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An Intro to Dow Theory

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Why Charles Dow's theory still matters after 100 years.

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Before Charles Dow began writing the theory that bears his name over a century ago, the idea of speculating on the markets was considered rather foolish. Yet Dow Theory is regarded as one of the leading schools of thought on basic market philosophy and is relevant to all traders. Dow Theory stresses technical analysis and the idea that focusing on price action can help determine the presence of three primary movements within the market, including:
  • Primary movement
  • Secondary movement
  • Daily fluctuations
The primary movement is what most investors commonly identify as the bull or bear market. In other words, the primary movement is the general trend of the entire market and can last from several months to multiple years. In an upward trend, or bull market, prices continue to climb and establish new historical highs with a succession of higher lows. There may be temporary fluctuations in pricing, and these are known as secondary movements.

Secondary movements are known by different names according to when they are identified. The rule is that they will be shorter and in the opposite direction of the primary movement. If they occur during a bull market, the secondary movement is commonly referred to as a market correction; in a bear market, the secondary movement is known as a rally.

Daily fluctuations vary greatly and can be caused by a number of factors, including world events. As with the secondary movements, daily fluctuations may buck the primary movement temporarily, but the market will continue traveling in the same overall direction until it is time for a primary trend change.

At the end of the day, Charles Dow believed that trends existed, that they could be identified, and that technical analysis was the best method for perceiving them. Dow and his followers were not necessarily concerned with identifying the exact point where a trend change would occur. Rather, they tried to capitalize on trends once identified. The earlier the trend was spotted, the greater the potential for profit. Some technical indicators used to help identify trends include:
  • Moving average
  • Simple moving average
  • Exponential moving average
  • Moving average convergence divergence indicator (MACD)
Although varying aspects of Dow's comprehensive theory have been disputed, the fact remains that the overall philosophy remains sound. The same principles that govern the equities markets also govern other markets: trends trends exist, trends tend to persist over time, and trends can be identified through technical analysis.

Indeed, technical traders tend to be the most successful because they constantly test their investment strategies using the most accurate analysis available. This greatly increases their odds of identifying and capitalizing on the long-term trends first identified by Charles Dow. It is interesting and amazing to note that until Charles Dow started compiling the Dow Jones Industrial (INDEXDJX:.DJI) and Dow Jones Rail Index (INDEXDJX:DJUSRR) and started writing about the stock market a little over one hundred years ago, stock speculation was regarded merely as a game for the rich or as gambling for the brave. Sure, there were the tape readers, but the majority of the public regarded Wall Street as a source of excitement -- the entertainment provided freely (unless you were on the wrong side) by figures such as Cornelius Vanderbilt, Jay Gould, and the infamous Daniel Drew.

In a series of stunning editorials for the Wall Street Journal at the turn of the century, Dow laid out the foundation of his own theory on the stock market. Among them were:
  • The market is always to be considered as having three movements, all going on at the same time.
  • The first thing to consider is the value of the stock in which the speculator proposes to trade, the second the direction of the main movement, and the third the direction of the secondary movement (i.e. stocks fluctuate together, but prices are controlled by values in the long run).
  • There are three phases to both a primary bull market and a primary bear market (not to be confused with the three movements mentioned above).
  • The formation of a "line" in the averages indicates accumulation or distribution.
  • The market represents a serious well-considered effort on the part of far-sighted and well-informed men to adjust prices to such values as exist or which are expected to exist in the not too remote future.
The method of making money in stocks, according to Dow, was to study basic conditions and exercise enough patience to capture the major movements. One of the few speculators who discovered this relatively new concept of making money on Wall Street at the time was Jesse Livermore. He was able to accomplish this only through trial and error and the making and losing of several fortunes as was highlighted in the classic book Reminiscences of a Stock Operator (a must-read for anyone!).

Editor's note: This story by Evan Lazarus originally appeared on T3Live.com.

To read more from T3Live, see:

What Could Derail Market's Historic Run?

Morning Call Express: Can the Trend Remain Our Friend?

Upgrades, Downgrades, Headlines - May 16, 2013

Check out T3Live.com's Virtual Trading Floor to follow these traders and their live portfolios on real-time throughout the day! Take a free trial.
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