The Curious Investor

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Back to the post series on Dow Theory. Today, we’ll look at how to use Dow Theory when examining an investment. Dow Theory’s basic tenets actually lend themselves to a very successful market timing strategy, though some argue that it is a little too reactionary and not necessarily the most efficient way of timing in and out of a stock.

Identifying the Primary Trend
The most important part of using Dow Theory in chart analysis is identifying the primary trend. This is done through peak analysis. A bullish trend is identified by finding a series of higher highs and higher lows. A bearish trend, lower lows and lower highs. A bullish trend is reversed when the stock cannot reach a new high and proceeds to a low lower than the previous level. A bearish trend is confirmed reversed when the stock approaches a previous low but does not breach down and proceeds to rally above its most recent relative high. For examples of peak analysis, check out my tutorial on how to draw trend lines.

The primary trend ought to be identified through a period long enough for your investment horizon. That is, if you invest over the period of a year, you should look back at least a year when trying to identify a primary trend in the stock. Further, stocks will not always move smoothly with easily identifiable peaks and troughs. The common rule is that a moves should move at least 3% to be counted as a peak or trough. Another simple solution, is to use a moving average to smooth out day-to-day fluctuations.

Volume
Volume is used to confirm or anticipate trend reversals in a stock’s chart. Dow Theorists believe that pullbacks during bullish trends and rallies during bearish trends will typically be on lower volume than the converse actions. This is because during a true bullish trend, buyers should be in control. During a bearish trend, sellers should be. This is a way to judge the strength of the primary trend and also a way to predict oncoming trend reversals. Check out the example below:

Looking at the Google run up, we find that, when the stock first pulls back, selling volume is immediately higher than the subsequent buying volume. Even though a confirming break down through the previous low is not seen for another two month, there is some significant evidence that the rally is reversing. I’ve also included a graph of On-Balance Volume which can sometimes be used to help you to better decipher changes in volume and what they may be signaling.

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