Introduction to Dow Theory
The Dow Theory is an integral part of technical analysis. It was used widely before the western world discovered candlesticks. The concepts are popular even today. Expert traders combine the best practices of the Dow Theory with candlestick patterns.
In today’s times, a technical analyst can use graphs and charts to analyse the market. However, a trader’s decision-making depends on various theories discovered over the years.
If you study the history of technical analysis, stock investing theories have existed for almost 100 years and can be traced back to Charles Dow and his writings.
Charles H. Dow, the founder of the Wall Street Journal, introduced the Dow Theory to the world. He wrote many editorials between 1900 and 1902. William P Hamilton compiled these articles with relevant examples.
In 1932, Robert Rhea published the Dow Theory with the collective writings of both these writers.
What is Dow Theory?
The theory helps investors understand how they can use the stock market to interpret the condition of the business environment. The theory was the first of its kind and helped in explaining the movement of the market in trends. Although the stock market has undergone several changes over the years, the principles of the theory still apply.
The Six Dow Theory Principles
The concept of the Dow Theory includes six basic tenets. Let’s discuss each one of them in brief.
- The market discounts everything.
According to this principle, the prices of stocks and indices reflect all information prevalent in the market. This information includes a change in inflation, earning announcements by companies as well as investor sentiment. Therefore, a trader must stick to analysing price movements rather than studying the company’s balance sheets.
- There are three trends in the market.
The primary trend highlights long-term market movement. A primary trend can continue for many years. The secondary trend introduces corrections to a primary trend. It is like movements in the opposite direction of the primary trend. The duration of the secondary trend can be from a few weeks to months. The third is minor trends. They refer to daily fluctuations in market movement. The duration of these trends is less than three weeks. Their direction is the opposite of the secondary trend. As per some analysts, minor trends imitate market chatter.
- Trends have three phases.
The third Dow Theory principle suggests that whether the market is on an upward trend or a downward trend, it is marked by three phases.
- Accumulation phase - This phase witnesses the entry of astute institutional investors since the market has touched a low. They purchase large volumes of the stock to change the market direction.
- Public participation phase - In this phase, many investors join as the stock prices are rapidly advancing.
- Panic phase - It witnesses aggressive buying by investors. It ends up in increasing speculative volume and large-scale public participation. Consequently, it is the best time for investors to book profits and exit.
- Indices confirm each other.
A single index cannot confirm a market trend. All indices must move in the same direction to reflect the market trend. For instance, during a bullish trend, Sensex, Nifty, Nifty Smallcap, Nifty Midcap, and the others should show an upward movement.
- Trends are confirmed by volume.
Trading volumes should verify the market trend. For instance, during a downward trend, the volume is higher when prices fall and lower when prices rise. Similarly, during an upward trend, the volume increases with price rise and decreases with price fall.
- Trends continue until definitive signals indicate otherwise.
This Dow Theory principle suggests that market trends prevail even if there is any noise in the market. It is possible to see a temporary trend reversal, but if there is an upward trend, the market will continue to move in the upward direction. There is no change in the status quo unless a clear reversal occurs.
Dow Theory Patterns
As a technical analysis tool, the Dow Theory has numerous patterns. These patterns help the trader and the investor identify opportunities in trading.
The most prominent Dow patterns are the trading range, the flag formation, the Double bottom and Double top formation, and the triple bottom and triple top.
The Dow Theory is considered to be one of the essential theories of technical analysis. Although Charles Dow developed it in the late 19th century, its principles are relevant even today. There are both supporters and critics of the theory. It relies on the six tenets we have discussed in this article. Traders can follow the trade and interpret all the distinct patterns involved in it to make the maximum advantage of the trade.
In a nutshell, the Dow Theory enables traders to analyse the trades and the related profits.
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Frequently Asked Questions
Charles Dow developed the Dow Theory in the late 19th century. It was based on his analysis of the market price action.
You can use the Dow Theory to analyse the market trend with daily line charts having two years of data. A trader needs to mark the tops and bottoms in the chart. After the tops and bottoms are marked, qualify them as Higher Top, Higher Bottom, Lower Top, and Lower Bottom. Find the trend by looking for a sequence.
- It is a Bullish trend if the sequence formed with Higher Top and Higher Bottom has significant volume.
- It is a Bearish trend if the sequence formed with Lower Top and Lower Bottom has significant volume.
Similar to candlesticks, the Dow Theory also has some vital patterns. These include the Double bottom and Double top formation, range formation, flag formation, and the Triple Bottom and Triple Top.
Although a lot of changes have occurred in the years since the Dow Theory first came into existence, the Dow Theory, along with its six tenets, are applicable today and are regarded as a valid strategy for trading by many traders trading in the stock market.