Dow Theory

1. Dow Theory: Principles (any 4)

Dow Theory is named after Charles H Dow, who is considered as the father of Technical
Analysis. Dow Theory is very basic and more than 100 years old but still remains the
foundation of Technical Analysis.

The theory has 6 basic principles which are as follows:

- First Principle: The Stock Market Discounts All Information

The first principle of Dow Theory suggests that stock price represents sum total of hopes,
fears and expectation of all participants and stock prices discounts all information that is
known about stock i.e. past, current and above all stock price discounts future in advance i.e.
the stock market makes tops and bottoms ahead of the economy. It suggests stock market
discounts all information be it interest rate movement, macroeconomic data, central bank
decision, future earnings announcement by the company etc. The only information which
stock market does not discount is natural calamities like tsunami, earthquake, cyclone etc.

- Second Principle: The Stock Market Have Three Trends

Dow Theory says stock market is made up of three trends

a. Primary Trend
b. Secondary Trend
c. Minor Trend

Dow Theory says primary trend is the main trend and trader should trade in direction of this
trend. It says primary trend is trader’s best friend which would never ditch trader in this
volatile stock market. If primary trend is rising then trend is considered rising (bullish) else
trend is considered falling (bearish). The primary trend is the largest trend lasting for more
than a year.

The primary trend is considered rising if each peak in the rally is higher than previous peak in
the rally and each trough in the rally is higher than previous trough in the rally.
The primary trend is considered falling if each peak in the rally is lower than previous peak in
the rally and each trough in the rally is lower than previous trough in the rally.

Dow Theory says secondary trends are found within the primary trend i.e. corrections when
primary trend is rising and pullback when primary trend is falling. More precisely secondary
trend is the move against the direction of the primary trend. The secondary trend usually lasts
for three weeks to three months.

(Secondary trend when market is bullish)

(Secondary trend when market is bearish)

Dow Theory says that secondary trend consists of short-term price movements which is
known as minor trends. The minor trend is generally the corrective move within a secondary
trend, more precisely moves against the direction of the secondary trend. The minor trend
usually lasts for one day to three weeks. The Dow Theory says minor trends are unimportant
and needs no attention. If too much focus is placed on minor trends, it can lead to total loss of
capital as trader gets trapped in short term market volatility.

- Third Principle: Primary Trend Have Three Phases

The Dow Theory says primary trend have three phases a.

a. Accumulation Phase
b. Participation Phase
c. Distribution Phase

The Dow Theory says that the accumulation phase is made up of buying by intelligent
investor who thinks stock is undervalued and expects economic recovery and long-term
growth. During this phase environment is totally pessimistic and majority of investors are
against equities and above all nobody at this time believes that market could rally from here.
This is because accumulation phase comes after a significant down move in the market and
everything appears at its worst. Practically this is the beginning of the new bull market.

The participation phase is characterized by improving fundamentals, rising corporate profits

and improving public sentiment. More and more traders participate in the market, sending
prices higher. This is the longest phase of the primary trend during which largest price
movement takes place. This is the best phase for the technical trader.

The distribution phase is characterized by too much optimism, robust fundamental and
above all nobody at this time believes that market could decline. The general public now feels
comfortable buying more and more in the market. It is during this phase that those investors
who bought during accumulation phase begin to sell in anticipation of a decline in the market.
This is time when Technical Analyst should look for reversal in the trend to initiate sell side
position in the stock market.
In the above figure:

● Accumulation phase from April 2003 to June 2003 during which nobody believed that
markets could rally but intelligent investor took buy side positions in the stock market.

● Participation phase from July 2003 to January 2004 during which largest and longest price
movement occurred.

● Distribution phase from February 2004 to May 2004 during which smart money closed buy
side positions in the market.

- Fourth Principle: Stock Market Indexes Must Confirm Each Other

Charles H Dow believed that stock market as a whole reflected the overall business condition
of the country. In other words, stock market as a whole is a benchmark indicator to measure
the economic condition of the country. Dow first used basis of his theory to create two
indexes namely (i) Dow Jones Industrial Index and (ii) Dow Jones Rail Index (now
Transportation Index).

According to Dow:

a. Rise in these two indexes reflects that overall business condition of the economy is
good.

The basic concept behind this is that if production is increasing then transportation of goods
to customer should also increase i.e. performance of companies transporting goods to
consumer should improve. According to Dow Theory, two averages should move in the same
direction and rising Industrial Index is not sustainable as long as Transportation Index is not
rising.
 b. The divergence in these two indexes is a warning signal.

Under Dow Theory, a reversal from a bull market to bear market or vice versa is not signalled
until and unless both indexes i.e. Industrial Index and Transportation Index confirm the same.
In simple words, if one index is confirming a new primary uptrend but another index remains
in a primary downtrend, then there is no clear trend.

Basically, Dow Theory says that stock market will rise if business conditions are good and
stock market would decline if business conditions are poor.

- Fifth Principle: Volume Must Confirm the Trend

Dow Theory says that trend should be confirmed by the volume. It says volume should
increase in the direction of the primary trend i.e.

● If primary trend is down then volume should increase with the market decline.

● If primary trend is up then volume should increase with the market rally.

Basically, volume is used as a secondary indicator to confirm the price trend and once the
trend is confirmed by volume, one should always remain in the direction of the trend.

- Sixth Principle: Trend Remains Intact Until and Unless Clear Reversal Signals
Occur

As we are dealing in stock market which is controlled by only one “M” i.e. Money and this
money flows very fast across borders. Hence stock prices do not move smoothly in a single
line, one day it’s up next day it might be down.

Basically, Dow Theory suggests that one should never assume reversal of the trend until and
unless clear reversal signals are there and one should always trade in the direction of the
primary trend.

2. Dow Theory: Trends

Dow Theory is named after Charles H Dow, who is considered as the father of Technical
Analysis. Dow Theory is very basic and more than 100 years old but still remains the
foundation of Technical Analysis.

Dow Theory says stock market is made up of three trends:

 a. Primary Trend
b. Secondary Trend
c. Minor Trend

Dow Theory says primary trend is the main trend and trader should trade in direction of this
trend. It says primary trend is trader’s best friend which would never ditch trader in this
volatile stock market. If primary trend is rising then trend is considered rising (bullish) else
trend is considered falling (bearish). The primary trend is the largest trend lasting for more
than a year.

The primary trend is considered rising if each peak in the rally is higher than previous peak in
the rally and each trough in the rally is higher than previous trough in the rally.

(Primary trend when the market is bullish)

The primary trend is considered falling if each peak in the rally is lower than previous peak in
the rally and each trough in the rally is lower than previous trough in the rally.

(Primary trend when the market is bearish)

Dow Theory says secondary trends are found within the primary trend i.e. corrections when
primary trend is rising and pullback when primary trend is falling. More precisely secondary
trend is the move against the direction of the primary trend. The secondary trend usually lasts
for three weeks to three months.
 (Secondary trend when market is bullish)

(Secondary trend when market is bearish)

Dow Theory says that secondary trend consists of short-term price movements which is
known as minor trends. The minor trend is generally the corrective move within a secondary
trend, more precisely moves against the direction of the secondary trend. The minor trend
usually lasts for one day to three weeks. The Dow Theory says minor trends are unimportant
and needs no attention. If too much focus is placed on minor trends, it can lead to total loss of
capital as trader gets trapped in short term market volatility.

3. Dow Theory: Phases of Primary Trend

Dow Theory is named after Charles H Dow, who is considered as the father of Technical
Analysis. Dow Theory is very basic and more than 100 years old but still remains the
foundation of Technical Analysis.

The Dow Theory says primary trend have three phases:

a. Accumulation Phase
b. Participation Phase
c. Distribution Phase

The Dow Theory says that the accumulation phase is made up of buying by intelligent
investor who thinks stock is undervalued and expects economic recovery and long-term
growth. During this phase environment is totally pessimistic and majority of investors are
against equities and above all nobody at this time believes that market could rally from here.
This is because accumulation phase comes after a significant down move in the market and
everything appears at its worst. Practically this is the beginning of the new bull market.

The participation phase is characterized by improving fundamentals, rising corporate profits

and improving public sentiment. More and more traders participate in the market, sending
prices higher. This is the longest phase of the primary trend during which largest price
movement takes place. This is the best phase for the technical trader.

The distribution phase is characterized by too much optimism, robust fundamental and
above all nobody at this time believes that market could decline. The general public now feels
comfortable buying more and more in the market. It is during this phase that those investors
who bought during accumulation phase begin to sell in anticipation of a decline in the market.
This is time when Technical Analyst should look for reversal in the trend to initiate sell side
position in the stock market.

In the above figure:

● Accumulation phase from April 2003 to June 2003 during which nobody believed that
markets could rally but intelligent investor took buy side positions in the stock market.

● Participation phase from July 2003 to January 2004 during which largest and longest price
movement occurred.

● Distribution phase from February 2004 to May 2004 during which smart money closed buy
side positions in the market.

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