Technical Analysis and Chart Interpretations. Ponsi Ed

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      On May 19, 2015, the Dow Jones Industrial Average closed at an all-time high of 18312.39 (point A). However, the Dow Jones Transportation Average failed to confirm this new high; in fact, the transportation index reached a six-month low just a few days later on May 22 (point B). This failure to confirm served as a warning to traders, who should have been bullish at the time, based on prior Dow Theory buy signals.

      The divergence of these two indices tells us that the market wasn't as strong as it appeared to be on the surface. Weakness in the transportation index could be a sign that demand for products could be waning. However, this would not be assumed unless and until it is confirmed by price action in the industrial index.

      While the divergence between the industrials and the transports in Figure 4.2 can be described as a warning sign, it's important to understand that it is not a sell signal. Divergence itself does not create a buy or sell signal as it pertains to Dow Theory.

      Divergence can be used as a buy or sell signal outside of the realm of Dow Theory. For example, many traders use divergence between the MACD (moving average convergence/divergence) indicator and the price as a buy/sell indicator. However this type of divergence is unrelated to Dow Theory. We'll discuss MACD divergence in a later chapter.

      When it comes to Dow Theory, there are no provisions for a neutral signal – it is always set to either buy or sell, based on the most recent signal. The most recent signal prior to the divergence in Figure 4.2 was a buy signal in December of 2014, so adherents of Dow Theory would have remained cautiously bullish.

      In order to generate a Dow Theory sell signal, the Dow Jones Industrial Average would have to confirm the breakdown in the Dow Jones Transportation Average by breaking below a major low point. Both of the indices would have to break down in order to generate a sell signal, according to the theory.

      According to Dow Theory, volume is also used to confirm the trend. Ideally, a bull market should feature an increase in volume as prices rise, and turnover should decrease as prices fall. The opposite would be true for a bear market; volume should increase on days when the market is falling, and decrease as prices are rising.