What is the Dow Theory
3. The Dow Theory as the Basis of Technical Analysis
In 1889, Charles H. Dow founded the Wall Street Journal. As early as 1884 he published a stock index that later became the "Dow-Jones Averages". These indices, which are regularly published in the Wall Street Journal, are now the indices for industrial stocks, transportation stocks, and utilities stocks. Observing the index resulted in the basic idea of the Dow theory, which is also the basis of technical analysis: share prices move in trends. Primary trends, secondary trends and tertiary trends are distinguished according to the duration of the price movements in the same direction. Primary trends are long-term trends that last a year or more, secondary trends are medium-term trends that last two months to a year, and tertiary trends are short-term trends that last a week to two months. The individual types of trends are shown as examples in Fig. 3.1. The Dow theory states that trend reversals can be recognized from the price development.
Figure 3.1: Primary, secondary and tertiary trends
Typically, in a downtrend, according to Dow theory, each low is below the previous low and each high is below the previous high. Similarly, in an uptrend, each high is above the previous high and each low is above the previous low. If, after a downtrend, a low suddenly lies above the previous low and the following high above the previous high, it is assumed that the downtrend has turned into an uptrend. Conversely, an upward trend has turned into a downward trend if, after an upward movement, a low is below the previous low and a high is below the previous high (Fig. 3.2).
Figure 3.2: Trend reversal according to the Dow theory
According to the Dow theory, this signal for a trend change is regarded as significant if it occurs not only in the index for industrial stocks, but also in the index for transport stocks. Monitoring the trend does not give buy or sell signals for individual stocks. It can only be used to confirm a buy or sell signal for a single share. According to the Dow theory, anyone who buys any stocks when the index indicates the start of a bull phase will in many cases not be able to achieve any investment success.
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