Dow Theory strategy

Why it works

Dow described three movements at once: the primary trend (months to years), secondary reactions against it (weeks to months) and minor daily noise. Most of the money is made by riding the primary trend and treating the reactions as opportunities, not as reversals.

The trend is defined by price structure alone. Higher highs and higher lows mean an uptrend; lower highs and lower lows mean a downtrend. Dow also looked for confirmation: the industrial and transport averages had to agree, and volume should expand in the direction of the trend.

The rules

Setup

• On the daily chart, mark the last two swing highs and swing lows.
• Uptrend: the latest high is above the previous high and the latest low is above the previous low. Downtrend: the opposite.
• Optional confirmation: a related market (for example the transport index for stocks, or the dollar index for a major pair) shows the same structure.

Entry

• In an uptrend, wait for a secondary reaction that holds above the previous swing low.
• Buy when price breaks back above the high of the reaction, confirming that the primary trend has resumed.

Stop loss

• Below the low of the secondary reaction: a break there would create the first lower low.

Exit and management

• Stay in while the structure holds. Trail the stop under each new higher low.
• Exit when price makes a lower high followed by a break of the last higher low: Dow's signal that the primary trend has turned.

Filters that improve it

• Volume should expand on the rallies and contract on the reactions.
• Avoid markets where swings overlap and no clear high-low sequence exists.

Worked example

Illustrative EUR/USD example on the daily chart: swing lows at 1.0650 and 1.0780, swing highs at 1.0900 and 1.1020. A reaction pulls back to 1.0890 and holds. When price breaks the reaction high at 1.0960, buy with the stop at 1.0880. Over the next weeks the stop is trailed under each new higher low until a lower high at 1.1140 and a break of 1.1050 end the trade.

Illustrative numbers, not a recommendation.

Common mistakes

• Calling a top on the first red week: a reaction is not a reversal until the structure breaks.
• Using swing points so small that every day is a new "trend".
• Ignoring the need for confirmation and trading every break.

How to practise it

In Candlemind, switch to the daily or 4H timeframe and mark the last two swing highs and lows before each trade. Only take setups in the direction of the structure and write the invalidation level before entering.

Pre-trade checklist

1. Two higher highs and higher lows (or the opposite)
2. A reaction that held above the last swing low
3. Entry on the break of the reaction high
4. Stop below the reaction low
5. Exit only when the structure breaks

Frequently asked questions