The financial markets can be a complex and daunting world, filled with various theories, indicators, and strategies. One theory that has stood the test of time and remains widely used by traders and investors is the Dow Theory.
The Dow theory is one of the oldest forms of analyzing financial markets. A lot of strategies today adopt the principle of the Dow theory, even in forex trading.
It was stipulated by one of the three titans of technical analysis named Charles H. Dow. During his lifetime, Charles Dow issued a couple of articles that went on to form his theory.
They were released in the Wall Street Journal between 1900 and 1902.
Unfortunately, Charles Dow passed away before he completed his theory of the market.
As time went on, his associates compiled theories from his previous articles.
One was William P. Hamilton, a man who improved Dow’s principles and broadened them into principles.
He explained it in his book, “The Stock Market Barometer: A Study of Its Forecast Value of 1922“.
Thereafter, Dow’s and Hamilton’s work was studied by Robert Rhea. His changes formed the Dow Theory into the theory we know today in his book, “The Dow Theory of 1932“.
What Is The Dow Theory?
From Dow’s findings, he noticed that the movement of stocks was either up or down in trends.
In 1897, Charles Dow developed two broad market averages; the industrial average and the rail average.
The industrial average contains 12 blue-chip stocks. In contrast, the rail average is comprised of 20 railroad enterprises.
The Dow theory states that the market is in an upward trend if one of these averages advances above a previous critical high and is followed by a similar advance in the other average.
That is, if the industrial average makes high, the transportation average is expected to also make high in the near future.
Understanding The Dow Theory
Dow’s theory makes six presumptions, they are:
The Market Discounts Everything
A lot of factors influence the marketplace. Even if traders are unaware, their combined activity influences an asset’s price.
Market participants spread information; this affects the price as its heavily reliant on it.
Additionally, every condition that could affect the supply and demand balance of the individual stocks is discounted too.
Market Trends In the Dow Theory
According to Dow’s theory, a bull/ bear market trend can be divided into three.
- Primary Trends
- Secondary Trends
- Minor Trends
Primary trends tend to last for a year or more; they are responsible for significant price movements, bull or bear. These trends are eventually interrupted by secondary trends when overstretched.
Secondary trends are pullbacks along with the primary trend; it moves contrary to the direction of primary trends. This retrace is occasionally 1/3 to 2/3 of the original price movement.
Compared to a primary trend, secondary trends are rather short-lived- 3 weeks to several months.
Lastly, minor trends are minute movements that occur daily and are considered noise in the Dow theory.
Primary Trends Have Three Phases
According to the Dow theory, primary trends pass through various phases. These phases differ depending on a bull or bear market.
Bull Market
For bull markets, primary trends advance, and there are three phases. The first is the accumulation phase which occurs when shrewd investors start buying stocks at low prices from weak sellers. During this phase, demand is extremely low.
Next, a phase that is distinguished by steady advances due to an increase in activity follows. This is usually the most profitable phase for a technical analyst.
The final phase is a phase denoted by an excess due to the general public being drawn to the market.
Bear Market
The primary trends of bear markets decline and have three phases as well. The first phase is the distribution phase. It occurs when the accumulation phase comes to an end. Good investors start selling their stocks because the market has been overbought.
Afterward, the panic phase follows, and buyers start to reduce while selling becomes more violent. The downtrend quickens due to the high volatility.
This phase is usually succeeded by a secondary trend that lasts for quite a while. Sometimes, it is characterized by sideways movement before the final phase begins.
In the final phase, traders that held through the panic phase start to sell to minimize losses.
The market action from the accumulation to the distribution phase is shown below.
The Averages Must Confirm Each Other
This means that for a trend to be valid, the Industrial and Transport averages must tally with one another.
Moreover, if the industrial average formed a primary uptrend, but the transport remains in a primary downtrend, a new trend has not started.
In brief, a trend is only confirmed when both of the averages move in the same direction. When this is not the case, the trend is not confirmed.
Volume Always Confirms The Trend
Placing A volume indicator can be used to validate the direction of trends. Ideally, volume increases when the impulse is in the direction of the primary trend.
Oppositely, it decreases in the direction of the secondary trend. A decrease/ reduction in volume indicates a weakness in the trend.
READ MORE: LEARN HOW TO USE THE ADX INDICATOR
A Trend Remain Valid Till a Reversal Occurs
Uptrends remain intact as long as higher and lower highs are made. It is only invalid when a higher high is failed to be made.
However, a reversal has to be signaled in both the primary trends of the industrial and transport average for a new trend to be confirmed.
In Dow’s theory, the market trend is determined by industrial and transport averages.
For an uptrend, both averages must advance above their respective previous high.
The three trends of the dow theory are primary, secondary, and minor trends.
Primary and secondary trends are very important and should be focused on. Minor trends are little changes in price and are considered noise.
READ MORE: Understand How to Use Bollinger Bands Indicator
Summary: A Guide To Understanding The Dow Theory
Dow’s theory was not intended to predict future pricing. Nevertheless, down the line, it was used for this purpose.
What he believed was the stock market as a whole as a means to measure overall business climates within the economy.
Therefore, by analyzing the overall market, this climate can be identified, and the direction of significant market trends can be found. With this, the likely direction of individual stocks is also realized.
A lot of theories, such as the Elliott wave theory and Wyckoff theory, were inspired by Charles Dow. Without our knowledge, we have all implemented the Dow theory in one way or the other.
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