of the theory. The three tenets are:
- the averages discount everything;
- the averages consist of three price movements, and;
- both averages must confirm.
Arguably, price averaging (in all its forms) is the most important tool traders have for assessing market movement. After all, the “average” represents all the price-influencing information known about a market. More importantly, it is the “smoothed” out version of that information. All the peaks and valleys have been removed, producing a more “accurate” view of price movement; thus, the longer the timeframe for the average, the more accurate the price. Thus, moving or exponential averaging produces the most accurate “pricing,” and those “smoothed out” peaks and valleys become accurate top and bottom parameters.
The theory also addresses the three issues influencing the forecasting of market movement – the primary, long term trend, the reaction to the primary trend, and the daily fluctuations. Of these, Dow Theorists consider the primary trend the most important. The other two are influential but misleading if looked at independently. Now, within the primary trend, both bull and bear markets have three phases, which identify the position and strength of the trend relative to the average highs and lows of both indices. Within the above is a series of articles, so I won’t go deeper now. Just understand that the three influence market movement in relative and varying degrees, and each identifies the position and strength of a trend.
Finally, confirmation between the two is, without exception, the most important aspect. Since this is a correlative relationship, forecasting market movement based on only one index will be misleading.
Dow Theory may or may not be useful to you as specific strategy, but within it are the fundamental elements of a solid strategy, and this is how it should be viewed. Studying it will make you a better trader because it will expand your understanding of basic market principles, exemplify the “reality” of intermarket relationships (especially in today’s markets), and, perhaps most importantly, it will “smooth out” some of your mental peaks and valley regarding the ebb and flow of broad-market movement – it will broaden and further shape your trading mindset.
Trade in the day; invest in your life …
