Dow Theory is one of the most used & well known theory used in technical analysis. The Concepts & principles are designed in a way that it is easy for a trader to understand.
Know everything about Dow Theory here.
About Dow Theory
Dow Theory is a part of technical analysis that helps the traders in identifying the market trends to generate profits.
Charles H. Dow came up with this based on his fundamental idea that the analysis of the stock market can help the analyst or trader understand various business conditions and thereby predict the market trends and the price movements of stocks.
Even though the theory came in years ago, several technical analysts still prefer it. The theory involves some basic principles and concepts, which we have discussed further in this section.
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Basic principles of Dow Theory
The Dow Theory is largely based on the following significant tenets devised by Charles Dow. The major principles are as follows.
The Stock Market Discounts Everything
The Dow Theory is largely based on the basic concept of the efficient market hypothesis (EMH).
The price of an underlying asset has an influence by all the changes in the surrounding business conditions.
The changes in the market conditions directly reflect all the market indicators.
Categories in Dow Theory
According to the theory, 3 different kinds of market trends can be observed which are the primary, secondary, and minor trends.
- Primary trend– It is the most important market trend that remains for a year or more. It is a long-term market trend and can be either bullish (primary uptrend) or bearish (primary downtrend). Moreover, it is suitable for traders in long-term trading.
- Secondary trend- These are in fact reactions or corrections to the primary trends and it usually lasts from days to months.
- Minor trend– These are the shortest market trends occurring daily and even for daily fluctuations or market noise.
Market indices must confirm with each other
Traders and analysts can confirm a market trend only if all the stock market indices move in a particular direction confirming to each other.
For instance, a bearish market trend can be confirmed only if all the averages move in the downward direction.
Volume Confirmation in Dow Theory
Along with trading prices, the market trends have to be confirmed by the trading volumes as well.
That is, to confirm an upward market trend the trading volumes have to increase along with the increasing prices and decline with the price drop.
Alternatively, in a downtrend, the volumes have to rise with the price drop and decrease with a price rise.
The Market Trends continue until Clear Signal
Traders might get confused with reversals and secondary reactions in the primary trends.
Therefore, Dow points out that, it is very important to confirm the important signal so that the minor and secondary trends within the primary trend are not misunderstood as a reversal signal.
Significance of Closing Price
Out of the 4 major price levels, open high, low, and close, the closing price is very important as it provides the final state of the overall stocks on a particular day.
The role of Sideways Market
The sideways market trend can effectively take the place of secondary market trends.
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Phases of Market according to Dow Theory
According to this the Dow theory the market trends comprise 3 different phases, the accumulation phase, the markup phase, and the distribution phase.
It is one of the most basic phases usually observed after a huge sell-off when traders would not buy new shares due to the fear of further sell-off situations.
It is the institutional, long-term investors who would buy maximum shares in such a situation, accumulating as many shares as possible.
This phase marks the baseline of the market since these institutional buyers support further price drops by buying shares from all interested sellers.
These institutional investors are sometimes referred to as ‘smart money’ and this phase may last for months.
Mark Up Phase
We can identify the markup phase with an upward trend in the stock price. The price is quick and sharp and once the price reaches its highest value the market starts attracting the public to invest.
This phase attracts public investments and is therefore also referred to as the public participation phase.
It is the phase when institutional investors begin to distribute their acquired market shares.
The distribution of shares by the astute investors at regular intervals controls the price from going further higher.
However, selling all the shares further creates a period of a huge sell-off. Therefore, this phase often happens by a new accumulation phase, beginning the cycle once again.
This cycle of phases is often different for different markets and can last for months or even years.
Patterns in Dow Theory
The Dow Theory is a form of technical analysis and various patterns help the analyst and the trader in identifying the possibilities in trading.
The popular Dow Theory patterns include the Double bottom and Double top formation, the triple bottom and top, trading range, and the flag formation.
Each of these patterns is discussed further in the following sections.
The Reverse Patterns
The double and triple patterns are two types of reverse patterns since the stock price recovers and bounces back to the particular levels within a limited time frame.
Consider a situation when the stock price is at one of its lowest levels, the price may show some significant recovery for a short period of two weeks or more and then drop down again.
This situation creates a double drop pattern in the chart and is referred to as the double bottom pattern. This pattern indicates a bullish trend and traders can profit from buying shares.
It happens in a situation when the stock price trends up to a particular level, comes down, and then again bounces back to the top-level within two weeks or more.
The double top pattern indicates a bearish trend and the traders can look for opportunities to sell.
Triple Bottom and Triple Top
These patterns are in the way the double bottom and double top patterns are formed.
The only difference is that in this case, the price level bounces back twice, that is the price hits a particular point thrice.
The market trends may continue to depict the bouncing pattern more than thrice as a result of which the price seems to show a sideways trend.
The sideways trend in the market creates a range within which the price fluctuates and usually this situation is difficult for trading.
However, there are opportunities in this range to generate profits, for which the upper range limit acts as the resistance level and the lower limit the support level.
The range pattern may continue for months or a few years and the width of the range comes by the duration of the pattern.
Stocks exhibit this range pattern or sideways trending market either due to the lack of some basic factors like new announcements, product launches, etc. or during the waiting period of new changes.
However, a change in both these factors can produce a range breakout with high volumes and a higher rate of price change.
A stop loss is essential while trading using range breakouts. An example of trading in range breakout with the use of stop-loss is as follows,
- Consider the stock in a sideways market, with the price oscillating between Rs.150 and Rs.300.
- Consider the range breakout to be at Rs.300, with the stock trading at Rs.350. In this case, the trader has to keep Rs.300 as the stop loss.
- The minimum price would be Stop loss + range width.
In this case it is, Rs.300 + 150 = Rs.450
Flag Pattern in Dow Theory
A flag pattern happens when the stock price rises sharply follows by a small decline of around 10% (correction). The pattern is what we call a flag formation since it creates a look of the flag on the leg.
The largest benefit of the flag formation is that, it provides the trader an additional opportunity to buy the shares that they might have left out.
This kind of pattern forms as a result of selling too many shares to gain profit, which further leads to a drop in price.
Reward to Risk Ratio (RRR) in Dow Theory
The Reward to Risk Ratio is a general concept in the trading system. Its general relation to the trading makes it important to mention here.
The fundamental benefit of RRR is that it calculates the possible returns during any particular period. Consider the following hypothetical example for better understanding.
- A stock trade enters at Rs.200 with Rs.180 as the stop loss and Rs.230 as the expected target.
- The risk involved is Rs.200 – Rs.180 = Rs.20
- The expected profit is Rs.230 – Rs.200 = Rs.30
- RRR = expected reward/ risk value, therefore RRR, in this case, would be 30/20 = 1.5
- That is, for every Rs.1 risk the trader can expect the benefit of Rs.1.4
The trader analyzes minimum RRR for adjustment analyzing the risks.
Role of Dow Theory in the checklist
The Dow Theory has a prominent place in the trading checklist. It helps the trader is looking at the trade from the perspective of the theory.
Moreover, it provides an additional confirmation to begin any trade.
Dow Theory – Conclusion
The Dow Theory is one of the most important theories of technical analysis. It was developed in the late 19th century by Charles Dow and is prominent even today.
The theory has had supporters as well as critics equally over these years. It is completely on the fundamental principles which we have described in this section.
Traders can benefit from the trade by following the trade and interpreting all the distinct patterns involved in it.
Therefore, traders can analyze the trades and the related profits using the Dow Theory.
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