Dow Theory

Dow Theory is one of the most foundational and influential theories in technical analysis. It was developed by Charles Dow, the founder of the Dow Jones & Company and co-founder of the Wall Street Journal, in the late 19th century. The theory's primary focus is to identify trends in the market, with the aim of providing traders with a framework for making informed investment decisions.

The theory is based on six tenets, which are as follows:

1. The market discounts everything: Dow believed that all information that can affect the market is already reflected in the price of a stock, index, or market.

2. The market moves in trends: The theory posits that the market moves in three distinct trends - the primary trend, the secondary trend, and the minor trend. The primary trend is the long-term trend and can last from a few years to several decades. The secondary trend is the medium-term trend that runs counter to the primary trend and usually lasts a few weeks to a few months. Finally, the minor trend is the short-term trend and can last from a few days to a few weeks.

3. The trend has three phases: The primary trend is broken down into three phases - accumulation, public participation, and distribution. In the accumulation phase, informed investors begin to accumulate stocks, leading to a rise in prices. In the public participation phase, the general public begins to take notice of the market and gets involved, resulting in further price increases. Finally, in the distribution phase, informed investors begin to sell their stocks, leading to a decline in prices.

4. The trend is confirmed by market indices: Dow believed that trends could be confirmed by market indices, such as the Dow Jones Industrial Average (DJIA) or the S&P 500. If an index is moving in the same direction as the trend, it confirms the trend's validity.

5. Volume confirms the trend: Dow also believed that the trend's strength could be confirmed by trading volume. If the volume is high during an uptrend, it confirms the trend's strength, and if the volume is low during a downtrend, it confirms the weakness of the trend.

6. Trends persist until a clear reversal occurs: The final tenet of the theory is that trends tend to persist until a clear reversal occurs. In other words, a trend is more likely to continue than to reverse until there is a clear indication that the trend is changing.

Dow Theory is widely followed by traders and investors, and its principles have been incorporated into many technical analysis tools and strategies. For example, many traders use moving averages to identify the primary trend and then look for opportunities to enter or exit the market based on the trend's strength and direction.

In conclusion, Dow Theory is a foundational theory in technical analysis that provides a framework for identifying trends in the market. By understanding the principles of the theory, traders can make more informed investment decisions and increase their chances of success in the market.