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Dow theory by P. Sai Prathyusha (1ST M.COM BUSINESS FINANCE)

Dow theory# introduction #meaning # basics# Principles of dow theory # six opinions # criticism # conclusion

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Dow theory by P. Sai Prathyusha (1ST M.COM BUSINESS FINANCE)

  1. 1. DOW THEORY P. SAI PRATHYUSHA 1ST M.COM (BUSINESS FINANCE) PONDICHERRY UNIVERSITY
  2. 2. INTRODUCTION The Dow Theory is a technical framework: • that predicts the market is in an upward trend if one of its averages advances above a previous important high, accompanied or followed by a similar advance in the other average. • The theory is predicated on the notion that the market discounts everything in a way consistent with the efficient markets hypothesis. • In such a paradigm, different market indices must confirm each other in terms of price action and volume patterns until trends reverse.
  3. 3. • The Dow Theory is one of the most popularly used concepts of charting & Technical Analysis. • It happens to be one of the oldest technical analysis tools as well. • Dow Theory days back to as early as 1900 to 1902 when Charles Dow laid the basic principles. • The Theory named after him as Dow Theory. • It helps investors in the stock market to understand the health of the trade condition. • The father of Dow Theory, Mr. Charles Dow died in 1902 but after his death work of Dow Theory was continued by William Hamilton. • The Dow Theory helps investors to know how the stock market used to understand the business environment’s health. • It was the first theory of technical analysis that explains the trends of market INTRODUCTION
  4. 4. INTRODUCTION • The Dow Theory is one of the most popularly used concepts of charting & Technical Analysis and happens to be one of the oldest technical analysis tools as well. Dow Theory dates back to as early as 1900 to 1902, when Charles Dow laid the basic principles which were named after him as Dow Theory. It helps the investors in the stock market to understand the health of the trade condition. The father of Dow Theory, Mr. Charles Dow died in 1902 but after his death work of Dow Theory was continued by William Hamilton. • The Dow Theory helps investors to know how the stock market used to understand the business environment's health. It was the first theory of technical analysis that explains the trends of market moves.
  5. 5. MEANING The Dow theory is a theory that says: THE market is in an upward trend if one of its averages (industrial or transportation) advances above a previous important high and is accompanied or followed by a similar advance in the other average. For example: if the Dow Jones Industrial Average (DJIA) climbs to an intermediate high, the Dow Jones Transportation Average (DJTA) is expected to follow suit within a reasonable period of time.
  6. 6. BASICS Understanding the Dow Theory The Dow theory is an approach to trading developed by Charles H. Dow who, with Edward Jones and Charles Bergstresser, founded Dow Jones & Company, Inc. and developed the DJIA. Dow fleshed out the theory in a series of editorials in the Wall Street Journal, which he co-founded. Charles Dow died in 1902, and due to his death several followers and associates have published works that have expanded on the editorials. Some of the most important contributions to Dow theory include the following: • William P. Hamilton's "The Stock Market Barometer" (1922) • Robert Rhea's "The Dow Theory" (1932) • E. George Schaefer's "How I Helped More Than 10,000 Investors To Profit In Stocks" (1960) • Richard Russell's "The Dow Theory Today" (1961)
  7. 7. Dow believed that the stock market as a whole was a reliable measure of overall business conditions within the economy and that by analyzing the overall market, one could accurately gauge those conditions and identify the direction of major market trends and the likely direction of individual stocks. The theory has undergone further developments in its 100-plus-year history, including contributions by William Hamilton in the 1920s, Robert Rhea in the 1930s, and E. George Shaefer and Richard Russell in the 1960s. Aspects of the theory have lost ground, for example, its emphasis on the transportation sector—or railroads, in its original form—but Dow's approach still forms the core of modern technical analysis. BASICS
  8. 8. BASICS
  9. 9. BASICS
  10. 10. PRINCIPLES OF DOW THEORY • There are six assumptions of the Dow Theory for studying by investors and analysts of the stock market. 1. The Market Discounts Everything: This assumption of Dow theory proposes that stock price reflects everything including all information past, current, and even future. This contains all data including sentiments of investors, profit announcements by companies, even rise or fall inflation. This Theory also works for events of an unpredictable account by which stock prices determine such as earthquakes and other natural disasters. This is also known as Efficient Market Hypothesis.
  11. 11. 2. Market Trends are of three types: The primary, secondary and minor trends that affect the market.  Primary Trend: The primary trend is one of the major trends for the market, which indicates how the market moves in the long-term. It can occur in both rising and falling market.  Secondary Trend: It is considered for correction to a primary trend. It’s an opposite action to the primary trend. This secondary trend has a range of 10 days to three months.  Minor Trend: In this trend, the market movement fluctuated on a daily basis. And these trends last usually less than three weeks. Minor trends are short term trends. 3. Market has three phases: These three phases in the market are accumulation, public participation, and distribution or panic phase. • In bullish markets the phases are described as below  Accumulation Phase: The accumulation market phase is when investors feel the change in the current market direction when they are entering the market.  Public Participation Phase: In this phase, investors enter the market just when the condition of the market improves and positive sentiments become noticeable.  Distribution or Panic Phase: This phase begins when the entire bullish news headline carried by media, there is buying on huge volume which is based on speculation. During the distribution phase, the trade news is bullish than ever, business value begins to advance quickly, & the community flock to the market in expectation of catching the movements.
  12. 12. Now talk about the bear market phases: • Distribution Phase: Usually the bear market starts when the bull market going to end. • Panic selling phase is: According to the name – best described by panic & fear. As a market price begins to failure and buyers become limited, people want to leave the market urgently when the very sharp drop occurs in the price of the market. • Discouragement phase: It occurs when the sharpest failures are finished. Stock investors thought that the market would improve, sell their portfolios which discouraged by the condition. This phase may be followed through a lengthy horizontal range, but after some time (sooner or later) things start to look positive and a new accumulation phase occurs in the market.
  13. 13. 4. The Stock Market Averages must confirm each other: Stock market averages must be in sync with each other. Companies operating across various different industries affect each other business in one way or the other. The key averages and stats of these industries , hence, get impacted by each other too. For example a manufacturing company may manufacture goods but for transporting it to the end user it will be using the transportation industry. So if the sales or profits or any particular averages in manufacturing goes up, then in ideal conditions even the transportation industry average shud also go up, considering all other factors remain the same. The Dow theory states that the averages across industry confirm the each other trends to some extent as well. 5. Trends are confirmed by volume: According to Dow Theory volume is a secondary factor but it’s important. Volume increases or decreases when price movement occurs in the trend direction or in reverse. If the price is moving in the direction of the primary trend then the volume should increase otherwise it will decrease if it is moving against the primary trend. Low volume indicates a weakness in the trend. Such as, in a bull market, if the price is rising then volume should increase, and fall if secondary pullback occurs. 6. Trends keep going until a clear reversal occurs: Primary trend reversals can be confused with the secondary trend. According to Dow Theory a trend keeps moving in the direction until some other external forces occur for changing the direction. However, the Dow Theory is relevant in nature of the Technical Analysis, it also have some criticism, which are as follows: • It’s not really a theory: The Dow Theory has no proper papers of academic research which were written as the theory and testing formulas. In the Wall Street Journal the Dow ideas were in fourth position over his column.  Being Too Late: The market trend does not covert from bearish to bullish until the previous reaction high has been exceeded. Some traders thoughts that Dow is simply too late and errors occurs in most of the moves.  Outdated: Many market traders feels that the Dow Theory is no longer available to give an exact economy reflection. IT, Pharmaceuticals and some other sectors have robust stock market participation.
  14. 14. DOW THEORY: SIX OPINIONS 1. Market Fluctuation: 3 broad types of market fluctuation are shown as below: Primary fluctuation: • which is also known as the major trend and lasts for a single year or extended to several years. Secondary effect: • which is also termed as the intermediate response can last starting from few days to over a period of few months. Minor fluctuations: • which are also called the Short Swing, can last for a few hours, a month or even somewhat more than that.
  15. 15. 2. Market Trend: • Following 3 stages are seen in terms of market trend. First phase: • which is called the accrual phase in which the investors generally purchase those securities that the common public are not buying. • In this stage, there are not many variations in the prices of the security because the demand for such securities is quite low and the supply is quite high. Second phase: • which is also called Public Participation. • Once the market comes to know about investors of this category, a quick price movement occurs in those particular stocks. • This category comes into play once the technical investors participate in security purchase. Third phase: • is also called the Distribution phase and • it comes into picture once the speculation activity begins and • these investors start giving out their accumulated stock prices in the market. DOW THEORY: SIX OPINIONS
  16. 16. 3. Impact of Information: • The third most important view is that all information regarding the security market is discounted. • Any fresh information related to the security market is applicable on all the security prices once the news is available to the retail investors. • As soon as the information regarding securities concerned is out in the open, the prices would change to reflect the impact of that information. • This fluctuation of price of securities with the real-time impact of information shows the efficiency of market hypothesis. DOW THEORY: SIX OPINIONS
  17. 17. 4. Averages: • The fourth bit of the Dow Theory is that the average in the security market should verify about each other. • Once in stock market, performances of the averages of securities start diverging. • this is a clear signal that there is a major change that will be soon seen in the market DOW THEORY: SIX OPINIONS
  18. 18. 5. Volumes: Tendencies in the market are validated by their respective volumes. This is explained as: • if the prices in the market are fluctuating on lower volume, there can be several clarifications for that • but on the contrary • if the price fluctuations are moving with higher volume, according to Dow Theory this movement will signify the true market view. DOW THEORY: SIX OPINIONS
  19. 19. 6. Market Signals: • The sixth and the vital most opinion is that until any fool-proof signals are received, the prevailing trend would continue to exist in the current market. • Dow was of the belief that trends always existed although there were some noises, which were heard in the market. • The markets can begin to move in a different direction, which can be completely the opposite of the market trend intermittently but they will again follow the trend once they realize that they are moving in a different direction. • However, it is very difficult to establish that the reversal shown is a permanent trend or temporary trend. DOW THEORY: SIX OPINIONS
  20. 20. 1. The average discounts everything: • The market reflects all available information which can affect it positively or negatively. • What it cannot anticipate is happening of the natural calamities, even that are discounted as soon as it happens. • It is similar to that of the first pillar of the technical analysis; the prices of the stocks absorb all the news as soon as the information is released. • Prices show the sum total of all the hopes, fears and expectations of all participants. • Interest rate movements, earnings expectations, revenue projections, presidential elections, product initiatives and all else are already priced into the market. BASIC TENANTS
  21. 21. 2. The Market has three trends: According to Dow theory, the market has only three trends a. Primary trend: • In Dow theory, primary trend is also considered as major trend in the market. • It has a long term impact and may remain in effect for more than 1 year. • It may also influence the secondary and minor trend. • Dow looks at it as tides in the sea as it affects the overall impact dramatically. b. Secondary trend: • Dow call a correction in the primary trend as secondary trend. • It usually last for three weeks to three months. • It generally retraces 33% to 66% of the primary trend. • In a bullish market secondary trend will be a downward movement and in a bearish market it will be a rally. • Dow calls it as waves in the sea. c. Minor trend: • The “short swing” or minor movement varies with opinions from hours to a month or more. BASIC TENANTS
  22. 22. Primary Trend: The primary trend is one of the major trends for the market, which indicates how the market moves in the long-term. It can occur in both rising and falling market. Secondary Trend: It is considered for correction to a primary trend. It’s an opposite action to the primary trend. This secondary trend has a range of 10 days to three months. Minor Trend: In this trend, the market movement fluctuated on a daily basis. And these trends last usually less than three weeks. Minor trends are short term trends. TRENDS
  23. 23. The three trends may be simultaneous. For instance, a daily minor trend in a bearish secondary trend in a bullish primary trend. TRENDS
  24. 24. Dow theory believes that major market trends consist of only three phases: Accumulation phase: • It is a period when investors are actively buying (selling) stock against the general opinion of the market. • At this phase trader keeps buying and selling the stock but the prices do not change as the demand is far less the supply in the market. Absorption phase: • In the second phase investor starts accumulating stock. • All the technical indicator starts working as there is a huge participation in the market. • This phase continues until rampant speculation occurs. Distribution phase: • After a huge hype in the prices because of the skewed supply of the stock the prices begins to retrace as the astute investors begin to distribute their holdings to the market. • As a result of it the prices start falling along with the volume. TRENDS The Market trends have three phases:
  25. 25. The market has three phases: accumulation, public participation, and distribution or panic phase. TRENDS
  26. 26. The market has three phases: accumulation, public participation, and distribution or panic phase. TRENDS
  27. 27. In bullish markets, the phases described as below Accumulation Phase: • The accumulation market phase is when investors feel the change in the current market direction when they are entering the market. Public Participation Phase: • In this phase, investors enter the market just when the condition of the market improves and positive sentiments become noticeable. Distribution or Panic Phase: • This phase begins when the entire bullish news headline is carried by media, there is buying on huge volume which is base on speculation. • During the distribution phase, the trade news is bullish than ever, business value begins to advance quickly, & the community flock to the market in expectation of catching the movements.
  28. 28. In bear market phases would be: Distribution Phase: Usually the bear market starts when the bull market going to end. Panic selling phase is: According to the name – best described by panic & fear. As a market price begins to failure and buyers become limited, people want to leave the market urgently when the very sharp drop occurs in the price of the market. Discouragement phase: It occurs when the sharpest failures are finish. Stock investors thought that the market would improve, sell their portfolios which discouraged by the condition. This phase may follow through a lengthy horizontal range, but after some time (sooner or later) things start to look positive and a new accumulation phase occurs in the market.
  29. 29. 3. Average must confirm each other: • In Dow’s time, the two averages were the Industrials and the Rails. • The logic behind the theory is simple: Industrial companies manufactured the goods and the rails shipped them. • When one average recorded a new secondary or intermediate high, the other average was required to do the same in order for the signal to be considered valid. • If the two averages acted in harmony, with both reaching new highs or lows around the same time period, then the prices of each was said to be confirming. • When one of these averages climbs to an intermediate high, then the other is expected to follow suit within a reasonable amount of time. • If not, then the averages show “divergence” and the market is liable to reverse course. • In other words if one average went to a new high, while the other was left behind, then there was bearish divergence. • If the opposite occurred, with one average reaching a new low while the other held above a previous bottom, then the divergence was bullish. BASIC TENANTS
  30. 30. The Stock Market Averages must confirm each otherBASIC TENANTS
  31. 31. 4. Stock market averages must be in sync with each other. Companies operating across various different industries affect each other business in one way or the other. The key averages and stats of these industries, hence, get impacted by each other too. For example: a manufacturing company may manufacture goods but for transporting them to the end-user it will be using the transportation industry. So if the sales or profits or any particular averages in manufacturing goes up, then in ideal conditions even the transportation industry average should also go up, considering all other factors remain the same. The Dow theory states that the averages across industry confirm each other trends to some extent as well BASIC TENANTS
  32. 32. 5. Volume must confirm the trend: • Dow recognized the volume as a secondary but important factor in confirming price signals. • In other words volume should increase in the direction of the major trend. • In a major uptrend volume should increase with the rally in price and should diminish during correction. • Also in a major downtrend volume should expand with the fall in prices and should contract during upward ripples. BASIC TENANTS
  33. 33. 5. Volume must confirm the trend: • According to Dow Theory volume is a secondary factor but it’s important. • Volume increases or decreases when price movement occurs in the trend direction or in reverse. • If the price is moving in the direction of the primary trend then the volume should increase otherwise it will decrease if it is moving against the primary trend. • Low volume indicates a weakness in the trend. • Such as, in a bull market, if the price is rising then volume should increase, and fall if secondary pullback occurs.
  34. 34. 6. A trend is assumed to be in effect until it gives a definite signal of reversal: Dow was a firm believer that market remains in a trend. It may deviate for a while because of noise but it will return as soon as its effect is over. There are many trend reversal signals like support/resistances, price patterns, trend lines, moving averages. Some indicators can also provide warnings of loss of momentum. Primary trend reversals can be confused with the secondary trend. According to Dow Theory, a trend keeps moving in the direction until some other external forces occur for changing the direction. BASIC TENANTS
  35. 35. Trends keep going until a clear reversal occurs
  36. 36. Criticism It’s not really a theory: The Dow Theory has no proper papers of academic research. It has written as the theory and testing formulas. In the Wall Street Journal, the Dow ideas were in the fourth position over his column. Being Too Late: The market trend does not covert from bearish to bullish until the previous reaction high has been exceeded. Some traders thoughts that Dow is simply too late and errors occur in most of the moves. Outdated: Many market traders feel that the Dow Theory is no longer available to give an exact economy reflection. IT, Pharmaceuticals and some other sectors have robust stock market participation.
  37. 37. Conclusion • Basically, Dow Theory represents Technical Analysis beginning. • By understanding this theory you can get a better understanding of an analyst view of how the markets work. • The main goal of the Dow Theory is to recognize the primary trend of the market. • It is useful for identification of trend and it’s also useful for signals of entry & exit. • The Dow Theory describes the stock market behavior. • Moreover, professional Traders and investors use to all trades on a stock exchange. • This is not a theory which used to produce perfect signals to buy and sell. • It provides basic ideas and rules about the market functioning. • It helpful, in the overall understanding of how it works. • Dow theory is an essential part of the Technical Analysis. • Traders and investors use it when they do various technical charting, use technical indicators and perform technical analysis.
  38. 38. • Basically Dow Theory represents Technical Analysis beginning. By understanding this theory you can get a better understanding of an analyst view of how the markets work. The main goal of the Dow Theory is to recognize the primary trend of the market. Dow Theory is useful for identification of trend and it’s also useful for signals of entry & exit. The Dow Theory describes the stock market behavior. Moreover, it can be applied to all trades on a stock exchange not only to stocks. This is not a theory which is used to produce perfect signals of buy and sell, however, it provides basic ideas and rules about the market functioning to the investors, and it can be helpful in the overall understanding of how it works. Besides, some ideas are still usable as they were before 100 years, and currently, effect of Dow Theory (Divergence, trend definition, concepts which used to construct indicators of stocks, etc.) is clearly visible on Technical Analysis. Dow theory is an essential part of the Technical Analysis and is one of the basic principles for traders and investors alike when they do various technical charting, use technical indicators and perform technical analysis. • At Share Gurukul, we offer courses on Technical Analysis with realtime training and trading support by one of the best technical analysts in the country. Join Share Gurukul today to learn how to use Dow Theory of Technical Analysis and build successful trading strategies for your portfolio.

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