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DOW THEORY
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Today the theory which we are going to study is the most basic and more than 100 years old, it still remains the foundation of Technical Analysis. This theory was developed by Charles H Dow who was the father of Technical Analysis. He never wrote a book nor published his complete theory but several followers and associates of him have published work based on his theory from 255 Wall Street Journal editorials written by him.

Dow Theory is very simple principles which any trader or an investor can apply. There are total six principles. They are as follow:-

1)      The Stock Market Discounts All Information:  The first principle of Dow Theory suggests that stock price represents sum total of hopes, fears and expectation of all participants and stock prices discounts all information that is known about stock i.e. past, present and future.

 It suggests stock market discounts all information be it interest rate movement, macroeconomic data, central bank decision, future earnings announcement by the company etc. The only information which stock market does not discount is natural calamities like tsunami, earthquake, cyclone etc.

 

2)      The Stock Market Have Three Trends: Dow Theory says stock market is made up of three trends-

  •  Primary Trend- This main trend and the longest, trader should trade in direction of this trend. It could either be bullish or bearish. The confirmation for trend come when each peak in the rally is higher than previous peak in the rally and each trough in the rally is higher than previous trough in the rally and vice- versa.
  • Secondary trend- These are corrections to the primary trend. Think of this as a minor counter reaction to the larger movement in the market.
  • Minor Trend- These are daily fluctuations in the market, some traders prefer to call them market noise.

 

3)      Primary Trend Have Three Phases:  The Dow Theory says primary trend have three phases-

 

  • Accumulation Phase- This phase occurs right after a steep sell off in the market. This phase is made up of buying by intelligent investor who thinks stock is undervalued and expects economic recovery and long term growth. During this phase environment is totally pessimistic and majority of investors are against equities and above all nobody at this time believes that market could rally from here. This is first indication the beginning of the new bull market.
  • Participation Phase- The participation phase is characterized by improving fundamentals, rising corporate profits and improving public sentiment. More and more trader participates in the market, sending prices higher. The most important feature of the phase is the speed. Because the rally is quick, the public at large is left out of the rally. New investors are mesmerized by the return and everyone from the analysts to the public see higher levels ahead
  • Distribution Phase- This phase is characterized by too much optimism, robust fundamental and above all nobody at this time believes that market could decline. The general public now feels comfortable buying more and more in the market. It is during this phase that those investors who bought during accumulation phase begin to sell in anticipation of a decline in the market. The selloff in the market leaves the public in an utter state of frustration.

 DOW THEORY

4)      Stock Market Indexes Must Confirm Each Other- Charles H Dow believed that stock market as a whole reflected the overall business condition of the country. Dow first used basis of his theory to create two indexes namely

(i)                  Dow Jones Industrial Index

(ii)                Dow Jones Rail Index (now Transportation Index).

Dow felt these two indexes would reflect true business condition within the economy. The basic concept behind this is that if production is increasing then transportation of goods to customer should also increase i.e. performance of companies transporting goods to consumer should improve. The two averages should move in the same direction and rising Industrial Index is not sustainable as long as Transportation Index is not rising. The divergence in these two indexes is a warning signal, a reversal from a bull market to bear market or vice versa is not signalled until and unless both indexes i.e. Industrial Index and Transportation Index confirm the same.

5)      Volume Must Confirm the Trend- Dow Theory says that trend should be confirmed by the volume. It says volume should increase in the direction of the primary trend.

 • If primary trend is down then volume should increase with the market decline.

 • If primary trend is up then volume should increase with the market rally.

 

6)      Trend Remains Intact Until and Unless Clear Reversal Signals Occur- Dow Theory suggests that one should never assume reversal of the trend until and unless clear reversal signals are there and one should always trade in the direction of the primary trend. Markets might temporarily move in the direction opposite to the trend, but they will soon resume the prior move.

 

Now that you have understood the concept of Dow Theory, apply the concept on Nifty 50 charts and make a guess what will happen next.


DOW THEORY

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