Dow Theory is a technical analysis (TA) approach developed by Charles H. Dow who is considered the father of technical analysis (FOTA). He was the co-founder of Dow Jones & Company and the first editor of The Wall Street Journal. Dow Theory is a elemental concept in technical analysis and provides a framework for understanding the movement of stock prices and making future investment decisions.
Main principles of Dow Theory are-
- The market discounts everything: Dow believed that the price of a stock reflects all available information about the company, including fundamental factors, market sentiment, and future expectations. Therefore, the price movement itself is the most reliable indicator of market conditions.
- The market has three trends: Dow identified three primary trends in the stock market: the primary trend, the secondary trend, and the minor trend. The primary trend is the long-term direction of the market, lasting several months to years and representing the major bull or bear phases. The secondary trend is a shorter-term correction within the primary trend, lasting a few weeks to months. The minor trend refers to day-to-day fluctuations.
- Confirmation: Dow believed that, for a trend to be valid, it must be confirmed by the movement of the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA). If both averages reach new highs or new lows together, it is considered a confirmation of the trend. Divergence between the two averages can signal potential reversals or weakness in the current trend.
- Volume should confirm the trend: Dow Theory places significant importance on volume as a confirming factor for price trends. Increasing volume during an uptrend or downtrend suggests strong buying or selling pressure, respectively, and validates the price movement. Conversely, decreasing volume during a trend may indicate weakening market interest and a potential reversal.
The importance of Dow Theory lies in its contribution to technical analysis (TA) and its influence on market analysis and trading strategies. It provides a framework for understanding the overall direction of the market and helps analysts, investors and traders to identify potential buying or selling opportunities. Dow Theory offers insights into market psychology and the underlying forces driving price movements by analyzing price trends, volume patterns and confirming indicators.
It is important to note that, Dow Theory is not a crystal ball and does not guarantee accurate predictions. It is just one of many tools used in technical analysis and should be combined with other indicators, chart patterns and fundamental analysis to make well-informed investment decisions.
Additionally, the modern financial markets have evolved significantly since Dow's time, so it's crucial to adapt and incorporate additional tools and methodologies to stay relevant in today's complex trading environment.
