Category Archives: Dow Theory

Concluding Dow Theory

As we discussed Dow ideas or Tenets yesterday which are pillars, but one more crucial rule of Dow was to consider or give most importance to closing price, irrespective of time frame of chart. He believed averages most close above or below previous low or high to confirm the trend.  So always consider closing price to trigger your analysis

Some criticisms of Dow theory

  • Believed to give reversals late, almost 20-25% after the high or low
  • Generally, buy or sell confirmation occurs in second phase of trend and so its believed to be a laggard

Still to confine this criticisms, Dow theory has captured 68% of the moves in S&P between 1920-1975.  And dow actually wanted to give overall idea of the long term trend through his theory so he never intended initiate trading calls.

 

Tenents of Dow Theory

Now lets list down some ideas of Charles Dow,  which are considered to be roots of technical research.  Across other books and website number of ideas listed may differ but overall, they are included in the broader categories as listed below:

  • Average Discounts Everything

This idea states that markets reflect every possible knowable factor that affects overall supply and demand, which me mentioned in our post earlier. This is considered to be the basic premises of stock market

  • Market has 3 trends

Any asset class, or markets, behave in three basic trends as Follow:

  1. Uptrend: Dow defines uptrend as a situation as each successive higher high on the price than the previous rally and successive low is also higher than the previous rally
  2. Downtrend: He defined it as a situation with lower low than the previous rally and lower high as Downtrend
  3. Continuation trend: It is defined as the situation where price trades in a particular range between the two rallies.

Dow considered three parts of each trend which are termed as primary, secondary and minor. He compared it with a wave where primary trend represents a tide, and secondary trend represents a wave which makes up for tide. While minor trends are considered to be ripples of the sea. It is generally considered that Secondary wave retraces 50% on avg of primary trend. It is just the most occurring retracement level while there are many other possibilities too.   

  • Major Trend has three phases

This idea simply states that each trend unfolds in three phases of markets

  1. Accumulation: A phase which represents informed buying or astute investors buying which takes place just after the bad news prevailed in the market. While common traders and investors are still bearish on the markets, this phase is controlled by insider buyers or fund managers
  2. Public participation phase: This phase is considered to be the longest one where all the common investors and traders are convinced of a reversal and they jump in to buy. Even technical trend followers begin to participate in the trend.
  3. Distribution phase: This is the end of the rally phase which is commonly signaled by the increasingly bullish headlines on magazines and newspaper. This is the time where same informed investors of accumulation phase starts exiting the position. High of the rally is pinched during this phase
  • Average must confirm each other.

Average here is referred to indices of the market. This idea of Dow states that any two averages which reflects a bunch of stocks traded should confirm each others trend. As an example, it means that Nifty and Nifty bank in India, should move in the same trend on any point of time and if they are not trending in the same direction, then the divergence should be considered for trading.

  • Volume must confirm the trend

Volume is one the most crucial tenant after the price to be considered for technical research. This idea states that any price movement or trend must be associated with volumes. If the major trend is bullish, than each rally should be seen with Volumes while vice-versa for bearish trend.

  • Trend is assumed to be intact until reversal signal

A trend is said to be intact until any clear sign of reversal is seen on the charts. So, as we go deeper into analysis, we will come across many tools which are designed to sign a reversal and until they are not spotted on charts, we should consider a reversal.

So this were the basic ideas or tenants of Dow theory which should be considered as pillars for learning or practicing technical analysis.  In next post we will conclude Dow theory and move on to the next step.

Father of Technical Analysis

After we got some basics clear on ‘What is Technical Analysis’ and cleared some myths on the same, now lets get familiar with the roots of technical.

In 1882, Charles Dow and Edward Jones founded Dow Jones and Company. It is believed by most technical analysts that most theories where founded by DOW and he published his ideas while he wrote for Wall street Journal. Basic ideas of Dow is considered to be the pillars of technical analysis.

Dow was the first person to publish first ever stock market average which consisted of 11 stocks on 3rd July 1884. But after few year in 1897, DOW realized that two separate indices were required to gauge economy and then he constructed a 12 stock industrial average and 20 stocks average. As the Economy expanded, more and more stocks were included in the industrial index to gauge economy better and by 1928 , 30 stocks were included in the index.

Interestingly Dow has never written a book, but he had published his ideas in Wall Street Journal editorials. After his death in 1903, S.A. Nelson, complied everything in one book and it coined the word, “Dow Theory”, which is considered to be a based for learning technical analysis.

There are few basic tenants of the theory which helps to analyze stock and economy at any point of time. I shall discuss in detail on the theory in my next post.