Before Charles Dow began writing the theory that bares his name over a century ago, the idea of speculating on the markets was considered rather foolish. Yet still, the Dow Theory is regarded as one of the leading authorities on basic market philosophy and is relevant to all traders. Dow Theory stresses technical analysis and the idea that focusing on price action can help determine the presence of three primary movements within the market, including:
- Primary Movement
- Secondary Movement
- Daily Fluctuations
Secondary Movements are really known by different names according to when they are identified. The rule is that they will be shorter and in the opposite direction of the Primary Movement. If they occur during a "bull" market, the secondary movement is commonly referred to as a market correction; in a "bear" market, the secondary movement is known as a rally.
Daily fluctuations vary greatly and can be caused by a number of factors, including world events. As with the secondary movements, daily fluctuations may buck the primary movement temporarily, but the market will continue traveling in the same overall direction until it is time for a primary trend change.
At the end of the day, Charles Dow believed that trends existed, could be identified, and that technical analysis was the best method for perceiving them. Dow and his followers were not necessarily concerned with identifying the exact point where a trend change would occur just that they existed and could be capitalized on once identified. The earlier the trend was spotted, the greater the potential for profit. Some technical indicators used to help identify trends include:
- Moving Average
- Simple Moving Average
- Exponential Moving Average
- Moving Average Convergence Divergence Indicator (MACD)
Indeed, technical traders tend to be the most successful because they are constantly testing their investment strategies using the most accurate analysis available. This greatly increases their odds of identifying and capitalizing on the long term trends first identified by Charles Dow. It is interesting and amazing to note that not until Charles Dow started compiling the Dow Jones Industrial and Dow Jones Rail Index and started writing about the stock market a little over one hundred years ago, stock speculation was regarded merely as a game for the rich or as gambling for the brave. Sure, there were the tape readers, but the majority of the public regarded Wall Street as a source of excitement - the entertainment provided freely (unless you were on the wrong side) by figures such as Cornelius Vanderbilt, Jay Gould, and the infamous Daniel Drew.
In a series of stunning editorials for the Wall Street Journal at the turn of the century, Dow laid out the foundation of his own theory on the stock market. Among them were:
- The market is always to be considered as having three movements, all going on at the same time.
- The first thing to consider is the value of the stock in which the speculator proposes to trade, the second the direction of the main movement, and the third the direction of the secondary movement (i.e. stocks fluctuate together, but prices are controlled by values in the long run).
- There are three phases to both a primary bull market and a primary bear market (not to be confused with the three movements mentioned above).
- The formation of a "line" in the averages indicates accumulation or distribution
- The market represents a serious well-considered effort on the part of far-sighted and well-informed men to adjust prices to such values as exist or which are expected to exist in the not too remote future.