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Stock Chart Trading: Dow Theory (Part 1)
Basic principles under the Dow Theory
Welcome to another part of our technical analysis series, whereby before this, we’ve spoken about a few simple chart patterns, as well as indicators that you can refer to while trading, examples of said indicators are: volume, moving average, relative strength index, MACD, Bollinger Bands, Fibonacci Retracement, and risk-reward ratio.
Now, we will move to another part of technical analysis, which you can consider as another level of indicator — the Dow Theory. The Dow theory is introduced by Charles H. Dow, which is also the person responsible for the Dow Jones. It incorporates 6 core tenets that are widely used even now.
For this part, we will look generally into the 6 tenets of the Dow Theory.
Table of Contents
Market moves in 3 broad trends.
What it means is that the market will generally move in three major trends:
The primary trend refers to the major trend which can go from 1 year to a few years. It can be a major uptrend or a major downtrend. Long-term investors will usually refer to this trend, while more active traders will look into this trend, while also looking at the other two trends below.
The secondary trend can move between a few weeks to several months. It usually acts as the minor correction phase to the primary trend. Some also consider sideway markets as secondary trends (a sideway market is when the price doesn’t really move up or down significantly).
This trend is also called the daily trend. It can go from several hours to several days. This trend would usually be used by intraday traders.
There are 3 phases under each trend.
Under the Dow Theory, the market movement is shaped by three phases which would often repeat itself. In an uptrend or a downtrend, there are three main phases under each.
This is where the trend is about to begin — a point where the prices and volumes are starting to bulk up.
It is when people start to hop on to the rally and the price goes up.
It is a point where people are speculating whether the trend will continue further or not. Experienced traders will often sell around this phase.
The distribution phase sometimes comes hand in hand with the speculation phase. It happens when the market is starting to realize that a decline is coming.
Much like the uptrend’s participation, this is a point where people start to gather in numbers and sell, causing a decline in price.
This is where people have abandoned hope and sell at whatever price they can salvage. The price will usually drop tremendously within this phase. Selling volume will also increase.
Everything is discounted into the stock market.
The usual argument against Fibonacci Retracement is that it’s a fallacious belief, and the fact that Fibonacci lines deeper into the trend tends to be of smaller margins from one to another, any opposite price movements are mistakenly believed to be a sign that the Fibonacci retracement works.
So here are the two key arguments — first, the lines are smaller near the top of the uptrend (or bottom of a downtrend) so any shift might easily touch these lines, without the lines actually having anything to do with it.
Second, the smaller lines are placed near the top of an uptrend or the bottom of a downtrend, which means that by that time, there is a high likelihood that the trend is already losing steam anyway.
Personally, however, despite agreeing with the arguments above, I am of the belief that Fibonacci retracement is usable because it is subscribed to by many, and the whole point of trading is to make use of the sentiments of many. Although, it may be more useful when dealing with stocks compared to forex, as stocks are less volatile, and there are not as many moving factors that can affect the price.
Averages must confirm each other
Initially, the Dow formulated two main averages to see how well the market is performing. One average is to gauge manufacturing, while the second one gauges the movements of said products in the economy. The logic behind the two averages that must be confirmed is that if manufacturing increases, the products should also move accordingly. Nowadays, there are more than just two averages, but the logic still stands.
Volumes must confirm trends
This is just like what we have discussed previously when we discuss about volume. When there’s any shift in trends — or at least when you think there is, volume will usually show you what’s happening. Volume here refers to the amount of successful trade for the day.
A high volume would usually indicate something is going on in the market, that’s why people are either swarming towards a trade or running away from it. If the trend is bullish, the buying volume will be high, and if the trend is bearish, the selling volume will be high.
Trends will continue until there is a reversal
Another core tenet under the Dow Theory is that a trend will continue until it reaches a reversal point. It’s quite hard to determine when a trend will cease to exist. In many cases, people will look to whether the shift is proportionate to the magnitude of the trend. For example, a sudden drop in price for the week doesn’t necessarily mean that a 5-years uptrend is coming to an end. Hence, unless there is a clear sign that a reversal is kicking in, there is a presumption that the trend is in continuation.
This is just one part of the Dow Theory, whereby we introduce the 6 core tenets first. How it’s going to be applied later on is that you’ll have to look if whatever we have explained before (like chart patterns, volume, moving average, etc.) forms a trend, and then you’ll also have to look at whether it is supported by the Dow theories or not. For example, if you’re investing in the long term, you can see if the trend signals are in line with the primary trend of the market, and so on.
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