Tenets, Technical Analysis and Dow Theory Definition
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Six Tenets of Dow Theory
The Dow Theory is an economic theory that postulates that stock prices move in a generally upward direction. The Dow theory was first proposed by Charles Dow in 1896 and has been modified and expanded over the years. The basic premise of the theory is that the stock market reflects the collective opinion of investors regarding the future performance of specific companies. There are 6 basic tenets of this theory explained below.
Understanding the Dow Theory
Dow theory is a technical analysis theory that has been developed over time and is still used by many today. Dow believed that the stock market as a whole was a reliable measure of overall business conditions within the economy and that by analyzing the overall market, one could accurately gauge those conditions and identify the direction of major market trends and the likely direction of individual stocks.
The theory has undergone further developments in its 100-plus-year history, including contributions by William Hamilton in the 1920s, Robert Rhea in the 1930s, and E. George Shaefer and Richard Russell in the 1960s. Aspects of the theory have lost ground, for example, its emphasis on the transportation sector—or railroads, in its original form—but Dow's approach still forms the core of modern?technical analysis.
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The first is that the stock market discounts everything, means that all information about a company is already reflected in the price of its stock. This includes things like earnings reports, news events, and analyst ratings.
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There are three primary kinds of market trends: bull markets, bear markets, and secondary trends. A bull market is a period of generally rising stock prices and investor confidence. A bear market is a period of generally falling stock prices and investor confidence. Secondary trends are shorter-term movements that happen within the larger trend of the market. Bull markets can turn into bear markets, and vice versa, but usually there is a clear trend in one direction or the other. Secondary trends can also be bullish or bearish, but they typically don't last as long as the primary trend. It's important to pay attention to the primary trend when making investment decisions, because it's more likely to continue than any secondary trend.
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Primary trends have three phases: accumulation, mark-up, and distribution. The accumulation phase is when the trend first forms and buyers start to enter the market. The mark-up phase is when the trend gains strength and prices increase as buyers continue to enter the market. The distribution phase is when the trend reverses and sellers start to exit the market. Many technical indicators are used to identify these phases, including price momentum. Price momentum measures the rate of change in price and is used to identify overbought and oversold conditions. When prices are increasing at a faster rate than they are declining, it is considered an overbought condition. This indicates that prices may be too high and could reverse course soon. When prices are decreasing at a faster rate than they are increasing, it is considered an oversold condition.
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In order for a trend to be established, Dow postulated indices or market averages must confirm each other. This means that the signals that occur on one index must match or correspond with the signals on the other. If one index, such as the Dow Jones Industrial Average, is?confirming?a new primary uptrend, but another index remains in a primary downward trend, traders should not assume that a new trend has begun.
Dow used the two indices that he and his partners invented, the?Dow Jones Industrial Average (DJIA)?and the?Dow Jones Transportation Average (DJTA), on the assumption that if business conditions were, in fact, healthy,?as a rise in the DJIA might suggest,?the railroads would be profiting from moving the freight this business activity required. If asset prices were rising but the railroads were suffering, the trend would likely not be sustainable. The converse also applies: if railroads are profiting but the market is in a downturn, there is no clear trend.
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In order to maintain a healthy bullish trend, volume must confirm the primary trend. A secondary pullback could be a sign that the market is losing strength and a reversal could be on the horizon. Volume is one of the most important indicators when it comes to trading and should not be ignored.
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Trends persist until a clear reversal occurs. For example, in the stock market, a minor trend can continue until there is a breakout on either the upside or downside. The trend will become more pronounced as it progresses, and traders will typically look to enter into a position when the trend is confirmed. A minor trend can also exist in economic indicators, such as gross domestic product (GDP) or inflation rates. These trends will typically last until there is a major shift in the data that indicates a reversal is taking place.
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Signals Technical analysis and Identification of Trends
In order to trade successfully, it is important to have an understanding of the signals technical analysis can provide. Technical analysis is the study of price movement over time and how it can be used to identify trends. There are three key indications that can help identify a major trend: uptrend, downtrend, and sideways trend.
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An uptrend is when prices make higher highs and higher lows. A downtrend is when prices make lower highs and lower lows. A sideways trend is signaled when prices move within a range and make neither higher nor lower highs nor lows.
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It is important to note that these signals are not always accurate, and there can be false signals. However, by using multiple indicators and tools, traders can increase the accuracy of their trades.
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Reversals and Sell Signal
Traders are always looking for an edge and one way to gain an advantage is to spot reversals in the market. It is a change in the direction of the trend and can provide a sell indication.
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There are a number of indicators that can be used, including moving averages, Bollinger bands, and candlestick patterns. Moving averages can be used to identify when a security is trading in a trend and Bollinger bands can be used to measure the volatility of a security. Candlestick patterns can be used to identify when a security has reached oversold or overbought levels.
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One of the most common candlestick patterns that is used to identify reversals is the hammer pattern. The hammer pattern is formed when a security rallies strongly in the face of heavy selling pressure and then closes near its lows.
Closing Prices and?Line?Ranges and Market Movement
Charles Dow relied solely on closing prices and was not concerned about the intraday movements of the index. For a trend signal to be formed, the closing price has to signal the trend, not an?intraday price movement.?
Another feature in Dow theory is the idea of line ranges, also referred to as trading ranges in other areas of technical analysis. These periods of sideways (or horizontal) price movements are seen as a period of?consolidation, and traders 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.
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