The Dow Theory is a foundational principle in technical analysis that is used by traders to identify the overall trend of the market. It emphasizes three main trends: primary, secondary, and minor. Confirmation, volume analysis, and S/R levels are the key components of the Dow Theory that allow traders to validate trends and identify potential entry and exit points.
Let’s take a look at the six tenets of the Dow Theory.
1. The market discounts everything. This principle suggests that all information, including past, present, and future events, is already reflected in the price. Therefore, studying price action alone is considered enough to get insights into market trends and potential future price fluctuations.
2. The market has three movements. According to the Dow Theory, the market consists of three primary movements: the main movement, medium swing, and short swing. The main movement can last from less than a year to several years and is either bullish or bearish. The medium swing typically lasts from ten days to three months and retraces from 33% to 66% of the price change since the previous medium swing or the start of the main movement. The short swing may last from hours to a month or more, often occurring simultaneously with the other two movements.
3. Market trends have three phases. The following tenet suggests that market trends consist of three phases: accumulation, public participation, and distribution. During the accumulation phase, informed traders buy or sell assets against the prevailing market sentiment. As other traders catch on, a rapid price change occurs in the public participation phase. It continues until speculation reaches a peak, leading to the distribution of holdings by the informed market participants in the last phase.
4. The trend is confirmed by volume. Volume is crucial in confirming the validity of a trend. In an uptrend, increasing volume indicates strong buying interest, confirming the bullish trend. Conversely, increasing volume during downward price movements suggests a bearish trend.
5. The averages must confirm each other. This tenet highlights the importance of using multiple indices or averages to confirm the direction of the market. For example, if the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) both reach new highs or lows simultaneously, it strengthens the signal of a prevailing trend.
6. Trends continue until a clear reversal occurs. The Dow Theory suggests that trends persist until there are clear reversal signals.
Learn more: An Introduction to The Dow Theory.