Introduction:
Charles Dow, who is referred to as "Father of Technical Analysis" has made immense contributions to the field of Technical Analysis. One of the important contributions include the DOW THEORY. The Dow Theory evolved from the work of Charles Dow, who published a series of The Wall Street Journal editorials between 1900 and 1902.
Principles of Dow Theory:
1) Averages Discount Everything-
Market averages discount everything means all the news and factors which affects the stocks are already priced in the index. This shows that just like stocks, the averages of these stocks, which we call INDEX also discounts everything in the market and everything is already priced in.
2) The Market has Three Trends-
A) Primary Trend:
Primary trend also called as major trend lasts from more than one year to up to may be around 3 to 5 years duration. The primary trend can be Bull run (bullish) or Bear run (bearish). However, the Bullish run may be interrupted by small corrections in between and so is Bearish run may also see some small up moves in the formation of Primary trend.
B) Intermediate Trend:
The intermediate trend lasts from around three weeks to months but normally less than a year. The intermediate trend may be bullish, but not necessarily the primary trend is. The primary trend may be bearish but the intermediate trend is bullish, that means overall long term trend is bearish, but now for some time the trend has changed and it is bullish and vice-versa. It may be 33, 50 or 66 % retracement of the prior trend.
C) Short Term Trend:
The short term trend may last from a week up to as long as 6 weeks. It is a minor trend and may be bullish or bearish or consolidation. As it is very short term, it is a bit difficult to analyse short term trends, and major focus remains on Primary and Intermediate trend.
3) The Market has Three Phases- Accumulation, Participation and Distribution-
A) Accumulation:
Accumulation phase is the first phase of a primary bull market where informed investors make buying decisions and there is no much noise in the market. People accumulate stocks on declines and hold it for gaining in coming times. The market may be down, but smart people think this is it and no more decline in markets -lets accumulate.
B) Participation:
Participation is the phase when market starts showing signs of reversal, and people join in and starts confidently buying stocks, taking the market to rise at higher levels, as most of the macro data like GDP, Inflation, IIP, etc works in the favour of the markets. In short, buying interests is at its peak.
C) Distribution:
Once the markets are heated up with excess buying, we see smart investors booking profits followed by other people who accumulated in the second stage of participation. Suddenly, lot of profit booking happens, and the markets are back in the selling spree. And hence the market falls like pack of cards, which is nothing but the distribution stage.
4) Averages must confirm each other:
Dow was of the view that two averages must confirm each other, which means the two average suggested by him - Rail averages and Dow Industrial, must go hand in hand. So, if the Dow Industrial is moving higher, and the Rail average is not performing, this means there is something fishy in markets, and the bullish run cannot be confirmed yet, and vice versa. So, averages must confirm each other. If the Dow Industrial is going up, even the Rail average must follow suit and vice versa.
5) Volumes must support the trend:
Dow was of the view that any run whether bullish or bearish must be confirmed with High volumes. If the volumes are small, it means that market trend is still not confirm. So, when markets rise, it must be accompanied with High volumes, and even when market falls, it should also comprise higher volumes for the trend to be confirmed.
6) It is considered that the trend remains in force until it gives definite signals that it has reversed:
This principle is basic principle of Technical Analysis. Practically, if it is not true, the entire technical analysis would not make sense. The principle is linked to the law of motion in general: anything that moves is likely to continue to move until an external force does not prevent it. So, don't take hasty decisions, wait for the confirmation that the trend has reversed its direction.
Criticisms to Dow Theory: (Taken from Kilpatrick book):
Although Dow Theory forms the building blocks for modem-day technical analysis, this theory is not without criticisms. One of the criticisms is that following the theory will result in an investors acting after rather than before or at market tops and bottoms. With Dow Theory, there is an inevitable lag between the actual turn in the primary trend and the recognition of the change in trend. The theory does not recognize a turn until long after it has occurred and has been confirmed. On the other hand, the theory, if properly interpreted, will recognize that primary trend change and will thus never allow a large loss. Dow's contention was that concentrating on any direction change of shorter duration than the primary trend increased the chances of having one's portfolio whittled away by high turnover, many errors in judgment, and increased transaction
costs. Therefore, Dow Theory is biased toward late recognition of a change in trend to minimize the costs of wrongly identifying a change in trend.
A second criticism of Dow Theory is that the different trends are not strictly defined. Often the interpretation of price swings is difficult to assign to a specific trend type. Secondary trend beginnings often appear like primary trend beginnings, for example. This makes the determination of the primary trend unclear at times and can incite investment in the wrong direction. Others, however, criticize Dow Theory for being too specific about the requirements needed to identify a change in trend. Requiring that only closing prices be used or that any break to a new level no matter how small is significant often places too much emphasis on a small change in price.
No comments:
Post a Comment