In this two-part article, we are going to discuss the Dow Theory and its six tenets through my perspective. I’m a trader who make a living using technical analysis for about 7 years, and I just use candlesticks and volume.
Charles Dow is considered the father of technical analysis, and he did great deeds during his lifetime, and the creation of the Dow Theory and its tenets was one of them.
As a journalist, he founded the Wall Street Journal, one of the most respected financial publications in the world.
As a market scholar, he invented the Dow Jones Industrial Average (DJIA) index. also, one of the most prominent indices used in the financial markets.
Yes, the man who lend his name to one of the most famous indices in the world, also developed the Dow Theory, a series of tenets that helps us to understand better the human behavior in the market.
Notice that technical analysis is all about behavior and psychology, and that’s why my trading style is reactive, not predictive.
Now, let’s talk about its six tenets, one by one, and I’ll give my opinion about each one of them.
- 1 – The Market Discounts Everything:
The first tenet says that the price will incorporate every single aspect of the market. Every information, news or events concerning an asset will have an immediate effect on its price.
I respectfully disagree with this tenet, because it’s simply not true (at least not anymore on most occasions).
The market is very efficient, indeed, but there’re times when you can find “distortions” on the price, and that can’t be explained by the Efficient Market Hypothesis.
Despite the Dow Theory concerns about the behavior and psychology of the market, it doesn’t embrace the behavioral finance. And that’s because this field wasn’t invented at the time the Dow Theory was fully developed.
In my view, the behavioral finance explains better the market irrationality, because it focusses more on our biases and emotions. And this is what really affect the market – our expectations towards it.
- 2 – There Are Three Primary Kinds of Market Trends:
This tenet is very interesting, because your trading style is defined by how long you keep your positions.
Day traders keep their positions for no longer than a day, while swing traders like to surf a bigger wave, and their positions last for weeks, or months. If you are a holder, you’ll maintain your positions for years.
That’s exactly where this tenet comes into play. According to the Dow Theory, a primary trend last for at least one year. And inside a primary trend, you’ll find secondary trends, which often works against the primary trend. That’s where the swing trader (like myself) enters. We try to catch a move, preferably favoring the primary trend, but only after it does a pullback on a secondary trend.
The tertiary trend is considered just noise by the Dow Theory, but there’re day traders who can make this a living.
- 3 – Primary Trends Have Three Phases:
Ok, this one is easy. You’ll find three types of trend in a primary trend, and their names will change depending on if it’s a bull or bear market.
If it’s a bull market: 1 – Accumulation; 2 – Public participation; and 3 – Excess.
If it’s a bear market: 1 – Distribution; 2 – Public participation; and 3 – Panic.
Where most people want to be? They want to put their money during the 1st phase, but they lack the technical knowledge and courage to do so.
The Public participation also is a great opportunity. But sadly, most people will have the courage to put their money only during the 3rd phase.
If you are a day trader, you shouldn’t care much about this. But as a swing trader, I’m always working hard on identifying the first phase of a trend.
The second phase also gives a lot of opportunities to make money, yes, but the first phase is the best one (and not always the riskiest one).
So this is it my friends, this was the part 1 out of 2 of the Dow Theory’s six tenets. I hope that you enjoyed.
Click here to go to part 2