An Introduction to Dow Theory
Every trader is dependent upon Technical Analysis (TA) in one form or another. TA forms the backbone of many trading strategies and is used the world over as a market analysis tool.
Have you ever wondered what forms the basis of a TA?
A concept credited to Charles Dow and refined by William Hamilton, Robert Rhea, and George Schaefer, named aptly enough “Dow theory” is one of the building blocks upon which Technical Analysis is built.
This article will provide the basic concept of Dow theory in an effort to show traders and market analysts the root of modern-day, computer-driven TA.
At the very core, Dow theory is a tool to determine the basic trend of the stock market. By trend, I am referring to the general movement, as shown on price charts, as either up or down. An uptrend is a series of higher highs and smart/big money begins to believe that the bull market is over, although the public still believes the uptrend will never end. They begin to sell stock to the public who readily buys all that can be thrown at them, oblivious to the obvious fact that the market is topping.
The market will start to go down, but most analysts and traders will refuse to believe the bull trend is over. This strong belief in the longevity of the bull trend will cause new money, sometimes a lot of it, to come into the market during these times. This new influx will result in sharp, severe rallies that will bring in even more capital into the market as it seems that the bull trend has resumed. This move will not take out the previous highs and is merely a reactionary rally. Then phase 2 begins.
1. The Big Move – The selling begins in earnest after the reactionary rally fails. The public starts to sell stocks, pushing the market down even faster. Bad news begins to sweep the news wires, what was once a rosy picture is filled with negativity and despair, leading us to the next and final phase of the bear trend.
2. Despair.