In Part 2 of our series on Dow Theory, we focused on the first tenet: the price discounts everything. In this article we will focus on the second tenet: the market has 3 trends. As a quick refresher, the 6 tenets of Dow Theory are:
- The price discounts everything.
- The market has 3 trends.
- Major trends have 3 phases.
- The averages must confirm each other.
- Volume must confirm the trend.
- A trend is assumed to be in effect until it gives definite signals that it has reversed.
The Market Has 3 Trends
While observing the markets, Charles Dow observed that the market tends to move in predictable trends. Not only that, but these trends also seem to move in sub-trends. This observation led to the idea that the market (or an individual stock) always has 3 trends at work. The 3 trends are:
1. Primary (Long-term Trend)
The primary trend is the large, big picture move that a stock is in. This trend can be anywhere from 2-5 years in length and is the main movement of the stock over time.
2. Intermediate (Mid-term Counter Trend)
The intermediate trend is one that usually moves counter to the large trend. (Truth be told, it can move with the primary trend as well, but when it’s moving with the primary trend it seems to blend in and is considered part of the primary move.) Dow said this mid-term trend usually lasts 6-9 months. However, I have certainly observed my share of shorter intermediate trends, and I adjust that timeframe down to 3-9 months. Either way you look at the timeframe, the effect is still the same. The intermediate trend moves on top of the larger primary trend.
3. Minor (Short-term Trend)
The minor short-term trend is just that. It moves on top of the intermediate trend as part of the overall primary move. Minor trends can be anywhere from a few days up to 3-4 weeks. While they can be a chance for a decent profit, sometimes the moves occur so fast it is very difficult to enter the trade. Often times by the time a minor trend is established, the trade is over. Still, it is good to understand how the minor trend works, and we can use it to time better entries into a trade within the more manageable intermediate trend.
Like Waves on the Ocean
To help draw a visual, Dow likened the three trends to the waves of the ocean. He said the primary trend is like the tide of the ocean. It moves in and out in a large cycle. The intermediate trend is like the waves of the ocean. They sometimes move with the tide and sometimes against it, but they form part of the motion of the ocean’s water movements. And finally, he likened the ripples on the waves to the minor or short-term trends.
Understanding these trends and the likely natural cycles of the market can give you a distinct advantage when placing your trades. When you understand how a market’s trends move, you will have a better likelihood of being on the right side of that trend, and that will lead you to greater profitability!
If you would like to learn how to apply Dow Theory to your own trading, please visit our website and sign up for a free class http://tradesmartu.com/site/scholarships.php. In our next article, Part 4, we will look at the three phases of major trends.