Dow Theory Simplified – 6 Tenets of Dow Theory Explained
Technical analysis has its roots and foundation in principles laid down by Charles H. Dow in his editorials sometime around the 1900s. Charles H. Dow was also the founder and editor of the famous Wall Street Journal, and his works in the editorials and writings became the cornerstone of Dow Theory.
Dow Theory explains price movements and the relationship between industrial averages; it was the first theory to explain market trends and the importance of volume in price analysis.
Following the death of Charles H. Dow, William Peter Hamilton, Robert Rhea, and E. George Schaefer took editorials and developed Dow theory.
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What Is Dow Theory?
Dow theory is founded on the efficient market hypothesis, which states that prices discount everything that occurs in the economy. It also correlates averages with trends, and if one of the averages is higher than its previous high, the market is in an uptrend.
Dow theory also talks about correlation in different indices in terms of price and volume.
In fact, the first application of Dow theory informs us about the similarity in patterns or movement, which is followed by DJIA (Dow Jones Industrial Average) and DJTA (Dow Jones Transportation Average).
Over the period technical analysis has evolved on broader terms but the basis of modern technical analysis is still believed to be the principle theory of Dow Jones.
Six Tenets of Dow Theory
Hamilton, Rhea, and Schaefer developed the below six tenets of Dow Theory, which played an important role in summarizing Dow’s 255 Wall Street Journal editorials.
- Market Discounts Everything
Markets reflect current economic conditions, regardless of what is known or unknown. The stock market discounts everything.
For example, if any news, event, or political changes occur, the stock market will readjust to accommodate those changes, thus always informing us about the current market scenario.
- Averages confirm Each Other
Stock market indices are correlated; the industrial average and the transportation average were the first to meet this Dow Theory criteria; however, as markets have evolved, we see that there are many indices that confirm each other, such as manufacturing, automobiles, infrastructure, finance, and railways.
- Market Trends
Market trends are classified into three types: primary trends, secondary trends, and minor trends.
The primary trend is the major market trend that persists over time; it is the broad direction of the overall market and is crucial for long-term investors.
Primary trend can be uptrend or downtrend.
Secondary trends are pullbacks or corrections to primary trends; the market does not always move in one direction; minor corrections during an uptrend or downtrend provide a better market structure as well as the opportunity for new investors or traders to enter new positions or book partial profits.
Minor trends are daily fluctuations, also known as market noise; only day traders or short-term traders pay attention to minor trends.
- Phases of Primary Trend
A primary trend has three phases. Phase 1 refers to accumulation, in which smart money tries to accumulate as many stocks as they can, which does not reflect in prices because they do it automatically, and periods of high volume activity are followed by occasional selling.
Phase 2 occurs when public interest in the stock grows and mass buying occurs; it is the stage of the market where major price movements are visible and prices rise rapidly due to retail participation.
Although this phase appears to be similar to accumulation, smart money distributes and offloads to book profits in the market.
- Trend & Volume Confirmation
According to Dow theory, any ongoing trend must be confirmed by a significant increase in volume. Often, price increases with more than average volume indicate a strong trend, whereas price increases without significant volume indicate weak hand buying.
Volume should also increase during an uptrend as prices rise and decrease during pullbacks or secondary trends.
- Trend Reversal
Trend reversal is very straightforward to observe in historical prices but difficult to predict in an ongoing trend that what is a reversal and what is pullback, Dow theory suggests that trend continues until there are some signals which suggest otherwise, but nothing significant has been mentioned under dow theory.
While there are technical analysis tools available today to differentiate between a reversal and a pullback or market noise, there is no proven method to provide a clear signal.
Dow theory in itself is not a trading setup, however a study conducted during 1902 to 1929 suggested that dow theory provided better risk adjusted returns over buy and hold strategy.
Dow theory was influential in the development of price action trading; concepts such as trend reversals, market phases, volume and price relationships are critical to technical analysis.
Dow theory also aided in identifying market trends in terms of price consolidation and chart patterns, which became the foundation of price action trading.