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Technical analysis has been an integral part of the Dow Theory since its inception. Even before candlesticks were invented in the west, the Dow Theory was widely used. Even today, Dow Theory concepts can still be used. Traders combine the best practices of Candlesticks with Dow Theory.
Charles H. Dow was the first to introduce the Dow Theory to the world. He also founded the Dow Jones financial news service (Wall Street Journal). He wrote several articles that began in the 1900s. These articles were later called 'The Dow Theory'. William P Hamilton deserves a lot of credit for compiling these articles and providing relevant examples over a 27-year period. Many things have changed since Charles Dow's time, so there are both supporters and opponents of the Dow Theory.
A few beliefs are the foundation of The Dow Theory. These beliefs are known as the Dow Theory tenets. These tenets were developed by Charles H Dow over many years of observation of the markets. The Dow Theory is based on 9 principles. These are the following:
| S.N | Tenet | What does it signify? |
|---|---|---|
| 01 | Everything Discounted by Indices | Stock market indices do not consider everything that is publicly available. Stock market indices will quickly adjust to the correct value if there is an unexpected and sudden event. |
| 02 | There are three broad market trends. | Primary Trend, Secondary Trend, Minor Trends |
| 03 | The Primary Trend | This is the main trend in the market, which can last from one year to several years. This indicates the overall market direction over the next several years. The primary trend is what the long-term investor is most interested in, but active traders are interested in all trends. A primary uptrend, or a primary decline, could be the primary trend. |
| 04 | The secondary trend | These are corrective actions to the main trend. This is a minor counter-reaction against the larger market movement. Examples: corrections in bull markets, rallies and recoveries in bear markets. Counter-trends can last from a few weeks up to several months |
| 05 | Minor Trends/Daily fluctuations | These fluctuations are market noise, or market noise as some traders prefer. |
| 06 | All Indices need to confirm each other. | A single index cannot be used to confirm a trend. For example, CNX Smallcap, CNX Midcap, CNX XNifty Nifty Smallcap and CNX CNX XNifty Nifty are all bullish. All move in the same direction upward. Markets cannot be categorized as bullish based on the actions of CNX Nifty. |
| 07 | Volumes must be confirmed | Prices and volumes should be confirmed. Volume should support the trend. Volume should increase with rising prices and decrease when they fall in an uptrend. In a downtrend the volume should increase as the price falls, and decrease as the price goes up. For more information on volume, you can refer to chapter 12. |
| 08 | Secondary markets can be substituted by sideways markets. | For a prolonged period, markets may trade sideways (trading within a range). Reliance Industries traded between 860 to 990 between 2010-2013. Sideways markets can substitute for secondary trends |
| 09 | The most sacred price is the closing price. | The close price is the most important level of stock prices. It represents the end of the day's evaluation. |
According to Dow Theory, the markets are composed of three phases that are self-repeating. These phases are the Accumulation, Markup, and Distribution phases.
The market's steep sell-off usually triggers the Accumulation phase. Many market participants would have been frustrated by the steep sell-off and lost hope for a rebound in prices. Stock prices would have fallen to rock bottom valuations but buyers would be reluctant to buy again in fear of another sell-off. Thus, the stock price stagnates at low levels. This is where the "Smart Money" enters the stock market.
Smart money is typically institutional investors who have a long-term view. They are always looking for value investments that can be found after a sharp sell-off. Institutional investors begin to buy shares in regular, large amounts over a long period of time. This is called an accumulation phase. Also, sellers who try to sell during an accumulation phase are more likely to find buyers and prices don't drop further. The accumulation phase is the end of the market. This is where support levels are most often created. The accumulation phase can last several months.
Short term traders are supported once the institutional investors (smartmoney) have absorbed all of the stocks. This is often correlated with a better business sentiment. These factors can cause the stock price to rise. This is the markup phase. The Markup phase is when the stock price rises rapidly and sharply. Speed is the most important characteristic of the markup stage. The rally is fast, so the public is not included. The return is captivating for new investors, and analysts as well as the general public are enthralled.
When the stock price hits new highs, 52 weeks high, or all-time high, everyone will be talking about it. News reports become optimistic and the business environment appears lively. Everyone (public) wants investments in the markets. As long as there is positive sentiment, the public wants the markets to be open for investment. This is where the distribution phase begins.
Smart investors, the judicious ones, will slowly start to sell their shares. All volumes that were sold by institutional investors (smart money), will be absorbed by the public, providing them with the much-needed price support. The distribution phase exhibits similar price properties to the accumulation phase. The distribution phase is where prices try to rise higher. This is when the smart money sells off their holdings. This action is repeated over a long period of time and the resistance level is formed.
The final step is when institutional investors (smartmoney) sell all their holdings. This will end any support for prices. The mark down of prices is the complete sell-off that follows the distribution phase. The public is left in utter frustration after the market selloff.
The selloff phase completes the circle. Next comes an additional round of accumulation, and the cycle continues. The entire cycle, from the accumulation phase to selloff, is thought to last several years.
It is important that you remember that not all market cycles are alike. In the Indian context, for example, the bull markets of 2006-07 and 2013-14 are very different. Sometimes, the market can move from accumulation to distribution over a long period of time. The opposite can be true for a shorter period of time. Market participants need to be able to evaluate markets in different phases. This sets the stage for developing an understanding of the market.
There are few patterns that are important in Dow Theory, just like in candlesticks. These patterns can be used by traders to identify trading opportunities. We will be looking at the following patterns:
Although support and resistance are also core concepts of the Dow Theory, we discussed them earlier and gave it a chapter due to their importance (in terms stop-loss and placing targets).
Double bottom and double top is taken as A reversal Pattern. A double bottom is when a stock's value hits a low level but then recovers quickly. The stock trades at a higher price (relatively to the low price) for at most 2 weeks. The stock then attempts to return to its original low price. If the stock holds steady and rebound, then a double bottom can be formed.
Double bottom formations are bullish and should be considered buying opportunities. This chart shows Cipla Limited's double bottom formation:
The time interval between the bottom formations is significant. The time interval between the bottom formations was very long.
Similar to a double top, the stock tries twice to reach the same high price but ultimately sells off. The time between crossing the high and the second attempt should be at most 2 weeks. The chart below (CairnIndia Ltd) shows the double top at 336 levels. Close inspection will reveal that the first top was Rs.336, while the second top was Rs.332. This small variation should be acceptable with some flexibility.
Based on my trading experience, double tops as well as double bottoms are very useful in trading. Double tops and double bottoms are always good opportunities.
Imagine, for example, a situation in which the double top formation and the 2 ndtop form a bearish pattern, such as a shooting stars.The conviction to get the trade is high as the candlestick as well as the Dow theory points towards unanimity to sell.
A triple formation is, as you might have guessed from the name, similar to a single formation except that the price level in a triple formation is tested three times instead of twice. The triple formation can be interpreted in the same way as the double formation.
The rule of thumb is that the more times that the price reacts to and tests a price level, then the more sacred it is. This is why the triple formation is more powerful than the dual formation.
The chart below shows DLF Limited's triple top formation. The sharp sell-off following testing the price levels for the 3 time periods, thus concluding the triple top.