An Introduction to Dow Theory

The Dow theory assumes that the averages discount every possible piece of information that could potentially impact the demand and supply of securities. The only exception to this is natural calamities, as these cannot be anticipated beforehand. Nonetheless, as these events occur, their impact is quickly analysed, priced in, and reflected in the averages . Update your email id and mobile number with your stock broker / depository participant and receive OTP directly from depository on your email id and/or mobile number to create pledge.

dow theory

We highly suggest you to go through our other TA chapters as well. We have talked about volume sparsely in this module as well as in a few other modules. That said, we will surely come up with a dedicated chapter on Volume within the Technical Analysis module in the coming days… Movement in one average must always be confirmed by movement in the other average.

The Dow Theory is basically built on 6 Tenets.

But smart investors who had accumulated shares at cheap valuations in the accumulation phase start selling their stake slowly in the distribution phase. You will also see record high trading volume during this phase. This happens because as institutional investors sell their shares, retail investors buy those shares which balances out the demand and supply ratio. This restricts the stock prices to move further up and you will find that the stock has again started to move sideways. During this phase, earnings growth and economic data improve and the public begins to tip-toe back into the market.

Secondary trend is basically a correction in a bullish market and rallies in a bearish market. Secondary trend are corrections within the primary trend moving in the opposite direction. This principle states that the stock and index prices represent all information that is currently known and available. Accordingly, pricing trends will change when new information becomes available.

In a Bull Market, volume increases when prices rise and dwindles as prices decline; in Bear Markets, turnover increases when prices drop and dry up as they recover. As per the Dow theory, The broad, overall, up and down movements usually last for more than a year and may run for several years. One was composed solely of the stocks of 20 railroad companies, for the railroads were the dominant corporate enterprises of his day and the other was called the Industrial Average. Dow states that this could be anything from less than a year to several years.

  • As you’ll recall from our earlier modules, here’s where options and futures are traded.
  • Conversely, let’s take a market where the prices are falling.
  • Angel One has created short courses to cover theoretical concepts on investing and trading.
  • And of course there are reversal signals to be looking for.

Which is saying that each successive wave that comes in is further away from the shore than the previous one. According to this theory there is an uptrend if each successive rally closes higher than the previous rally. The market is quick to assimilate and factor in all information that is known and available.

3 What is Dow Theory?

This phase occurs when institutional investors or smart investors have completely sold out their stake. And retail investors are still holding on to the shares bought by them. The stock prices might dip down a bit which creates fear and nervousness among retail investors and they start selling their stake at nominal profits or even losses. This selling pressure pushes the stock prices further A evaluation of methods for danger management in projects down and leads to the accumulation phase again. Then, in the response phase, as short-term traders throng to the markets, we see a sharp rise in the index price from around 900 during May 2003 to around 2000 during January 2004. At this point, there’s a resistance that builds up since institutional investors start to sell off their holdings, leading to the formation of a distribution phase.

dow theory

However, when significant price movements occurred with high volume, Dow believed that this gave a ‘true’ market view. Technical Analysis has some very solid roots, The Dow Theory. From 1900 to the time of his death in 1902, Charles Dow wrote a series of editorials published in The Wall Street Journal regarding his theory of the stock market.

So, after seeing a steep fall in the markets, investors sell their stake out of fear thinking that the stock prices will crash further. In this phase shares are available at attractive valuations. Smart investors or institutional investors keep looking for such accumulation opportunities. So, when retail investors are selling their holdings out of fear, smart investors accumulate stocks at attractive valuations. This restricts the stock prices to move further down and we see a sideways trend and support levels are formed.

Types of Stock Market Analysis

The Dow Theory was also the first to identify that the stock market moves in trends with multiple different phases for each trend. It clearly outlines the different trends that the stock market typically tends to go through – primary trends, secondary trends, and minor trends. And for each trend, there are the following three phases – accumulation phase, public participation phase, and distribution phase. We’ll see more about this in the next section of this chapter. This is the third phase of the market cycle where the stock hits new highs and retail investors become optimistic thinking that the rally will continue.

dow theory

So you should look for the reversal signal during a uptrend or downtrend. If the uptrend or downtrend is not supported by volume means the trend is becoming weak and it may reverse after sometime. There are two types of investors Big investors like Institutes and Small investors like you and me. When the prices are down and everyone says market crashed and economy is doomed this big players slowly buy the stocks. The reason for this is that the uptrend shows strength when volume increases because traders are more willing to buy a stock in the belief that the upward momentum will continue. And on the other side, in a downtrend, volume must increase when the price falls and decrease when the price rises.

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This shows that a higher number of trades are following the downtrend, pointing to a bearish market. To identify that a trend has been established, it’s essential that all the market indices must confirm each other. So, the movement of one index must match the movement of all other indices in the market.

Then comes a period that everyone says market at its peak and economy and everything is just awesome. Looking at above chart, Nifty is in primary uptrend and secondary trend is counter against the primary trend indicated by red arrow. At the same time minor trend is shown with blue arrows, which is usually called as noise too. During the market day, there are many fluctuations that often make lead traders and investors to make decisions that may or may not conform with the prevailing trend. However, at the end of the day, as the closing price approaches, most trader sand investors want ito tap into the current trend and this determines the closing price of the stocks.

Believed to be the father of modern technical analysis from the western world Charles Dow developed the Dow Theory based on his analysis of the market action in the late 19th century. This theory laid down the initial foundation for the development of technical analysis. It is till today considered an important aspect of understanding markets and how they largely trend. Well, this brings us to the end of our introduction to technical analysis. Now, it’s time to look at one particular segment of the financial markets – the derivative segment. As you’ll recall from our earlier modules, here’s where options and futures are traded.

Tenet 2: The market has three trends

For an investor, this is the least important of all three trends. The primary trend represents the overall trend of the market and usually lasts anywhere between a year to several years. In a primary up trend, each high crosses the previous high and each low fails to cross the previous low. As long as this pattern continues, the primary uptrend is in effect. Similarly, in a primary down trend, each low crosses the previous low and each high fails to cross the previous high. As long as this pattern continues, the primary downtrend is in effect.

However, it could be worthwhile thinking of this as relating to the long-term trend as seen through the weekly or monthly chart. Dow created what we know today as the Dow Jones Industrial Average, a select list of eleven large companies that encompassed a wide range of business areas. His theory was that the health of these companies would mirror the health of the economy, and, as these company’s output and revenues changed, then the economy would change as well.

Her goal is to help readers make better investment decisions. The minor trend behaves like ripples which are formed when you throw a pebble into still water. Now, let’s move ahead and understand the six basic tenets of the Dow Theory. The Dow Theory is a theory based on observations of Mr Charles Dow.

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