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What is Dow Theory?
Dow Theory is a trading approach developed by Charles Dow who is also known as the father of Technical Analysis. It is still the basis of the technical analysis of financial markets. The basic idea of Dow Theory is that market price action reflects all available information and the market price movement is comprised of three main trends.
Most modern-day technical analysis theory has an origin from ideas proposed by Dow and his partner Edward Jones back in the 19th century. Those ideas were published in the Wall Street Journal and are still assimilated by most of the technicians. Dow Theory still dominates the far more sophisticated and equipped modern study of technical analysis.
The 6 tenets of Dow Theory :
1. Market moves in summation of three trends
- The PRIMARY TREND: It can be as long as years and is the ‘main movement’ of the market.
- The INTERMEDIATE TREND: lasting between 3 weeks to several months, retraces the last primary move some 33-66% and is difficult to decipher.
- The MINOR TREND: is least reliable, lasting from several days to few hours, constitutes of noise in market and may be subject to manipulation.
2. Market trends have three phases
Be it the bull trend or the bear trend, either ways there are three well-defined phases for each. For an uptrend, the phases are Revival of confidence (accumulation), Response (public participation), Over-confidence (Speculation) . The three defined stages of the Primary Bear Trend are Abandonment of hope (Distribution), Selling on decreased earnings (doubting), Panic ( distressed selling )
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3. All news is discounted in the stock market
Prices know it all. All possible information and expectations are factored into prices beforehand.
4. Averages must confirm
Initially, when the US was a growing industrial power, Dow had formulated the two averages. One would reflect the state of manufacturing and the other, the movement of those products in the economy. The logic was that if there is production, then those who move them about should also be benefiting, and hence new peaks in the industrial average needed to be confirmed by the peaks in the transportation average. Today, the roles have changed, but the relations remain among sectors and so does the necessity of confirmation.
5. Volumes confirm trends
Dow was of the belief that trends in prices could be confirmed by volumes. When the movements in price were accompanied by high volumes, they would depict the ‘true’ movement of the prices.
6. Trends continue, unless definitive reversals come about
Irrespective of the day-to-day erratic movement and market noise that may be witnessed in prices, Dow believed that prices moved in trends. Reversals in trends are hard to predict unless it’s too late due to the nature and difference in magnitude of trends. However, a trend is believed to be in action unless definitive proofs of reversal emerge.
By understanding the Dow Theory, traders are better able to spot hidden trends that more experienced investors may be noticing. This allows them to make more informed decisions regarding their open positions.
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