Charles H. Dow gave us the Dow theory almost 100 years back to help market participants understand the movements of the securities markets more clearly.
Even now, it is called the bedrock of modern technical analysis.
What is Dow Theory?
Dow theory consists of 6 fundamental tenets.
These 6 tenets together help a trader identify how the market is moving and how to participate in that movement –
Tenets of Dow Theory
- The average discounts everything (news, events etc.)
- Market moves in 3 trends – primary, intermediate and minor
- Every major market trend has 3 phases – accumulation, consolidation and distribution
- Averages must confirm each other – (sector and individual stock price should have matching trend)
- Volume should confirm the trend
- A trend in motion shall be assumed to continue till definite reversal signals are noticed.
Explanation of Dow Theory
Let me explain each of the 6 tenets very quickly –
The average discounts everything
Here, ‘average’ means the index (Dow Jones Industrial Average) and ‘discounts everything’ means reflects all information that is either published or anticipated.
Charles Dow also co-founded the Dow Jones. So while writing his theory, he referred to the DJIA as the ‘average’. In present day context, ‘average’ would refer to any popular, well regulated and stable market index like – NIFTY50, S&P500, NIKKEI, KOSPI etc.
So, the first tenet means that all the published or anticipated information is already reflected in the price of the index. So basically, there’s no need to follow information like events, results etc. if you follow the price movements closely.
Market moves in 3 trends – primary, intermediate and minor
Primary trends last at least a year or more.
Intermediate trends last for at least a month to several months. And minor trends last for a few days.
Look here, for Dow, the lowest trend lasted for at least a few days.
He did not mention any lower time frame than daily.
Partly because in those days, hourly or lower timeframe data was not available to the public. Another reason is, a trend is more reliable if it respects a larger time frame.
Every major market trend has 3 phases – accumulation, consolidation and distribution
Trends do not start, stop or change direction abruptly. If you ignore minor trends that last only a few days, bigger trends always have 3 phases.
First, the smart money starts to move in quietly using the early information. This is called the accumulation phase. During this phase, the security starts to move up slowly, with higher volumes on the green days.
After the smart money has already entered, the security briefly enters a lull phase while the information gets spread. This period, marked by largely sideways movement in the price, is called the consolidation phase.
Finally, the retail participants enter the security after learning about the information and noticing its quiet rise recently. Here the price of the security explodes and the market gets filled with chatter and noise of its performance.
Ironically, the smart money actually starts to lighten their positions at this point. Slowly, the up move stalls. The price also starts to come down, either after a brief sideways spell or directly. This phase is known as distribution phase, since the majority ownership of the security gets distributed from a large few to the smaller mass here.
Averages must confirm each other
The price of a security should be in sync with its category or sector in general.
In a secular bull market, you’ll generally find most of the sectors and indices going up. The reverse is true for bear market. Also, the stocks in a bullish sector should mostly act bullish and stocks in a bearish sector should mostly act bearish.
Volume should confirm the trend
Stocks in a bullish trend should have bigger volumes in green days. Stocks in bearish trend should have bigger volume in red days.
Volume is the 2nd level of confirmation for a stock trend. The first level is confirmed in the final tenet below.
A trend in motion shall be assumed to continue till definite reversal signals are noticed
A security in an uptrend will be considered to be in uptrend until it makes 2 consecutive lower high-lower lows.
A security in a downtrend will be considered to be in a downtrend until it makes 2 consecutive higher high-higher lows.
Application of Dow Theory in real life
Knowledge without application is useless.
Now, the focus of my work here is to help regular 9-5 job holders build extra sources of cashflow. For such people to use Dow theory for picking stocks, it is better to use only weekly and monthly trends.
I’ll now show you a recent example where Dow theory could be beautifully applied for making profitable investment decisions –
Thid id NIFTY 50 weekly chart –
Just by looking at this chart once, you can see that the primary trend is bullish.
Why?
Because, this trend is enduring for years. After the covid low of March 2020, NIFTY50 has consistently moved higher. Yes, there has been downturns. But those lasted from few weeks to few months, implying those are the intermediate trends.
Now, to see minor trends, lets zoom in to daily charts –
Here you see 2 examples from the NIFTY 50 Daily chart where the price made quick whipsaw movements within a few days.
First, it corrected sharply. Then it came back up to almost the same position before the correction. That means a quick bearish trend followed by a sharp bullish trend.
Thus, in each image, you can see 2 minor trends unfolding within days.
Conclusion
Now, tell me…
If you’re a relaxed investor and only look at markets after office hours or during weekends, which trends are you most likely to catch?
Obviously primary and intermediate trends.
Now, let me give you a homework. Open up monthly and weekly charts of BANK NIFTY, NIFTYMIDCAP150 and NIFTYSMALLCAP250 and tell me what do you think about their primary and secondary trends?
Tell me in the comments below.