Part 2: Dow Theory

Dow Theory

Dow Theory is a trading approach developed by Charles Dow, who is also termed as the father of Technical Analysis. Dow Theory is being used since the time when candlesticks were not discovered by the western world. Even today, the Dow Theory's concepts form an integral part of trading.

Introduction to Dow Theory

Even today, traders and investors follow the concepts and principles of Dow Theory, which form the very basics of Technical Analysis. Dow Theory still dominates the far more sophisticated and equipped modern study of technical analysis. The main idea behind Dow Theory is that market price action reflects all the relevant information required for trading & the market price moment comprises of 3 trends.

The 6 Tenets of Dow Theory

1) Market Discounts Everything- The first statement of Dow Theory states that market price comprises all the relevant factors that can affect the price moment. The price always reflects everything there is to know such as a company's earnings, interest rate decision, quarterly results, etc.

Let us assume that a firm ABC is going to announce its earnings and the company has almost doubled its net profits. After the announcement of the news, the price will start breaking resistance after resistance (it will shoot upwards). A chartist who is unaware of the results will look at the technicals that would suggest to him that the price is making higher highs and higher lows indicating a good upward momentum. The chartist would take the trades accordingly. Hence it is said that the market prices reflect everything capable of affecting it.

2) The Market Comprises of 3 Trends- Primary Trend, Secondary Trend & Tertiary Trend

Primary Trend- It is the main movement of the market and it can last many years. It indicates a broader multi-year direction of the market. It can be a primary uptrend or a primary downtrend.

Secondary Trend- They can be termed as corrections to the primary trend. They are a minor counter-reaction to the larger movement. They, last 3 weeks to several months.

Tertiary Trend- They last a few hours to several days. These are termed noise.

3) The Market Trends Have 3 Phases:-

Accumulation Phase- It is the phase in which the smart money (institutional investors & HNIs) are buying the stock/asset in phases and slowly accumulating it.

Public Participation Phase- When the price of the asset rises, the dumb money (retail investor) enters the market to make a quick buck. Retail investors are required to push the prices more up.

Excess Phase- In the excess phase, the prices reach new highs. This blinds the dumb money, more new retailers are joining the rally every day.

Distribution Phase- The smart money starts booking profits & the market goes sideways with little corrections. However, new retailers are still joining with high greed. It can be related to the beginning of a downtrend. The new retailers will get trapped.

Fear Phase- This is the phase close to the end of a downtrend. The market is engulfed with so much fear that the retailers are not sure whether to enter or not.

4) The Indices Must Confirm Each Other- In order for a trend to be established, Dow postulated, indices or market averages must confirm each other. Dow used The Dow Jones Industrial Average (DJIA) & The Dow Jones Transportation Average (DJTA). Both indices must confirm each other when forming new highs & new lows. They do not have to move in a lock stop fashion.

5) Volume Must Confirm Trend- Uptrend is confirmed when the volume increases because more traders are willing to put their money in. In a downtrend also volume must increase when the prices fall, indicating a large no. of sellers. If there is a divergence, then something is not right.

6) A Trend is Said to be Continous Until a Reversal is Confirmed- If a market is rising, it is likely to continue rising. If it is falling, it will continue to fall. Unless acted upon by a force, the market will not change trend.