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Dow Theory - Explained

The Dow Theory, the financial market theory developed by Charles H. Dow, is based on six fundamental principles that were a precursor to modern technical analysis.

Charles Dow believes that the stock market as a whole is a reliable measure of global economic conditions and that analyzing global markets makes it possible to accurately assess these conditions and predict the direction of major market trends and individual expectations. I believed that I could identify a direction for stock.

Charles Dow built on his theory the Dow Jones Industrial Index and the Dow Jones Rail Index (now known as the Transportation Index), originally developed for The Wall Street Journal. ) was created. Charles Dow created these indices because he believed they accurately reflected the economic and financial condition of companies in two major sectors of the economy: manufacturing and railroads (transportation).

Dow Theory Explained

The Dow Theory relies on analyzing the maximum and minimum market movements to make accurate predictions about market direction. According to Dow Theory, the meaning of these ups and downs is in relation to previous fluctuations. This method teaches investors to read trading charts and better understand what is happening to an asset at a particular point in time. This simple analysis allows even the most inexperienced person to see the context in which financial instruments evolve.

In addition, Charles Dow argued that the price of an asset and the resulting trading movement on his charts already contained all the information and forecasts available to make an accurate forecast. The traders and technicals of his analysts endorsed the common beliefs.

Dow Theory Trading Strategy

Most trading strategies in use today rely on a key concept called "trend". This was a novel idea by Charles H. Dow when he published his writings in the late nineteenth century. More than a century later, the Dow Jones Industrial Average market index, created by an American journalist to explain his theory, is probably the most watched index today. Charles H. Here are Dow's writings, what they mean, and the six core principles that underpin the Dow Theory.

1: The Market Discounts Everything

In other words, stock and index prices reflect all the information available, only the information that is not obvious. This is known as the efficient market hypothesis (EMH).

2: A market with three trends

The Dow Theory emphasizes that the primary trend usually lasts more than a year. They determine whether the market is bullish (up) or bearish (down). A secondary trend is a correction movement within the primary trend. These typically last 3 weeks to 3 months, leading to corrections (stock prices falling) in bull markets and rebounds (stock prices rising) in bear markets. Finally, there are small trends that last only a few days and are mostly "market noise", i.e. unpredictable short-term fluctuations in stock prices.

3: Primary trend remains valid until a clear reversal occurs

This is one of the most controversial elements of the Dow Theory. In fact, a primary trend reversal is often confused with the emergence of a secondary trend. So caution is advised, as Dow Theory makes it difficult to distinguish between the two until an event has occurred.

4: Three phases of the primary trends

During the first stage of the primary trend, investors will benefit from either an accumulation stage (before the bull market) or a distribution stage (before the bear market). Traders then move to the second general participation phase, where the maximum price movement occurs. Finally, the market goes through its third surplus phase. It is characterized by periods of euphoria (end of the bull market) or panic/despair (end of the bear market).

5: Volume should confirm the primary trends

Trends should be supported by volume. In an uptrend, the volume should increase when the price rises and decrease when the price falls, and in a downtrend, the volume should increase when the price falls and decrease when the price rises.

6. Major trends should be confirmed in all market indicators

This final tenet that two opposing primary trends cannot coexist in two different market indices was arguably the most important one for Charles H. Dow. In other words, a major trend in one market index should always be confirmed by a similar trend in another and vice versa. In response to this last tenet, Charles H. Dow did not stop at creating the Dow Jones Industrial Average. He also contributed to the development of another market index, the Dow Jones Transportation Average.

Does the Dow Theory Work?

Although much has changed in the last 100 years, the Dow Theory and its six principles are still applicable today and are considered a valid trading strategy by many traders. Much of what we currently know about technical analysis is rooted in Dow Theory. For this reason, every financial person using technical analysis should be familiar with the six basic principles of the Dow Theory.

Source: CMC Markets UK

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