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Dow theory

Origin
• Charles Dow (left) & Edward Jones (right) established
Dow Jones & Company in 1882.
• They created the two indices i.e.,
• the Dow Jones Industrial Average
• (DJIA) and the Dow Jones
• Transportation Average (DJTA) to
• provide a good indication of the health of the economy.
• Dow explored the relationship between the two indices
and published his theories in editorials in the Wall Street
Journal, which pioneered Technical Analysis.
• Even in today’s highly technologically developed market,
Dow Theory holds its basic tenets.
SIX basic tenets
1. The averages discount everything
2. The market has three trends
3. Major trends have three phases
4. The Averages must confirm each other
5. Volume must confirm the trend
6. A trend is assumed to be continuous until
definite signal of its reversal
1. The averages discount everything
• The market reflects all available information
which can affect it positively or negatively.
What it cannot anticipate is happening of the
natural calamities, even that are discounted as
soon as it happens. It is similar to that of the
first pillar of the technical analysis; the prices
of the stocks absorb all the news as soon as
the information is released. Prices show the
sum total of all the hopes, fears and
expectations of all participants.
2. The market has three trends
• According to Dow theory, the market has only three trends
a. Primary trend: In Dow theory, primary trend is also
considered as major trend in the market. It has a long term
impact and may remain in effect for more than 1 year. It may
also influence the secondary and minor trend. Dow looks at it
as tides in the sea as it affects the overall impact dramatically.
b. Secondary trend: Dow call a correction in the primary
trend as secondary trend. It usually last for three weeks to
three months. It generally retraces 33% to 66% of the primary
trend. In a bullish market secondary trend will be a downward
movement and in a bearish market it will be a rally. Dow calls
it as waves in the sea.
c. Minor trend: The “short swing” or minor movement varies
with opinions from hours to a month or more.
The market has three trends
3. Major trends have three phases
• Major Trends Have Three Phases.
Dow mainly paid attention to the primary (major)
trends in which he distinguished three phases:
• Accumulation phase – the most astute investors are
entering the market feeling the change in the current
market direction.
• Public participation phase – a majority of technicians
begin to join in as the price is rapidly advancing.
• Distribution phase – a new direction is now commonly
recognized and well hiked; economic news are all
confirming which all ends up in increasing speculative
volume and wide public's participation.
4. The Averages must confirm each other
• In Dow’s time, the two averages were the Industrials
and the Rails. The logic behind the theory is simple:
Industrial companies manufactured the goods and
the rails shipped them. When one average recorded
a new secondary or intermediate high, the other
average was required to do the same in order for the
signal to be considered valid.
• When one of these averages climbs to an
intermediate high, then the other is expected to
follow suit within a reasonable amount of time. If
not, then the averages show “divergence” and the
market is liable to reverse course
5. Volume must confirm the trend
• Dow recognized the volume as a secondary but
important factor in confirming price signals. In other
words volume should increase in the direction of the
major trend. In a major uptrend volume should
increase with the rally in price and should diminish
during correction. Also in a major downtrend volume
should expand with the fall in prices and should
contract during upward ripples.
6. A trend is assumed to be continuous
until definite signal of its reversal
• Dow was a firm believer that market remains in a
trend. It may deviate for a while because of noise but
it will return as soon as its effect is over. It is like
Newton’s law of motion “an object in motion tends
to continue in motion, until some external force
causes it to change direction”.
• There are many trend reversal signals like
support/resistances, price patterns, trend lines,
moving averages. Some indicators can also provide
warnings of loss of momentum.