An important part of Dow theory is distinguishing the overall direction of the market. To do this, the theory uses trend analysis.
Before we can get into the specifics of Dow theory trend analysis, we need to understand trends. First, it’s important to note that while the market tends to move in a general direction, or trend, it doesn’t do so in a straight line. The market will rally up to a high (peak) and then sell off to a low (trough), but will generally move in one direction.
An upward trend is broken up into several rallies, where each rally has a high and a low. For a market to be considered in an uptrend, each peak in the rally must reach a higher level than the previous rally’s peak, and each low in the rally must be higher than the previous rally’s low.
A downward trend is broken up into several sell-offs, in which each sell-off also has a high and a low. To be considered a downtrend in Dow terms, each new low in the sell-off must be lower than the previous sell-off’s low and the peak in the sell-off must be lower then the peak in the previous sell-off.
Now that we understand how Dow theory defines a trend, we can look at the finer points of trend analysis.
Dow theory identifies three trends within the market: primary, secondary and minor. A primary trend is the largest trend lasting for more then a year, while a secondary trend is an intermediate trend that lasts three weeks to three months and is often associated with a movement against the primary trend. Finally, the minor trend often lasts less than three weeks and is associated with the movements in the intermediate trend.
Let us now take a look at each trend.
In Dow theory, the primary trend is the major trend of the market, which makes it the most important one to determine. This is because the overriding trend is the one that affects the movements in stock prices. The primary trend will also impact the secondary and minor trends within the market.
Dow determined that a primary trend will generally last between one and three years but could vary in some instances.
Regardless of trend length, the primary trend remains in effect until there is a confirmed reversal.
For example, if in an uptrend the price closes below the low of a previously established trough, it could be a sign that the market is headed lower, and not higher.
When reviewing trends, one of the most difficult things to determine is how long the price movement within a primary trend will last before it reverses. The most important aspect is to identify the direction of this trend and to trade with it, and not against it, until the weight of evidence suggests that the primary trend has reversed.
Secondary, or Intermediate, Trend
In Dow theory, a primary trend is the main direction in which the market is moving. Conversely, a secondary trend moves in the opposite direction of the primary trend, or as a correction to the primary trend.
For example, an upward primary trend will be composed of secondary downward trends. This is the movement from a consecutively higher high to a consecutively lower high. In a primary downward trend the secondary trend will be an upward move, or a rally. This is the movement from a consecutively lower low to a consecutively higher low.
Below is an illustration of a secondary trend within a primary uptrend. Notice how the short-term highs (shown by the horizontal lines) fail to create successively higher peaks, suggesting that a short-term downtrend is present. Since the retracement does not fall below the October low, traders would use this to confirm the validity of the correction within a primary uptrend.
general, a secondary, or intermediate, trend typically lasts between three weeks and three months, while the retracement of the secondary trend generally ranges between one-third to two-thirds of the primary trend’s movement.
Another important characteristic of a secondary trend is that its moves are often more volatile than those of the primary move.
The last of the three trend types in Dow theory is the minor trend, which is defined as a market movement lasting less than three weeks. The minor trend is generally the corrective moves within a secondary move, or those moves that go against the direction of the secondary trend.
Due to its short-term nature and the longer-term focus of Dow theory, the minor trend is not of major concern to Dow theory followers. But this doesn’t mean it is completely irrelevant; the minor trend is watched with the large picture in mind, as these short-term price movements are a part of both the primary and secondary trends.
Most proponents of Dow theory focus their attention on the primary and secondary trends, as minor trends tend to include a considerable amount of noise. If too much focus is placed on minor trends, it can to lead to irrational trading, as traders get distracted by short-term volatility and lose sight of the bigger picture.
Stated simply, the greater the time period a trend comprises, the more important the trend.