Understand Dow Theory: How Dow Theory Works?

Trading in the stock market requires not only knowledge but also an understanding of many potential scenarios that may occur in the future. Since no one knows how the market will react in the next moment, various theories have been developed. Dow Theory is one of them.

What is Dow Theory?

Charles H. Dow, the founding Dow Jones & Company member, developed the Dow Theory. The basis of this theory is that the stock market incorporates all known information and demonstrates identifiable trends and patterns in price movements. The performance of two indices, the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA), confirms these trends.

According to Dow Theory, if one index reaches a new high, the other must soon follow for the trend to be confirmed. This theory stresses the importance of volume and price movements and suggests that the trend remains until an apparent reversal occurs.

What are the Principles of Dow Theory?

Dow’s theory is based on the following principles:

1. The Market Discounts Everything

The first principle states that all known information is reflected in the market prices. This includes current events, news, future expectations, and sentiments.

2. Primary Trends Have Three Phases

The primary trend has three phases: the accumulation, the public participation (or big move), and the distribution phase. Let’s understand them:

  • During the accumulation phase, the general public usually does not participate in the market due to prevailing pessimism from the previous downtrend.
  •  In the second phase, retail investors begin to enter the market in large numbers. This phase typically sees the largest price movements and is often fuelled by media coverage and growing investor enthusiasm.
  • In the distribution phase, the market reaches its peak. The general public, driven by greed and a fear of missing out, continues to buy, not realizing that the trend is about to reverse.
3. Volume Must Confirm the Trend

The volume should increase if the price moves toward the trend and decreases during corrections against the trend. This serves as a confirmation of the trend’s strength.

4. Indices Must Confirm Each Other


Indices must confirm each other for a trend to be established. For example, if the industrial average reaches a new high, the transportation average should also reach a new high to confirm the trend.

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Different Types of Trends in Dow Theory

Dow’s theory identifies the following three types of market trends:

  •  Primary trends: They represent the broad direction of the market over a significant period, lasting a year or more. They can be bullish or bearish, reflecting long-term market sentiment. For example, a bull market starting from a low point and reaching new highs over several years points to a primary trend.
  •  Secondary trends: They are corrective movements within the primary trend, often seen as pullbacks or rallies. They can remain there from a few weeks to a few months. For example, during a primary bull trend, a market correction that temporarily pushes prices down before resuming the upward trajectory is a secondary trend.
  •  Minor trends: In this, there are short-term movements that form within secondary trends. They can last days to weeks and are often noisy in the market, influenced by daily news or minor events.

Limitations of Dow Theory

  • While Dow Theory provides a framework for understanding market movements, it does not offer specific guidelines for entry and exit points in trading. This makes it less practical for some traders.
  • The theory often identifies trends after they have occurred, which means it can act as a lagging indicator. This delay can result in missed opportunities or late entries into the market.
  •  Dow Theory was formulated when markets were less complex. With the availability of high-frequency trading and algorithmic trading, the relevance of this theory in predicting market movements may be reduced.
  • Dow Theory may not effectively forecast major economic events that can cause market shifts, such as economic crises, political instability, or natural disasters.

Dow Theory helps traders and analysts identify the market’s direction by analyzing stock price peaks and troughs. While some aspects of Dow Theory have been challenged, its core principles remain relevant. If you are new to the market, you can take a stock trading or option trading course in Hindi or English from Upsurge.club.


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