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What is The Dow Theory in Technical Analysis?

BitForex Editor
Nov 06, 2020

The Dow theory is notably regarded as the first aspects of technical analysis which was developed and propounded by Charles Dow, who discovered the upward and downward movement trend of stocks, even though their movements usually vary.

The Dow theory is based on a financial theory which states that the market is moving upward if one out of its averages, either transportation or industrial, moves above a previous high and is accompanied by a similar advance in the other average. For instance, if the Dow Jones Industrial Average moves to an intermediate high, then within a reasonable period of time, the Dow Jones Transportation is bound to follow suit.

Understanding The Dow Theory

The Dow theory was established as an approach to trading, which was brought about by Charles H. Dow, as earlier stated, who, with Charles Bergstresser and Edward Jones, established the Dow Jones & Company, Inc. and in 1896, created the Dow Jones Industrial Average. Dow explained and expatiated on his theory in various editorials of the Wall Street Journal, which he also co-founded.

In 1902, Charles Dow died, and as a result of this, he was never able to publish any of his finished theory on the markets; however, several individuals and associates have published works which were based on the editorials, and some of the vital contributions to Dow theory include; Robert Rheas; The Dow Theory, William p. Hamilton’s; The Stock Market Barometer among various others.

Charles Dow was of the opinion that the entire stock market can serve as reliable means of measuring the total business conditions within the economy, and through the analysis of the overall market, a person could accurately gauge those conditions as well as determine the direction of significant market trends as or position including the direction of individual stocks.

Since the establishment of this theory, it has undergone further development over the course of its 100 plus years in history by some associates as well as followers like Robert Rhea, Richard Russel, William Hamilton, amongst others. Over the years, some areas of the theory have lost grounds like the emphasis on the railroads or transportation sector in its original form. However, the approach of Dow still forms the basis of modern technical analysis.

How The Dow Theory Works

The Dow theory consists of six main tenets, which include:

The Market Discounts Everything

The Dow theory functions on EMH, which is better known as the Efficient Markets Hypothesis, which stipulates that the prices of assets incorporate or integrates all available information. It basically means that this approach is the antithesis of behavioral economics.

Factors such as management competence, competitive advantage as well as earnings potential amongst others are priced into the market, and even if they are not, every person is aware of any of these details. Some core aspects and readings of this theory also discount future events in the form of risk.

There are three kinds of market trends, which are the primary trend, the secondary trend, as well as the tertiary trend. Proper examination of these trends can provide investors or traders with the ease of finding opportunities. The market usually experiences primary trends that tend to last a year or more, like in the case of the bear or bull market. Within these extensive trends, they also experience secondary trends, which often work against the primary trend, for example, the rally within a bear market or the pullback within a bull market. Secondary trends tend to usually last from 21 days (three weeks) to three months. In conclusion, there are some minor trends which last less than three weeks.

Based on the theory of Charles Dow, a primary trend is bound to pass through three phases. Those three phases include; accumulation, public participation as well as the excess phase in a bull market. While in a bear market, they are referred to as the distribution phase, the public participation phase, as well as the despair or panic phase.

Indices Must Confirm Each Other

Charles Dow propounded that for a trend to be established, market averages must confirm each other. This basically means that the signals which take place on one index must be the same or correspond with the signals on the other. If an index, like the Dow Jones Industrial Average, confirms a new primary uptrend while another index is still in a primary downward trend, then traders should not be of the assumption that a new trend has started.

Volume Must Confirm the Trend

If the price moves in the direction of the primary trend, then volume should increase, but if it moves against it, then it is bound to decrease. Low volume signifies the weakness of a particular trend. For instance, as in the case of a bull market, as the price increases, so should volume, and it should fall during secondary pullbacks. If during a pullback, the volume picks up, then that signifies that there is a reversal in the trend as an increased number of market participants turn bearish.

Primary trends reversal often tends to be confused with that of secondary trends. It can be hard to know whether an upswing in a bear market is, in fact, a reversal or just a short-lived rally before it hits the lowest of lows, which is why the Dow theory emphasizes caution by insisting the confirmation of a possible reversal.

Some people or critics are of the opinion that the Dow theory is old and outdated, especially in relation to the principle which states that an average must back another or support another. However, some investors still consider the Dow theory to be most useful today. This is because it doesn’t only concern identifying as well as determining financial opportunities but also because of the various concepts of market trends that Dow’s theory propounded. This further means that Dow’s work gave birth to the idea of market trend, which is now regarded as an essential aspect of the financial world.

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