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The Dow theory is a financial theory derived from Charles H. Dow’s editorials. Charles Dow was one of the co-founders of Dow Jones & Company, Inc.
The Dow theory basically states that a change between bear and bull outlook in a stock market will happen if confirmed by other indices. The theory is established on a set of ideas derived from Charles H. Dow’s editorials.
The original version of the Dow theory states that the market rises if one of its averages (e.g., industrials or transportation) crosses a previous important high and is followed by a similar rise in another average. For instance, to confirm a trend, if the Dow Jones Industrial Average (DJIA) advances, the Dow Jones Transportation Average (DJTA) must follow the same.
The Dow Theory is based on few principles, however, few things have changed since the principles have been put in place. Dow Theory acts as a foundation on which western chart patterns are derived. Let’s look at the key principles.
Principles of Dow Theory
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There are three market trends: primary, secondary, and minor
The primary trend has three different phases in both bear and bull markets
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In case there is a swift and unforeseen discount in the stock market, the indices react promptly and adjust to indicate the exact value.
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The volume must always support the trend. The volume must rise with price increments and tumble as the price drops in an uptrend.
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A trend cannot be confirmed based on one index. It is impossible to call a market bullish if only one index is moving higher. Hence, a trend can only be revealed if multiple indices move in the same direction.
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Trends generally continue in the same direction until there are solid hints for triggering the reversal. Therefore, traders must be clear and confirm trends with several sources before confirming them as a reversal.
Drawbacks of Dow Theory
One of the major disadvantages of Dow theory is that it is a lagging indicator. Predicting the market trend by using supply and demand takes longer duration and chances are that one could miss out to act early.
Further, at times the determination of primary trend could be challenging and unclear. Reading market moves during volatile periods could be daunting using the Dow Theory.
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