Experience Trading
on the Go
on the Go
Reading time: 8 minutes
Dow Theory is a fundamental principle of technical analysis employed to identify the overall trend and spot reversals in the stock market. It suggests that market prices follow trends over time, with various factors coming into play.
Charles H. Dow developed the outline of Dow Theory to explain how the stock market moves in observable patterns. He initially published the theory through a series of editorials in The Wall Street Journal (which he co-founded with Edward Jones and Charles Bergstresser). Still, the theory’s structure remained incomplete up until he died in 1902. William Hamilton and Robert Rhea later formalised his writings from the Wall Street Journals into 'Dow Theory'.
The first market average created by Dow in 1884 contained 11 stocks, 9 of which were railroad stocks. Twelve years later, in 1896, Dow introduced the Dow Jones Industrial Average (DJIA), which consisted of 12 industrial stocks – 'smokestack' companies. A year following this, a separate average was formed to help assess railroad stocks' performance, now known as the ‘Dow Jones Transportation Average’ (DJTA).
The DJIA has since become one of the world's most followed stock market indices, listing 30 major blue-chip US companies.
The six principles of Dow Theory, also known as ‘tenets’, refer to the core fundamental ideas that guide the theory. These basic rules or beliefs underpin how the theory interprets market behaviour and trends.
The first tenet of the Dow Theory states that the market discounts everything. According to the theory, the current price of a stock reflects all available information about the past and present. Future events are swiftly discounted in the market and reflected in price action.
Natural disasters and calamities (‘Acts of God’) are difficult to predict and are excluded from the current market price. If a sudden and unexpected event were to occur, the stock market would quickly adjust itself to reflect an accurate value.
The theory suggests that all factors are priced into the market over time, and stock prices reflect this accumulated knowledge.
Dow discussed three trends that reflect various market phases: ‘primary trend’, ‘secondary trend’, and ‘minor trend’. The theory emphasises the importance of understanding these trends to help identify market behaviour. Below is a visual of the three trends using Apple’s (AAPL) weekly price chart:
The primary trend shows the overall market direction and can last several years. Depending on its direction, it's regarded as a bull (uptrend) or bear (downtrend) market and can be used as a barometer for the economy's overall health. The primary trend is also considered inviolate, which means it is stable and not easily affected. Minor rallies or corrections may occur, but they do not alter the course of the primary trend. Long-term investors are particularly interested in identifying and following primary trends.
Intermediate secondary trends are formed within the primary trend and can last for weeks or months. Simply put, it is a counter-reaction to the market's overall direction. In a bull market, corrections often reflect investors' profit-taking and counter-trend selling, as shown in the above chart. In contrast, pullbacks can indicate profit-taking and counter-trend buying in a bear market.
Some traders attempt to recognise secondary trends and capitalise on smaller price movements. However, it is worth noting that Dow was cautious about this approach, considering it too risky. Since secondary trend reversals share similar characteristics with primary trends, they can be mistakenly perceived as changes in primary trends or wrongly viewed as the only reaction during a change in primary trend.
According to Dow, minor trends are short-lived, considered ‘market noise,’ and unimportant to long-term investors. They often only last less than three weeks. The minor trend is a short counter-reaction to more significant movement and reflects changes in the intermediate trend.
The theory suggests that the value of daily averages can be misleading except for when 'lines' are formed. A 'line' is 2-3 weeks of horizontal price movement in an average (essentially, a consolidation), within a range of 5%, and is usually a sign of accumulation (buying) or distribution (selling). If price breaks out above or below this range, it suggests that price will continue in the direction of the breakout.
The primary market trends go through three phases before self-repeating and reversing.
This cycle sees an accumulation phase, a public participation phase, an excess phase in a bull market, a distribution phase, a public participation phase, and a panic (despair) phase in a bear market, as shown in the sketch below.
Also called the consolidation phase, the accumulation (or distribution) phase occurs before the bear (or bull) market trend ends. At this point, informed investors begin formulating positions. Over time, as more investors get involved, the accumulation (or distribution) phase slowly transitions into a markup (or markdown) phase.
In the accumulation phase, the price consolidates after a downtrend. It gradually shifts from lower lows and lower highs (a downtrend) to higher highs and higher lows, creating a new uptrend. Meanwhile, in the distribution phase, price consolidates after an uptrend and gradually shifts to a new downtrend.
Following the lead of the investors in the accumulation stage, the broader public starts participating in the market at an increasing rate. Optimism is generally fuelled by better-than-expected earnings, further powering the rise.
Conversely, in a bear market, the buying activity slows down, and the selling intensifies, eventually causing the stock price to decline, which can be further strengthened by disappointing earnings.
At this stage, the bull market has reached a point of rampant speculation, advancing on hopes and expectations. Distress selling is a point of panic in a bear trend, regardless of their prices.
Think of this phase as one last push before capitulation.
Dow Theory states that the indices must confirm each other. Dow used two indices, the DJIA and the DJTA, to confirm trends.
As per the theory, a trend is established when the major indices move in tandem. If DJIA reaches a high and DJTA follows the same trend, this would help confirm the bull market. Conversely, if both indices decline, it could confirm the bear market.
If the major indices trade in opposite directions, the trend is inconclusive, and traders become cautious. A bull or bear market trend can only occur if indices or averages offer the same signal.
According to Dow Theory's fifth tenet, the volume must confirm the trend. This means that the trading volume should increase when the price moves toward the primary trend and decrease if it's moving against it. A rise or fall in volume shows the market's authentic optimism or pessimism.
While volume alone cannot signal a trend reversal, it is an important secondary confirmation. High market prices with less volume on rallies and more activity on declines can mean that the market is overbought. Conversely, low market prices, accompanied by slow declines and increased volume on rallies, suggest the market is oversold.
This tenet of volume confirmation remains relevant to date, as volume plays a crucial role in modern trading practices.
The final tenet conveys that market trends persist until there is a clear signal that they have reversed. During an uptrend, there could be a temporary reversal or correction, but the market may continue to rise. As discussed earlier, the secondary trend could sometimes be misinterpreted as a reversal. Therefore, distinguishing between regular market volatility and true trend reversals is crucial when determining a trend.
1. What is Dow Theory?
Dow Theory, developed by Charles Dow in the late 19th century, is a fundamental principle of technical analysis used to identify the overall trend and reversals of the stock market.
2. What are the three market trends?
Primary trend: The overall market direction, which can last several years.
Secondary trend: A brief counter-reaction to the market's direction lasting for weeks to months.
Minor trend: A minor counter-reaction which lasts less than three weeks.
3. Is the Dow Theory relevant to today’s trading methods?
Yes, traders today use many principles of Dow Theory, such as those related to confirming volume and trends.
Access 10,000+ financial instruments Auto open & close positions News & economic calendar Technical indicators & charts Many more tools included
By supplying your email you agree to FP Markets privacy policy and receive future marketing materials from FP Markets. You can unsubscribe at any time.
Source - cache | Page ID - 41049
