The Dow Theory was introduced by Charles H. Dow, who was a journalist, first editor and founder of Wall Street Journal. Charles Dow was also a co- founder of Dow Jones and Company. Dow Theory provides a base for the technical analysis which is done now days in stock market. This theory helps in doing technical analysis on price movement of the stock by keeping in mind all the things related to sector rotation.
Dow was of the view that the stock market from an overall point of view is accountable for the business conditions prevailing currently in economy and an investor can easily measure these conditions once he is able to analyse the market trends and movement of stocks in the market in individuality.
There are 6 basic opinions of Dow Theory which can be described as:
1) Market movements – there are 3 types of market movement shown in the market. a) Primary movement which is also known as the major trend which can last for a single year or extend to several years; b) secondary reaction which is also known as the intermediate reaction can last from few days extending to few months; c) minor movement which is also called the short swing can last for few hours, a month or more than that.
2) Three phases are seen in market trends which are :- a) Phase 1 – which is also called the accumulation phase in which investors generally buy those stocks which the common public is not buying. In this phase, there are not many changes in the prices of the stock because the demanding people for such stocks are low and the market is huge for its supply; b) Phase 2 – which is also called as public participation phase. As soon as the market comes to know about such investors a quick price change occur in those particular stocks. This phase comes into picture when technical investors participate in stock purchase; c) Phase 3 – this phase is also called distribution phase. This phase comes into picture when the speculation activity starts and these investors start distributing their accumulated stock prices in the market.
3) The third important opinion of this theory is that all news regarding the share market is discounted. Any new information which is related to stock market is applicable on all the share prices as soon as the news is available in the general public. As soon as the news regarding stocks is out in the market, prices will change to show the effect of that news. This change of prices of stocks with the immediate effect of news shows the efficiency of market hypothesis.
4) The fourth opinion of Dow Theory is that the averages in the stock market should confirm about each other. When in stock market, performances of the averages of stocks starts diverging this is a clear indication that there is a major change in the air which will be soon seen in the market.
5) Trends in the stock market are confirmed by their respective volumes. This statement can be explained as if the prices in stock market are moving on lower volume there can be several explanations for that but on the other hand if the price movement s are moving with higher volume, according to Dow Theory this movement will represent the true market view.
6) The sixth main important opinion of Dow Theory was that until some definite signals don’t prove that the trend has ended this means that trend still exists in the current market. Dow was of the opinion that trends existed though there were some noises which are heard in the market. Markets can start moving in different direction which can be opposite to the market trend for some time but they will soon follow the trend as soon as they realise that they are moving in a different direction. It is very difficult to determine that the reversal which is shown is a permanent trend or temporary trend.
From this article we can conclude that, Dow Theory was an important invention by Charles Dow but technical analysis tools given by him are interpreted differently by different investors in the stock market.