Introduction to Dow Theory
Dow Theory is a set of principles that form the basis of technical analysis in trading. Developed by Charles H. Dow, a co-founder of Dow Jones & Company, these principles serve as guidelines for understanding market trends and making informed trading decisions. In essence, Dow Theory provides a lens through which traders can analyze and predict market movements.
Principles of Dow Theory
There are six basic tenets of Dow Theory, each highlighting a different aspect of market behavior. Understanding these principles can significantly enhance a trader’s ability to navigate the financial markets.
1. The Market Discounts Everything
The first principle of Dow Theory posits that all current, past, and even future events are reflected in the market price. This includes factors such as economic conditions, political events, and natural disasters. Essentially, if information can potentially affect supply and demand, it is already factored into the market price.
2. There are Three Types of Market Trends
According to Dow Theory, there are three types of market trends: primary, secondary, and minor. Primary trends last for a year or more and represent the broad market direction. Secondary trends are corrective phases within the primary trend and can last from three weeks to three months. Minor trends last less than three weeks and are short-term fluctuations within the secondary trend.
3. Primary Trends Have Three Phases
Dow Theory suggests that primary trends have three distinct phases: accumulation, public participation, and distribution. The accumulation phase is when informed investors start to buy or sell. The public participation phase is when the majority of traders follow the trend. The distribution phase is when informed investors start to do the opposite of the prevailing trend.
4. The Stock Market Indices Must Confirm Each Other
This principle states that for a primary trend to be valid, it must be confirmed by the performance of stock market indices. For instance, if the Dow Jones Industrial Average reaches new highs, the Dow Jones Transportation Average should also reach new highs. If the indices diverge, it could be a warning sign that the trend is about to change.
5. Volume Must Confirm the Trend
Volume refers to the number of shares or contracts traded in a security or market during a given period. According to Dow Theory, the trading volume should increase in the direction of the primary trend. For example, in an uptrend, the volume should increase when prices rise and decrease when prices fall.
6. Trends Exist Until Definitive Signals Prove They Have Ended
The final principle of Dow Theory asserts that a market trend is assumed to be in effect until it gives clear signals that it has reversed. This means that traders should remain with the trend until there is a clear indication that the trend has changed.
Application of Dow Theory in Trading
Dow Theory’s principles provide traders with a framework for understanding market trends and making informed decisions. By analyzing market phases, confirming trends with volume and indices, and staying with the trend until it ends, traders can use Dow Theory to enhance their trading strategies and improve their market predictions.
Conclusion
While Dow Theory might seem complex at first glance, its principles are straightforward and can be incredibly valuable for traders. By offering insights into market trends and behavior, Dow Theory helps traders make more informed decisions and ultimately, achieve better trading results. As with any trading strategy, however, it’s important to remember that Dow Theory isn’t foolproof and should be used in conjunction with other market analysis tools and techniques.
