The Dow Theory is a technical assumption that predicts the uptrend market if one of its averages goes above a previous high.
In 1901 Charles H. Dow presented the Dow Theory when he compared the trends with the ocean waves.
What is the Dow Theory?
The Dow Theory is a trading approach presented by Charles H. Dow, who, with Edward Jones and Charles Bergstresser. They developed the Dow Jones & Company Inc. company and created the Dow Jones Industrial Average in 1896.
Dow assumed that the stock market was a reliable measure of business conditions within the economy. By analyzing market trends, one could gauge these conditions and identify the direction of the specific asset’s market trends and price.
The Theory interprets about markets by using six rules:
- The Dow Theory works according to the efficient market hypothesis (EMH). The EMH states that asset prices contain all available information. In other words, the EMH gives a complete picture of behavioral economics.
- Financial markets experience primary trends that can last for a year or more such as bullish or bearish trends. Within these broader trends, there come secondary trends that often works in the form of pullbacks. These secondary trends can last from three weeks to three months. Finally, there are small trends that last for less than three weeks and produce greater market noise.
- According to the Dow Theory, a primary trend passes through three phases. These are the accumulation phase, the public participation phase, and the excess phase in bullish markets. In bearish markets, they are the distribution phase, the public participation phase, and the panic phase.
- For a trend to occur, Dow stated that indices or market averages must confirm each other. This means that the signals that emerge on one index must match the signals of the other. Suppose an index, such as the Dow Jones Industrial Average, confirms a new primary uptrend, but another index remains in a primary downtrend. In that case, traders may not consider this a new trend.
- Volume increases when the price moves in the direction of the primary trend and decreases if it is driving against it. The low volume shows a weakness in the trend.
- Reversals in primary trends should not be confused with secondary trends. It is difficult to determine whether an uptrend in a bear market is a reversal or a short-lived rally. Therefore, Dow proposed that reversals should be confirmed first.
How to use the Dow Theory?
Charles Dow relied on closing prices and didn’t consider price fluctuations happening thought the day. For a signal to be formed, the closing price has to signal the trend, not an intraday price movement.
Another feature in Dow Theory is line ranges, also called trading ranges. These periods of sideways price movements are seen as a consolidation period, and traders should wait for the price to break the trend line before entering the trades.
One drawback of implementing Dow Theory is the identification of trend reversals. It is difficult for a new trader to locate trend reversals. In this case, one method that can be used to detect trend reversals is peak-and-trough analysis. A peak is the highest price of a market movement, while a trough is the lowest market movement price. Note that Dow Theory represents that the market doesn’t move in a straight line but rather in forms of peaks and troughs.
An upward trend in Dow Theory is a series of higher peaks and troughs. Conversely, a downward trend is a series of lower peaks and troughs.
Dow Theory conclusion
Although the Dow Theory signals uptrend and downtrend, it may be best to combine the Dow Theory with other technical analysis and fundamental analysis forms.
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