In this article, We learn about “Dow Theory “.Let’s Go!
Dow Theory is widely regarded as one of the earliest forms of technical analysis.
It was originally promulgated by Charles H. Dow, who noted that stocks tend to rise or fall in trends, and that they tend to move together, although they may vary in degree.
In 1897, Charles Dow developed two broad market averages. The “Industrial Average Index” includes 12 blue-chip stocks, and the “Railway Average Index” includes 20 railway companies.
is now known as the Dow Jones Industrial Average and the Dow Jones Transportation Average.
Dow Theory originated in a series of articles published by Charles Dow in the Wall Street Journal between 1900 and 1902.
Dow Theory is the common ancestor of most modern technical analysis principles.
Interestingly, Charles Dow did not use his observations to predict potential price movements, but rather as a barometer of the general business environment.
It was not originally intended to predict stock prices. However, subsequent work has focused almost exclusively on this use of the theory.
After Dow’s death in 1902, his close friend Samuel A. Nelson attempted to explain Dow’s method in his book, “The ABC of Stock Speculation” .
William P. Hamilton, who succeeded Charles Dow as editor of The Wall Street Journal, refined the principles of Dow and developed them into a theory in This is explained in the book Stock Market Barometer: A Study. Its predicted value for 1922 “.
Dow’s work and Hamilton’s work were both analyzed and studied by Robert Rhea, who in his book “
The Dow Theory 1932″ further distilled Dow Theory as theory as we know it today.
Fundamentals of Dow Theory
Dow Theory contains six postulates:
1. Average discount everything
averages discount all factors because they reflect the combined activity of thousands or even millions of traders, speculators and investors at the same time.
The prices of individual stocks reflect everything known. As new information arrives, market participants spread the word quickly and prices adjust accordingly.
Thus, every known and foreseeable event is discounted, as is every condition that could affect the supply and demand of individual stocks.
2. The market is made up of three major trends
At any given time in the stock market, three forces are at play: the primary trend, the secondary trend, and the secondary trend.
- A major or major trend that usually lasts at least a year can last for many years. This trend usually results in a price movement of at least 20%. When a primary trend is overstretched, the primary trend is interrupted by a secondary trend that moves in the opposite direction to correct the primary trend.
- Secondary trend interrupts the movement of the primary trend and moves in the opposite direction. However, it is very difficult to identify a secondary trend while it is developing. Minor trends last at least three weeks, but can last several months, and usually retrace at least 1/3 of the previous price action. Sometimes, a secondary trend can completely retrace the previous move, but usually it will stop at 1/2 or 2/3 of the previous move.
- Minor trends are daily fluctuations in the average. It usually lasts less than six days and does not have any importance in the Dow Theory.
Dow Theory holds that since stock prices are subject to some degree of manipulation in the short term (major and minor trends are not), minor trends are unimportant and can be misleading.
3. The main trend is divided into three stages
A bull market is characterized by the progression of major trends and usually consists of three phases:
- Accumulation Phase When savvy investors start buying shares at low prices from sellers, those sellers are coerced by the fact that the economic news is still bad and often the worst. During this phase, trading activity typically remains moderate but begins to increase.
- The accumulation phase is followed by a phase characterized by steady progress accompanied by increased activity as the improvement enterprise begins to gain attention. This is often the most profitable stage for technical analysts.
- The final phase is characterized by amazing progress as more and more members of the public are attracted to the market.
A bear market is characterized by a downward primary trend, and like a bull market, it usually consists of three phases:
- Distribution Phase Occurs when savvy investors start selling their holdings when they bought during the accumulation phase of the last bull market. During this phase, trading activity typically remains high but begins to decrease.
- The Panic Phase ensues as buyers dwindle and sales become more urgent. The downward trend accelerates to a nearly vertical decline characterized by climatological quantities. This phase is usually followed by a long-term recovery (secondary trend) or a sideways move before the final phase begins.
- The final phase is characterized by buyers who held on during the panic phase or bought during the recovery who were unwilling to sell. The frustrated sell-off is not as violent as the panic phase.
4. Means must confirm each other
Industry and transportation must confirm each other for effective trend changes to occur.
Both averages must exceed the previous minor peak (or trough) to confirm a change in trend.
In other words, both averages must move in the same general direction. If the two averages do not follow the same trend, then the trend is not 100% valid.
5. Volume confirms trend
Dow Theory focuses primarily on price action. Volume is only used to confirm uncertain situations.
Volume should expand in the direction of the main trend.
- If the main trend is down, volume should increase during market declines.
- If the main trend is up, volume should increase during market upswings.
6. The trend remains unchanged until a clear reversal signal is given
An uptrend is defined by a series of higher highs and higher lows. In order for an uptrend to reverse, price must make at least one lower high and one lower low (the opposite is true for a downtrend).
When both industrials and transports are signaling a major trend reversal, the new trend is most likely to continue.
However, The longer a trend lasts, the less likely it is that the trend will stay the same.
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