What it is:
Dow Theory is an analysis that explores the relationship between the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA). When one of these averages climbs to an intermediate high, then the other is expected to follow suit within a reasonable amount of time. If not, then the averages show "divergence" and the market is liable to reverse course.
How it works (Example):
Dow Theory has its origins in the writings of Charles Dow -- founder of the Wall Street Journal and creator of the Dow Jones Industrial Average. His editorials pioneered technical analysis. On his death in 1902, William Hamilton continued Dow's work, writing editorials of his own until 1929. Robert Rhea then collected the work of both of these men and used it as a basis to publish The Dow Theory in 1932.
This book expounds upon many key principles of technical analysis, such as defining the nature of the primary, secondary and minor trends. Dow Theory divergence is fully explained in the idea that "the two averages must confirm."
In Dow's time, the two averages were the Industrials and the Rails. The logic behind the theory is simple: Industrial companies manufactured the goods and the rails shipped them. When one average recorded a new secondary or intermediate high, the other average was required to do the same in order for the signal to be considered valid.
If the two averages acted in harmony -- with both reaching new highs or lows around the same time period -- then the price action of each was said to be confirming.
However, if one average went to a new high, while the other was left behind, then there was bearish divergence. If the opposite occurred, with one average reaching a new low while the other held above a previous bottom, then the divergence was bullish.
At present, of course, the rails are now the Transports. However, Dow Theorists argue that the principle remains valid. As such, they contend that the activity of the Industrials and Transports provides a filter to detect whether the stock market is in a healthy or unhealthy state.
Why it Matters:
The behavior of the Dow Jones Industrial Average (DJIA) typically grabs the headlines. Few investors, however, are aware of the tenets of Dow Theory. By understanding the Dow Theory, traders are better able to hidden trends that more experienced investors may be noticing. This allows them to make more informed decisions regarding their open positions.