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Understanding Dow Theory

Charles Dow, journalist, founder and editor of the Wall Street Journal, developed a theory for stock market movements and was one of the pioneers of technical analysis. Based on 255 Wall Street Journal editorials published between 1900 and 1902, the Dow Theory resonates from classrooms to trading floors, and unlike most academic market studies, it has valid world trading applications. First applied to the stock market and stock indexes, a number of its concept are applicable to other markets such as commodities, futures and forex.

Charles H. Dow created the first market indices, the transportation average and the industrial average. The main purpose of these indices was to find stability by combining less active stocks and to smooth out unpredictable price movement. Using these indices, he came up with six assumptions about the market, all of which still hold value today.

The Fundamental Principles of Dow Theory

  1. The Averages Discount Everything
    At the beginning of the twentieth century there was significantly less regulation and liquidity in the market; thus, price manipulation was rife. Using averages, Dow could decrease the regularity of strange moves in a single stock, i.e., moves that seemed out of character or unreasonably large. This principle assumes that the current price reflects all the information about an asset, and as fresh information filters through, the price of the asset adjusts accordingly.
  2. The Market has Three Trends
    The market has three classifications of movements: minor movements or short swings, the secondary swings, and the primary trends. The minor fluctuations vary with opinion from a few hours to a month or more, and occur within the primary and secondary movements. Often called market noise, they only serve to divert a trader’s attention from the real profit potential offered by secondary and primary trends.The secondary or medium swing may last from 10 days to 3 months, and is a counteractive reaction to the primary trend. Usually, the medium swing retraces about 25% to 75% of the last primary price change, which is the main trend for the market. The primary trend can be bearish or bullish and may last from a few months to several years. A bull market describes a wave of rising prices while a bear market describes declining prices.
  3. The Principle of Confirmation
    Two of the three key averages; i.e., the utilities, transportation, and industrials, must confirm direction for the bull or bear market to exist. Initially, the Dow Theory needed the confirmation on only the railroads and utilities. Today, much has changed and the aim is to guarantee that the bull or bear market is an extensive economic trend and not a narrow industry–related event.
  4. Volume Confirms the Trend
    When trading, volume is a key piece of the puzzle, as it helps traders work out the interest behind each price movement. The basic principle is that volume ought to increase with the primary or major trend to provide confirmation of the movement. Whether it is a bull or bear market, volume must increase as the trend rises.
  5. Only Closing Prices are Important
    At the close of trading, there is always high volume as traders with long and short time frames come together to settle on the fair price. Before the close of trading, day traders, hedge funds, and other investors liquidate their positions thereby reversing their earlier impact.
  6. The Trend Remains Intact
    The Dow Theory assumes that a trend should continue in effect until it gives a definite reversal signal, which is the basis of all trend following rules. However, it does not state how long a trend will continue.

Implementing a theory is not as easy as it sounds; however, understanding Dow Theory is important to discern how markets move and how to take advantage of such moves.

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