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miércoles, 17 de febrero de 2016

Dow Theory

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Charles Henry Dow (1851-1902), the precursor of technical analysis, during the late nineteenth century, wrote in the business newspaper Wall Street Journal 255 editorial explaining his studies of the market graphics, based mainly on price movements and trends formed by these movements. His work was compiled based on these editorial and is currently known as Dow Theory.

Basic principles of the Dow Theory

Dow Theory is based on these six main points, and lays the foundation for much of what is now known as technical analysis.

The index reflects everything

All information is discounted in the markets and reflected in prices.

The three market trends

Dow Theory determines that market prices move forming three trends: Primary, Secondary and Minor.
  • Primary trend: It lasts more than one year, between one and three years, but this may vary in some cases and is the main direction of the market.
  • Secondary trend: Usually it last between 3 weeks and 3 months and moves within the Primary, but this movement is against the Primary trend and more volatile than itr. Therefore, these are the main trend corrections.
  • Minor trend: This the last of the three types and is defined as a minor movement of three weeks, moving within the secondary trend. The movements of the Minor trend are against the Secundary trend.

The three primary phases of trends

Dow says that there are three phases for each primary trend. In a bullish primary trend there is the accumulation phase, the public participation phase and excess phase while in a bearish primary trend we have the distribution phase, the public participation phase and a panic phase. You can see that in this third principle applies the psychology and is ahead of Elliott wave theory.

Principle of confirmation

A trend exists until suddenly ceases to exist and start a new trend. Dow explains that when two indexes as the Dow Industrial and  Dow Jones Transport agree with the trend, the market continues that trend, but if one of the two indices changes the trend and comes in contrast to the another index, is a sign that the market begins to doubt creating a period of confusion or turbulence entering in a "no confirmation". When this occurs ceases to exist a clear trend which is the indication of a change in market direction.

In short, Dow argues that an uptrend is confirmed when the Dow Jones Industrial Index and the Dow Jones Transportation jointly reach new highs, and a downtrend is confirmed when these stock indices reach new lows. If one of them reaches a maximum and the other does not, this is a 'no confirmation' that often lead to a turnaround.

Here many analists think that Dow at that time did this analysis for their index,  but applies the novel concept of price divergence which is widely used in technical analysis.

Trading volume must confirm the trend

A high trading volume is required to confirm the trend. From this postulate it derives the idea that the volume should increase when the price moves in the direction of the trend and decrease when the price moves in the opposite direction of the trend. For example, in an uptrend, volume should increase when the price goes up and decrease when the price falls, otherwise, in a downtrend, the volume should increase when the price fall and decrease when the price rises.

In an uptrend, the reason this happens is that the trend shows strength when volume increases because traders are more willing to buy an asset in the belief that the bullish momentum will continue. The volume goes down during periods of corrective signals because most traders are not willing to close their positions as they consider that the primary thrust of the trend will continue.

The trend is in effect until replaced by an opposite trend

It happens when an uptrend becomes bearish, or when a downtrend becomes bullish. Here it is important to determine the transitions between these two trend directions.

Dow based his studies on the closing prices to determine market trends and not on intraday prices.

Later Ralph Nelson Elliott developed a study of the financial waves based on the Dow Theory an as a complement, it was a breakthrough in understanding how stock markets work.

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