Thursday, October 29, 2009

What is Dow Theory and Why It Matters to You

What Dow Theory?

Charles Dow never wrote about any Dow Theory nor presented it as a trading system.

However, Dow Theory today serves as a theory on underlying stock prices and is very much a pillar of technical analysis. The theory was derived based on editorial articles that Charles Dow had wrote and it was subsequently called the "Dow Theory" by others who referred to his work.

Dow himself never spoke about any such theory. If anything, Dow was more a scholar than a speculator.

Dow Moves to New York City

Dow was born in a small town in Conneticut in 1851. He apparently held around twenty jobs before he found his passion in journalism. After certain life events, Dow decided that carrying out journalism at the Providence Journal was too small for him. He packed and moved to New York City with an old friend, Eddie Jones.

Together with Jones and a friend named Charles Milford Bergstrasser, they decided to go into a news distributing business. They called their company Dow, Jones and Co.

Perhaps the most lasting contribution to finance was the Dow Jones Average that was the first attempt by someone to create a sort of aggregate indicator of stock market trends. The Dow Jones Average is still what most people turn to if they want to find out how the market is doing today.

6 Basic Tenets of Dow Theory?

One of the assumptions of Dow Theory is that trends in stock prices, once under way, will always tend to persists until the market itself sends out a signal that these trends are about to be reversed. The 6 basic tenets of Dow Theory are as follows:

1. The market has three movements. A main movement( measured in years), medium movement (months to a year) and short swing (hours to a month). It can be said that these 3 movements can occur simultaneously, for example: "a daily short swing in a bearish medium movement under an overall bullish main movement."

2. Market Trends Have Three Phases. The accumulation phase, public participation phase and distribution phase. The accumulation phase is when investors who are in the "know" are buying stocks against general market opinion. The stock price does not change much in the accumulation phase. The publich participation phase is when this information becomes known and there is a rapid price surge. The distribution phase is when astute investors exit their holdings.

3. The Stock Market Discounts All News. The stock market price quickly adapts to any information that becomes available.

4. Stock Market Averages Confirm Each Other. When two averages move together, it confirms that the direction is correct. If two averages diverge, it means change is likely to come.

5. Trends are confirmed by Volume. Low volume trading does not make up a trend. Only high volume indicates a trend.

6. Trends exist until definitive signals prove they have ended. There are times when there are market noises and small reversals occur against the trend. This noises should be ignored and the trend should be given the benefit of the doubt. Difficulty lies in deciding which tools to use to decide whether the trend has ended.

Analysis of Dow Theory & Why It Matters to You

Till date, there has been no conclusive evidence on the profitability of using the Dow Theory. While studies remain inconclusive, some have have argued that Dow Theory produces excess risk adjusted returns compared to a simply buy and hold strategy.
Today, many chartists or technical analysts still consider Dow Theory's definition of a trend and its insistence on the study of historical price action of stocks as one of the pillars of technical analysis.

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