Dow Theory: A Brief Introduction

The Dow Theory has been around for nearly 100 years and has dominated the technical analysis of stocks until the present. It was developed by Charles Dow, perfected by William Hamilton, and conveyed by Robert Rhea.

Concisely, the Dow Theory was first introduced by Charles Dow, who is known as one of the fathers of technical analysis, founder of a financial news publishing firm, ‘Dow Jones & Company’, and the first editor of Wall Street Journal. After his death, William Hamilton took his work forward, and in 1932 Robert Rhea combined and published the writings of both the geniuses. The Dow Theory assists the investors in understanding the market better and asserts that the market behaves in the same way as it did 100 years ago.

The Basic Understanding Of Dow Theory

The theory expounded on the movement of trends in the market and explained the relation the stock market has on the financial health of the business environment. Accordingly, by examining the entire market, one can sense the inclination of the market trends as well as the direction of individual stocks. The theory has undergone several alterations, but the fundamental ideas put forward by Dow and Hamilton still endure a common notion of Wall Street.

How Does The Dow Theory Works?

Overall there are six principles of Dow Theory that form the core of the modern technical analysis.

Market Discounts Everything

The basic idea behind the tenet is the price of the stocks includes everything to know about the markets. Everything incorporates revenue potential, competitive edge, management skills of the company, changes in the inflation rate, news of natural calamity, along with the emotions of the investors in the stock price. Future events are also included in the stock price to avoid risk.

This is in short the Efficient Market Hypothesis which claims that the asset prices include all the available information in the market.

The Market Has Three Trends

The three trends are as follows: –

Primary trends; the trend lasts for a considerable amount of time specifically, for a year or more, depicting either an uptrend or a downtrend. The uptrend shows the patterns of peaks, whereas a downturn presents a situation of a trough.

Secondary trend; they go opposite to primary trends. For example: – if the primary trend is bullish, the secondary trend will be bearish. They generally last between three weeks to three months.

Minor trends; are the variations in the market trends on a day-to-day basis. The trend shows variations within the secondary trends and lasts for less than three weeks.

Dow wrote, “Records of trading show that in many cases when a stock reaches top it will have a moderate decline and then go back again to near the highest figures. If after such a move, the price again recedes, it is liable to decline some distance”.

Primary Trends Have Three Phases

There are three phases under primary trends

In Bull Market, these phases are called :

  • Accumulation phase
  • Public participation phase
  • Excess phase

Whereas in Bear Market, the three phases are :

  • Distribution Phase
  • Public Participation Phase and
  • Panic Phase

When the market comes down, the big investors do inform buying and start purchasing the shares. That is called the accumulation phase.

In the public participation phase, when the market brings good business news, the small investors initiate the purchase of stocks with the growth in buying prices.

The excess phase takes place when the economy reaches its peak, and the newspapers start publishing the bullish stories, the public participation increases with volume. The big investors begin selling the shares bringing the market down and then the bear market phases start.

Indices Confirm Each Other

Employing a single index cannot confirm a market trend. Hence different indices and market averages should be put into operation to give an exact picture of market trends.

Dow used two indices, the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA), on the supposition that no bullish or bearish trend could take place until both the averages provide the same signal. Additionally, a past trend gets exhibited when the two averages moved in the opposite direction.

Volume Must Confirm The Trend

Dow believed market trends get influenced by trading volumes. For example, in a bullish trend, the volume increases with the rising price, and volume falls when the price decreases. Similarly, in a bearish trend, the volume and price depict an opposite relationship where an increase in volume causes the price to fall, and a decrease in volume leads to a rise in price.

Trends Continue Until A Change To An Opposite Direction Occurs

The theory states a trend will clasp to continue, despite a minor disturbance in the market. For example; – during an upward trend, a slight deviation can occur, but eventually, the market will continue to move in an upward direction. Primarily, the reversals in trends are hard to predict. Thus, some technical tools help in spotting the reversal trends, such as support and resistance levels, price patterns, trend lines, and moving averages.

Significance of Dow Theory

Even though the Dow Theory is roughly 100 years old, but it is still useful in forming a trading strategy, identifying trends, and indicating the right time to enter and exit the market.

The Dow Theory is extremely important for trading. Mainly everything in trading depends on trends that are a crucial element of trade. Before trading, the investors focus on the market being bullish or bearish, or else at most deduce the direction of the primary trend. Thus, Dow Theory provides an idea about the market trends to the investors for making their trading journey fuss-free.

If you want to know more about Dow Theory, check out the YouTube video on Choice Broking channel where our research analyst explains this in greater detail.