Dow theory is a theory related to the general business cycle that uses Dow Jones compiled averages to interpret the strength of any proposed expansion or contraction of the market.
Under this theory, if both the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) are crossing new highs or lows, then this indicates a strong trend in the business cycle.
By contrast, if only one of these essential indicators is moving strongly, then it would suggest that the contraction or expansion is weak and unlikely to continue.
Dow Theory: Factories and Trains
Dow theory is based on the simple yet highly insightful and practical belief in the connection between goods produced, goods transported and economic cycles.
For example, if factories are producing a larger amount of goods, which is generally an indicator of an economic expansion, yet trains and trucks are not transporting these goods, then this would suggest that factories are over-producing and the corresponding increase in the DJIA is likely to reverse.
According to Dow theory, only an economy that is both producing and transporting a significantly higher amount of goods can be said to be in a strong expansionary phase, and the same concept holds during economic contractions.
Day Trading & Dow Theory
Dow theory is one example among many of market theories that are used to explain and predict market behavior. Most day traders employ one or more of these theories to maintain a general picture of current market trends, even if day traders do not trade directly on these trends themselves.
Even if a day trader does not accept Dow theory or some similar theory, they can still trade on these ideas by predicting what other investors will do as a result of their belief in Dow theory.
Dow theory is a simple yet incisive market theory based on the connection between industrial output and transportation. Day traders will need to decide for themselves how reliable this theory is, or any similar theory, seems to them.
However, the existence and widespread use of Dow theory and similar theories is important for day traders to understand and acknowledge.