What is the Dow Theory?
The Dow Jones theory or Dow Theory describes market trends, price action, and market philosophy. It has been developed by Charles Dow in the late 19th century. In this market philosophy, there are three main assumptions:
1) Manipulation of the primary trend is not possible.
2) The market reflects all available information. Sometimes good news will not raise the price of the asset.
3) The theory is not infallible. Using Dow theory traders can not beat the market. This is more market philosophy than trading strategy.
In this article, we will try to describe how we can use basic market philosophy to think about the bear market.
Dow Theory Sell Signal is usually after the distribution phase where we can see a strong bearish move. Stage two, when we have a huge drop in price is very important because the next days and week’s price can follow the bearish trend. Of course, false reversals, false trends are very common in volatile markets, and very often next market prediction move is very hard to estimate. In the article How banks trade forex we analyse deeply phases of trading. In this article, we will connect this approach with Dow’s theory and practical example.
Before that, there are 4 rules that we need to know before we analyze bearish move :
1. Everything gets Discounted in the Market
The operation of Dow Theory is on the efficient market hypothesis (EMH), stating that prices of assets incorporate the available information. This approach is simply behavioral economics antithesis.
Potential of earnings, management competence, competitive benefits, all such factors, and a lot more get priced in the market, even when not all individuals know such details. With stricter theory readings, all future events get discounted in risk form.
2. Primary Trends are Available with Three Phases
Accordingly, with the Dow Theory, the primary trend passes through three phases. In a bear market, these are public participation, panic, and distribution phase and in a bull market, they’re public participation, accumulation, and excess phase.
3. Volume needs Trend Confirmation
Volume has to increase when price moves in the direction of the primary trend and decreases when it moves against it. The low volume signals are a weakness in the trend. Let’s suppose, in the bull market, the volume must increase upon rising price, and also falls with secondary pullbacks. If in such example the volume picks during pullback, this would be a sign that there is a reversing trend as a lot of market participants would turn bearish.
4. Trends Persist Until there is Clear Reversal
Primary trend reversals are often confused with secondary trends. Thus, it would be difficult to determine whether the bear market upswing becomes short-lived or reversal rally to get followed through lower lows, and Dow theory must advocate caution, insisting that possible reversal must get confirmed.
Dow Theory Sell Signal
When we trade some long term trade it is important to recognize three main phases.
In stage 2, Big move, we can see a huge drop in price. Usually in forex trading or stocks trading price will very fast (in few days) drop below EMA200 moving average after the stage of distribution. This is the period where technical indicators show oversold conditions. Beginners traders very often try to buy asset at this moment and make usually mistake. Usually, next days and week’s price will try to make new lows and the bearish trends can not be finish so fast. Long term traders increase sell positions and many of them enter into a trade for the first time. The next phase, Stage 3 – Despair, is the slow bearish trend and can be present for a very long time.
Among the most relied upon theories in the financial market history is the Dow theory. Whether you’re into short term stock market trading, an intraday trader, or are looking for long term investment, knowing this certainly helps in having a lot of strategies. He founded Dow-Jones’s financial service WSJ (Wall Street Journal) and Dow Jones Company co-founder. Even post 100 years Dow Theory would still be considered and dominated as the most sophisticated contemporary study meant for technical analysis.
Presently, the beliefs are quite relevant to the stock market. Also, Further, the Dow theory was developed with including the contributions put up though William Hamilton in the 1920s, Richard Russell and George Shaefer in the 1960s.
According to Dow Theory, the market is the upward trend when one of the averages (transportation or industrial) advances more than the previous important high and gets followed and accompanied through similar advances in another average.
Dow Theory has been a popular trading approach developed through Charles H. Dow with Charles Bergstresser and Edward Jones, founded the Dow Jones & Company, Inc. and also developed DJIA. The theory was fleshed out with editorial series in the Wall Street Journal, which was co-founded.
In 1902, Charles Dow died, and because of the death, the complete story wasn’t published on markets, but various associates and followers had published works with got expanded on editorials. Some vital contributions for Dow Theory are as follows:
“The Dow Theory Today” by Richard Russell (1961)
“The Stock Market Barometer” by William P. Hamilton (1922)
“The Dow Theory” by Robert Rhea (1932)
Dow had a theory that the entire stock market was ideal for identifying business conditions within the economy after analyzing the market, accurately one gauge such conditions, and identifies major trends in the market that are most likely individual stock direction.
Even though being a theory of up to a hundred years old, the Dow Theory still remains relevant in the present trading market.
This is due to the understanding of Dow Theory helps traders to benefit through exploiting and spotting trends in the market. The most important criticism of Dow Theory is that it is really not a scientistic theory – it is more market philosophy. There is no scientific proof that this theory can be applied in every single market situation. Traders can use Dow sell signal market philosophy to analyze bearish movement (and bullish too) and to understand phases. Very often when I see big picture, daily and weekly charts, I can make better decisions as a trader.