The Dow theory was developed in the late 19th century by Charles H. Dow. The theory expresses his ideas on price action in the stock market. Charles also invented the famous stock market index known as the Dow Jones Industrial Average (also known as the Dow). The Dow is price weighted and its value is affected by the performance of the most prominent companies listed in the stock exchanges in the United States as well as macroeconomic factors. Most methods and indicators used in technical analysis are based on the Dow Theory.
The Dow theory is made up of six principles:
- The averages discount everything
This principle states that all the fundamental factors, economic, political, technological factors, future events and other important factors affecting price have already been factored in and priced into the market except for natural calamities such as earthquakes. The only remaining influence on the stock price is human emotion. - The market has three major trends
A trend has three parts: primary, secondary and minor. When looking at a chart for a particular stock, we need to consider different time frames. Open metatrader 5 and select a chart. Then select the time frame that you want.
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The chart that is opened is for a 1 hour time frame. This means that each candlestick represents an hour. The candle highlighted in orange was formed at 2 pm. It is a bullish candle which means that the price closed higher than it opened.
When analysing the market, we must look at it from 3 time frames, that is, primary, secondary and minor. The primary trend is the major trend. If the primary trend is moving in an upward direction then the market is generally in an uptrend and if the primary trend is moving downward then it is in a downtrend. To minimise losses, traders consider trading in the direction of the trend.
The secondary trend is a correction to the primary trend and the minor trend is the corrective move within the secondary trend.
How long the timeframe is depends on the trader. For example a swing trader can look at the daily time frame as the primary (long time frame), then the 1 hour time frame as the secondary (medium time frame) and the 15 minute time frame as the minor (short time frame).
- Major trends have three phases
According to the Dow Theory, a primary trend moves in three phases: the accumulation phase, public participation phase and the distribution phase. The accumulation phase is the phase of buying undervalued stocks. The public participation phase is the longest phase with large price movements. In this phase, traders tend to enter more trades with the confirmation of the ongoing trend. In the distribution phase traders start selling their stocks anticipating that the market will decline.Recommended: Read more on Price action analysis using the Wyckoff method
The ongoing trend is confirmed only when the different market averages confirm each other. This means that the signals that occur on one market average must correspond to signals on the other market average. For example if the Dow Jones Industrial average indicates a primary uptrend, then another indice must confirm that the market is in an uptrend.
Volume is necessary in confirming the strength of the trend and it should increase in the direction of the primary trend. There should be an increase in volume when the market is in an uptrend or downtrend. In a primary bullish market, volume should be heavier on advances then during the correction phase the volume and participation should decrease. The correction phase is the phase when both buyers (bulls) and sellers (bears) become undecided. In a primary bearish market, volume should increase on the declines and decrease during the correction phase. Volume can be measured by indicators such as On Balance Volume (OBV), Chaikin Money Flow indicator (CMF), Relative Strength Index (RSI) among others.
- The market averages must confirm each other
The ongoing trend is confirmed only when the different market averages confirm each other. This means that the signals that occur on one market average must correspond to signals on the other market average. For example if the Dow Jones Industrial average indicates a primary uptrend, then another indice must confirm that the market is in an uptrend. - Volume must confirm the trend
Volume is necessary in confirming the strength of the trend and it should increase in the direction of the primary trend. There should be an increase in volume when the market is in an uptrend or downtrend. In a primary bullish market, volume should be heavier on advances then during the correction phase the volume and participation should decrease. The correction phase is the phase when both buyers (bulls) and sellers (bears) become undecided. In a primary bearish market, volume should increase on the declines and decrease during the correction phase. Volume can be measured by indicators such as On Balance Volume (OBV), Chaikin Money Flow indicator (CMF), Relative Strength Index (RSI) among others. - A trend is assured to be in effect until it has given definite signals that it has reversed.
A trader may continue trading in the direction of the trend until there is a clear indication of a trend reversal which can be identified by using technical tools and indicators.
The theory helps traders develop better trading strategies that will help them maximise their profits. It also helps us understand that the primary trend is useful for identifying the direction of the market, hence, a trader will need to take careful consideration before entering a sell position in a bullish market and vise versa.
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