So, the other day, Dev and Tara were chilling at a cafe, savoring their delicious coffee, when Tara expressed her eagerness to learn more about technical analysis.
Dev, with a smile on his face, knew this was his chance to introduce her to one of the most important foundations of Technical Analysis – the Dow Theory.
“Have you ever heard of Charles Dow?” Dev inquired. “He was a financial journalist during the late 1800s and early 1900s, and he’s widely recognized as the father of modern technical analysis.”
Tara shook her head with keen interest, asking Dev to enlighten her further.
“Dow Theory’s origins date back to the late 1800s, a time when Charles Dow was working as a financial journalist in New York City,” Dev said.
“As you can imagine, the stock market was still a relatively new concept, and there was much ambiguity about how to evaluate it. Dow and his partner, Edward Jones, founded Dow Jones & Company. They were attempting to develop a technique to forecast market trends for their readers at the Wall Street Journal,” Dev continued.”Their research was based on the concept that the stock market reflects the overall well-being of the economy and that shifts in the economy will be mirrored in the market.”
Tara listened intently and connected the dots, “Oh, I get it now. That’s why the renowned Dow Jones Industrial Average (DJIA) is named after them, right?”
“Absolutely,” replied Dev and continued “Charles Dow is the founder of DJIA and several other indices. His work began with research and a series of articles he wrote for the Wall Street Journal. However, the term ‘Dow Theory’ was coined later on by William Hamilton who was his successor at Wall Street Journal and it became popular when Robert Rhea, an early technical analyst wrote a book called ‘The Dow Theory’ in the 1930s.”
“As you can imagine,” Dev continued, “the market has changed over time, and with that, the Dow Theory has also evolved. Several variations and interpretations of the theory exist today, based on various technical indicators and methods of interpreting market trends. However, the core principles have remained consistent.”
Tara was fascinated by the history and evolution of the Dow Theory, “Wow, it’s amazing how it all started with their research and now it’s evolved into an entire field of technical analysis.”
Beginning to see the value of the theory, she asked Dev “So what are the core principles of the Dow Theory?”
“There are six key tenets,” Dev commented and began outlining and explaining the six tenets of Dow Theory.
1. The averages discounts everything.
“Market indices or averages incorporates all available information”, Dev elaborated.
“Essentially, this implies that the stock price reflects all known information about a company, while indices, which are made up of a group of stocks, reflect a sector’s or economy’s health. Prices are influenced by the thoughts, biases, emotions, and expectations of all market players, reflecting general consensus. Moreover, in case of any sudden and unexpected events, the price adjusts quickly factoring in the expected consequences.”
2. The market moves in trends.
“According to Dow, the stock market moves in trends, which he classified into three parts: primary, secondary, and minor,” Dev illustrated.
“The primary trend is the longest-term trend and can last for several years. Dow believed that primary trend is not susceptible to manipulation, and is instead driven by the long-term economic progression or contraction of a market or industry. The secondary trend is a shorter-term trend that typically lasts several months to a year and represents the market’s reaction to primary trends. Lastly, minor trends are the smallest and shortest-term trends, lasting only a few days.”
3. Market trends have three phases
Dev revealed the third principle of Dow Theory, which further piqued Tara’s interest. “The market has three phases,” Dev described, “namely the accumulation phase, public participation phase, and distribution phase.”
Tara listened intently, eager to learn more.
He continued, “During the accumulation phase, the ‘smart money’ invests in stocks with the expectation of future growth. As the public catches on, the public participation phase begins, leading to an upward trend in stock prices.
Finally, in the distribution phase, the ‘smart money’ starts selling their shares, causing the market to level out or even decline.”
ETMarkets.comHowever, Tara was curious about what “smart money” meant.
“Smart money refers to savvy investors who make big bucks by being ahead of the curve and making smart investments based on research,” Dev replied.
“It’s usually institutional investors like hedge funds or private equity firms who have significant resources to conduct research and analysis. But it can also refer to individual investors who have a proven track record of making successful investments.”
Thrilled to learn something new, Tara urged Dev to continue. “Sure thing,” Dev grinned. “Let’s move on to the fourth tenet of Dow Theory.”
4. Stock market averages must confirm each other.
“One of the essential tenets of the Dow Theory was based on a concept known as ‘Confirmation’, that stock market averages must confirm each other to confirm a trend.”
Dev went on to explain further. “Dow believed that to confirm a trend, the Dow Jones Industrial Average and the Dow Jones Transportation Average must move in the same direction, showing higher highs and higher lows for an uptrend (lower highs and lower lows for a downtrend). However, if these averages moved in opposite directions, it could indicate a potential trend reversal.”
“Dow also used only closing prices because he believed that the closing price is the most reliable indicator of market sentiment. He felt that the closing price reflected the collective views and opinions of all market participants, and it provided a clear picture of the supply and demand dynamics of a particular stock or index.” Dev added.
ETMarkets.com5. Volume must confirm the trend.
The fifth tenet of the Dow Theory emphasized the importance of volume in confirming market trends.
Dev elaborated “According to this principle when the market is moving in an upward direction, the volume should increase as prices rise and decrease as prices fall. Conversely, when the market is trending downward, the volume should increase as prices fall and decrease as prices rise”.
ETMarkets.com6. Trends remain in effect until a clear reversal occurs
“Now let me shed some light on the sixth tenet of Dow Theory, which, according to Dow himself, was a crucial principle to follow!” Dev started explaining.
“Dow firmly believed that trends don’t come to an end until there’s a clear sign of a reversal, and that’s an exciting notion to hold onto! As a trader, you must never assume that a trend has finished without witnessing a clear signal of a reversal. This could include a change in the direction of the market averages, a change in volume, or a change in the behavior of the market participants. Always remember, the trend is your friend until it ends!”
As Tara pondered the intricacies of Dow theory, she asked Dev, “Wouldn’t it make sense to ride the primary trend for maximum benefit?”
Dev sensed Tara was getting the hang of things and replied, “Absolutely, Dow believed in capturing the primary trend as it can last for years, and reversals are quite rare. Premature exits can lead to underperformance despite identifying the trend.”
“In uptrends, there are higher highs and higher lows, so should we still hold on when prices dip?”, inquired Tara.
Dev smiled knowingly, “Ah, that’s a common mistake amateurs make, trying to predict the highs and lows. The truth is, no one knows the high or low until a significant price reversal occurs. But here’s the thing: In an uptrend, prices rise, and so do the highs and lows. Overall, the price rises are larger than the declines. So, as long as the trend is intact, trading in the direction of the uptrend will yield higher profits than losses. When losses start to increase compared to profits, it could signal the trend is ending or reversing.”
Tara was fascinated by the Dow Theory and how it could be applied to technical analysis. “Thanks for explaining all of that,” she said. “I can see why it’s such an important theory in the field.”
Dev smiled. “It has definitely stood the test of time,” he said. “And it’s still widely used by investors and technical analysts today. However, it is important to note that neither the Dow nor Hamilton and Rhea considered this theory to be a magical formula for profit. They were aware that it was not infallible.”
Part 1
https://economictimes.indiatimes.com/markets/stocks/news/learn-with-etmarkets-understanding-price-trends-key-to-successful-technical-analysis/articleshow/99006193.cms?from=mdr
Part 2
https://economictimes.indiatimes.com/markets/stocks/news/learn-with-etmarkets-want-to-understand-price-trends-here-are-6-key-techniques/articleshow/99182923.cms
(The author is CEO TradingHeads.com, Yubha.com)
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)
