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Dow theory

The theory is named after Charles Dow who was editor of The Wall Street Journal. He is not its creator. SA Nelson and W. Hamilton who were using his research and written articles created this theory. Although it was written more than 100 years ago, it is still base of research of every technician.

In 1884, Dow created the first index which was calculated using prices of the shares of 11 companies. Later, in 1897 he came to the conclusion that it is better to use two indices: index of 12 shares of industrial companies (Dow Jones Industrial Index) and Index of 20 shares of railway companies (Dow Jones Rail Index). By the 1928 the industrial index grown up to include 30 stocks. On that number it stands today.

The basic principles of the theory are:

(1) The averages disccount everything

Price changes on stock exchange include all knowledge of Wall Street. So it's enough to analyze price.

This principle is identical to the first axiom of technical analysis (everything is included in price), just this principle is applied to the entire exchange not only to specific stock. The principle is the same whether it is applied on one or more stocks.

(2) Prices are moving in trends

Dow defined uptrend as a situation in which each successive rally closes higher then previous rally high and each successive rally low closes higher than previous rally low. This means that the uptrend consisting of rising peaks and troughs. For downward opposite logic is applied.

Dow believed that every trend consists of three parts: primary, secondary and minor. He compared the trend with the movement of the sea. The primary trend is tide, secondary waves make up the tide, and the minor trend is a small wave.

The observer can see the tide if each successive wave comes further than it did in prior movement. If the farest point of the coming waves begins to move towards the sea, it means that the tide disappears.

The secondary trend is a correction of the primary and usually lasts from three weeks to three months. Typically, retracements are between a third and two thirds of previous trend and often that value is 50% of previous trend.

Minor trend usually lasts less than 3 weeks and represents the fluctuations of the secondary trend.

(3) Primary trend has three phases

Uptrend or bullish trend has three phases: accumulation, phase of growth and market expansion phase. Accumulation phase is characterized by extreme pessimism. News is bad as the estimates of market movement. At this stage, investors are able to buy stocks that nobody wants and can become rich. It can be considered that this is an ideal time to buy. The second phase is the longest and it is characterized by growth and optimism. In the third phase there are signs of inflation. A volume of trading is high and traders have high confidence in market.

Downward trend or bearish trend also consists of three phases: distribution, panic and phase of dissapointment. Distribution phase is the beginning of the price declining. There is nothing in the media to indicate the beginning of this phase and people are still buying stocks. After corrections prices are rising, but they stabilize on lower level than they were before the fall. If the price falls below the previous bottom, a downtrend is confirmed and next phase begins. In phase of panic stocks are soled massively and the prices are falling quickly. The last phase is characterized by pessimism, no one wants to buy although prices are low. Until all bad news do not incorporate in the price, falling continues. After that, the cycle starts from the beginning.

(4) The averages must confirm each other

Dow believed that the signal for growth or decline in the market can not be identified on the basis of one index. Both of the indices, Dow Jones Industrial and Dow Jones Rail must give a signal. Of course signals do not have to occur simultaneously, they can occur in a short period of time.

(5) The trend should be confirmed by volume

If the price changes with a small trading volume, there are various explanations for that: for example, presence of aggressive sellers. But the right picture of the market is seen only when the price changes with large volume. Dow beleived that volume is secondary indicator and that volume has to grow in the direction of the primary trend. Thus, in an uptrend volume should increase when prices rise and fall as well as prices fall. For downtrend the oposite statement is true.

(6) It is considered that the trend remains in force until it gives definite signals that it has reversed

This principle is basic rule of technical analysis. Practically if it is not true, the entire technical analysis would not make sense. The principle is linked to the law of motion in general: anything that moves is likely to continue to move until an external force does not prevent it.

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