Inside Trade | Dow Theory

Dow theory

After providing you a brief background about the famous duo, Charles Dow and Edward Jones, I'll now give you one of their main contribution in the field of technical analysis. The Dow theory.

Although Charles Dow really didn't coin the term, his contribution mainly through Dow Jones industrial average and articles he wrote on WSJ had been the key to this financial market theory.

The theory mainly revolves on the principles such as the cyclical character of the market processes, directed character of price changes, interrelation between exchange rates and trading volume, etc. which gave birth to the 6 pillars of the theory.

1. There are three types of market movement
   the trend may be classified into 3 different classes: primary, secondary, and minor trends.
   Primary – is a trend which will last for a long time maybe in less than a year or for several years. Also known as long – term trend.
   
   Secondary – is a trend which is expected to last for over 3 months and serves as corrective trend. It is sometimes called as intermediate trend.
   
   Minor – is a trend who has a momentarily effect and is expected to only exist in 3 weeks or less. It mainly reflects short term market fluctuations thus arriving to its other name as short-term trend.
   
   
2. There are 3 phases in the market
   
   According to the theory, a long term trend has 3 phases which is related to the behavior of the investors. Accumulation phase, public participation phase, and lastly distribution phase.
   
   In the first phase, big time investors conducts deals which may be contradictory to the general opinion. After that, the second phase begins wherein active and technically oriented traders are starting to ride the decisions made by the big time investors. Their main concern in following the decision of the big time investors is to go with the flow of the trend. It strengthens the momentum of the first phase as the time goes by. After seeing it, the general public will then start to participate thus marks the beginning of the third phase and the cycle continues.
3. The stock market considers all news
   
   The stock price has an immediate reaction to any new information. Any news may have an effect on the stock price thus it must be considered.
4. Stock indexes must confirm each other
   
   In the Dow theory, indexes must confirm the current trend and signals for a possible trend reversal. Mistiming may happen if one of signal is released earlier than the other.
   
   
   
5. Trends are confirmed by the volume
   
   The increase of the trading volume is an evidence of the main trend.
   
   
6. Trends still exist until a clear reversal is displayed
   
   Though trends may reverse anytime, a confirmation must still be evident in the market. Corrective signals must be taken into account because sometimes it is mistaken as a signal for trend reversal.