What is Dow Theory? Beginner’s Guide to Market Trends & Principles

What is Dow Theory? An easy explanation

Has it ever crossed your mind that investors predict the ups and downs of the stock market? Well, they often use Dow Theory, a method of technical analysis for the stock market. Dow Theory helps to understand market movements, especially for long-term trend followers and smart investors.

What is Dow Theory?

Dow theory, given by Charles H. Dow, is a method of analysing market trends. The focus is on analysing the market trends so that the investors can anticipate future trends and make a sound decision.

The Dow theory is based on three main principles:

The market moves in trends (uptrends, downtrends, and sideways trends).
These trends can be analysed and confirmed using a specific rule.
The market discounts everything (all information is already priced in)

Fundamentals of Dow Theory:

There are mainly six fundamental key points of the Dow theory;

Market Discounts Everything: The Concept Behind this simple concept is that the stock market reflects all available information — economic news, earnings reports, political events, interest rate changes, and other factors playing a role in it. All these mentioned factors are ‘priced to stock’.

a. In simple words, how well a stock will return can be reflected in its price trends.

b. The best part about it is that, using this method, the investors don't need to put a lot of effort into analysing a specific stock.
Market Trends: There are three types of market trends associated with Dow Theory, which are mentioned below:

a. Primary Trend (1-3 years): This is the kind of trend that represents the overall direction of the market. This reflects the nature of the market sentiment, being bull or bear.

b. Secondary Trend (3 weeks to 3 months): This kind of market trend is short-term in nature, focusing on corrections or rallies within the primary trend.

c. Minor Trend (Days to weeks): This market trend indicates the daily fluctuation in the market and its bullish or bearish nature. Now very useful for long-term investors.

d. Example: At the time of the pandemic's market downfall, the primary trend was down, followed by the secondary uptrend caused by the push.
Now, we will understand the phases of the Primary trend The Primary trend has three phases explained below:

a. Accumulation Phase: In this phase of the primary trend, the investor with a higher risk appetite invests in stock when the other, more fearful investors wait to follow the bold investors' lead.

b. Public Participation Phase: As optimism grows over time and more general public and non-traders try to earn profits with the hyped trends.

c. Excess Phase: In this phase, some of the new investors impulsively invest with the influence of trends irrationally, and some of them end up exiting the market with a loss.

d. Note: All the above phases explained vary based on the nature of the market sentiment of bull and bear. Further explanations are given below.
Averages Must Confirm Each Other: In the concept of the Dow Theory, it is preferred that the various indexes should be tallied with some of the price indexes, such as the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA).

a. Application: When the DJIA index is showing a high average in index price, but DJTA is not tallying with it, that means the upward trend is only temporary.
Volume Must Confirm the Trend: The volume is considered secondary to the average index in Dow theory, but it is important. An upward trend supported by increasing volume is considered stronger than one with weak volume.
Trends Persist Until a Clear Reversal Occurs: This means when a trend is established, it will last until confirmed evidence is showed up showing a reversal outcome against the trend. It is suggested to wait for confirmations instead of guessing.

Let's deep dive into the phases of the market with the context of Bull and Bear:

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Bull Market Phases>

Accumulation Phase: After a long downturn, the market starts regaining its position. In this phase, the Bull will try to buy as many stocks as they can in this period, pushing the market into an upward trend.
Public Participation: As the market progresses general public gets attracted, and the flow of investment increases.
Excess point: At this point, the market is flooded with investors, which leads to an irrational investment trend.

Bear Market Phases>

Distribution: The smart bear-type investors start selling their holdings into their strength.
Public Reaction: The decrease in the value of stock causes panic in investors/public, and then they start selling their holdings, causing a downward trend in the market.
Despair: The prices of the stocks see a massive downfall, and most of the investors exit the market.

How Dow Theory Applies to Today’s Markets?

The Dow theory was introduced a long time ago, but it is still applicable in modern stock market scenarios. Although the DJIA and DJTA are still in use, modern traders often use other indexes like:

In India, modern traders primarily use the Nifty 50 and Sensex as benchmarks for stock market performance.
Alongside other sector-specific and broader market indices. -These indexes represent the performance of major companies listed on the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE).
The concept of cross-market confirmation is applied here.
- For example, when the Sensex is indicating a rise, the smart investor will cross-check it with the Nifty50, and if it doesn't match with it, the trend showing in the Sensex will be considered as temporary.

Tools to apply Dow Theory:

Charting Platforms: Some of the popular charting platforms can be used in India, such as Zerodha Kite, TradingView, Fyers One, and 5paisa, which will help an investor in comparison.
Indicators That Complement Dow Theory: An investor should keep indicators in mind to make a sound decision based on Dow Theory. a. On-Balance Volume (OBV). b. Moving Average Convergence Divergence (MACD). c. Relative Strength Index (RSI). d. Moving Averages (MAs). e. Volume.

Dow Theory vs Other Technical Frameworks:

Feature	Dow Theory	Elliott Wave Theory	Moving Average Systems
Basis	Trends and volume	Waves of crowd psychology	Trend-following signals
Timeframe	Long-term	Varies	Short to mid-term
Confirmation	Volume + index match	Fibonacci-based waves	MA crossovers
Simplicity	Moderate	Complex	Simple

Benefits of the Dow Theory:

The Dow theory helps an investor to avoid emotional decisions and provides logical, rational decisions, with a clearer market direction.
Make the investor focus on long-term strategies instead of being fixated on quick-money schemes.
The best part of Dow theory is its versatility, which can be applied to stocks, crypto, indices, and even commodities.

Limitations of Dow theory:

No theory is perfect, and sure, Dow theory also has its drawbacks as well, some of them are mentioned below-

It has a lagging nature, which often results in a delay in providing a proper picture of the market trend.
The interpretation of the Dow theory is very subjective; therefore, it requires judgment to confirm reversals.
The Dow theory is not suited for individual stocks as it only focuses on the market trend as a whole, and it lacks specificity.

How can a beginner use the Dow theory?

A beginner should focus on major indicators and tally with various sources rather than being fixated on one.
To observe and identify the long-term trend, a beginner should use weekly charts.
Watching for Divergence can help signal a reversal. When volume or index confirmation fails.
A beginner investor acts impulsively, and mostly makes decisions based on emotions; therefore, they need to be Patient: Wait for confirmation before acting.

Conclusion:

Dow theory is one of the market analytical theories, which was introduced a long time ago but remains relevant as of today's standards because the psychology behind price movements has not changed. This theory provides logical disciplines relevant to price, an approach to understanding these movements and helps investors avoid emotional decisions, which often lead to regrets. Instead, they should wait for the trend confirmation before acting impatient. The Dow theory is a time-tested framework that is still effective. Understanding the market phases, trends and confirmations, with proper knowledge of volume dynamics, can help the investor to make sound investment decisions.

Frequently Asked Questions (FAQs) on Credit Scores

Can Dow Theory be used in intraday trading?

The Dow theory is not effective in intraday trading as it is built for long-term trend identification.

Is Dow Theory useful for crypto markets?

Yes, the Dow theory can be applicable for the crypto market when it is properly used to analyse trends, volume, and investor psychology apply to all asset classes.

How often should I check trends?

An investor can check trends weekly, or monthly reviews will be best. But they should avoid daily over-checking.

Does Warren Buffett use Dow Theory?

YThere is no clear indication or any statement that Buffett follows technical analysis, but he believes in long-term trends, which is a core principle of Dow Theory.

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