I was going through John J Murphy book. I thought of sharing it with you all. Hope this will be helpful.
Charles Dow and his partner Edward Jones founded Dow Jones & Company in 1882. Dow published his ideas in a series of editorials he wrote for Wall Street Journal. Most technicians today consider dow theory as corner stone of technical analysis. Few highlights of the Dow Theory analysis:
- The averages discounts everything:
The market reflect every possible knowledge factor that effects overall supply and demand. Ofcourse market can not anticipate events like earthquake or other natual calmities, but they quickly discount such occurances and almost instanteneously assimilate their affects into the price action.
- Markets has three main trends
The market has three major trends – primary, secondary and minor. Dow defined uptrend as a situation in which each successive rally closes higher than the previous rally high and each successive rally low closes higher than previous rally low. He compare the trend to tide, wave and ripples of the sea. As per Dow the primary trend lasts for more than year, intermidiate trend last for between three week to three months and the minor trend lasts for lesser than three weeks.
- Major trend has three phases
Dow identified three phases of the major trend – accumulation phase, public participation phase and a distribution phase. Accumulation phase – where astute investors do an informed buying. Public paricipation phase – at this juncture the trend followers start to participate. At public participation phase business news starts to improve and price start to rise rapidly. Distribution phase begins when the newspaper start publishing the bullish stories, when speculative volume and public participation increase. In this last phase the informed investors start selling.
- Volumn must confirm the trend
Dow recognised volume as a secondary but an important factor in confirming price signals. In a major uptrend as the price increase the volume increase and deminish as the prices fall. Dow gave importannce to closing price most and considered volume as secondary.
- A trend is assumed to be in effect untill it gives definite signals that it has reversed
Study of support and resistence, price patterns, trendlines, moving averages and other technical tool availiable to spot the reversal signal. Some indicator help detarmining the loss of movementum at an earlier stage. The difficult task for a dow theoriest is to identify the secondary correction in an existing trend and first leg of a new trend in opposite direction.
Dow mainly stressed on closing prices and he did not considered intraday penetration valid. Dow theory worked well in past. However, it does have some criticism. Before generating a signal, it misses 20% - 25% of a move. A buy signal usually occur in the second phase of an uptrend as prices penetrate a previous intermidiate peak. This is also, Incidentally, about where trend following technical systems begin to identify and participate in existing trends.