Dow Theory is a method to analyze the stock market using the help of the analyzing the movements of different indices, such as Dow Jones Industrial Average and the Dow Jones Transportation Average. It was developed by Charles Dow who was the co-founder of the Wall Street Journal and the Dow Jones and the company.
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Dow Theory was based on these following principles:
- The market discounts everything.
This means that the market price reflects all the available information and expectations about a stock or an index, any new or unexpected event will cause the market to adjust quickly to incorporate it.
- Market moves in three major trends.
According to the Dow Theory market moves in three major trends- primary, secondary and minor. The primary trend reflects a long term major trend which can last for a year to several years. The secondary trends can be referred to as a counter trend or a corrective trend which can last for weeks to several months. The minor trend is the daily noise or fluctuations in the market which can last for a few hours to a few days.
- These trends have three phases.
These trends have three phases: accumulation, public participation and distribution.
- Accumulation Phase:
The accumulation phase starts when informed investors start buying or selling stocks in anticipation of a change in the primary trend.
Once an accumulation phase ends in a particular asset, then from that point the market starts its second phase: Public Participation Phase.
- Public Participation Phase:
The public participation phase starts when the general public follows the informed investors and joins the trend.
These two phases lead an asset’s price to increase. Once these two phases are completed market moves for its third phase: Distribution Phase.
- Distribution Phase:
Once the accumulation and public participation phase ends then the distribution phase comes into play. The distribution phase is when informed investors start selling or buying stocks to take profits or cut losses before the trend reverses.
- The trends must be confirmed by volumes.
According to this principle trend must be confirmed by the volumes. Volume refers to the number of shares traded in a given period of time. According to Dow Theory volumes should increase in the direction of the primary trend and the volumes should decrease in the direction of secondary trends. For example, during an uptrend volumes should be higher when prices rise and lower when prices fall.
- The trends should be confirmed by different indices.
Dow Theory states that no major change in the market can occur unless both the industrial and transportation indices confirm it. For example, if the industrial index reaches a new all time high but the transportation index does not then the uptrend is not confirmed and can be a weak or false sign.
- Sideways market can substitute secondary trends.
This principle states that sometimes, instead of correcting in the opposite direction of the primary trend, the market might move sideways or in a narrow range for a long period. This sideways or narrow can indicate that there is no clear direction among the investors. This sideways movement can act as a secondary trend and precede a major change in the primary trend.
Conclusion
Dow Theory is one of the oldest and most influential theories in technical analysis. It provides a framework to understand how the market behaves and how to identify major trends and changes in them. In order to identify these phases and trends in the market you need to spend time reading charts and try to identify these principles in the market. Once you master this chart reading skill then it will surely help you in your stock market journey.