The Dow Theory

The Dow Theory, also known as the Dow Jones Theory, forms an important part of technical analysis. Its principles help traders understand the market better and identify price and volume movements more accurately. This theory was propounded by Charles Dow years ago, even before candlestick charts were invented. Basically, the Dow Jones Theory suggests that the market moves in trends. And understanding this theory can help traders identify market trends, so they can make smarter trading decisions.

What is the Dow Theory? 

The Dow Theory is essentially a collection of six basic principles or tenets that explain how the stock market moves. These six tenets were first put forward and published in a series of editorials that Charles Dow wrote between the years 1900 and 1902 in the Wall Street Journal. However, it came to light only upon his death, thanks to the efforts of William Hamilton, George Schaefer, and Robert Rhea, who compiled it and presented it as the Dow Theory.

This financial theory is such an integral part in modern-day technical analysis. In fact, concepts like uptrends, downtrends, support levels, and resistance levels were derived from the Dow Theory. Now, let’s get down to business.

The theory essentially says that the market is considered to be in an uptrend if one of the stock market indices rises up beyond its resistance level and another stock market index quickly follows suit. Confused? Here’s an example that can help clear things out for you.

You know already that there are two primary broad market indices in India - the Sensex and the Nifty, right? Now, say that the resistance levels of Nifty and Sensex is 10,000 and 30,000 respectively. Spurred by an increase in the buying interest, Nifty breaks its resistance level of 10,000 and rises up to 10,800. At around the same time, the Sensex also breaks its resistance level of 30,000 and climbs up to 30,700. Since both the indices have broken their resistance levels and risen past them one after the other, the stock market can be said to be in an uptrend according to the Dow Theory.

That’s not all. The Dow Theory also says that the stock indices must move in conjunction with each other not just with regard to price action, but also in terms of volume as well. What this essentially means is that in the above example, the trading volumes of Nifty and Sensex should also be similar to each other.

For instance, say that the volume of Nifty was at 271 lakhs when it climbed up to 10,800. For the market to be considered to be in an uptrend, the volume of Sensex should also be near about the same figure when it climbed up to 30,700. If there’s any discrepancy in the volume, the stock market cannot be said to be in an uptrend.

The Dow Theory was also the first to identify that the stock market moves in trends with multiple different phases for each trend. It clearly outlines the different trends that the stock market typically tends to go through - primary trends, secondary trends, and minor trends. And for each trend, there are the following three phases - accumulation phase, public participation phase, and distribution phase. We’ll see more about this in the next section of this chapter.

The six basic tenets of the Dow Theory

For all its usefulness, the Dow Jones Theory is essentially a simple concept that includes six basic tenets. Let’s get right into them.

Tenet 1: The market discounts everything

This is just what the Efficient Market Hypothesis suggests, remember? According to this tenet, the prices of stocks and indices reflect all available and known information. This means that price trends will move according to the new information that becomes available. Traders can study these price movements to understand how the market is likely to move in the near future.

Tenet 2: The market has three trends

This is perhaps one of the most popular tenets of the Dow Jones Theory. It explains that the market moves in three main trends, as listed here.

Primary trends:

These trends are the main movements in the market, and they can last for one or more years. They determine if a market is bullish (moving upward) or bearish (moving downward). For individual traders who make up most of the retail trading segment, it’s generally considered a smarter idea to move with the primary trend instead of against it.

Secondary trends:

Secondary trends are those price patterns that act as corrective points within major primary trends. They’re generally spread over a period ranging from three weeks to a few months. And they move in the opposite direction of the primary trend. For instance, in a primarily bullish market, you may see a bearish secondary trend for a few weeks before the market picks up again.

Minor trends:

Minor trends, as the name signifies, occur over a very short range of time. Often, they only last for a few hours or a few days. These trends are essentially just market noise, and they’re the least reliable patterns if you’re looking for market trends to follow. Minor trends can be in the opposite direction of the primary trend or the secondary trend.

In the above image, notice how the primary trend of the market from July 2017 to July 2018 is on an uptrend (from around 9,450 to around 10,800)? And in-between, we have minor trends that last for a few days or two weeks, at the most. The secondary trend occurs between February 2018 and April 2018, when the market goes downward, against the primary uptrend.

Tenet 3: Market trends have three phases

Whether the market is moving upward or downward, every trend is marked by three phases. These phases are listed here.

• Accumulation phase
• Public participation phase
• Distribution phase

Let’s look at what happens during these three phases.

The accumulation phase

This phase generally occurs right after a steep downtrend, during which many investors and traders lose hope of the prices rising upward. So, although the prices may have touched the lowest possible point for that cycle, buyers remain hesitant to purchase the stock. Because of this, the price of the stock continues to stagnate at low levels. 

At this point, astute institutional investors enter the market. They recognize that the market has touched a low, and in a bid to accumulate the stock at such low prices, they begin to purchase large volumes of the stock regularly, over a prolonged period of time. This is what results in the formation of support levels, since the huge volumes of stock purchase by these smart investors kickstarts the sluggish demand and gives the stock price a much-needed upward push.

The public participation phase

Also known as the response phase, the public distribution phase is when short-term traders, who follow technical trends, notice the activity that’s taking place and enter the markets. They begin buying the stock as well, causing a quick rise in the price of the asset. In this manner, a bullish trend is established, which is why this phase is also known as the mark-up phase. This rising trend is generally swift and steep, so a large segment of the public is initially left out of the trading rally.

Soon, the news about the markets becomes generally positive, causing more buyers to enter the trading arena. Analysts and researchers see high price trends, and this eventually increases the public participation in the markets. 

The distribution phase

At the peak of the mark-up phase, the price of the stock reaches new high levels. As news of these trends become more publicly available, everybody begins to invest in the stock. Here’s where the smart investors again enter the picture. Contrary to what occurred in the accumulation phase, here, institutional investors start to sell off their holdings systematically. They do so when others in the market are focused on buying. 

The supply of the stock thus constantly increases. And whenever the stock price attempts to go past a certain point, the increased sell-off from institutional investors prevents it from rising past that mark, leading to the formation of resistance levels. Eventually, the huge sell-off stagnates the price at certain levels and keeps it from rising further. And then, a downtrend begins, leading to a bear market.

In the image below, notice how the market is on a primarily downward trend from January 2000 to around August 2001? Then, nearabout September 2001, there’s a panic price action point after which the institutional investors come in, making the period from around January 2002 to May 2003 an accumulation phase. Notice how there are many support levels that are formed in this phase.

Then, in the response phase, as short-term traders throng to the markets, we see a sharp rise in the index price from around 900 during May 2003 to around 2000 during January 2004. At this point, there’s a resistance that builds up since institutional investors start to sell off their holdings, leading to the formation of a distribution phase. 

Tenet 4: The indices must confirm each other

To identify that a trend has been established, it’s essential that all the market indices must confirm each other. So, the movement of one index must match the movement of all other indices in the market. Only then can we label the market as being bullish or bearish, as the case may be.

For instance, say the CNX NIFTY is primarily moving in the upward direction, but NIFTY 500, CNX NIFTY Midcap, and many other indices in the market are primarily moving downward. In this case, it wouldn’t be right to classify the market as bearish (moving downward), since CNX NIFTY is moving up instead. Only when all the indices move in the same direction can you identify the trend concretely, according to the Dow Theory.

Tenet 5: The trading volume must conform with the price trends

According to this tenet, any primary trend in the market, whether upward or downward, must be supported by a corresponding increase in the trading volume. To make it clearer, let’s take the example of a market phase where the prices are on the rise. In order to classify this as a primarily bullish market, the trading volumes should increase when the prices go up (since this is the primary trend) and fall when the prices go down (since this is the secondary trend). In other words, more trades should be following the primary upward trend rather than the secondary downward trend.

Conversely, let’s take a market where the prices are falling. Here, to classify this as a primarily bearish market, the trading volumes should increase when the prices go down (since this is the primary trend) and fall when the prices go up (since this is the secondary trend). In other words, more trades should be following the primary downward trend rather than the secondary upward trend.

In the image above, see how the trading volume rises even as the price falls, and how the volume decreases when the price rises? This shows that a higher number of trades are following the downtrend, pointing to a bearish market.

Trend 6: Trends persist until there is a clear reversal 

Charles Dow recognized that it’s easy to confuse secondary trends with trend reversals. This is because both these price movements move in a direction that’s opposite to the primary trend. For instance, say the market is now primarily bearish (or falling downward). A temporary upswing may seem like a trend reversal. But then again, it could also just be a secondary trend. So, as the Dow Theory says, you’ll have to continue to consider the market as bearish even with a temporary upswing until it’s clear that the upward movement is established. In that case, it would be a trend reversal, making the market bullish.

How is the Dow Theory useful for traders?

The Dow Theory primarily helps traders identify market trends with greater accuracy, so they can take advantage of potential price action points. It also helps traders act with caution and not move against the market trends. And above all, the Dow Theory stresses on the importance of the closing price as a good indicator of the general sentiment of the market. 

This is because throughout any trading day, trades can happen all over the place. But as the closing bell draws nearer, most market participants will want to conform with the trend. Accordingly, the closing price of a stock is determined, depending on how the traders react as the trading day draws to a close. This can give you a great deal of insight into where the market is heading collectively. With these inputs, you can even develop Dow Jones trading strategies that help you make well-informed trading decisions.

Wrapping up

Well, this brings us to the end of our introduction to technical analysis. Now, it’s time to look at one particular segment of the financial markets - the derivative segment. As you’ll recall from our earlier modules, here’s where options and futures are traded. Check out the chapters in our next module to learn all about futures, call options, and put options.

A quick recap 

• There are six basic tenets to the Dow Theory.
• The first tenet states that the market discounts everything.
• The second tenet states that the market has three trends: primary, secondary and minor.
• The third tenet states that market trends have three phases: accumulation, public participation and distribution.
• According to the fourth tenet, the indices must confirm each other for a trend to be established.
• The fifth tenet says that the trading volume must conform with the price trends.
• Lastly, trends persist until there is a clear reversal.
• The Dow Theory primarily helps traders identify market trends with greater accuracy, so they can take advantage of potential price action points. 
• It also helps traders act with caution and not move against the market trends. And above all, the Dow Theory stresses on the importance of the closing price as a good indicator of the general sentiment of the market.