Charles Dow, the editor of The Wall Street Journal around the beginning of the 20th century, provided a framework to study the stock market that would become known as the Dow Theory.
He had created the Dow Jones Industrial Average and the Dow Jones Transportation Average in the late 1800s to track the moves of the economy, and he found that this economic forecasting tool could help him make money trading stocks. When both indices are moving in the same direction, a confirmed trend is in place and traders can become more aggressive.
Dow Theory is based on the premise that the economy grows when manufacturers are producing as much as possible. Economic growth translates into profits for the companies, and this would be seen in the performance of their stocks. Getting goods to market requires that the transportation industry also be growing, and that would drive the stocks of the transport companies higher.
How Traders Use It
Dow Theory is used to identify the direction of the major trend in the stock market. Movements in the two averages must confirm each other to show a trend change.
To signal a bull market, both averages must rise above their most recent highs. A bear market is signaled when both the Dow Jones Industrial Average and the Dow Jones Transportation Average drop below their most recent lows.
A move to a new high or low by just one of the averages is not a trading signal. Dow also ignored the smaller moves in the stock market since his goal was spotting only the primary trends that could last for months rather than the short-term trends that unfold over the course of a few days.
In the chart below, we see the stock market reached a bottom in March 2009. Dow Theory offered a buy signal in July of that year, 35% above the low. Traders missed significant gains, but enjoyed more than 30% upside over the next year.
As this example shows, Dow Theory signals will always be late, but they also can give traders a much higher degree of confidence.
Why It Matters To Traders
Although Dow wrote about his theory from 1900 to 1902, the ideas still work today. Dow Theory signals continue to highlight every major stock market move. The system's rules work well for trend followers who are comfortable missing the first part of a big move.
(This article originally appeared on ProfitableTrading.com).