Dow
Theory At a Glance
Dow Theory
is based on the philosophy that the market prices
reflect every significant factor that affects supply
and demand - volume of trade, fluctuations in exchange
rates, commodity prices, bank rates, and so on. In
other words, the daily closing price reflects the
psychology of all players involved in a particular
marketplace - or the combined judgment of all market
participants.
The goal of
the theory is to determine changes in the major trends
or movements of the market. Markets tend to move in
the direction of a trend once it becomes established,
until it demonstrates a reversal. Dow theory is interested
in the direction of a trend and doesn't offer any
forecasting ability for determining the ultimate duration
of a trend.
Much of
today's technical analysis is based on Dow's original
"trend following' system -
- Classification of
a trend
- Principles of confirmation
or divergence
- Use of volume to confirm
trends
- Use of percentage
retracement
- Recognition of major
bull and bear markets
- Signaling the large
central section of important market moves
- Dow theory has been
successful in identifying 68% the major trends
over the years
The three
trends are:
- Uptrend: successively
higher peaks (highs) and higher troughs (lows)
- Downtrend: successively
lower peaks and troughs
- Sideways Channel:
peaks and troughs don't successively rise or fall
Each market
trend has three parts compared to tides, waves and
ripples.
- The primary (major)
trend or tide is a long term trend lasting from
a year to several years
- The secondary trend
(or mid-term trend) or wave lasts three weeks
to three months and represents corrections of
one third to two thirds of the previous movement
- most often fifty percent of the movement.
- The minor trends (short-term
trends) or insignificant ripples last less than
three weeks and represent fluctuations in the
secondary trend.
The
major trend has three phases:
- Accumulation phase:
knowledgeable investors buy issues with good potential
- Public Participation
phase: Prices increasing rapidly and bullish markets
are reported
- Distribution phase:
Astute investors sell first, thereby leading the
public
A Major
or Long-term Stock Market Trend:
- Must be confirmed
by the Dow Averages, calculated on closing prices
only, not the daily high or low (this provides
the overall stock market trend)
- Should have volume
increase/decrease in the direction of the trend
- Stays in effect until
it gives definite reversal signals
Shortcomings
of the Dow Theory:
- The major criticism
of the Dow Theory is its slowness: It misses about
25% of a move before giving a signal, primarily
because it is a trend following system designed
to identify existing trends.
Also see
trendlines, tops
& bottoms, and triangles.
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