Personal Finance
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7 mins read
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September 23, 2021
The Dow Theory: An Explainer
Your one-stop-shop to understanding the basics of Dow Theory — and how it can help you make smart investments.
If you’re new to investing, you know better than most that it’s tough to understand how to make smart investment decisions. And while there is more information available now than ever before, it can still be difficult to fully comprehend the underlying theories driving these recommendations. Enter: Dow Theory.
Dow Theory has been around for nearly a century and was developed by Charles Dow as a method to understand the market, its trends, and how it functions over time. Dow Theory can be used both for stock investing and to understand cryptocurrency trends.
So, regardless of where your interests lie, Dow Theory can help you make smarter decisions and feel more confident about how you are investing your money.
Dow Theory: The Basics
From a high-level perspective, Dow Theory describes market trends and how they typically behave. While the market is by no means predictable, the Dow Theory provides a framework and signals for understanding the market better and, as a result, making trading decisions.
Let’s break down the basic tenets of Dow Theory below:
- Market prices take all existing and upcoming information into consideration. This is called the efficient market hypothesis. Essentially, when analyzing the market, you can simply focus on the price of a stock versus any particular variable that may shift the price of that stock (known as “market noise”).
- Price movements are not as random as they may appear — according to Dow Theory, they actually typically follow trends, whether they be long or short-term trends.
Six Factors that Drive Dow Theory
Now, the points above are the most essential basics to understanding Dow Theory. But we’ll now dive a little deeper into the six main factors that drive Dow Theory below.
1.
Three Movements Theory:
The market has 3 types of movements. We call the main movement of the market the
primary movement.
This is a major trend in the market that can last a year or more. The second, or intermediate, movement of the market is called the
medium swing.
In a time span of anywhere from 10 days to 3 months, trends can occur in a medium time frame. These medium swings are often in the opposite direction of the primary swing, so it’s a pullback. Finally, the third movement of the market is called the
short swing
, which often represents short-term speculation in the market. If you don’t follow the market closely, this is the swing that drives news and speculation, which is often very noisy.
2.
Three Phases of Market Trends:
When it comes to market trends, there are three phases of the primary trend.
- The
accumulation phase,
when
start buying or selling the stock against the general perception of the market
- The
public participation phase,
when the rest of the market begins to follow the actions of the knowledgeable investors, causing the price to move.
- The
distribution phase
, when
begin to redistribute their holdings in the market (which occurs after the speculation of the absorption phase).
3.
As soon as it becomes available, the market incorporates new information
: As mentioned above, this means that the price of an asset will change to take any new news into account. As such, the asset price is an accurate reflection of the expectations of the market participants. Moreover, the asset price integrates factors such as
, earnings expectations, revenue projections, major elections, product initiatives, and more.
4.
All stock market averages must confirm each other:
If two companies or sectors are causally linked, an increase in one company will lead to an increase in the other company and vice versa. Generally this is more applicable to sector averages than individual companies, so a divergence in the averages is indicative of a broader shift beyond just the two companies.
5.
All market trends are confirmed by volume:
What this means is that if you see a large move on low volume, it's often because of a large player in the market or a low liquidity day). On the other hand, if you see a large move on high volume, you can be more confident that the move is the result of a market trend, because there are a lot of market participants pushing the price to where it is.
6.
All trends exist until it is shown that they have ended:
Essentially, the market remains in trend despite “market noise”. It isn’t easy to find definitive proof that a trend has reversed or ended.
Applying Dow Theory
Understanding Dow Theory is an important first step in learning how to read
because it can help you to perform technical analysis, which is a tool to predict the probable price of a currency pair. Otherwise, though, Dow Theory is primarily used by traders.
Dow Theory also helps traders to filter out the “white noise” because it is only concerned with the closing prices versus intraday movements within the markets. As such, traders can use Dow Theory to focus on only the price movements relevant to them.
Overall, Dow Theory is a helpful tool that people can use in order to make informed decisions. While critics of Dow Theory exist, ultimately it’s up to each individual to determine how useful it can be for their investment decisions.
