What is Dow Theory?
In the current day and age, a technical analyst can use different tools such as charts and graphs in order to analyse the market. His thought process and decision-making are based on different theories that have been developed over the years.
But if you go back in the history of technical analysis, the foundation of this branch of stock investing can be traced back to Charles Dow and his writings.
Dow Theory: A brief history
Dow Theory was first introduced by Charles Dow, who was the founder of Dow Jones and Company and the first editor of the Wall Street Journal. This theory is based on the many editorials he had written between the years of 1900-1902. Following his death, William Hamilton continued the work.
In 1932, the writings of these two men were collectively published as the Dow Theory by Robert Rhea.
What is Dow Theory?
The theory explains how the stock market can be used by investors to understand the health of the business environment. It was the first theory to explain that the market moves in trends. And while a lot has changed in the stock markets over the years, the basic tenets of Dow Theory still hold water.
Six tenets of Dow Theory
Dow Theory in stock trading
The market discounts all news
This principle explains that any information available in the market is already reflected in the price of stocks and indices. This includes all data such as earnings announcements by companies, rise (or fall) in inflation or even sentiments of investors.
As a result, it is better to analyse price movements instead of studying earnings reports or balance sheets of companies.
The market has three trends
This theory was the first to propound that the market moves in trends. The trends are:
Primary trend is the major trend for the market. It indicates how the market moves in the long-term. A primary trend could span many years.
Secondary trends are considered to be corrections to a primary trend. This is like an opposite movement to the primary trend. For example, if the primary trend is upward (bullish), the secondary trend(s) is downward. These trends could last anywhere between a few weeks to a few months.
Minor trends are fluctuations to the market movement on a daily basis. These trends last for less than three weeks and go against the movement of the secondary trend. Some analysts consider minor trends to mirror market chatter.
Trends have three phases
The theory says that there are three phases to each primary trend: accumulation phase, public participation phase and panic phase.
The beginning of a primary upward (or downward) trend in a bull (or bear) market is known as the accumulation phase. Here, traders enter the market to buy (or sell) stocks against common market opinions.
In the public participation phase, more investors enter the market as business conditions improve and positive sentiments become evident. This results in higher (or lower) prices in the market.
The panic phase is marked by excessive buying by investors. This could result in great speculation. At this stage, it is ideal for investors to book profits and exit.
Indices confirm each other
A trend in the market cannot be verified by a single index. All indices should reflect the same opinion. For example, in case of a bullish trend in India, the Nifty, Sensex, Nifty Midcap, Nifty Smallcap and other indices should move in the upward direction. Similarly, for a bearish trend, all indices should move in a downward direction.
Trends are confirmed by volume
The trend in the market should be supported by trading volumes. For instance, in an upward trend, the volume rises with increase in price and falls with decrease in price. And in a downward trend, the volume increases with fall in price and decreases with price rise.
Trends continue until definitive signals indicate otherwise
The theory says that market trends exist despite any noise in the market. That is, during an upward trend, a temporary trend reversal is possible but the market continues to move in the upward direction. In addition, the status quo remains until a clear reversal happens in the market.