Dow’s theory, in the world of trading, is a theory formulated by Charles Henry Dow in 1897. It consists of a set of principles that aim to predict the future behaviour of a market. Regarded as one of the foundational theories in technical analysis, Dow’s theory is primarily based on chart analysis.
To formulate his theory, Charles Henry Dow created two indices in 1884, which he analysed for years: the Dow Jones Industrial Average (DIJA) and the Dow Jones Transportation Average (DJTA). Through his analysis of these indices, Dow believed he could predict not only the behaviour of the overall economy but also that of various sectors that exhibited a correlation with one another.
Dow’s theory was confirmed by his observation that a peak or trough in the Dow Jones Industrial Average was typically followed by a corresponding peak or trough in the Dow Jones Transportation Average.
Dow noticed a clear correlation between the industrial indicator he created and the transportation indicator. He observed a ripple effect during periods of increased or decreased demand. In other words, when industrial companies experience higher demand, they generate more profits, leading to an increase in their share prices. This growth often extends to other sectors that benefit from the overall economic upturn.
Through his formulation, Dow established the principles of technical analysis and is widely regarded as the father of this approach. He also outlined a series of principles that aid in identifying the market direction and determining the prices of assets being traded.
Principles on which the Dow theory is based
Let’s take a look at the six principles established by Dow in his theory.
Price and indices reflect everything
Dow believed that prices and the information conveyed by indices reflect all the factors influencing the market. This viewpoint underscores the notion that the stock market is a leading indicator, as it incorporates expectations before the broader economy reacts.
Markets move in trends
Dow established that markets exhibit trend-based movements. While a crisis might originate in a specific sector, it can have a cascading effect, dragging other sectors down and generating a bearish trend characterised by a general decrease in demand.
Dow provided an official classification of trends based on their direction and duration. According to its direction, the trend can be bullish (prices rise, and the highs and lows occur at increasingly higher points) or bearish (prices fall, and the highs and lows occur at increasingly lower points).
Based on duration, there are three types of trends:
- Primary trend: The longest and strongest trend lasting one to three years or more. Each primary trend consists of three phases, varying depending on whether it is bullish or bearish. For a bullish trend, the phases are accumulation, public participation, and excess phase. For a bearish trend, the phases are distribution, public participation, and panic.
- Secondary trend: A shorter-term trend that moves against the primary trend. Its duration typically ranges from three weeks to three months and is referred to as a “correction” of the primary trend in trading terminology.
- Tertiary trend: An even shorter-term trend that corrects the secondary trend. Its duration is less than three weeks.
Volumes confirm trends
Dow emphasised that volume should confirm the prevailing trend as it represents the number of executed operations. In an uptrend, rising prices should be accompanied by increasing volume, whereas falling prices should be accompanied by decreasing volume. In a bearish trend, falling prices should be accompanied by increasing volume, while rising prices should be accompanied by decreasing volume.
Correlation between the two indices
To confirm the Dow theory, it is essential to observe the trend in both indices mentioned by Dow. Both indices should exhibit a similar trend; otherwise, it could indicate a deviation from the theory. Dow stated that a peak or trough in the industrial index is typically followed by a corresponding peak or trough in the transportation index.
The trend remains valid until evidence of another trend emerges
ow’s theory suggests that a market’s trend remains in force until evidence of a different trend emerges. As long as the observed indices continue to support the prevailing trend, it is considered valid.
Only closing prices are considered
The Dow theory focuses solely on closing prices. Highs and lows occurring during a trading session are not taken into account. Only the prices recorded at the close of each session are considered in the analysis.
The Dow theory and the Dow Jones indices
As highlighted throughout the article, there is a significant connection between Charles Henry Dow and the well-known “Dow Jones” indices. In 1882, Dow, along with his partner Edward D. Jones, founded Dow Jones & Company Inc.
This very company, two years later in 1884, introduced two sectoral indices for the New York Stock Exchange, which are now recognised as the Dow Jones Industrial Average and the Dow Jones Transportation Average. Have a look at this Dow Jones guide to find out more.
The Dow theory in the world of trading
Finally, it is important to highlight that the Dow theory holds significant recognition within the trading world and in the realm of the stock market. Charles Henry Dow is widely regarded as the father of technical analysis due to his formulation of this theory. The principles established by Dow have greatly influenced the field, and today, many traders and investors employ technical analysis, which incorporates key elements of chart analysis.
Thanks to Dow’s groundbreaking work, technical analysis has become a prevalent approach utilised by market participants to analyse and make informed decisions regarding stocks and other financial instruments. The enduring relevance of Dow’s theory underscores its enduring impact on the trading and investment landscape.
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What is the significance of Dow’s theory in the world of trading?
Dow’s Theory provides a foundational framework for understanding market behaviour and predicting future trends.
How does Dow’s theory classify market trends?
Dow’s Theory classifies market trends based on their direction and duration. In terms of direction, trends can be bullish or bearish. Dow’s Theory recognises primary, secondary, and tertiary trends, each varying in length and significance.
Can Dow’s theory be applied to modern-day trading?
Yes, Dow’s Theory remains applicable to modern-day trading and is widely used by traders and analysts. While the original theory was developed over a century ago, its principles have stood the test of time. Market participants continue to analyse price patterns, study market indices, and assess volume trends, all in line with the core tenets of Dow’s Theory.