Dow’s theory is a general rule for technical analysis based on Charles Dow’s theories. Charles Dow was the founder of The Wall Street Journal and a significant partner of the Dow Jones. The stock market index was also introduced to the market as DJT by this person.
Most of his theories didn’t write and implemented in the capital market. Many had acquired his knowledge experimentally and used it in other fields. After his death, Willian Hamilton compiled Dow’s valuable ideas and theories in writing, now known as Dow Theory.
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This article introduces the Dow Theory, discussing the different stages of market trends based on Dow’s work. As with any theory, the following principles are not infallible and are open to interpretation.
The market reflects everything
According to Dow theories, anything can affect the market. The efficient Market Hypothesis is closely related to this issue in that any information in the world can cause prices to rise or fall in the capital market.
For example, if a large company wants to increase its annual revenue, the market reacts to this news before it happens. Demand for the Company’s stock is the first thing to improve. Even after Company implemented the decisions, this was not done, perhaps to the extent that it changed the market decisions themselves.
In some cases, Dow observed that a company might see their stock price reduce after good news because it wasn’t quite as good as expected.
We mentioned one of the essential principles of the stock market. Even many people who do the technical analysis are proficient in such cases. Of course, fundamental analysis people do not agree with this theory and see market changes based on a usual trend.
Market trends
Dow’s activities shaped market trends. These types of entities have become the main elements of the world of economics. Dow’s theory interprets market trends as follows:
- Primary trend: Lasting from months to many years, this is the direct market movement.
- Secondary trend – Lasting from weeks to a few months.
- Tertiary trend – Tends to die in less than a week or not longer than ten days. In some cases, they may last only for a few hours or a day.
By dividing market trends into primary, secondary, and tertiary, any investor can identify the best way to allocate credit. There is a potential for investment in each sector.
If you believe that the cryptocurrency market has a positive primary trend but is currently experiencing a negative secondary trend, you may sell it when its price first rises.
The main problem here is being able to figure out what kind of trends you are currently seeing. Technical analysis is instrumental here. Many of the world’s largest companies spend billions of dollars hiring people who can perform practical technical analysis professionally.
The three phases of primary trends
Dow established that long-term primary trends have three phases. For example, in a bull market, the phases would be:
- Accumulation:When prices are at an all-time low and many are leaving the market with a negative outlook, more innovative people are starting to buy the stock at the lowest possible price to resell it at a particular time.
- Public Participation: At this stage, the general investor’s clothing returns to the market as a bullish chart, and purchases increase rapidly.
- Excess & Distribution – In this case, many have not yet realized that they have reached the price ceiling. Now the leading investors are starting to sell extensively and selling these shares to people who are still hot to buy. And the story is reversed in this case.
In a bear market, these phases work precisely the opposite. The trend starts with the distribution of tokens and continues with a public company. In the third phase, the general public leaves the market in despair and sells its capital, but more innovative shareholders start buying more to make more profit at a given time.
There is no guarantee that each phase will run smoothly, but the majority of traders and shareholders carefully consider these phases before starting a trade. Market cycles are defined in this way.
Cross-index correlation
Dow believed that stakeholders should confirm the initial trends in one market index based on the trends seen in another market index. In this case, both indexes are known as the Dow Jones Transportation Index and the Dow Jones Industrial Average.
In addition, the transportation market has a lot to do with industrial activities. The more the manufacturing industry there is, the higher the stock price of transport companies will be because every commodity needs to transport to be sold.
Keep in mind that there is a strong relationship between the manufacturing industry and the transportation market. If one works correctly, the other can grow. Of course, due to the digitalization of products, many of these rules are quickly broken.
Volume matters
Dow believed that more volume would lead to more trades. The higher the volume, the more we can conclude that we are facing a correct trend in the market. When the volume of transactions decreases, the price action does not show the market more accurately.
Trends are valid until a reversal is confirmed
On the other hand, Dow believed that if a company were to be on the trend bar, it would go to the end until the opposite was the case.
Therefore, it is better to be careful when facing the opposite trend, as long as this routine is the primary trend. Understanding whether a process is the beginning of a primary trend or a secondary trend requires a great deal of experience. Many traders have mistakenly accepted reverse routines, which were only a secondary trend.
Conclusion
Some critics argue that the Dow Theory is outdated, especially regarding the principle of cross-index correlation (which states that an index or average must support another). Still, most investors consider the Dow Theory to be relevant today. Not only because it concerns identifying financial opportunities but also because of the concept of market trends that Dow’s work created.