Dow Theory Knowledge Technical Analysis

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.

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