Technical Analysis

The 6 tenets of Dow Theory:

1. The averages discount everything except acts of God

   1. This is a basic principle of technical analysis, anything and everything that CAN affect the price is already reflected and discounted in the price.

2. There are three types of trend

   1. Major – Major trends last for more than a year and often many years.
   2. Secondary – Secondary trends may endure for several weeks to several months. They are also called corrections because they’re regarded as interruptions in the major trend. They may trace from one-third to two-thirds of the price trend but only temporarily.
   3. Minor – Minor corrections last up to a few weeks and there may be two or three of them within an intermediate trend.

3. Major trends go through 3 phases – Accumulation, Trending & Distribution

   1. Accumulation phase is when price levels are relatively low, astute investors start buying or accumulating new positions.
   2. As more buyers join the buying price advances rapidly and economic conditions are strong and healthy. This is the second phase of the market otherwise known as the trending phase.
   3. At some point a buying climax occurs. More buyers are caught up in the buying enthusiasm, often less astute investors and speculators. By this time the trend has likely been going up for months and suddenly the prices seem too high and the market becomes overpriced. This is when the sensible investors begin to sell off, the third phase, the distribution phase.

4. Volume should confirm the trend

   1. The movements in the direction of the major trend were usually accompanied by heavy or increasing volume. Any market movements, whether up or down are considered to be stronger if increased volume goes along with it. Volume can be seen as a signal of market aggression.

5. Price action determines the trend

   1. A bullish trend is defined by a series of higher highs and higher lows in the price action. A bearish trend is the opposite and can be described as lower highs and lower lows. Whilst this is accurate, technical analysis is not a science and so you are unlikely to see perfect trends.

6. The averages must confirm each other

   1. This is one of the most important principles of Dow Theory. To confirm the potential future strength of the economy, the share prices of companies that make goods should rise, but also the share price of companies that distribute (i.e. transport) these goods must also rise. Although Dow referring to the transportation and industrial averages, he was touching on the much broader and more significant principles of confirmation and divergence. No one indicator in technical analysis can be regarded as the one-and-only signal, signals must confirm each other for the buy or sell signal to be considered valid.

As you can see, Dow Theory acts as the theoretical foundation for technical analysis.