Applying Dow Theory to Modern Markets
Introduction to Dow Theory
Dow Theory is a fundamental concept in technical analysis that was developed by Charles Dow. It is based on his collection of editorials in the Wall Street Journal, which formed the basis for modern technical analysis. Dow Theory is a method used to analyze and understand the market, and it’s based on the idea that the market has three movements, which are the primary trend, secondary reaction, and minor trend.
The Principles of Dow Theory
Before we delve into how to apply Dow Theory to modern markets, it’s crucial to understand its six basic principles. These principles include:
The Market Discounts Everything
According to Dow Theory, everything that can affect the market, including broader economic factors and market psychology, is already priced into the market.
There are Three Types of Market Trends
Dow identified three types of trends within the market: primary trends, which last a year or more; secondary trends, which can be corrective phases of the primary trend and last from three weeks to three months; and minor trends, which are short-term fluctuations within the secondary trend.
Primary Trends Have Three Phases
These phases are the accumulation phase, where informed investors start to buy; the public participation phase, where many traders start to follow the trend; and the distribution phase, where informed investors start to sell their positions.
Stock Market Indexes Must Confirm Each Other
This principle states that for a primary trend to be valid, it must be confirmed by other indexes. This helps to ensure that the trend is broad-based and not just confined to one sector.
Trends Exist Until Definitive Signals Prove They Have Ended
In other words, a trend in motion will continue until a clear reversal signal occurs.
Volume Must Confirm the Trend
Volume should increase in the direction of the primary trend. This means that in an uptrend, volume should increase when prices rise and decrease when prices fall.
Applying Dow Theory to Modern Markets
While Dow Theory was developed in the late 19th century, its principles are still applicable to today’s markets. Here’s how you can apply them:
Identify the Trend
The first step in applying Dow Theory is to identify the primary trend. This can be done by looking at the highs and lows on a price chart over a longer-term period.
Look for Confirmation
Once you’ve identified a primary trend, look for confirmation from other indexes. For example, if you’ve identified a primary uptrend in the S&P 500, look for confirmation from the Dow Jones Industrial Average or the NASDAQ.
Monitor Volume
Monitor the volume to confirm the trend. If the trend is up, volume should increase when prices rise and decrease when prices fall. If the trend is down, volume should increase when prices fall and decrease when prices rise.
Watch for Reversals
Finally, watch for signals that the trend has reversed. This could be a break of a trendline or a pattern like a head and shoulders formation.
Conclusion
While the markets have evolved significantly since Charles Dow’s time, the principles of Dow Theory remain relevant. By understanding and applying these principles, traders and investors can gain a better understanding of market trends and make more informed decisions.
