Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 75% of retail investor accounts lose money when spread betting and/or trading CFDs with this provider. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.

The six tenets of Dow Theory

The Dow Theory, a financial markets theory developed by Charles H. Dow, rests on six basic tenets that were a precursor to modern-day technical analysis.

Most trading strategies used today hinge on one key concept, the "trend". This was a novel idea when Charles H. Dow published his writings at the end of the 19th century. However, more than a century later, the Dow Jones Industrial Average market index, created by the American journalist to illustrate his theory, is probably now the most followed index on the planet. For a better understanding of Charles H. Dow's writings and their implications, here are the six basic tenets that underpin his theory.

One: the market discounts everything

In other words, the prices of stocks and indices reflect all available information, and the only information that cannot be reflected is that which is unknowable. This is known as the Efficient Market Hypothesis (EMH).

Two: the three-trend market

Primary trends tend to last for one year or more. They dictate whether a market is bullish (upward moving) or a bearish (downward moving). Secondary trends are the corrective moves within a primary trend. They typically last between three weeks and three months, and lead to corrections (a drop in stock prices) in a bull market and rallies (upticks in stock prices) in a bear market. Finally, there are minor trends that only last a matter of days and which are largely "market noise", in other words, unpredictable short-term fluctuations in stock prices.

Three: primary trends remain in effect until a clear reversal occurs

This is one of the more controversial elements of Dow Theory. Indeed, reversals in primary trends can easily be confused with the emergence of secondary trends. The Dow Theory therefore advocates caution, as it is difficult to distinguish between the two until after the event.

Four: the three phases of primary trends

The first phase of primary trends determines that informed investors profit from an accumulation phase (before a bull market) or a distribution phase (before a bear market). Traders then move towards a second public participation phase, which is when the largest price movement occurs. Finally, the market experiences a third excess phase, characterised by a period of euphoria (at the end of a bull market), or of panic/despair (at the end of a bear market).

Five: volume must confirm the primary trends

The first phase of primary trends determines that informed investors profit from an accumulation phase (before a bull market) or a distribution phase (before a bear market). Traders then move towards a second public participation phase, which is when the largest price movement occurs. Finally, the market experiences a third excess phase, characterised by a period of euphoria (at the end of a bull market), or of panic/despair (at the end of a bear market).

Six: primary trends must confirm each other across market indices

This last tenet, that two opposing primary trends cannot coexist on two different market indices, was doubtless the most important to Charles H. Dow. In other words, the primary trend discovered on a market index must always be confirmed by a similar trend on another market index and vice versa.

It was in response to this final tenet that Charles H. Dow did not stop at creating the Dow Jones Industrial Average. He also contributed to the development of another market index, the Dow Jones Transportation Average.

Disclaimer

CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

CMC Markets does not endorse or offer opinion on the trading strategies used by the author. Their trading strategies do not guarantee any return and CMC Markets shall not be held responsible for any loss that you may incur, either directly or indirectly, arising from any investment based on any information contained herein.

Live account

Access our full range of markets, trading tools and features.

Open a live account

Demo account

Try spread betting with virtual funds in a risk-free environment.

Open a demo account

TOP