Investment in stocks is nothing but a gamble if it is not backed by a thorough understanding of the markets and a good amount of research of the stocks too. Investors and traders undertake fundamental and technical analysis of the markets and the stocks to make better and profitable decisions for their portfolios.
Fundamental analysis is the study of the financial statements of the company, its key ratios, and the product cycle. Technical analysis of the stocks and the markets is the study of their price and volume movements. There are many tools for technical analysis like candlesticks, bar charts, etc. Dow Theory is one of the many aspects of technical analysis. It is widely used by traders and investors to analyze market trends and make suitable portfolio decisions.
Given below are the meaning and a few relevant details of Dow Theory.
What is Dow theory?
Dow Theory is also known as the Dow Jones Theory and is one of the oldest tools or techniques. The theory was proposed and introduced by Charles H. Dow in the early 1900s. After his death in 1902, his work was continued by William Hamilton and their collective work was published by Robert Rhea under the Dow Theory in 1932. This theory is the basic analysis of the price movements and trends formed out of such movements. This theory is still relevant even after a century when we have many modern and sophisticated technical analysis tools and techniques.
What are the principles of Dow theory?
As mentioned above, Dow Theory is the understanding of the price trends and the reaction of the market participants to such movements. This theory has 6 basic tenets or principles that help traders and investors in analyzing the markets. These tenets are discussed below.
The markets discount everything
The very first principle of Dow Theory is that the market and the price of the stock discount everything. The prices react to any new known or unknown development in the market and adjust accordingly to reflect the true value of the stock. It accounts for all the fundamental factors as well as the current investor sentiments. Hence, it is always better to monitor the price movements and to get the correct idea of the current and future projections of the stock movements.
There are three basic market trends
According to Dow Theory, the market is made up of three basic trends that move in a cycle. A brief explanation of these trends is given below.
- Primary Trend
This is a major trend of the market. It often lasts for a period ranging from a year to several years together. This primary trend determines if the market is bullish or bearish. The majority of retail traders or small investors move as per the primary trend.
- Secondary Trend
Secondary trends of the market are the price corrections in the primary trends. These corrections usually range from three weeks up to a few months. The secondary trend usually goes in the opposite direction as the primary trend as it is the slight correction to it.
- Minor Trends
Minor trends are the daily fluctuations in the markets that last for a few hours or a few days. Most traders and investors refer to the minor trends as market noise as they cannot be relied on to determine the correct trend. Minor trends can be in the direction of the primary trend or the secondary trend depending on the price movements.
Market trends have three basic phases
Just as there are three basic trends in the market, each trend also has three basic phases. The details of these phases are given below.
- Accumulation phase
This is the initial phase when the investors actively buy stocks which are against the prevailing market sentiment. The accumulation phase is usually when the institutional investors enter the market after a steep sell-off and absorb the excess shares in the market. The demand for the stocks in this phase is quite low and it is thus the perfect opportunity for long-term investors to enter the market to maximize their returns.
- Public participation phase
This is the next phase of the market trend. In this trend, traders usually notice the high activity in the market and take suitable positions. This gives a push to a bullish market resulting in increasing prices as known as a mark-up phase. This is quite a swift phase hence, a majority of small investors are often left out of it.
- Panic phase
This is the final phase of the market trend and follows at the peak of the mark-up. As the stock gains more popularity, it increases the participation from small investors too who try to gain the maximum advantage of the current momentum. However, this is when the institutional investors exit the market after gaining the maximum advantage of the increased prices. This increases the supply in the market due to excessive sell-off and eventually, the prices reach stagnation before slipping down leading to a bear market or the mark-down of the prices.
This final phase completes the market cycle and it keeps repeating over the years. It is to be noted that every market cycle is different in terms of market highs and market lows as well as the duration of the phases. Therefore, it can be difficult to predict them accurately and hence requires a deep understanding of the markets and their price movements.
All indices have to confirm with each other
Another important tenet of the Dow Theory is that to ascertain or establish the occurrence of a market trend, all the indices have to confirm the same. If only one index is moving in an upward or downward direction, it does not determine the market trend. For the market to be defined as bearish or bullish all the indices have to move in a similar direction.
Volumes confirm trends
The volumes of the stocks have to move in accordance with the market prices. This principle states that in an increasing trend the volume of stocks should increase as the prices rise and fall as the prices fall. On the other hand, the volume must increase when the price falls and decrease when the prices rise in a downward trend.
Trends continue till there is a definitive or clear signal of reversal
Secondary trends can be quite easily considered to be trend reversals by many investors or traders. Dow Theory, therefore, states that it is important to consider the prevailing trend to continue until there is a definitive change in the market and the price movement.
How can Dow Theory be used by traders?
Dow Theory is one of the key tools used in market analysis and allows the traders and investors to make correct price decisions. It also gives due importance to the closing prices of the stock. The market fluctuates all day and therefore it is difficult to determine a definitive trend. However, as the trading day comes to a close, most investors and traders conform to the underlying trend. This highlights the underlying market sentiment and determines the price and volume action.
Dow Theory although very old, it is still a relevant concept of technical analysis. Most traders and investors still rely on Dow Theory to determine market trends correctly. Dow theory can help the trader and investors know the basics of market trends and help them not make rushed decisions.
During the market day, there are many fluctuations that often make lead traders and investors to make decisions that may or may not conform with the prevailing trend. However, at the end of the day, as the closing price approaches, most trader sand investors want ito tap into the current trend and this determines the closing price of the stocks. Hence, closing prices are an important factor as per Dow Theory.
There are a few basic patterns as per Dow Theory which can be used to identify the trading opportunities. These patterns are mentioned below.
-Double Bottom and Double Top Formation
-Triple Bottom and Triple Top
Some other tools of technical analysis are candlesticks, bar charts, moving averages, Relative Strength Index, etc.
Dow Theory was introduced by Charles H. Dow in the early 1900s. After his death in 1902, his work was continued by William Hamilton and their collective work was published by Robert Rhea under the Dow Theory in 1932.