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What Is Dow Theory and How to Use It in Trading?

The Dow Theory is only one of a few tools today’s traders can use when involved in technical analysis. Together with graphs and charts, it creates an effective background to generate all needed data regarding the price and market movements.

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Despite the fact, the way technical traders got used to performing decision-making has changed, some of the original concepts introduced decades ago can still be quite helpful. And the Dow Theory is definitely one of them. In this article, we will discuss some of its crucial tenets as well as how to use Dow Theory in trading.

A Brief Introduction to Dow Theory

The theory got its name after the founder Charles Dow, who was believed to introduce the concept in 1900 during his work on editorials and other educational materials. However, Mr. Dow died before completing his work, and the theory was later developed and presented to the public by Robert Rhea in 1932.

The Dow Theory Explained

So, what is Dow theory and how does it work? The concept shows investors how to use the stock market to generate specific data, for instance, the business environment health. The Dow Theory appeared to be the first work that explained the fact that the market moved in trends. Although, many decades have passed since the theory’s debut. Some of its tenets still hold the water:

1. The stock market reflects the news

The principle is quite simple. It says that all news and data are already shown by the stock market. All you need is to spot it. Indices and stock prices display different aspects such as companies’ earning announcements, inflation increase or decrease, investors’ sentiments, and more.

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2. Three major market trends

While the market moves in trends, we need to identify them:

  • A primary or major trend indicates the market moves in the long run (it may cover a several-year span).
  • A secondary trend appears to be a correction for the major one. As a rule, it opposes the primary trend. If the major trend is bullish, the secondary trend is likely to be bearish.
  • A minor trend occurs in the form of fluctuation. It takes place daily and generally lasts for no longer than a couple of weeks.

3. Three major trend phases

According to the Dow Theory, all trends have three phases. They are as follows:

  1. The accumulation phase is when traders enter the market with either a buy or sell position.
  2. The phase of public participation describes positive sentiments and more investors entering the market.
  3. The panic phase indicates an overbought market with an excessive number of buying investors (generally, a result of growing speculations).

4. All indices reflect the same opinion

The theory says that all indices confirm each other and reflect the same opinion. If one index moves in an upward direction (for example, Sensex), others should follow the same way.

5. Volume confirms the trend

Trading volumes must support the stock market. It works the following way: a rising volume in the uptrend results in a growing price and vice versa.

6. Trends keep going unless they signalize to stop

Always keep in mind that a trend continues unless you spot a definitive signal for it to stop. In other words, investors should avoid the market noise and make decisions based on a thorough and in-depth market analysis.

The Bottom Line

The Dow Theory was established more than a century ago. However, it still provides relevant insights for investors letting them react properly to the stock market changes or moves. Understanding the Dow Theory will let you spot and exploit market trends faster with more precision.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.