Developed by Charles Dow, refined by William Hamilton and articulated by Robert Rhea, Dow Theory addresses not only technical analysis and price action, but also market philosophy. Many of the ideas and comments put forth by Dow and Hamilton became axioms of Wall Street. At a high level, Dow Theory describes market trends and how they typically behave. At a more granular level, it provides signals that can be used to identify and subsequently trade with the primary market trend. The theory centers around identifying the trend for the Dow Jones Rail now Transportation Average and the Dow Jones Industrial Average, and using volume to confirm those trends.
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This method holds good in watching and determining the flood tide of the stock market. Confirmation by both is an integral part of the Dow Theory. The "few hypotheses": Manipulation is possible day-to-day but the primary trend cannot be manipulated. The Averages discount everything except acts of God. The theory is not infallible. The "definite theorems": There are three movements of the averages. The first, and most important, is the primary trend.
The second, and most deceptive is the secondary reaction. The third, and usually unimportant, is the daily movement. Both the Industrial and Transportation averages must confirm a trend. The determination of a major trend has come to be known as a signal to Buy or Sell, although Dow never called them such. Finally, a breakout above the previous rally high by both, constitutes a BUY Signal for the developing Bull market.
The chart represents how the Dow Jones Industrial Average and the Transportation Average might look under the most usual BUY signal B-1 : More than one bounce can occur within the confines of the bounce highs and the lows.
Any such non-confirmation by the other Average is inconsequential.
Six basic tenets of Dow theory[ edit ] The market has three movements 1 The "main movement", primary movement or major trend may last from less than a year to several years. It can be bullish or bearish. The three movements may be simultaneous, for instance, a daily minor movement 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 or absorption 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 demanding absorbing stock that the market at large is supplying releasing.