Dow Theory

Lovelesh Sharma, CMT, CFTe, Co- Founder @ MarketFeds

Dow Theory is one of the foundational principles of technical analysis, developed by Charles H. Dow, the co-founder of Dow Jones & Company, in the late 19th and early 20th centuries. The theory provides a framework for understanding and analyzing stock market trends and is based on six basic principles:

The Market Discounts Everything: The first principle asserts that the price of a security reflects all available information about that security, including its underlying fundamentals and market conditions. Therefore, there is no need to analyze extraneous factors separately, as they are already factored into the stock’s price.

The Market Has Three Movements: Dow Theory identifies three types of market movements:

Primary Trend: The primary trend is the major, long-term direction of the market, lasting several months to years. It can be upward (bullish) or downward (bearish).
Secondary Reaction: This short- to intermediate-term movement goes against the primary trend. It typically lasts a few weeks and retraces a portion of the primary trend’s movement.
Minor Fluctuations: Short-term fluctuations in stock prices that do not significantly affect the primary trend.
Primary Trends Have Three Phases: Within a primary trend, there are three distinct phases:

Accumulation Phase: Smart money or institutional investors are accumulating positions in the early stages of a bullish trend.
Public Participation Phase: As the trend gains momentum, more investors and traders enter the market, causing prices to rise further.
Distribution Phase: Smart money starts to take profits and exit positions in the early stages of a bearish trend.
Indices Must Confirm Each Other: According to Dow Theory, the movements of the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) should confirm each other to validate the current trend. In a bullish trend, both averages should make higher highs and higher lows. In a bearish trend, both averages should make lower lows and lower highs.

Volume Confirms the Trend: Volume should increase during the direction of the primary trend. In a bullish market, volume should rise as prices advance, indicating strong buying interest. In a bearish market, volume should increase as prices decline, indicating strong selling pressure.

Trends Persist Until Reversed: Dow Theory assumes that trends persist until clear evidence of a reversal. Therefore, traders and investors should not try to predict when a trend will change but rather react when clear signals of a trend reversal are evident.

Dow Theory is still considered relevant today and forms the basis for many technical analysis principles traders and analysts use to understand market trends and make informed investment decisions. However, it’s important to remember that no theory or principle is foolproof, and investors should use Dow Theory in conjunction with other forms of analysis and risk management strategies