Dow Theory: The Foundation of Technical Analysis Posted at 12:15 PM | in Charles Dow
and his partner Edward Jones started Dow Jones & Company in the year 1882. It is believed
that much of what all the technicians use around the world have its origins from the
original "Dow Theory" as proposed by Mr. Charles Dow through a series of editorials in the
Wall Street Journal. On July 3,1884, Dow published first stock market average comprising
of closing prices of 11 stocks, nine Rail Road companies and two Manufacturing firms. This
was the first time someone used averages to define the overall movement of the market.
The market averages in form of Sensex and Nifty we use today in Indian market have its
origins from this concept as proposed by Mr. Charles Dow.
In the year 1984, Market Technician Association presented Gorham-Silver bowl to Dow
Jones & Company for the lasting contributions they made in the field of investment
analysis.
The 6 points of Dow Theory can be summarized as below:
1) Averages Disconuts Everything - It states that the overall mood of the market is
reflected in the index, that means if our sensex and nifty indices are rising constantly that
means the overall trend of the market is bull and most of the stocks will be rising. All the
economic policies, investor's sentiments, futures expectations are reflected in the averages.
2) Three Trends of the Market- Dow said that there are three trends in the market
Primary, Secondary and Minor. He compared these trends with tides, waves and ripples in
the see respectively. Tides are major moves of the market lasting for period more than a
year, Secondary Trend usually lasts from three weeks to three months while the minor
trend is for short term for a period less than three weeks. By trend here we mean the
overall direction of the price movement. So, by primary trend we would mean the price
movement for a period lasting for more than a year, secondary trend will include the price
movement in period ranging for three weeks to three months and minor trend means the
overall direction of price in period less than three weeks.
3) Three Phases within the Trend - Dow mainly focussed on primary trend (the trend
ranging for period more than a year) and he proposed this trend has three phases:
Accumulation Phase- This is the phase when a particular stock is trading at low
levels with low volumes unknown to the general public. This is the point where
smart long term investors take positions in this stock before anyone else.
Public Participation Phase- The price of the stock starts moving upwards, volumes
start increasing more people start investing in the stock.
Distribution Phase- At this point the stock has reached to substantial higher levels.
The general public discovers the stock. Newspaper, magazines etc. start publishing
bullish views on the stock. At this point the old smart investors exit their holdings
before anyone else starts exiting.
To see a live example of this you can check the charts of Prima Plastics prior to the year
2013 it was in accumulation phase the moving in the range of 11-14 with low volumes,
abrupt movement some days it was opening at lower circuit other day at upper circuit.
Starting form April-May 2013 the stock started moving upwards here volume increased
people started discussion about it and the stock moved upwards till 75 levels and the stock
is still in public participation phase. After some time it may happen that the general public
at large discover the stock and the old smart investor start exiting at that time it will enter
in distribution phase.
4) Averages must confirm each other - "No bull or bear phase can began unless both
averages give same signals" said Dow referring to his industrial and rail averages. We can
interpret as no major bull or bear market will begun unless all the major averages say Nifty,
Sensex, Bse small cap index, mid cap index, bank nifty etc. all give us the same signal of
major strength or weakness.
5) Volume confirm the Trend - In a bull market volumes should rise with uprises and fall
in downsides while in bear market volumes will be more whan the stocks come
downwards and less when it moves upwards.
6) Trend continues untill it gives definite signals of reversal - A trend or overall price
movement will continue untill a major signal of reversal occur. A number of technical tools
can be used to spot it like support and resistance, chart patterns, moving averages, trend
lines etc we will be learning all of these in our series.
Dow mainly relied on closing prices and didn't paid much attention to intraday movement
of prices. The same is used and followed by us even today as what matters is where the
price closes at the end of day intraday fluctuations isn't of much significance unless you are
a intraday trader.
So friends that was a quick view about Dow Theory in our coming posts we will be learning
about charts and Trend Analysis. Undoubtedly, The Dow Theory is a solid foundation of
what we use today as technical analysis almost all the concepts we will be learning in this
field have their origins somewhere from these basic points suggested by Mr. Charles Dow.
