Introduction to Dow Theory
Dow Theory is one of the oldest methods used for market forecasting and technical analysis. Formulated by Charles H. Dow, co-founder of Dow Jones & Company, this theory lays the groundwork for understanding market movements and directions. Despite being over a century old, Dow Theory’s principles are still applied by traders and investors today to analyze and predict market trends.
Basic Tenets of Dow Theory
The core of Dow Theory lies in several basic principles. These are fundamental concepts that set the stage for market analysis. Understanding these principles is crucial for anyone looking to apply Dow Theory in their trading or investment strategy.
Market Movement Has Three Phases
Dow Theory suggests that the market moves in three distinct phases: the accumulation phase, the public participation (or big move) phase, and the distribution phase. The accumulation phase is characterized by investors “in the know” beginning to buy or sell, unnoticed by the general public. During the public participation phase, the majority of traders and investors catch on to the trend and join in, driving prices significantly. Finally, the distribution phase sees these informed investors start to sell off or buy back their positions to the masses.
The Market Consists of Three types of Trends
According to Dow Theory, there are three types of trends within the market: upward (bull) trends, downward (bear) trends, and correction or sideways trends. Each of these trends has both primary movements that can last a year or more, secondary movements lasting a few weeks to a few months, and minor trends that are short-lived.
Indices Must Confirm Each Other
For a trend to be considered valid, the major indices, such as the Dow Jones Industrial Average and the Dow Jones Transportation Average, must confirm each other. For instance, if one index is reaching new heights while the other remains stagnant or falls, it may indicate that the market direction is not truly supported and could be a false signal.
Volume Must Confirm the Trend
Volume is another essential element in Dow Theory. For a trend to have validity, it must be accompanied by a corresponding volume. If a market is moving in a particular direction on high volume, this is seen as a valid move. Conversely, if the market direction is on low volume, it could indicate a lack of conviction in the move.
Trends Continue Until Definitive Signals Prove Otherwise
One of the foundational beliefs of Dow Theory is that a trend remains in effect until a clear reversal is evident. This means that short-term market fluctuations should not deter investors if the overall trend is still intact. Recognizing these reversal patterns is key to applying Dow Theory effectively.
Applying Dow Theory in Market Forecasting
Applying Dow Theory to forecast market direction involves careful analysis of market trends, volumes, and index confirmations. Traders and investors use these principles to make calculated decisions on when to enter or exit the market. By identifying the phases of market movement and understanding the nature of trends, Dow Theory can help in predicting future market behaviors.
Observe the Market Phases
Identifying which phase the market is currently in can provide insights into what the market is likely to do next. Observation of accumulation and distribution patterns can signal the beginning or end of a market trend.
Analyze Trends and Volume
Analyzing the primary, secondary, and minor trends, in conjunction with volume, gives a clearer picture of market strength or weakness. High volume in the direction of the primary trend confirms the trend’s validity, while weakening volumes may suggest a reversal or a pause in the trend.
Watch for Confirmations
Confirmation between indices, as well as confirmation between market trends and volume, are crucial steps in Dow Theory analysis. These confirmations can affirm the current market direction and provide a stronger basis for market predictions.
Conclusion
Dow Theory provides a solid framework for understanding and forecasting market movements. By applying the theory’s basic tenets, traders and investors can enhance their market analysis and make more informed decisions. While no method can predict market movements with absolute certainty, Dow Theory offers time-tested principles that are valuable to any market participant looking to decipher market trends.