Dow Theory – What is the Dow Theory?

What is the Dow Theory?

This is one of the dated theories in the stock market that has been around for around 100 years now. Its components are still applicable today despite the heightening technology. It is a theory that was developed by Charles Dow from the Wall Street stock market documentaries. Charles died before the theory materialized and thus Hamilton, one of his closest friends refined it. Later, Robert Rhea articulated the theory.

Simply put, the theory addresses technical analysis of the price movements and the market in general and also the philosophy of the stock market. Most of the ideas and statements that Dow and Hamilton formulated are still used upto date showing the evidence that the stock market has not changed much since Dow’s time. Though the theory can be applied to individual stocks, the concepts work best for group stocks.

Principles of Dow Theory

  1. Three main movements make the market

The primary, secondary and the minor movements control the market. The primary movement may last for many years or sometimes less than a year. It is either bearish or bullish. The secondary movement also known as the intermediate lasts between ten days to three months. It repeats 33% to 66% of the main or primary price changes. The minor movement lasts from hours to months – sometimes more depending on the opinion. In some instances, the three movements happen together.

  1. Stock market discounts everything

Any new information fed into the stock market is incorporated immediately to have new information into the system and different prices. The stock will update with this new information to reflect new prices.

  1. There are three stages in market trends

First is the accumulation stage that is characterized by active buying and selling of stocks. During this stage, there are no major price fluctuations as the investors concentrate on absorbing the large supplies by the market. The market catches on the investors and fast price fluctuations are witnessed. The second stage is the absorption stage where technically oriented traders come in and speculations are rampant. This is the point where the third stage, distribution, comes in as the investors distribute their shares to the stock market.

  1. Volume determines trends

Dow simply implied that volumes determined price trends. There could be an array of answers to the relation between prices and low volumes like the zeal of an investor. However, Dow believed that the true market is viewed through the relationship of prices and high volumes. Dow also believed that the market could in the future move in the direction it moves when many participants are active in stocks. The price movements during this active movement were an indication of a sprouting trend.

  1. Averages must move in the same direction

An investor looking for a good manufacturer to invest in stocks should scrutinize the progress of the company that gives them the output to the market. The two averages should be parallel; diverse averages should act as a warning and the investor should keep away from such a manufacturer.

  1. Trends will exist until proved otherwise by definitive signal

Trends, according to Dow, will still exist despite the forces in the market. Markets might move contrary to the trends but will soon move back to the initial direction. It is a challenge to determine whether, the reversal means the start of a new trend or just normal and temporary movement. Dow Theory does not recommend the determination however.

Application of Dow Theory by investors

The objective of Dow Theory was the identification of the primary trend and make use of the big moves to increase the returns. Dow and Hamilton had in mind that the market is heavily affected by emotions and is subject to reaction of the traders both negatively and positively. To this end, they identified and followed the trend as their main cause of trading in stocks. The trend stays intact without change until proven otherwise.

Investors use the Dow Theory to identify facts about the market and stay void of assumptions that that may expose them to risks. With the right information, the trader is able to make informed decisions and forecast the future of the market for better returns. The theory is used a basis for analysis by traders and the guidelines that they feel comfortable with and can comprehend.

Hamilton and Dow believed that an in-depth study and analysis is required if an investor is to succeed in the stock market. Success and failure may alternate during the process and that investors must interpret their analysis well to get a near-perfect prediction of the market trends.

It is not possible to get the complete direction of the market but with clear information and analysis, an investors is able to predict the most probable points of success, where to invest and where not to.

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