Explaining Dow Theory - Does it Deliver Results in the Stock Market?
Dow Theory is one of the most respected theories in the financial markets. Whether you are doing intraday trading, short-term trading, or long-term investing, understanding this theory can help you create various strategies.
What is Dow Theory?
Dow Theory was created by Charles Dow in the late 1800s. Charles Dow, the founder of the Dow-Jones financial news service (now The Wall Street Journal) and Dow Jones and Company, developed this trading strategy. Even after a century, Dow Theory is still influential and considered a key study in technical analysis.
The Essence of Dow Theory
Charles Dow compared the stock market to ocean tides. He explained that just like the ocean's high tide, you can observe the stock market's highs and lows to understand its movement. He believed that analyzing the stock market can provide insights into the economy.
How Does Dow Theory Work?
Dow Theory operates based on several principles:
The Market Reflects Everything: Market prices include all known and unknown factors that impact supply and demand. This means that everything, including natural disasters, political events, economic policies, and earnings forecasts, is already considered in the market prices.
The Market Has Three Trends:
Primary Trend: This is the main movement of the market, lasting from one to several years. It can be a bull market (rising) or a bear market (falling).
Intermediate Trend: This trend lasts from three weeks to several months and includes market corrections in a bull market or rallies in a bear market.
Minor Trend: These are short-term movements lasting from a few days to a few hours and are often seen as noise in the market.
Major Trends Have Three Phases:
Accumulation Phase: Smart investors start buying when the market is at its lowest, even when most people are pessimistic.
Public Participation Phase: More investors join in as the market starts rising, leading to significant price increases.
Distribution Phase: Smart investors start selling at high prices, while the public continues to buy, thinking the market will keep rising. This eventually leads to a market decline.
Confirmation Between Averages: Dow believed that both the Industrial and Rail (Transportation) Averages should confirm each other. If both are rising, it confirms a bull market.
Volume Confirms Trends: High trading volume should support an uptrend, while low volume should accompany market corrections.
Trends Persist Until Reversal Signals: Just like Newton's first law of motion, market trends continue until a significant external force causes a reversal.
Identifying Trend Reversals: Recognizing trend reversals involves analyzing peaks (high points) and troughs (low points). An upward trend has higher peaks and troughs, while a downward trend has lower peaks and troughs.
Market Manipulation: Charles Dow believed that while short-term movements could be manipulated, the primary trend of the market could not.