Dow Theory Explained: What It Is and How It Works - A Comprehensive Guide
Dow Theory Explained: What It Is and How It Works - A Comprehensive Guide
What is Dow Theory?
Dow theory is a financial theory that states that a market is in an uptrend if one of its averages (for example, industrial or transportation) moves above a previous significant high and is accompanied by or followed by a similar advance in another average. For example, if the Dow Jones Industrial Average (DJIA) climbs to an intermediate high, an investor might buy the Dow Jones Transportation Average (DJTA) to confirm an uptrend.
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Key Takeaways
- Dow Theory is a technical framework that predicts that the market is in an upward trend if one of its averages moves above a previous significant high, accompanied or followed by a similar advance in another related average.
- The theory is based on the assumption that the market discounts everything, in line with the efficient market hypothesis.
- In such a pattern, different market indices should confirm each other in terms of price action and volume patterns until the trend reverses.
Understanding Dow Theory
Dow Theory is an approach to trading that was developed by Charles H. Dow, who along with Edward Jones and Charles Bergstresser founded Dow Jones & Company, Inc. founded and developed the Dow Jones Industrial Average in 1896. Dow illustrated the theory in a series. editorializing in the Wall Street Journal, which he co-founded.
Charles Dow died in 1902, and due to his death, never published his complete theory on the markets, but a number of followers and collaborators have published works that have expanded on the editorial. Some of the most important contributions to Dow Theory include the following:
- The Stock Market Barometer (1922) by William P. Hamilton.
- Dow Theory by Robert Rhea (1932).
- E. George Shaffer's How I Helped More Than 10,000 Investors to Profit in Stocks (1960).
- Richard Russell's Dow Theory Today (1961).
Dow believed that the stock market as a whole was a reliable measure of overall business conditions within the economy and that by analyzing the overall market, one could accurately gauge those conditions and identify the direction of important market trends. and the likely direction the individual stock could take. ,
Aspects of the theory have lost ground—for example, its emphasis on the transportation sector and railroads—but Dow's approach is the core of modern technical analysis.
How Dow Theory Works
Dow Theory has six main components.
1. The Market Discounts Everything
Dow Theory operates on the efficient market hypothesis (EMH), which states that asset prices incorporate all available information.
Earning potential, competitive advantage, management ability – all of these factors and more price the market, even though not everyone knows all or any of these details. In a more strict reading of this principle, future events are also discounted as risks.
2. There are Three Primary Types of Market Trends
Markets experience primary trends that may last a year or more, such as a bull or bear market. Within broader trends, secondary trends make smaller movements, such as a pullback within a bull market or a rally within a bear market; These secondary trends can last from a few weeks to a few months. Lastly, minor trends can last from a few days to a few weeks. These small fluctuations are considered as market noise.
3. Primary Trends Have 3 Phases
According to Dow Theory, primary bull and bear trends go through three phases.
The phases of a bull market are:
- Accumulation Phase: Prices rise with the increase in quantity.
- Public Participation (or Big Move) Phase: Retail and average investors begin to notice the upward trend and typically join in. This is the longest phase.
- Excess Phase: The market reaches a point where experienced investors and traders begin exiting their positions while the larger average investing population continues to increase their positions.
The phases of a bear market are:
- The Distribution Phase, where news of the decline begins to be distributed through various channels to the entire investment community.
- Public Participation Phase: A bull market opposes the participation phase—average and retail investors are selling stocks and exiting positions to cut losses. Again, this is typically the longest phase.
- Panic (or Despair) Phase: Investors have lost all hope of a correction or a complete reversal and massive selling continues.
4. Indices Must Confirm Each Other
For a trend to be established, the indices posted by the Dow or the market averages must confirm each other. This means that the signals coming on one index must match or correspond to the signals on the other index. If one index, such as the Dow Jones Industrial Average, shows a new primary uptrend but another remains in a primary downtrend, traders should not assume that a new trend has begun.
Dow used two indices that he and his partners had invented, the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA), on the assumption that if business conditions were healthy—as in an increase in the DJIA— May suggest - the railroads would benefit from the freight traffic needed for this business activity; Thus, DJTA will also be increasing.
5. Volume Should Confirm The Trend
Trading volume generally increases if the price moves in the direction of the primary trend and decreases if it moves against it. Low volume indicates weakness in the trend. For example, in a bull market, buying volume should increase as price rises and fall during secondary pullbacks because traders still believe in the primary bullish trend. If selling volume increases during a pullback, it could be a sign that more market participants have turned bearish.
6. Trends Persist Until a Clear Reversal Occurs
Reversals in primary trends can be confused with secondary trends. It is difficult to determine whether the bear market surge was a reversal or a short-term rally followed by still lower lows. Dow Theory advocates caution, insisting that a potential reversal should be confirmed by comparing indices.
Special Attention
Here are some additional points to consider about Dow Theory.
Closing Price And Line Range
The Charles Dow relied entirely on closing prices and was not concerned about the intraday movement of the index.
Another feature in Dow Theory is the idea of a line range, also known as a trading range in other areas of technical analysis. These periods of sideways (or horizontal) price movements are viewed as periods of consolidation. Therefore, traders should wait for the price movement to break the trend line before making any conclusions as to which direction the market is headed. For example, if the price moves above the line, it is likely that the market will move up.
Identifying Signals And Trends
One challenging aspect of applying Dow Theory is correctly identifying trend reversals. Remember, a follower of Dow Theory trades with the overall direction of the market, so it is important that they recognize the points at which this direction changes.
One of the main techniques used to identify trend reversals in Dow Theory is peak-and-trough analysis. A peak is defined as the highest price of a market movement in a period, while a trough is seen as the lowest price of a market movement in a period. Note that Dow Theory assumes that the market does not move in a straight line, but rather from highs (peaks) to lows (troughs), with the overall market movement in one direction.
An upward trend in Dow Theory is a series of progressively higher peaks and troughs. A downtrend is a series of successively lower peaks and troughs.
The sixth principle of Dow Theory argues that a trend remains in effect until there is a clear indication that the trend has reversed. Similarly, the market will continue to move in a primary direction until a force, such as a change in trading conditions, is strong enough to reverse the direction of this primary move.
Shift
A primary trend reversal is indicated when the market cannot make consistent peaks and troughs in the direction of the primary trend.
During an uptrend, a reversal occurs when the index fails to reach consecutive higher highs and higher lows over a long period of time. Instead, the index moves in a series of lower highs followed by lower lows.
A reversal of a downward primary trend occurs when the market is no longer falling to lower lows and higher highs. Consecutive higher highs and higher lows in a downtrend market indicate a potential reversal to an uptrend.
It is important to remember that a primary trend reversal can take months to present itself – a change in price direction over a period of one month, two months or three months can only be a market correction.
Dow Theory FAQs
What are the 3 trends in Dow Theory?
The three tendencies are primary, secondary and secondary. The primary trend is the long-term trend, which is called bull or bear. Secondary trends are smaller trends, such as market corrections. Finally, the smaller trends are the day-to-day price movements in the market.
What is the goal of Dow Theory?
The overall goal of Dow Theory is to identify the primary trend of the market through evidence and confirmation.
What Factors Affect the Dow?
The Dow Jones Industrial Average, better known as the Dow, is affected by the prices of the stocks that make up the index. Stock prices are affected by many factors.
Last Line
Dow Theory attempts to identify the primary trend a market is in. It consists of three primary tendencies, each composed of secondary and minor tendencies. The theory assumes that the market already has knowledge of every possible factor and that prices reflect current information. This implies that there is no need to further investigate why an asset is priced the way it is, but relies on price movements and volume to act and signals and confirmation for trend reversals.
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