What Is Dow Theory

Hello, this is Bitpunk. Trends and trading volume are key to stock investing. Today, let's take a look at Dow Theory, the foundation of those concepts. Dow Theory originates from Charles Dow, the founder and editor of The Wall Street Journal. He never explicitly laid out Dow Theory himself, but it is known that after his death, several editors came together to build it. Dow Theory is also the theory that gave birth to the Dow Jones Industrial Average.

The Basic Principles of Dow Theory

1. The market is the measure of everything.
   Dow believed that the market reflects every factor. What we commonly call good news or bad news is usually already priced into the market before it turns out to be true or false.

2. Market trends come in long-term, medium-term, and short-term trends.
   Dow divided market trends into long-term (Primary), medium-term (Secondary), and short-term (Tertiary). The long-term trend serves as the baseline, and he saw that when the medium-term and short-term trends move against the long-term trend, you can consider it as an entry point.

3. A primary trend consists of three phases: accumulation, public participation, and excess & distribution.
   Accumulation and distribution are usually carried out by professionals or large players, but quick-witted individuals can take part too. At the start of a bull market, there is usually an accumulation period during which prices move sideways. After that, as prices rise, the public starts buying in and a full-fledged bull market begins. As the uptrend accelerates and then begins to turn, the accumulating players unload their holdings and exit. In a bear market, these phases play out in reverse.

4. Cross-index correlation analysis is valid.
   In the early days of Dow Theory, something called the Dow Jones Transportation Average drew attention. The idea was that in the industrial era, an increase in the production of goods would lead to an increase in transportation, so the index was used to double-check the other. It is rarely used today.

5. Trading volume matters.
   Dow believed that a strong trend must be accompanied by high trading volume. The higher the volume, the more firmly established the trend tends to be. On the other hand, if volume is low, even if the trend is holding, it may mean the trend could reverse or is not a reliable one.

6. A trend remains valid until it reverses.
   Dow believed that an uptrend or downtrend stays valid until it reverses. Fundamentally, he thought that as long as the long-term trend doesn't break, it will continue until it is reversed.

Closing Thoughts

Dow died in 1902, and his theory became famous during the Great Depression of the 1930s. Because of this, some people today consider Dow Theory outdated. However, Dow Theory, with its emphasis on trends and trading volume, is still used by most financial professionals and investors today. From a trend-trading perspective, using Dow Theory to judge market trends and weigh when to buy and sell is still a worthwhile approach.