Dow Theory – The Main Tenants

Essentially, Dow Theory is nothing more than a method of technical analysis applied to stock price movement.  It’s often used as a study of stock trends, and has a long history of being used to help determine when the right time to buy or sell stocks is.  It’s not used as much as it once was, but Dow Theory is still well worth understand since it can help you learn how market trends affect your portfolio and your trades.  There are a few basic tenets on which this theory is built, and understanding them is really the key to understanding the entire process.

Dow Theory watches three basic types of movements in the market.  These include movements that focus on short, medium, and long term movements.  These movements can happen simultaneously or separately, but are the foundation of Dow Theory. Another tenant is that the stock market and its trends will quickly be affected by news – as soon as news related to any stocks is released the price of stocks will change to reflect that news.  This is also a basic tenant of efficient market hypothesis, and one that you can’t overlook if you’re investing.  Keeping an eye on new developments is vital.

Also, market movements occur in three basic phases according to the Dow Theory.  The first phase, known as the accumulation phase, occurs when investors who are ‘in the know’ – those with inside information – are making trades based on their knowledge.  The next phase is known as the public participation phase.  This is when other general traders notice the movements being made by the inside investors, and when this occurs the market prices will shift quickly to reflect the new trend.  At this point the third phase, known as the distribution phase, will occur.  This is when those original investors begin to distribute their shares among the public market, often for serious profits.

The final tenants of Dow Theory include additional info on the overall trends in the market.  First, market averages have to confirm one another.  The central rules behind this tenant applied mainly to the 20s, when Dow Theory was introduced.  Additionally, according to this theory trends are usually confirmed by volume, and they exist until various signals prove that they’ve reached their end.  While many people consider this theory archaic and outdated, some of the basic principles are still very much valid in today’s economy.  Take a closer look at Dow and you may find some tips for investing.

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