The Dow theory can be seen as the foundation for the study of technical analysis.
Dow Theory believes that the stock market as a whole is a reliable measure of overall business conditions in the economy. By analyzing the overall market, one can accurately assess such conditions. Thereby identifying important market trends as well as the trend of each stock.
In other words, when the stock market goes up or down, even if there are some stocks going against the market, ¾ of the stocks will move like the market & surely the remaining stocks will be affected more or less by the trend.
Dow Theory is associated with the stock average index with the name “Dow Jones Index”, a collection of 30 large & leading US stocks.
1. Disadvantages of Dow Theory.
Dow Theory is important in technical analysis, but it also has disadvantages such as:
- Large Lag. The Dow Theory attaches great importance to trading the main trend. That is, it will signal to sell after the top forms or buy after the bottom forms for a large period with a large price segment. That causes a rather large delay in judgment and trading compared to some other methods.
- The trend cannot be clearly classified. Dow Theory has 3 trends including primary trend, secondary trend, and minor trend. It is difficult to accurately identify trends and identify trend reversals.
- Dow Index. Dow Theory uses averages to confirm trends, but the indexes that make up the average are influenced by a variety of factors of their own.
2. Main tenets of Dow theory.
Dow Theory has six main tenets:
Price reflects everything:
This principle is based on the efficient market hypothesis, which states that asset prices combine all available information. That is, everything must be shown in terms of price, the price reflects all the information, not excluding any factors.
Accordingly, all factors (potential income, future, competitive advantage, management capacity, ROA, ROE, risk, stock valuation indexes, dividend level …) are shown. price & are all correct, even if not everyone knows all or any of these details. In a more rigorous understanding of this theory, even future events are discounted as risks.
The market has 3 main trends:
In Dow theory, the market is represented by 3 main trends: Primary trend (level 1), secondary trend (level 2), and minor trend (level 3).
Major Trend (Level 1). Trends usually last for a year or more. Trends represent major market movements such as bullish or bearish. This is considered the main trend to invest in for high returns.
Secondary Trend (Level 2). Located within the primary trend, usually lasting from 3 weeks to 3 months. The secondary trend tends to be opposite to the primary trend. Understand as a retracement in a bull market or a rally in a bear market.
Minor Trend (Level 3). Located in a secondary trend, usually lasting from a few days to 3 weeks. Small trends are considered market noise, they are noisier and associated with more traps. This trend is often less invested because it carries a high risk and price volatility is usually not large.
The main trend consists of 3 phases:
For bull markets:
- Accumulation phase. The price increase starts at a moderate level with an increase in volume.
- Bullish phase (massive volatility). Small investors begin to notice an uptrend and enter the market to make a profit. This is the longest period and usually has the greatest price volatility.
- Excess (transition) phase. The market reaches a point where experienced investors begin to withdraw from the market while new small investors continue to add to their positions.
- Distribution Phase. The decline in price starts at a moderate level along with an increase in volume.
- Bear Phase (Major Volatility). Small investors begin to notice a downtrend and withdraw from the market to reduce their losses. This is the longest period and usually has the greatest price volatility.
- Panic phase (desperate). Investors see no hope of a correction or a rebound and continue to sell off on a large scale.
Indicators must confirm each other:
To confirm an established trend, the Dow & the market average must confirm each other. This means that trend signals occurring on one indicator must match or correspond to trend signals on the other in order to confirm an established trend. If one indicator shows a new up (bearish) trend, but the other is still in the main down (up) trend, the new trend is not considered established.
Dow uses the industrial average and the transportation average to confirm each other. Dow Theory assumes that if business conditions are healthy when the industrial average rises, the transportation average rises as the profit from the transportation of goods increases, and vice versa.
Volume must confirm the trend:
Volume usually increases if the price moves in the direction of the main trend and decreases if the price moves in the opposite direction. That is when the primary trend is up (down) the price, then to confirm that trend, the volume must also increase (decrease) according to the main trend, and in the secondary trend down (up) the price, then the volume will decrease (increase). ) follow. The volume is opposite to the trend, signaling a weakness in the trend, and a high probability that the market is about to reverse the trend.
If the primary trend is bullish, buying volume will increase as price rises and decrease in bearish secondary trends as traders still believe in the primary uptrend. If selling volume increases during a bearish secondary trend, then it could be a sign that many market participants are turning bearish.
If the primary trend is bearish, selling volume will increase when the price is falling and decrease in bullish secondary trends as traders still believe in the primary downtrend. If buying volume increases during a bullish secondary trend, it could be a sign that many market participants are moving into a bullish trend.
The trend persists until a clear reversal:
Reversals in primary trends can be confused with secondary trends. It is difficult to determine whether a secondary trend within the primary trend is a reversal of the primary trend.
Dow Theory favors caution, emphasizing that a possible reversal can be confirmed by comparing indices. And only when there is clear confirmation will the trend reversal be confirmed.
Although Dow theory is important and has a great influence on technical analysis, it should be considered in combination with other technical analysis methods to overcome the limitations of Dow theory such as Accurately identifying trends, reversals, and lags…