What is Dow Theory?
The Dow Theory is a financial concept based on a set of ideas from Charles H. Dow‘s writings. Fundamentally, it states that a notable change between bull and bear trend in a stock market will occur when index confirm it.
The trend that is recognized is considered valid when there is strong evidence supporting it. The theory states that if two indicators move in the same way, the primary trend that is identified is genuine.
However, if the two indicators don’t align, then there is no clear trend. This approach mainly focuses on changes in prices and trading volumes. It uses visual representations and compares different indicators to identify and understand trends.
The Dow Theory originated from the analysis of market price movements and speculative viewpoints proposed by Charles H. Dow. It served as a fundamental building block for technical analysis, especially in a time when modern software-based technical analysis tools did not exist.
Robert Rhea’s book “The Dow Theory” thoroughly explores the evolution and significance of the theory in speculative endeavours, closely examining the Wall Street Journal editorials written by Charles H. Dow and William Peter Hamilton in the 19th century.
This theory represents one of the earliest efforts to comprehend the market by considering fundamental factors that provide insights into future trends.
The main version of the theory primarily focuses on comparing the closing prices of two averages: the Dow Jones Rail (or Transportation) (DJT) and the Dow Jones Industrial (DJI). The premise was that if one average surpassed a specific level, the other average would eventually follow suit. Dow used an analogy to illustrate this concept, likening the market to the ocean.
He explained that just as waves rise to a certain point on one side of the beach, waves on another part of the beach will eventually reach that same point. Similarly, in the market, different sectors are interconnected, and when one sector shows a particular trend, others tend to follow suit as they are part of a larger whole.
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The Paradigms of Dow Theory
To comprehend the theory, it is essential to grasp the various rules formulated by Dow. These principles, often referred to as the tenets of Dow theory, serve as guiding paradigms
- Three major market trends:
The tenets of Dow Theory classify trends based on their duration into primary, secondary, and minor trends. Primary trends can be either upward (uptrend) or downward (downtrend) and can last for months to years.
Secondary trends move in the opposite direction to the primary trend and typically last for weeks or a few months. Minor trends, on the other hand, are considered insignificant variations that occur over a shorter time span, ranging from a few hours to weeks, and are considered less significant than the primary and secondary trends.
- Primary trends have three distinct phases:
- Bear markets can be divided into three distinct phases: distribution, public participation, and panic.
- In the distribution phase, there is a gradual selling off of assets by investors.
- The public participation phase occurs when more individual investors start selling their holdings, leading to a broader decline in the market.
- The panic phase is characterized by widespread fear and selling pressure, often resulting in a sharp and rapid decline in prices.
- On the other hand, bull markets experience three phases: accumulation, public participation, and excess.
- During the accumulation phase, astute investors start buying assets at lower prices, anticipating an upward trend.
- The public participation phase occurs as more investors join the market and buy assets, contributing to the market’s upward momentum.
- The excess phase represents a period of exuberance and speculative buying, often marked by overvaluation and unsustainable price increases.
- Stock market discount everything:
Market indexes are highly responsive to various types of information. They can reflect the overall condition of an entity or the economy as a whole.
For example, any significant economic events or problems in company management can impact stock prices and cause movements in the indexes, either upward or downward.
- Trend confirms with volume:
When there is an uptrend, trading volume rises and decreases while a downtrend starts
- Index confirm each other:
When multiple indices move in a consistent manner, following the same pattern, it indicates the presence of a trend.
This alignment among indices provides a strong signal of market direction. However, when two indices move in opposite directions, it becomes challenging to determine a clear trend. In such cases, conflicting signals make it difficult to deduce a definitive market trend.
- Trends continue until solid factors imply the reversal:
Traders should be careful of trend reversals, as they can often be mistaken for secondary trends. To avoid this confusion, Dow advises investors to exercise caution and verify trends with multiple sources before considering it a genuine reversal.
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How Does Dow Theory Work in Technical Analysis?
The Dow Theory played a crucial role in the development of technical analysis in the stock market and served as its foundational principle. Which, approach to analysis highlights the importance of closely observing market data to identify trends, reversals, and optimal entry and exit points for maximizing profits.
As the market is considered an indicator of future performance, the application of technical analysis based on the Dow Theory helps investors make profitable trading decisions by identifying established long-term, mid-term, or short-term trends. By using this approach, investors can gain insights into market dynamics and make informed decisions to enhance their trading outcomes.
The Dow Theory has significantly influenced technical analysis in the stock market, serving as a cornerstone for its development and advancement. By analysing the careful examination of market data, this theory helps traders to identify trends, spot reversals, and determine optimal buy and sell points for maximizing profits.
The market itself is considered a reliable indicator of future performance, and technical analysis aligned with the Dow Theory assists investors in making profitable trading decisions by detecting established long-term, mid-term, or short-term trends. By using this analytical framework, investors can gain valuable insights into market behaviour and make well-informed choices to improve their trading outcomes. The Dow Theory’s enduring impact continues to guide traders in their pursuit of success in the dynamic world of stock market investing.