Dow Theory is a theory on stock price movement that was developed by Charles H. Dow, the founder of the Wall Street Journal, and his partner Edward Jones. The theory is based on the analysis of the stock market and is considered one of the foundational principles of technical analysis.
The Dow Theory is comprised of six basic tenets:
1. The market discounts everything: This principle suggests that all known information about a stock, industry, or the overall market is already reflected in the price. Therefore, the price movement itself is the most important indicator.
2. The market has three trends: The Dow Theory identifies three primary trends in the stock market – the primary trend, the secondary trend, and the minor trend. The primary trend represents the long-term direction of the market, while the secondary trend consists of corrections against the primary trend. The minor trend is short-term fluctuations within the secondary trend.
3. The market averages must confirm each other: According to this principle, for a trend to be considered valid, both the Dow Jones Industrial Average and the Dow Jones Transportation Average must move in the same direction. If one average moves in one direction and the other does not follow, it could signal a potential reversal.
4. Volume should confirm the trend: This principle states that volume should increase in the direction of the primary trend. If the volume decreases while prices are rising or falling, it may indicate a weakening trend.
5. A trend is assumed to be in effect until it gives definite signals that it has reversed: The Dow Theory suggests that trends tend to persist and should be assumed to continue until there is clear evidence of a reversal.
6. Trends have three phases: According to Dow Theory, trends are made up of three phases – accumulation, public participation, and distribution. During the accumulation phase, informed investors begin buying or selling stocks. In the public participation phase, general market participants start to join in, driving prices higher or lower. Finally, during the distribution phase, informed investors start to unwind their positions.
The Dow Theory provides a framework for understanding market behavior and has influenced many aspects of technical analysis and trading strategies. While it is over 100 years old, many of its principles are still considered relevant today.
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