Basic Tenets Of Dow Theory: Technical analysis has come a long way over the years and one can employ various methods to arrive at their trading decisions. But the foundation of technical analysis dates back to the early 1900s based on the collected work of Charles Dow.

His observations which are currently known as Dow Theory are still used by the market participants to base their investment/trading decisions. In this article, we will explore the 6 Basic Tenets Of Dow Theory and get a better understanding of them.

What is Dow Theory?

Basic Tenets Of Dow Theory - Charles Dow Image

Charles Dow, propagator of the world-famous Dow Jones Industrial Average Index. He along with Edward Jones, founded the world-famous Dow Jones Industrial Average Index and also published principles or tenets explaining how the market moves.

These principles were first published in a series of Wall Street Journal editorials written by Charles Dow between 1900 and 1902. However, it was only after his death that these tenets came to light, thanks to the efforts of William Hamilton, George Schaefer, and Robert Rhea, who assembled and presented it as the Dow Theory.

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6 Basic Tenets Of Dow Theory

Following are the six basic tenets of dow theory:

1. The Market Discounts Everything

The Dow Theory functions on the efficient market hypothesis (EMH), which states that asset prices reflect all available information.

This means that price trends will change in response to new information that is available. Competitive advantage, earnings potential, management competence—all of these and other criteria are priced into the market, even if everyone is aware of all or all of them.

2. Markets consist of three types of trends

This is one of the significant tenants of dow theory that explains the movements in the market with three main trends

Primary Trend:

The primary trend is the main trend in the market that can last for more than a year. This trend can either be bullish or bearish and indicates long-term movement in the market. The other two trends will be formed within the primary trend. Dow refers to it as tides in the sea.

Secondary Trend:

The secondary trend is the one that runs counter to the primary trend. It is assumed to be a correction of the primary trend, causing the primary trend to lose two-thirds of its value. This trend can last from a duration of three weeks to a few months. Charles Dow calls it waves in the sea.

Minor Trend:

The minor trend is a small pullback of the secondary trend that can last anywhere between a few days to a few months. Dow considers these trends as market noise.

Market Movements Image
Source: Tradingview

3.  The market trends have three phases

As per Dow Theory, the market is marked by three phases irrespective of whether it is in an upward or downward trend.

The phases in the upward trend consist of:

Phase 1- Accumulation phase: This is the beginning of an uptrend where the investor/traders enter the market to buy the securities against the common market conception.

Phase 2-Public participation phase: Also referred to as the response phase, the public participation phase is when retail and average investors begin to notice the upward trend and join in. It is the important and longest phase of a trend. 

Phase 3-Excess phase: This is a phase where signs of instability appear and experienced investors and traders begin closing their positions. The larger average investing population, on the other hand, continues to add to their investments. This will be followed by a fall in the security.

The phases in the downward trend consist of:

Phase 1-Distribution phase: This is the beginning of an uptrend where the investor/traders sell the securities against the common market conception.

Phase 2-Public participation phase: Retail investors notice the downtrend and start selling stocks and exiting positions to reduce losses. It is again the longest phase in the market

Phase 3-Panic phase: Investors have given up hope of a correction or full reversal and are continuing to sell at a large scale which has caused the security to fall significantly.

6 Basic Tenets of Dow Theory - Phases of market

4. Indices Must Confirm Each Other

As per Charles Dow, the trends must confirm with each other in order to determine if the trend has been established. Meaning, the movement of one index must correspond to the movement of all other indices in the market. Only then can we call the market bullish or bearish.

Suppose, the NIfty 50 is primarily moving in an uptrend, but the other indices in the market like the Nifty 500, and NIFTY Midcap are in a downtrend. In this situation, it is not accurate to consider that markets are bearish, as the NIfty 50 is bullish. According to Dow, only when all of the indices move in the same direction can the trend be identified concretely.

5. Volume Must Confirm the Trend

Trading volume increases when the price goes in the direction of the primary trend and falls when it moves against it. Low volumes indicate a weakness in the trend.

For instance, Buying volume should increase as the price rises during a bullish primary trend and should the selling volume should fall during secondary pullbacks. 

If selling volume increases during a pullback, it may indicate that more market participants are becoming bearish.

6. Trends Persist Until a Clear Reversal Occurs

Charles Dow noticed that secondary trends might be easily confused with trend reversals. This is because both of these price fluctuations go in the opposite direction of the primary trend. 

Assume the market is currently predominantly bearish. A brief rise may appear to be a trend reversal. However, it is possible that this is merely a secondary tendency. As per Dow theory, even if the market is temporarily up, you must continue to consider it bearish until it is evident that the upward momentum has been established.

In Closing

As we conclude our article on the ‘6 Basic Tenets Of Dow Theory’, it is important to note that, though technical analysis has advanced a long way, these theories still remain relevant today. Market Participants use these theories along with the technical tools at their disposal to make informed decisions in the market.

Written By Aaron Vas

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