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Definition: Dow Theory
Dow Theory is a concept of technical analysis which can be used by investors to study markets and perform trading and investing activities. According to the theory, an investor can understand the market trends and business environment by looking at market as a whole. The theory is based upon the price movements of the stocks which is the key indicator in the Dow Theory.
Dow Theory was formulated by Charles Dow in 1900s. Dow Theory is constituted of 6 parts:
1. According to Dow Theory, there are 3 trends/movements of the market that are:
Primary Trend: the major movement of the market which exists for a time period of more than 3 months and could last up to years. There are 2 primary trends: Bearish Trend and Bullish Trend
Bullish Trend is where the markets are going up
Bearish Trend is where the markets are going down
Secondary Trend: the secondary movement exists for a period of 10 weeks to 3 months
Minor Trend: the minor trend exists for a period of less than one month and could exist for hours also. This includes the daily ups and downs in the market
2. Now the market trends have 3 phases:
Accumulation Phase: This phase occurs when there is a beginning of new trend, upward or downwards. The informed investors start this by buying or selling the securities while the prices of the securities remain the same.
Public participation Phase: Generally after looking at what the informed investor are doing, the trend followers opt to replicate, thereby increasing the demand of the securities and thereby increasing/decreasing the prices.
Distribution or panic Phase: This phase occurs when due to speculations the uninformed investors are trying to buy almost at the peak prices. If there is any sudden news they could start to panic and reverse their actions by buying or selling the securities, thereby creating a distribution or panic phase. Thus this phase marks the beginning of a new primary trend.
3. Market incorporates all news and is reflected in the stock prices.
4. The market indexes like BSE, NSE (Indian market indexes) should move in correlation
5. All 3 trends are confirmed by the volume i.e. volumes of the trading stocks which will also signal the price movements.
6. The Trends continue to exist until a strong signal is given
For Example: If a company is in pharmaceutical business, according to Dow Theory if all indexes like BSE and Healthcare index (point number 4 above)are going up, and there is a patent which has got approved for the company. The company’s stock will go up and investors will be attracted towards it. In the long run, the company will tend to behave well along with the market. If there is any news of shock to the market or industry, the company will also be affected due to the environmental noise. Hence the primary trend and minor trends can be seen in the stock of the company. An investor can look at the overall market indexes and can judge the trend in the long and short run and invest in the company accordingly.