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Introduction to Dow Theory

When Charles Dow published his observations at the end of the 19th century in the Wall Street Journal he, unfortunately, did not name his observations. His theory was named "Dow Theory" by later chartists and it is Dow Theory in which modern technical analysis has its roots.

Dow Theory is based on the philosophy that market prices reflect every significant factor that affects supply and demand - volume of trade, fluctuations in exchange rates, commodity prices, bank rates, and so on. In other words, the daily closing price reflects the psychology of all players involved in a particular marketplace - or the combined judgment of all market participants.

The goal of the theory is to determine changes in the major trends or movements of the market. Markets tend to move in the direction of a trend once it becomes established, until it demonstrates a reversal. Dow theory is interested in the direction of a trend and doesn't offer any forecasting ability for determining the ultimate duration of a trend.

Dow's original "trend following' system highlighted the following points

  • Classification of a trend
  • Principles of confirmation or divergence
  • Use of volume to confirm trends
  • Use of percentage retracement
  • Recognition of major bull and bear markets
  • Signaling the large central section of important market moves
  • Dow theory has been successful in identifying 68% the major trends over the years

It is these observations where the understanding of trend becomes one of the most important concepts in technical analysis (or the most important concept for the trader is to be on the right side of the trend).

Trends

There are three directions a trend can have:

1. Uptrend: successively higher peaks (highs) and higher troughs (lows)
2. Downtrend: successively lower peaks and troughs
3. Sideways Channel: peaks and troughs don't successively rise or fall

Each market trend has three parts compared to tides, waves and ripples.

1. The primary (major) trend or tide is a long term trend lasting from a year to several years.
2. The secondary trend (or mid-term trend) or wave lasts three weeks to three months and represents corrections of one third to two thirds of the previous movement - most often fifty percent of the movement.
3. The minor trends (short-term trends) or insignificant ripples last less than three weeks and represent fluctuations in the secondary trend.

Shortcomings of the Dow Theory:

The major criticism of the Dow Theory is its slowness: It misses about 25% of a move before giving a signal, primarily because it is a trend following system designed to identify existing trends.