By Chad Langager and Casey Murphy, senior analyst of ChartAdvisor.com

Dow theory represents the beginning of technical analysis. Understanding this theory should lead you to a better understanding of technical analysis and of an analyst's view of how markets work.


Let's recap what we've learned:


  • Dow theory was formulated from a series of Wall Street Journal editorials authored by Charles H. Dow, which reflected Dow's beliefs on how the stock market behaved and how the market could be used to measure the health of the business environment.
  • Dow believed that the stock market as a whole was a reliable measure of overall business conditions within the economy and that by analyzing the overall market, one could accurately gauge those conditions and identify the direction of major market trends and the likely direction of individual stocks.
  • The market discounts everything.
  • Dow theory uses trend analysis to determine which way the market is headed.
  • Primary trends are major market trends.
  • Secondary trends are corrections of the primary trend.
  • Primary trends are made up of three phases. For an upward trend, these phases are: the accumulation phase, the public participation phase and the excess phase. For a downward trend, the three phases are: the distribution phase, the public participation phase and the panic phase.
  • Market indexes must confirm each other. In other words, a major reversal from a bull or bear market cannot be signaled unless both indexes (generally the Dow Industrial and Rail Averages) are in agreement.
  • Volume must confirm the trend. The indexes are the main signals that indicate a security's movement, but volume is used as a secondary indicator to help confirm what the price movement is suggesting.
  • A trend will remain in effect until a clear reversal occurs.
  • Dow relied solely on closing prices for determining trends, not intraday price movements.
  • Peak-and-trough analysis is a key technique used to identify trends in Dow theory.
  • Since the advent of Dow theory, more advanced techniques and tools have expanded on this theory and begun to take its place.
  • One problem with Dow theory is that followers can miss out on large gains due to the conservative nature of a trend-reversal signal.
  • Another problem with Dow theory is that over time, the economy - and the indexes originally used by Dow - has changed.







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