Modern technical analysis is primarily based on the observations and tenets of the Dow theory. Developed and proposed by Charles H. Dow, who also co-developed the Dow Jones Industrial Average (DJIA) index, this theory helps you understand how the market moves. If you plan to trade or invest in the markets and capitalise on short-term or long-term price movements, it is crucial to understand the Dow theory.
Check out what this theory is and what its key tenets are.
What is the Dow theory?
The Dow Theory is a financial theory that states that the market is in an upward trend if one of its key averages, such as the Dow Jones Industrial Average (DJIA), surpasses a previous significant high. This movement is confirmed by a similar rise in another average, like the Dow Jones Transportation Average (DJTA). This confirmation suggests that the upward trend is “broad-based” and not isolated to a single sector. For example:
- Say the DJIA reaches an intermediate high.
- To validate the bullish trend, investors look for the DJTA to also climb to a new high.
- This dual confirmation helps to distinguish genuine market trends from temporary fluctuations.
- Also, it provides investors with a more reliable signal of market direction.
Also read: What is a Doji candlestick pattern?
How does it work?
The Dow Theory is based on the idea that the stock market moves in three distinct trends:
- The primary trend
- The secondary trend
- The minor trend
The primary trend represents the overall market direction and can span several years. It defines the long-term movement as either “bullish” or “bearish”.
The secondary trend acts as a corrective phase to the primary trend. It lasts several months and is often seen as a temporary reversal within the broader trend.
Lastly, the minor trend shows short-term market fluctuations. Usually, it lasts a few days and reflects the market's day-to-day volatility.
Additionally, the theory highlights the role of trading volume in validating price movements. Rising prices accompanied by high volume indicate:
- A strong bullish signal
- Widespread investor confidence
Conversely, falling prices on high volume suggest a bearish outlook and significant selling pressure. Another crucial aspect of Dow Theory is “trend confirmation”. As per this approach, a trend is only considered valid if it is visible across different market averages. For example:
- Say both the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) move in the same direction.
- Now, this alignment confirms the prevailing trend.
- It provides a more reliable indicator of market sentiment.
Importance of Dow Theory
Several traders use Charles Dow’s Theory in technical analysis. Despite being developed decades ago, it still holds relevance. Let us look at some key reasons why it remains important:
- Understanding market trends
The Dow Theory helps investors understand the direction of the primary, secondary, and minor trends. It gives investors a clear picture of the overall market direction, which optimises trading outcomes. - Identifying stock trends
Dow Theory helps investors determine whether a stock is in an uptrend, downtrend, or sideways trend. This understanding allows investors to make better decisions about when to buy or sell. - Technical analysis
Dow Theory helps identify critical levels, such as support and resistance. It also helps traders draw trendlines, which highlight the overall direction of trends and are essential in understanding the market’s movement over time. - Risk management
By recognising the current market trend, investors can adjust their portfolios to manage risk better. For example, investors might increase their exposure to equities during a bullish primary trend, whereas during a bearish trend, they might reduce their holdings. Additionally, this understanding allows investors to set appropriate stop-loss levels and limit potential losses. - Long-term investing
The Dow Theory is particularly useful for long-term investors. It helps identify the primary trend, which is important for picking quality stocks and making better long-term investment decisions.
The six tenets of the Dow theory
Charles Dow proposed six main principles via the Dow theory. Together, these tents can give traders a comprehensive view of how trends and market phases work. Check out the six tenets that make up the Dow theory.
1. The market discounts everything
This tenet in the Dow theory essentially means that the prevailing price of any stock or security considers all relevant information. Price and volume information, valuation, earnings and profit potential, management strength and demand and supply are all accounted for. So, whenever any new information surfaces, the prices will incorporate those details and change accordingly. This is also known as the Efficiency Market Hypothesis (EMH).
2. You can identify three types of market trends
The Dow theory identifies three types of price trends in the market, depending on the duration over which they last. They are:
- Primary trends: These are broad, long-term trends that can last for several years. They are either overarchingly bullish or bearish. If you are planning to invest with a long-term outlook, primary trends are important for your investment decisions.
- Secondary trends: Secondary trends are smaller corrective trends that occur within long-term primary trends. They may last for a few weeks or a few months. For instance, in a primary bullish market, prices may temporarily decline for 2-3 weeks before rising again.
- Minor trends: Minor trends are further smaller trends within secondary price patterns. They last for very short periods — from a few hours to a few days. You can use this aspect of the Dow theory in technical analysis for short-term orders like intraday or swing trades.
Also read: What is a morning star candlestick pattern?
3. Primary trends have three distinct phases
A closer look at the primary trends reveals three main phases, where stock prices behave differently. These phases include:
- Accumulation: The accumulation phase begins at the end of a prolonged bear market. Retail investors remain afraid to take long positions because of the potential for further price declines. However, institutional investors infuse smart money into the market and purchase (or accumulate) the securities in large volumes.
- Public participation: The accumulation of stocks causes a price reversal and drives it upward. By using the Dow theory in technical analysis, short-term traders notice this and begin to buy the stock, leading to stronger bullish price movements. As public participation grows, it causes the market to move upward overall.
- Distribution: In this phase, retail investors continue to remain optimistic about the price rally, so the upward movement continues and peaks. This is when institutional investors start distributing or selling off their holdings, leading to a growing supply. As a result, prices begin to fall, leading to the start of a downward trend.
4. The indices need to confirm each other
To recognise a bullish or bearish trend, all the indices in the market must confirm one another. This means that all the indices must move upward for a trend to be labelled as bullish (or downward for a trend to be labelled as bearish).
5. The trading volume must also confirm a trend
The volume is a secondary but equally important indicator as the price in the Dow theory. That is why this tenet suggests that the volume must confirm a trend to make it more reliable. Rising prices coupled with rising trading volume signals a strong bullish trend, and falling prices with growing trading volumes mean that the bear market is strong.
Also read: What is the bullish engulfing pattern?
6. Trends continue till the prices show a distinct reversal
Secondary trends are often mistaken for reversals of the primary trends. This tenet in Dow theory helps differentiate between the two. To recognise a reversal in the primary trend, look for confirmation in the indexes. The primary trend is said to continue as long as the prices do not reverse from the direction they are moving in.
Pros of Dow theory
Charles Dow's theory offers several benefits to investors. Let us look at some major ones:
1. Long-term perspective
The Dow theory focuses on long-term market trends. It provides investors with a broader understanding of market movements over extended periods, which helps them recognise the overall direction of the market.
Also, by emphasising long-term trends, Dow theory encourages investors to remain focused on long-term growth potential rather than getting distracted by temporary market noise.
2. Easy to understand
Dow Theory is built on straightforward concepts and provides clear guidelines for identifying market trends. This simplicity makes it a useful tool for investors looking to understand market behaviour.
3. Follows market trends
Dow theory is based on the belief that the “market is always right”. This implies that the market reflects all available information and is always correct in its price movements. By identifying the current market trend (upward, downward, or sideways), investors can make better decisions about when to buy or sell securities.
Cons of Dow theory
While Charles Dow's theory has many advantages, it also comes with some limitations that investors should be aware of. Let us study the major ones:
1. Not always accurate
The Dow theory is a powerful tool for analysing market trends. However, it does not always accurately predict future price movements as it focuses heavily on historical ones. Also, it does not account for sudden and unforeseen events such as:
- Political changes
- Economic crises
- Natural disasters
2. Ignores other important factors
Dow theory mainly analyses price trends and volume data. It does not consider the fundamentals of companies, such as:
- Earnings
- Revenue
- Debt levels
These factors are crucial for understanding a company's true value and potential.
3. Limited to 30 stocks
The Dow Jones Industrial Average (DJIA), which Dow theory primarily relies on, includes only 30 large-cap stocks. This small sample size does not represent the broader market accurately. Investors looking for insights into the entire market usually find Dow theory unattractive.
Dow theory trading strategy
Investors must note that the Dow theory trading strategy is based on the principles of Dow theory, which focuses on trend analysis for making investment decisions. Let us understand how you can execute this strategy by following some simple steps:
Step 1: Identify the primary trend
Analyse long-term price movements, usually over several months to years. This analysis will help you determine the “primary trend”. Remember that an uptrend is identified by consistently higher market movements, while a downtrend is characterised by consistently lower movements.
Step 2: Confirm the trend
After identifying the primary trend, confirm it by looking at other indicators, such as trading volume. Usually, increasing volume in the direction of the trend supports its validity.
Step 3: Identify secondary trends
Within the primary trend, recognise secondary trends, which are shorter-term movements lasting several weeks to a few months. These trends provide opportunities for traders to enter or exit the market.
Step 4: Look for trend reversals
Trends generally continue until there is evidence of a reversal. To spot trend reversals, look for signs of trend weakening or reversal, such as changes in trading volume or breaks in key support or resistance levels.
Step 5: Use Dow theory technical analysis
Technical analysis is crucial in this strategy. Use charts and technical indicators to identify:
- Key support and resistance levels
- Trend lines, and
- Patterns that indicate market direction
Step 6: Implement risk management
Always remember that risk management is essential. To limit your potential losses, set stop-loss orders. Moreover, position sizing and other techniques can be used to manage market exposure effectively.
Conclusion
This sums up what the Dow theory is and how its six key tenets explain the broad fundamentals as well as the nuances of market movements. With this knowledge, you can interpret historical price movements and anticipate future market changes more easily. Whether you are trading in the market over the short term or investing with a long-term outlook, the Dow theory can help you understand the market better.
