Dow theory is one of the most trusted theory in history of financial market. Whether you are intraday trader, short-term trader or a long term investor knowing this will certainly help you in building different strategies.
Dow Theory or Dow Jones Theory is a trading approach developed by Charles Dow in late 19th century, who also founded the Dow-Jones financial news service WSJ (Wall Street Journal) and co-founder of Dow Jones and Company.
Even after 100 years dow theory still dominates and considered one of the most sophisticated contemporary study on technical analysis.
This theory or beliefs is still very much relevant for stock market at present. Also, dow theory was Further developed with time included contributions by William Hamilton in the 1920s, Robert Rhea in the 1930s, and E. George Shaefer and Richard Russell in the 1960s.
William P. Hamilton’s “The Stock Market Barometer” (1922)
Robert Rhea’s “The Dow Theory” (1932)
E. George Schaefer’s “How I Helped More Than 10,000 Investors To Profit In Stocks” (1960)
Richard Russell’s “The Dow Theory Today” (1961)
Today in this post we will be discussing about various principles based on this unique theory. After learning you can make more informed decisions regarding your open positions in market.
I hope this will certainly help anyone who participate in any form of trading or investing in financial market.
What is Dow Theory?
On January 31st,1901 Charles H. Dow equated the stock market to the tides of the ocean and he wrote in the Wall Street Journal
“A person watching the tide coming in and who wishes to know the exact spot which marks the high tide, sets a stick in the sand at the points reached by the incoming waves until the stick reaches a position where the waves do not come up to it, and finally recede enough to show that the tide has turned. This method holds good in watching and determining the flood tide of the stock market.”
Dow Theory is an technical analysis that investigates the relationship between the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA).
The theory was made keeping in mind both the indices. It observes when one of these averages rise to some high, then the other is expected to follow same within a reasonable amount of time. If this does not happens, then the averages show “divergence” and the market is responsible to reverse it’s trend.
In other words, if one average went to a new high, while the other was left behind, then there was bearish divergence. If the opposite occurred, with one average reaching a new low while the other held above a previous bottom, then the divergence was bullish.
Dow believed that in order to analyse the current condition in economy one can look for the present condition of stock market. Stock market can give the valuable measures to understand the reason behind high and low trend in economy or individual stocks.
How Dow Theory Works?
There are 9 tenets that are behind the Dow Theory. They are as follows:
1.The Averages Discount Everything:
Every known or unknown component that may perhaps affect both demand and supply is already considered in the market price. The next observation is that the market reflects all available information.
Even the information which are not in public domain. Everything there is to know is already reflected in the markets through the price. However natural calamities like drought, cyclone, flood or earthquake can’t be factored.
All major geopolitical events, trade war, domestic policies, elections, GDP growth, changes in interest rates, earning projections or expectations are already priced in the market.
The unexpected events will definitely occur, but it usually affect the short-term trend. The primary trend will remain unaffected.
2.The Market Has Three Trends:
a)THE PRIMARY TREND:
It can be as long as one year to several years and is the ‘main movement’ of the market. These movements are typically referred to as bull and bear markets. This primary uptrend is called as bullish on the other hand primary downtrend can be considered as bearish trends.
The reality of the situation is that nobody knows where and when the primary uptrend or downtrend will end.
As you can see in the image above when a stock is moving in primary uptrend it makes new high followed by few lows not lower than the previous lows.
Similarly the same patterns follows when it is in primary downtrend. We will learn below how to atleast identify the trend, so that one can ride the profits with the ongoing trend.
The objective of Dow Theory is to utilize what we do know, not to make chaotic guess about what we don’t know. Through a set of guidelines from dow theory one can measure to identify the primary trend and stay with it.
b)THE INTERMEDIATE TREND OR SECONDARY TREND:
This trend can last between 3 weeks to several months. Secondary movements are reactionary in nature, think of them as corrections during bull market, or rallies & recoveries in the bear market.
In a bull market, a secondary trend is considered a correction. In a bear market, secondary trend are called reaction rallies.
So suppose if a stock during its primary uptrend made a high, it will retrace back to some points to make a low (known as intermediate trend or correction).
Likewise during an primary downtrend, a stock can make a high after falling for several months or years(known as bear market rallies).
c)THE MINOR TREND OR DAILY FLUCTUATIONS:
This trend is least reliable which can be lasting from several days to few hours. Dow theory suggests not to put much attention to these trends. As a Long-term investor it is just the part of corrections in secondary uptrend or downtrend rally.
This are just daily fluctuations happening in market on day to day basis. It constitutes of noise in market and perhaps be subject to manipulation.
Out of the three trends mentioned only primary and secondary trends are trustworthy. However, the study of daily price action can add valuable insight, if you look in context of the larger picture.
So when you are looking for daily price action of several days, or weeks try to evaluate bigger structure getting formed. By putting enough attention one can certainly benefit in short term rallies.
A few pieces of a structure are meaningless, yet at the same time, they are essential to complete the entire picture.
3.Major Trends Have Three Phases:
Dow significantly paid attention to the primary trends (major) in which he spotted three phases. These are Accumulation phase, Public participation phase and Distribution phase.
These phases are cyclic in nature and repeats over the time.
This phase occurs when the market is in bearish trend, sentiments are negative with no hope for any upcoming uptrend. For example as we saw in Indian share market a steep low in mid cap stocks, making new lows every other day.
Most of the investors see them stay in this trend for unknown time period. However, this is the time when big investors, huge fund houses, institutional investors start accumulating them gradually.
Stocks are cheap, but nobody seems to want them but the so called ‘smart money’ find this period attractive enough to invest.
This is known as smart money keeping their view for long term investment. Although you would see sellers in market still selling these stocks, they find the buyers easily.
One thing is very important to keep in mind, this is level when stocks will create their major support level. You might have heard many analyst saying on television screen that this particular stock or market has bottomed.
This is the first stage of a bull market, stocks begin to find a bottom and quietly firm up.
b)Public participation phase:
At this phase the market have already absorbed the negativity with ‘smart money’ getting invested. This is the second stage of a primary bull market and is usually sees the largest advance in prices.
During this phase majority of public(retailers) also thinks to join in as the price is rapidly advancing. However most of them are left behind due to speed in rallies as well as the averages start heading higher.
If you are also a trader or investor you might have this experience and a regret of not able to participate with rally. It is a period followed by improved business conditions and increased valuations in stocks.
Earnings of company starts to rise again and confidence starts to get build. You can consider this as the easiest stage to make money as participation is wide and the trend followers begin to participate.
The third stage is the excess phase which eventually be turned to distribution phase. During the third and final stage, the public (retailers) gets fully involved in the market, as they get mesmerized by the bull market rally.
Some of them who felt left will still try to look for valuations and want to be part of the rally.
But this is the time when ‘smart money’ starts liquidating shares on every high. Whereas public will try to buy at this level absorbing all liquidating (sell-off) volumes made by big investors.
As a matter of fact the normal investors will look it as an opportunity to make an entry as it seem the stock is trying to find a support level.
On contrary in the distribution phase, whenever the prices attempt to go higher, the smart money off loads their holdings.
Over a period of time this action repeats several times and thus forms the resistance level. Once all the shares are off-loaded, the price does not find support. This leads to steep fall in prices of shares, which eventually is the beginning of bear market.
This is how the bull market start from beginning till end.
Just as accumulation is the benchmark of the first stage of a primary bull market, distribution marks the beginning of a bear market. As the “smart money” begins to realize that business conditions are not quite as good as once thought, they start to sell stocks.
The public is still involved in the market at this stage and become willing buyers.
All this phases takes few months to years to complete. Another key point is after the completion of distribution phase, market moves in opposite direction.
This is the beginning of bear market, where sentiments will start turning negative, you will see more and more companies filing bankruptcy, change in economic growth etc.
During bear market the level of frustration rises among retail investors as they start loosing all hopes.
4.The Averages Must Confirm Each Other:
Dow used to say that unless both Industrial and Rail(transportation) Averages exceed a previous peak, there is no confirmation or continuation of a bull market.
Both the averages did not have to move simultaneously, but the quicker one followed another – the stronger the confirmation.
To put it differently, observe the image above, as you can see both the averages are in bull market, trending upward from Point A to C.
The industrial average is intact and rising towards new peak, however there is slight down movement seen in transportation, due to which it failed to make a high above the point A.
Transportation average fall to point D which created a new low in the market, confirming the weakness in the sector. This may result in trend is getting changed towards bear from bull and further decline can lead to downfall in industrial averages as well.
To talk about this theory of average must confirm each other in Indian stock market prospect, you can not call the market bullish overall, if there is bullishness in only Nifty auto or Nifty Bank indices. If market is bullish than all other indices must follow the same trend.
5.Volume Must Confirm the Trend:
Volume is a tool to know how many shares have been bought and sold in a given period of time. It helps in analysing the trends and patterns.
Whether you are talking about shares of an individual stock or the number of options contracts traded, or an entire stock market, volume information can be found just about anywhere.
Now according to dow theory, a stock must be in uptrend with high volume and low in corrections. On the other hand volume must rise during price fall in a stock and low volume should appear when stock rises during downtrend.
6. Trend Is expected to Be Continued Until Definite Signals of Its Reversal:
Quite similar to Newton’s first law of motion which states that an object will remain at rest or in uniform motion in a straight line unless acted upon by an external force.
In simple words an object will remain in their state of motion unless a external force acts to change the motion.
Likewise, the market will continue to move in a primary direction until a force, such as a change in business conditions, is strong enough to change the direction of this primary move. You can also see the signals for reversals when a trend is about to change.
7.Closing Prices and Line Ranges:
Dow theory strongly relied solely on closing prices and was not much concerned about the intraday movements of the index. So out of open, high, low & close only closing price is the most important.
You need to understand that for a trend signal to be formed, the closing price has to signal the trend, not an intraday price movement.
You have definitely observed phases in market, when there is no volatility in a stock. The prices will stick in trading ranges, it will move within few points up and down. This period is called consolidation time, it is kind of secondary move.
As a trader you should wait for the price movement to break the trend line before coming to a conclusion on which way the market is headed. For example, if the price were to move above the line, it’s likely that the market will trend up and vice-versa.
8.Signals and Identification of Trends:
One of the major challenges faced while implementing Dow theory is the accurate identification of trend reversals. Remember, if you are following the dow theory one should be not only looking for overall market direction, but also the definite reversal signals.
One of the main skill used to identify trend reversals in Dow theory is peak and trough or high and low analysis. A peak is defined as the highest price of a market movement, while a trough is seen as the lowest price of a market movement.
Dow theory suggests that the market doesn’t move in a straight line but from highs (peaks) to lows (troughs), with the overall moves of the market trending in a direction.
An upward trend in Dow theory is a series of successively higher peaks and higher troughs. A downward trend is a series of successively lower peaks and lower troughs.
9.Manipulation In stock Market:
According to Charles dow the manipulation of the primary trend is not possible. where as Intraday, or day to day trading and perhaps even the secondary movements could be vulnerable to manipulation.
These short movements, from a few hours to a few weeks, could be subject to manipulation by large institutions, speculators, breaking news or rumors.
There is possibility that speculators, specialists or anyone else involved in the markets could manipulate the prices in short run.
Individual shares could be manipulated for example the security rise up and then falls back and continues the primary trend. With this in mind one need to be aware of the situations while trading and investing.
However, it would be next to impossible to manipulate the market as a whole. The market is simply too big for any kind of manipulation to occur.
Best Dow Patterns To Use For Trading And Investing In Stock Market:
Till now we have learned only about the theory, however when it comes for practicality, dow offers certain patterns similar to candlestick patterns. These dow patterns can be very useful while one trade or invest in share market.
Let us try to learn them one by one.
What is Double Top Formation Pattern?
As you can observe in the chart (day )above of a double top formation getting formed. The stock after a rally reaches a point (acting as resistance) and start falling again. This is a bearish signal for the stock.
Stock tries break the resistance level again within same price zone, however it resulted in a steep fall in price. As a short term trader one can take the benefit of this situation by looking for selling opportunity after the double top formation has formed.
What is Double Bottom Formation Pattern?
Similar to top, double bottom formation pattern occurs, when a stock touches the bottom range (acting as a support level) twice. One can look for buying opportunity after getting the confirmation of formation as it is considered as a bullish reversal pattern.
One thing need to remember is the zone of support and resistance should be nearby while pattern is getting formed.
What is Triple Top Formation Pattern?
In the same fashion triple top and bottom formation happens. Only difference is the stock price has tested certain zone thrice. This shows the level of confirmation, as stock has hit those levels thrice one can take calculated risk while trading at those positions.
What is Triple Bottom Formation Pattern?
What is Range formation Pattern?
This happens when a stock has no influence of any news like change in management, joint ventures, mergers, acquisitions etc. and it is stuck within a range.
There are no sign of any trigger happening as nothing has changed technically or fundamentally for the company. There are no upcoming results, nothing has changed for the company, this is also known as sideways market.
The price follows a narrow range hitting the same upper and lower level multiple times. Therefore stocks follows a trading range, this situation is beneficial for both buyer and seller.
Of course, as a investor one does not want this, but as a trader one can look for buying and selling opportunities. The lower level will act as a support and the upper will act as a resistance.
Till there is no range breakout, any event leading to break the range both the buyers and sellers can benefit.
Remember the range will break only when there is high volume on either side.
What is Flag formation Pattern?
This pattern usually occurs during a steep rally in the stock. When a stock rallies, it does gives scope for retail participants to book profit, which they do in most scenarios.
Any one who has missed the rally can make an entry and be part of it. You can call it just a correction for time being, before going for another rally. Most important thing to notice is the volumes during the fall.
Volume will be on the lower side as the smart money is still invested in the stock, only some retail investors are booking profit. The overall sentiment is still positive for the stock.
Why Dow Theory Is Not Infallible?
Dow Theory is not a sure-fire means of beating the market hence it is not something which is infallible or fault-less. Some of the criticism received about Dow Theory is that it is really not a theory.
Neither Dow nor Hamilton wrote proper academic papers outlining the theory and testing the theorems. The ideas of Dow and Hamilton were put forth through their editorials in The Wall Street Journal.
Dow Theory is also been criticized as being outdated and no longer an accurate reflection of the economy. This may be a valid point, however the DJTA is one of the most economically sensitive indices.
The stock market has always been seen as a great predictor of economic growth.
By understanding the Dow Theory, traders are better able to spot hidden trends that more experienced investors may be noticing. This allows them to make more informed decisions regarding their open positions.
The goal of Dow theory is to identify the primary trend and catch the big moves. The market mostly influenced by emotion and prone to overreaction, both up and down. With this keeping in mind, your aim is to concentrate and identify the trend and then follow the trend.
Dow Theory helps investors identify facts, not make assumptions or forecast. It can be dangerous when investors and traders begin to assume. Predicting the market is a difficult, if not impossible, game.
In the end I just wanted you to follow this steps while trading or making an investment in market.
1. The stock should form a observable candlestick pattern.
2. Support & Resistance should confirm to the trade. Always place stop loss around S&R.
3. Make sure to trade with average volumes on both buy and sell. If volumes are less wait for the correct time to make an entry.
4. Remember the Dow Theory perspective of Primary, secondary & trends.
5. Check the type of formation patterns like Double, triple, range, flag etc.
6. Use Technical Indicators like ( MACD, SMA, EMA, RSI, FIBONACCI, BOLLINGER BAND ) for confirmation.
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