Applying Dow Theory to Modern Markets
Introduction to Dow Theory
The Dow Theory, named after Charles H. Dow, one of the founders of The Wall Street Journal and the Dow Jones Company, is a fundamental framework used to analyze and understand market behavior. It was developed in the late 19th century and is still widely used by traders and investors today. The theory is based on six basic tenets that are used to interpret market trends and make decisions about buying and selling securities.
The Six Basic Tenets of Dow Theory
1. The Market Discounts Everything
According to this principle, the market price of a security is determined by every piece of relevant information. This includes not only the financial health of the company and its earnings prospects but also broader economic factors, political events, and investor psychology.
2. There are Three Types of Market Trends
Dow identified three types of trends: primary (long term), secondary (medium term), and minor (short term). These trends can be upward, downward, or sideways.
3. Primary Trends Have Three Phases
In an upward primary trend, there are three phases: accumulation (savvy investors start buying), public participation (the majority of investors join in), and distribution (savvy investors start selling). In a downward primary trend, the phases are distribution, public participation, and panic selling.
4. Indices Must Confirm Each Other
For a primary trend to be valid, it must be confirmed by more than one index. For example, if the Dow Jones Industrial Average is in an upward trend, it should be confirmed by a similar trend in the Dow Jones Transportation Average.
5. Volume Must Confirm the Trend
Volume should increase in the direction of the primary trend. For example, in an upward trend, volume should increase when prices rise and decrease when prices fall.
6. Trends Continue Until Definitive Signals Prove They Have Ended
A trend is presumed to be in effect until there is a clear signal that it has reversed. This principle is often summarized as “the trend is your friend.”
Applying Dow Theory to Modern Markets
While the Dow Theory was developed in the context of the stock market, its principles can be applied to any market, including commodities, forex, and cryptocurrencies.
1. Identify the Primary Trend
The first step is to identify the primary trend. This can be done by looking at the price chart of the security and identifying the overall direction of the price movement.
2. Look for Confirmation from Other Indices
Once you have identified the primary trend, look for confirmation from other indices. For example, if you are trading stocks, you could look at the trends in different sectors or in the broader market.
3. Monitor Volume
Monitoring volume can provide additional confirmation of the trend. If volume is increasing in the direction of the primary trend, this is a positive sign.
4. Wait for Clear Reversal Signals
Finally, it is important to wait for clear reversal signals before concluding that the primary trend has ended. This can help to avoid false signals and premature exits.
Conclusion
While the Dow Theory is over a century old, its principles remain relevant today. By understanding and applying these principles, traders and investors can gain a deeper understanding of market behavior and make more informed decisions.