What is the DOW Theory?

Is trading difficult or easy? What are the factors associated with it? Remember, everything in the universe functions on logic and theory. When theory is in place, you are in a better position to relate your studies while practically performing it. The same phenomenon applies to trading as well. Subsequently, there are several theories made by some great leaders, and we are going to chalk out one of the most important one – The DOW Theory.

What is the DOW Theory?

The Dow Theory, which describes how the stock market moves, is essentially a collection of six fundamental ideas or tenets. This financial theory is so crucial to technical analysis in the present day. In reality, the Dow Theory served as the foundation for ideas like uptrends, downtrends, support levels, and resistance levels. Let's get right to it now.

In essence, the idea states that an uptrend is present in the market if one stock market index rises over its resistance level and another index rapidly follows suit. An uptrend basically means the overall direction of the price movement of a particular stock to be in the upward manner. Whereas, downtrend means the direction of the price movement falls and is in the downward manner. The resistance level as the name suggests, basically means a price point on the chart, where traders expect maximum supply (selling) for the particular stock. Resistance stops the price from rising further and is always above the current market price.

Confused? Here is an illustration to help you understand the situation.

The Sensex and the Nifty are India's two main wide market indices. Let's imagine that the Nifty and Sensex resistance levels are 10,000 and 30,000, respectively. As a result of an increase in purchasing activity, Nifty breaks over its 10,000 resistance level and climbs to 10,800. The Sensex also surpasses its 30,000 resistance level and rises to 30,700 at roughly the same time. According to the Dow Theory, the stock market is in an uptrend since both indices have broken through and gone past their resistance levels one after the other.

Not only that, according to the Dow Theory, the stock indices must move in tandem not only with respect to price movement but also with respect to volume. This basically means that, in the aforementioned example, the trading volumes of the Nifty and the Sensex should also be comparable.

Additionally, the Dow Theory was the first to recognize that each trend on the stock market goes through a number of distinct phases. It explains in detail the many trends—primary trends, secondary trends, and minor trends—that the stock market frequently experiences. Furthermore, there are the three phases of accumulation, public participation, and distribution for each trend.

Basic tenets of the DOW Theory:

Tenet 1: The market discounts everything

This principle states that the stock and index prices represent all information that is currently known and available. Accordingly, pricing trends will change when new information becomes available. These price changes can be studied by traders to determine how the market will probably change in the near future.

Tenet 2: The market has three trends

This is perhaps one of the Dow Jones Theory's most well-known premises. It explains that the market shifts according to these three key patterns.

Primary trends: These trends, which might last one or more years, are the main market movers. They determine whether a market is bullish (rising) or bearish (falling) (moving downward). Moving with the main trend rather than against it, is typically thought to be a better strategy for individual traders, who make up the majority of the retail trading market.

Secondary trends: Price patterns that operate as reversal points for larger primary trends are referred to as secondary trends. Typically, they happen over a period of three weeks to a few months. They also follow the primary trend's polar opposite. For instance, before the market recovers, you can observe a negative secondary trend in a generally bullish market for a few weeks.

Minor trends: As the name implies, minor trends happen over a very little period of time. They frequently only last a few hours or days. These patterns are the least trustworthy if you're seeking for market trends to follow because they are essentially just market noise.

Keep an eye out to know about the remaining four tenets of the Dow theory.

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