5 Principles of Dow Theory 🏙️ The Modern Study of Technical Analysis 📈

5 Principles of Dow Theory 🏙️ The Modern Study of Technical Analysis 📈

Strategy

September 2024

Dow Theory is one of the earliest and most well-known principles of technical analysis. While originally developed in the early 20th century, Dow Theory still provides a solid framework for studying market trends and price movements today. This article will outline the 6 main tenets of Dow Theory and how they are applied in technical analysis. 🧑‍

1. Markets Discount Everything

One of the core beliefs of Dow Theory is that a security's price reflects all relevant information about its intrinsic value. The market is assumed to be essentially rational and efficient in processing new information quickly. As a result, technical analysts believe analyzing historical price data can provide insights into future price behavior. 📈

2. Markets Move in Trends

Dow Theory asserts that markets trend in the primary direction of the predominant trend. Technical analysts seek to identify and trade with the prevailing trend rather than against it. This tenet emphasizes identifying and profiting from continuation patterns rather than countertrend moves against the main trend. 📈

3. Trends Have Three Phases
3. Trends Have Three Phases

Trends are said to have three distinct phases according to Dow Theory - the accumulation phase, public participation phase, and dissipation phase. Technical analysts watch for signs that a trend is maturing and look to exit prior to a trend reversal. ⏳

4. Trends Continue Until Definitive Signs of Reversal

When a trend is in force, Dow Theory states it will remain intact until clear technical indications emerge that the trend has changed direction. Analysts, therefore, trail stop losses Move with prices and look for multiple technical confirmations of trend changes. ✅

5. Volume Must Confirm the Price Trends
5. Volume Must Confirm the Price Trends

Finally, Dow believed volume should accompany trend moves in the direction of the trend. Heavy volume on up days confirms uptrends, while heavy volume on down days confirms downtrends. Lighter volume against the trend may signal impending trend changes. 📈

Conclusion

While developed nearly a century ago based on stock market indexes, Dow Theory remains highly influential in technical analysis today. Its six tenets provide a simple yet robust framework for identifying and profiting from long-term price trends in the market. Understanding these core principles is crucial for any investor employing technical tools in their analysis and trading. 🧑‍💼

📮FAQ

Some Frequently Asked Questions.

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Dow Theory is one of the earliest and most influential principles of technical analysis, developed in the late 19th/early 20th century by Charles Dow. It asserts that stock market trends tend to move in primary, intermediate, and minor cycles and that the market discounts all information.

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The 6 main tenets of Dow Theory are: 1) Markets discount everything, 2) Markets move in trends, 3) Trends have 3 phases, 4) Trends continue until a reversal is shown, 5) Averages must confirm each other, 6) Volume must confirm price trends.

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To identify trends, Dow theory advocates looking for confirmation between the Dow Jones Industrial Average and Transportation Average changing direction in a sustained move. You also check that volume confirms the price move and look for continuation patterns rather than countertrend moves against the prevailing trend direction.

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The 3 phases of a trend in Dow Theory are: 1) Accumulation phase, where volume declines as the trend is forming. 2) Public participation phase, when volume accelerates as public awareness increases. 3) Dissipation phase, marked by decreasing volume as the trend nears its end.

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According to Dow Theory, heavy volume on up days in a prevailing uptrend confirms the trend, while heavy volume on down days in a downtrend confirms it. Lighter volume against the trend could signal a potential reversal. You analyze volume in conjunction with price moves.

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For the averages to confirm each other according to Dow Theory, both the Dow Jones Industrial Average and Transportation Average must clearly change direction and sustain the move in an unambiguous trend change. This confirmation between the two is necessary to assert a new primary trend.

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