Basics of the Dow theory
What is the Dow Theory_
Updated 11.03.2022

The Dow theory is the base without which one won’t be able to conduct technical analysis. It is developed based on Charles Dow’s works. In doing so, based on his works, one of the primary indices of the modern financial market were developed. But in this article, we’ve collected the core information about the Dow theory for you to know.

Who is Charles Dow?

Many are familiar with Charles Dow as he was an editor of the Wall Street Journal. And one of the chief specialists in a publishing house with expert knowledge. Also, for many years he served as a co-founder of the Dow Jones & Company, which is one of the leading agencies on financial information in the world. It is his works based on which industrial and transport indices were developed, still actively used even these days.

The feature of the works of this person is that his ideas lacked specifics. Many of Dow’s works were understood and finalized after his death. The editors of the publishing house had taken on this task, thanks to whom the basics of this theory were developed.

What principles underlie Dow theory?

Principle 1: Market considers all events 

Based on this, it’s safe to say that available information about the success of any large company is reflected in price before it’s officially announced. For example, while the company is preparing to release an official report about the increase in income, information about it is already being reflected in the market. The demand for stocks has increased, as has the price too, and the publication of reports eventually affects the further rise only a little.

According to the observation, some companies face an effect when the price may reduce after the report with positive dynamics. The news turned out to be good but not good enough to attract investors or new buyers. Everything has already been reflected in the dynamics of the company in the market.

This principle is actively used during technical analysis. However, it’s not considered to be a fundamental one. The latter means that the real cost cannot be reflected by the market one.

Principle 2: Key market trends 

This concept has proved to be one of the most important aspects of the modern financial world. It gained development thanks to the works of Ch. Dow. His own theory is based on the existence of three trends that differ by the duration of action:

Sometimes a minor trend is considered in an even narrower way – from several hours to several days. Most often, investors are guided by the primary one since it is the key trend when considering the need for entering. It’s clear that the absolute majority will prefer a long-term perspective.

However, it often happens that the primary trend is contrary to the other two. For example, a specific cryptocurrency has a positive primary trend. But, similar to many other cryptocurrencies, it suffers from short periods of negative secondary and minor trends. It means that an investor can purchase cryptocurrency at a lower price but sell it when the price rises.

The main difficulty is to accurately define the type of the actual trend now and use it. For this purpose, investors and traders use deep technical analysis. Also, other tools allowing to identify the type of the current trend in the market are used.

Principle 3: Each trend has three phases 

Based on the works of Dow, we can claim that long-term trends feature only 3 phases. For example, during the bull market, these phases will be located like this:

  1. Accumulation. It means that after the period of a bear market, potential buyers won’t be quick with the decision. While the price remains low and the evaluation negative, market participants will accumulate assets till the moment of the cost increase.
  2. Public participation. A situation occurs when others start understanding prospects. Following experienced traders, many of them also begin buying up assets. As a result of this, the price starts rising.
  3. Allocation. An intensive purchase occurs, active speculation takes place, too. The trend is coming to an end until there is a trend reversal. Also, assets start to be allocated via sales to those who don’t know about the upcoming drop of the cost yet.

If we take the bear market as a basis, the above three phases will occur vice versa. The first phase will be the allocation of assets, and everything will end with accumulation. It indicates that the upward trend follows the downward trend in most cases and vice versa. Experienced traders and investors can identify the character of trends and their phases to make the right decision.

Nevertheless, we can’t say this principle works 100%. But it’s way more convenient for many to monitor the market using such a method.

Principle 4: Cross-correlation

The basis of the Dow theory is the fact that the trend is confirmed by another market index. But a similar system worked perfectly only regarding transport and industrial Dow-Jones index. Why is it so?

The thing is that the transport market at times of Charles Dow’s work was tightly connected with the industry. There is nothing strange in this scenario since large industry requires the support of infrastructure. Back then, it included specifically railway transport. Using the railway, raw materials and ready goods were supplied.

That is why there was a strong bond between industry and the transport market. One couldn’t function properly without the other one. If problems occurred in the transport market, manufacturing faced them as well.

Does this index work today? Yes, it does, but not for all groups of goods. Some of them do not require the supply and transport system being created in digitized form.

Principle 5: Importance of volumes

Trading volume was one of the main market indices for Dow. If the trend is strong, then the bidding will be high, too. The higher demand for the asset, the more stable trend becomes. During large volumes, the movement of the price accurately reflects the tendency. If there aren’t many of them, the trend will not occur clearly, and a fixed growth and cost of assets will not reflect the actual situation in the market.

Principle 6:  How the trend acts before the reversal

When the market is in the phase of a primary trend, it will continue to move. For example, the price of stocks rises due to good reports and the reaction of publishers. According to Dow theory, the price will grow until the reversal emerges.

That is why one needs to attentively monitor the changes: so that he can accurately define the initial trend namely. There were cases when reversals were just a secondary trend. It influenced the income of investors and traders. It is recommended to use analyses and various financial tools in order not to be wrong.

Let us conclude

Today, there are those who think Dow’s theory is irrelevant. It specifically applies to cross-index correlation. But the majority still find this theory important and necessary for optimal work of the market and market participants. Thanks to the theory, it becomes possible to define favorable phases that will bring the highest profits. And the concept of modern market relations itself formed mostly due to the work of Charles Dow.