Dow Theory
The strategy described here is based on the Dow Theory. It corresponds to the strategy known in German-speaking countries as "Markttechnik".
The where and the why
The aim of the dow theory is to explain WHY and WHERE to enter. Because only if you understand the mechanisms of the market, you will be a better trader than all those who buy only because "lines of an indicator cross" or this reaches a "magic value".
The dow theory considers all market participants at any point in time and thus tries to answer two of the most important questions: "Who is buying" and "Who is selling" at what point in time? Or put another way - where is the price at which buyers enter the market, the strongest possible movement occurs, and you can profit from a strong trend?
For each of the following chapters, please refer to the corresponding schematic chart.
Point 1 - the low
When a price falls, it eventually forms a new low. Many traders try to catch exactly this low. However, this often becomes the proverbial "grab the falling knife". Unfortunately, you can only tell afterwards whether it was really a low or whether the price will fall even further. Point 1 can therefore only be recognized when the price has already risen again. It is more like a game of chance to hit this point and you need a firm belief in "at some point it must go up again" if you enter here.
Who is a buyer here?
Traders who have managed to hit the low.
Fundamental investors who think the stock is cheap and always buy when the price falls.
Point 2 - the first high
From point 1, the price rises again. But the higher it rises, the fewer buyers there will be who are still willing to buy in at these high prices. On the contrary - more and more investors are in the plus and will try to realize their profit. As a result, the number of sellers increases along with the price, until there is a point at which there are more sellers than buyers and the price falls again. A new high has formed.
This point can also only be recognized in retrospect and is therefore difficult to exploit for trading.
Who is a buyer here?
Traders who think "oh, it's going up - I want to be there". Quasi the attempt to jump on the moving train.
Who is a seller here?
This is one of the most important questions that the dow theory wants to answer. Because nobody wants to buy exactly when many sellers come into the market.
And the answer is: potentially all buyers from point 1! Because these are all in the plus and would like to end their trade with profit. And thus there are certainly too many sellers at this point for anyone to want to buy here.
Point 3 - a new (higher) low
If the price continues to fall and falls below point 1, the stock becomes uninteresting for us. The reason for this is that there are obviously more sellers than buyers. However, we are looking for stocks with strong trends - and thus stocks in which buyers keep coming back and which remain attractive for existing buyers.
If, however, there is still interest in the value and buyers are always found, the value will rise again after a certain correction. Only with the rise, the new low can be recognized as such and drawn in. Only if this low is higher than the first low of point 1, we can assume that there are also more new buyers who are willing to pay higher prices.
And also this point can only be identified in retrospect and is therefore very difficult to use for accurate trading.
Who is a buyer here?
Potentially all sellers from point 1! They have realized profits, still consider the value attractive and are looking for another opportunity to enter. This is now offered to them by a lower price again.
Traders who did not hit point 1 and now see an opportunity to enter.
Traders who try to hit a low after a high (point 2).
Furthermore, fundamentally oriented investors are potential buyers. They consider the stock to be undervalued in the long term and will buy again and again when the price falls.
Who is a seller here?
Traders who have not managed to exit at point 2 and have now been stopped out, for example.
A new high ... and the answer to the "Where?" and the "Why?".
The price has risen again and forms the entry point according to the dow theory: a new high which is also numbered "2". This answers the question of "where". But why is exactly this point so interesting? The question of "why" can be answered by looking at the other market participants:
Who is the seller here?
Buyer of point 1? Unlikely. If they had wanted to sell at this price, they could have done so at the first high - at the last point 2. Quite obviously, they assume that prices will continue to rise and remain invested.
Buyers from point 2? Unlikely and even irrelevant. Point 2 was a high and thus the point at which there were no longer enough buyers and therefore sellers determined the price. Even if these buyers sell now, there are not enough of them to be relevant. Apart from that, they have a strong interest to stay invested as they are just starting to make profit now.
Buyers from point 3? Also unlikely. These buyers could also be the same ones who already bought at point 1 and sold at point 2 (proving a very lucky hand). But from point 3 to this new high, the gain is much less than from point 1 to point 2. Buyers will most likely stay invested.
Who is a buyer here?
Here you have to put yourself in the shoes of the many traders who trade according to a trend following system. Inevitably, more and more trend-following indicators will now gradually provide signals, leading to the entry of many traders.
When a stock marks new high points, more traders will also become aware of it. The upward trend becomes more and more apparent and everyone wants to be part of it. Positive price trends attract traders and investors. Even the media interest increases and suddenly the value appears in the top 10 of the last days.
Another argument for this point: you don't see it after the fact. It becomes visible immediately, as soon as the trend emerges. You don't even have to sit in front of the computer and wait patiently to see if or that there is a new high. Instead, you can create a stop-buy order in advance. This is then executed immediately when the new high is reached and you are in the trade.
The trend break
After the question of how a trend is created, one must naturally ask the question of when a trend is ended. And this is exactly the case when a lower low is formed, that is, when the price falls lower than the last point 3. This is the end of the uptrend.
From a dow theory perspective, this is an exit from a long trade. The stop loss should be set here at the latest. Of course, you can leave it "a little air" due to an always existing fuzziness and set it a few points below the last point 2.
Implementation
Of course, you can manually click through all stocks of your watchlist on a regular basis and look for new dow theory buy signals.
Or - you can use our indicator. It plots all important information about buy signals and trades in the chart and can even inform you by mail about upcoming buy signals, even before the actual signal arises. Read more about this and many other features that our indicator can offer you in our manual.