The best starting point for us will be the oldest and most famous of all technical theories in existence, the famous Dow Theory. A lot of what we now call “technical analysis,” in fact, one way or another, follows from the theory of Charles Dow. Even in a modern world crammed with computers and new technologies, Charles Doe’s ideas still find application. Many technical analysts are unaware that much of their supposedly latest tools are based on the principles laid down by the Dow. That is why it is necessary to start studying technical analysis with an overview, even a cursory one, of the Dow theory.
Basic tenets of Dow Theory
- The market has three trends.
The primary trend may last from less than a year to several years. It can be bullish or bearish. The secondary trend or intermediate trend may last from ten days to three months and generally retraces from 33% to 66% of the primary price change since the previous medium swing or start of the main movement. The minor trend varies with opinion from hours to a month or more. For instance, the three trends may be simultaneous, a minor daily trend in a bearish secondary reaction in a bullish primary movement.
- Market trends have three phases
Dow Theory asserts that major market trends are composed of three phases: an accumulation phase, a public participation phase, and a distribution phase. The accumulation phase (phase 1) is a period when investors “in the know” are actively buying (selling) stock against the general opinion of the market. During this phase, the stock price does not change much because these investors are in the minority absorbing (releasing) stock that the market is supplying (demanding). Eventually, the market catches on to these astute investors, and a rapid price change occurs (phase 2). This happens when trend followers and other technically oriented investors participate. This phase continues until rampant speculation occurs. At this point, the astute investors begin to distribute their holdings to the market (phase 3).
- Volume must confirm the trend
Volume increases as prices move higher and dimmish as prices fall.
- The trend continues until it gives clear signals that it has changed
The trend tends to continue. The possibility that an existing trend will continue is usually higher than that it will change. By following this simple principle, you are more likely to be right than wrong. The most challenging task is to distinguish a regular interim correction to an existing trend from the first segment of a new movement in the opposite direction. The trend continues until it gives clear signals that it has changed.
Many technical tools are available to traders to assist in the difficult task of spotting reversal signals, including the study of support and resistance levels, price patterns, trendlines, and moving averages. Some indicators can provide even earlier warning signals of loss of momentum. Still, they can be interpreted differently by different investors. Determining whether a reversal is the start of a new trend or a temporary movement in the current trend is not easy.
Understanding and appreciation of Dow Theory provides a solid foundation for any study of technical analysis. It will become clear as you continue to learn TA and experience the market.