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Dow Theory

Dow’s ideas were initially published in Wall Street Journal editorials. Later, the so-called tenets of the stock market were organized and completed in a book by William Peter Hamilton, Dow’s associate and successor,  who took over as chief editor of Wall Street Journal. The book was published in 1922 and was titled The Stock Market Barometer. The theory was elaborated further by Robert Rhea in his book Dow Theory published in 1932.

Originally, the principles formulated by Charles Dow were used to analyze the Dow Industrial and Rail Averages that he created. However, most of Dow’s insights apply successfully to commodity and futures markets.

  • The market counts everything;
  • The market has three trends;
  • Primary trend has three phases;
  • Indices must confirm each other;
  • Trade volume must confirm the trend;
  • Trend exists until definitive signals prove that they have ended.

The market counts everything
According to Dow Theory, any factors connected with supply and demand will be inevitably reflected in the movement of an index. That information includes everything, sometimes even such force majeure as an earthquake, a disaster or any other occurrence. Of course, such events cannot be predicted, but the risks are priced in and if something happens, it is immediately reflected in the price movements.

The market has three trends
In Dow terms, if a market is in an uptrend, each peak and each low in the rally must be higher than the previous one.

Accordingly, speaking of a downtrend, each new low and new peak in the sell-off must be lower than the previous one. When the market is in a sideways movement, each new peak and each new low are located around the same level. Dow Theory determines three categories of trends: primary, secondary, and minor. The primary trend is of major importance and it may last for a year or even several years. Dow believed that most investors in the stock market first of all take into account the main price movement. He compared the categories of trends with the tide, waves, and ripples of the sea.

The main trend is indeed similar to a tide. The secondary, or intermediate, trend represents the waves that make up a tide, while minor trends act like ripples on the waves. If you note the highest level reached by the wave during the tide, you can determine the direction of the tide. If each successive wave reaches further inland than the preceding one, then the tide is flowing in. If waves recede, the tide is running out. The secondary, or intermediate, trend represents corrections in the primary trend and usually lasts three weeks to three months. These intermediate corrections retrace between one-third and two-thirds (or sometimes even a half, or 50%) of the previous trend movement. Minor, or near-term, trends last up to three weeks and represent short-term fluctuations in the intermediate trend.

Primary trend has three phases
Dow Theory identifies three phases of the primary trend. The first one is called the accumulation phase and it is the period when the most far-sighted and informed investors start buying because the market has already adjusted to bad economic news. The second, or the public participation phase, begins when technical trend-followers join trading. Prices surge up rapidly and economic news turns better. The trend enters the third and the last phase which bears the name of the distribution phase. It takes place when the large public comes into the market boosting trading which is fuelled by positive news. The press publishes extremely bullish stories, the economists make optimistic forecasts, and the speculation volume increases. Now the astute investors, who started to “accumulate” near the bear market bottom when no one else wanted to buy, begin to “distribute”, i.e. sell when everyone tries to buy.

Those who have already got to know Elliott Wave Principle probably recognize these three phase of the bull market. Ralph Elliott developed his theory in 1930s based on the Dow Theory by Robert Rhea. Elliott identified three phases of the bull market as well. However, the main difference lies in the confirmation principle, which is described in the fourth tenet of Dow Theory.

Indices must confirm each other
In this respect, Dow was talking about the Dow Industrial and Rail Averages. He believed that any signal indicating an upward or downward movement should occur in both indices. This means that the upward trend begins only when both indices exceed previous intermediate peak. If only one index rises, it is still too early to register an upward trend. The theory does not demand the indices to coincide, but a short gap between them gives stronger confirmation. The divergence between the indices signifies that the previous trend continues and the market sentiment has not changed yet. At this point, Dow Theory differs from Elliott Wave Principle, which requires a signal to occur in only one index.

Trade volume must confirm the trend
Dow recognized the trade volume as a very important factor in confirming the signals from the price charts. In simple words, the volume should increase in the direction of a major trend. In a major upward trend, the volume increases as prices go higher. At the same time, it decreases when prices fall. In a major downward trend, everything is quite the opposite. The volume increases when prices go down and it diminishes during intermediary rallies. However, the volume is a secondary indicator. Under Dow Theory, buy and sell signals are based entirely on closing prices.

Trend exists until definitive signals prove that they have ended
This principle forms grounds for all trend-following approaches. According to this rule, a trend in motion is set to continue its motion. Of course, it is not easy to spot reversal signals. However, the analysis of support and resistance levels, price patterns, trendlines, and moving averages among other tools will help you to understand when there is an emerging trend reversal. Oscillators, for example, can provide even earlier signals if momentum has been lost. The existing trend is more likely to continue rather than change its direction.
If you keep in mind this simple rule, you will not make mistakes very often.

The most difficult task for traders who apply Dow Theory, as well as any other principle, is to distinguish between an ordinary intermediary correction in an existing trend and the first stage of a new trend moving in the opposite direction. There is some disagreement among the analysts as for the signal of the final trend reversal.

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