Content
What is Dow Theory?
Basic principles of Dow theory
The market takes into account all events
Market Trends
Three main phases of each trend
Cross-index correlation
Value of volumes
Trend action before reversal confirmation
Conclusion
What is Dow Theory?
Dow Theory is the basis for technical analysis based on the writings of Charles Dow regarding his theory of market behavior. Dow was the founder and editor of the Wall Street Journal and co-founder of Dow Jones & Company. As part of the company, he helped create the first stock index, known as the Dow Jones Transportation Index (DJT), followed by the Dow Jones Industrial Average (DJIA).
Dow never described his ideas as a concrete theory, nor did he call them such. However, many found out about it through his editorial in the Wall Street Journal. After Doe's death, other editors such as William Hamilton refined these ideas and used his papers to piece together what is now known as the Doe Theory.
This article provides an introduction to the Dow Theory, looking at the various stages of market trends based on his work. As with any theory, the following principles are not infallible and are open to different interpretations.
Basic principles of Dow theory
The market takes into account all events
This principle is closely related to the so-called efficient market hypothesis (EMH). Dow believed that if there is a discount in the market, it means that all available information is already reflected in prices.
For example, in anticipation of a company reporting a positive increase in profitability, the market will reflect this news before this happens. Demand for their shares will increase before the report is released, and then the price may not change much after the expected report is released.
Dow was also able to note that in some cases, a company may even see its stock price decline after good news is released because the news was not as good as the community expected.
This principle is still considered true by many traders and investors, and especially those who regularly use technical analysis. However, those who prefer fundamental analysis disagree with this statement and believe that market value does not reflect the real, intrinsic value of a stock.
Market Trends
Some people say that Dow's work gave birth to the concept of market trend, which is now considered a critical element in the financial world. The Dow Theory states that there are three main types of trends:
Primary or main trend - Duration of action, from several months to decades, this trend is also the main movement of the market.
Minor Trend – Duration of action from several weeks to several months.
Minor or Minor Trend – This trend may be limited to less than one week or ten days. In some cases, the duration reaches several hours or one day.
By studying various trends, investors are given the opportunity to choose the most appropriate moment to enter. While the primary trend is key when considering an entry, secondary and minor trends contradict the primary.
For example, if you believe that a cryptocurrency has a positive primary trend, but periodically experiences a negative secondary trend, you are given the opportunity to buy it cheaper and try to sell it once the value increases.
In this case, the problem is only to correctly determine the type of trend, this is the whole essence of deep technical analysis. Today, investors and traders use a wide range of tools to identify and understand the current trend.
Three main phases of each trend
Dow found that long-term primary trends involve three phases. For example, in a bull market the phases would look like this:
Accumulation - After the previous bear market, asset values are still low as mass sentiment is overwhelmingly negative. Experienced traders and market makers begin to accumulate assets during this period before significant price increases occur.
Public Participation – The market, at a given time, is recognizing the opportunity that experienced traders have already observed, and the community is becoming an increasingly active buyer. At this stage, prices are rapidly rising.
Distribution – While the majority of participants continue to speculate, the trend is approaching its end. Market makers begin to distribute their assets, i.e. sell them to those who do not yet realize that there will soon be a trend reversal.
In a bear market, the phases will be in reverse order. The trend will begin with the distribution of their assets from those participants who recognized the signs of a downtrend, and will be further accompanied by community participation. In the third phase, the community will continue to desperately speculate that the market will continue to fall, but investors who notice the coming shift will begin to accumulate assets again.
There is no guarantee that this principle will work perfectly, but thousands of traders and investors consider these phases before making appropriate financial decisions. It should be noted that the Wyckoff method also relies on the idea of accumulation and distribution, which can also be traced to the somewhat similar concept of market cycles (the transition from one phase to another).
Cross-index correlation
According to Dow, the main trend observed in the chart of one of the indexes should be confirmed by the trend of the other market index. At that time, this mainly concerned the Dow Jones Transportation and Industrial Averages.
The transport market of that time (mainly railways) was closely linked to industry. This went without saying: in order to produce more goods, it was first necessary to increase rail transport activity to supply the necessary raw materials.
Thus, there was a clear relationship between the manufacturing industry and the transport market. If one market is in a normal, healthy state, then the other is likely to be as well. However, the principle of cross-index correlation is not so good today because many products are digitized and do not need physical delivery.
Value of volumes
Like many other investors, Dow believed that trading volume was the most important secondary indicator because a strong trend should always be accompanied by high trading volume. The higher the volumes, the higher the likelihood that the price movement reflects the true market trend. Otherwise, on small volumes, the trend is poorly manifested, as is the increase in the price of the asset, which in turn does not reflect the real, healthy effect of the trend.
Trend action before reversal confirmation
From the Dow's perspective, if the market is trending, it will continue to move. For example, if the price of a company's shares begins to react positively after the publication of good news, they will continue to rise until the trend reversal is properly manifested.
For this reason, Dow recommended that all such changes be treated with caution until the new primary trend is confirmed. Naturally, distinguishing a minor trend from the start of a new major trend is not easy, and traders often encounter misleading reversals that end up being a minor trend.
Conclusion
Some critics argue that the Dow Theory is outdated, especially with regard to the principle of cross-index correlation (which states that an index or its average should support or be relatively consistent with another index). However, most investors believe that the Dow Theory is still relevant, not only for identifying the phases of the most favorable financial opportunities, but also because the concept of market trends is the fruit of his work.