The Dow theory is a theory describing the stocks prices behavior with time. The theory is based on a series of publications by Charles H. Dow (1851-1902), an American journalist, the first editor of 'The Wall Street Journal' and one of the founders of the 'Dow Jones and Co'. After the Dow’s death the theory was refined by William P. Hamilton, Charles Rhea, and George Schaefer and named as the 'Dow theory'. Dow himself didn’t use this term.
The Dow theory is a basis of technical analysis. It consists of six basic tenets.
There are three types of trends
Definition of a trend given by Dow is as follows: in ascendant (descendant) trend every next pike and every trough should be higher (lower) than the previous one.
According to the Dow theory, there are three types of trends: primary (or long-term), secondary (or intermediate), and minor (or short-term).
Every primary trend has three phases
The Dow theory confirms that every primary trend consists of three phases: the accumulation phase, the public participation phase, and a panic phase. During the former, most of the rational investors begin to buy (sell) stocks contrary to the collective opinion of the market. This phase is not attended by the sharp price movements because the number of such investors is small. At some point somee market players catch a new trend and active traders, using technical analysis, start following the rational investors. This phase entails price movements. During the third phase new trend is recognized by the whole market and agio begins. In this moment mature investors start getting their profit and close the positions.
Stock market takes into account all news
Stock price quickly respond to any new information. It concerns not only financial and economic indicators but also any news in general. This statement of the Dow theory conforms to the Efficient Market Hypothesis.
Stock indexes must confirm each other
Such statement applies to the Dow Industrial and Rail Averages indexes. Under the Dow theory, current trend and signals to the trend reverse must be confirmed by both indexes. And some mistiming in the signaling is accepted, i.e. one of the signals can give a sign of trend reversal earlier than another one. Trends are confirmed by the trades volume.
Dow thought that for trend defining it was necessary to take trade volumes into consideration. Stocks price change with small trade volume can be explained by numerous reasons and doesn’t characterize the development of the current trend or new trend.
Trend remains in effect until clear reverse occurs
This statement should be explained as follows: trend tend to continuation, so the price changes that are not corresponding to the trend, in case you are not sure, should be interpreted as temporary correction but not trend reversal.
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