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Invented by Charles Dow (famous for his industrial average indexes), Dow Theory is the root behind most technical analysis. Although the theory is of limited use to day trading specialists, it is worth studying as it highlights some interesting facts about the market. There are 6 threads to the theory:- 1 The Averages Discount Everything, i.e. if a stocks price accurately reflects everything that is known about it, then the market averages (the indices) reflect everything known by all stock market participants about all stocks. 2 The Market Is Comprised of Three Trends - the Primary trend, Secondary trends, and Minor trends. The primary trend is either bullish or bearish and may last for several years. Higher highs and higher lows mean the primary trend is up. Lower highs and lower lows mean the primary trend is down. Secondary trends are shorter term reactions against the Primary trend lasting only a few months (and retracing up to two-thirds of the previous Secondary trend). Minor trends last only a few days or weeks, can be manipulated, and should therefore be discounted. 3 Primary Trends Have Three Phases - firstly aggressive buying by the smart money while everyone else is depressed and bearish. Secondly, accumulation as everyone starts to get more bullish. Thirdly, the peak as the general public create a buying frenzy. 4 The Averages Must Confirm Each Other - the Industrials and Transports indices must agree if the trend is to truly change. 5 The Volume Confirms the Trend - Volume should expand in the same direction as the primary trend. 6 A Trend Remains Intact Until It Gives a Definite Reversal Signal - e.g. in order for an uptrend to reverse, prices must have at least one lower high and one lower low (and vice versa for a downtrend). |
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