The Basic rules of Stock Market Trading and Investing which are still useful even after more than 120 years of publishing. Modern Day Analysts are now combining both the Dow Theory and Candlesticks for better accuracy.

Whether you are trading Short-Term, Positional, Long-Term, or even Futures and options, this theory is useful.

Here are the 6 Rules:

1.      MARKET DISCOUNTS EVERYTHING

Charles Dow says the Stock Price and Index Price reflect all news and information available. The Dow Theory operates on Efficient Market Hypothesis where only information which is still unknown is only excluded such as natural calamities. But these events are priced in the form of risk. If they are not priced in, market starts to respond to these news and information very early.

Here is the Sensex Chart (hourly) from 20-Feb-2020 to 23-Mar-2020, where Index was discounting Corona Virus fear and Index fell from 41300 to 26300 even before actual first wave started in India.

2.      THE THREE TREND MARKET

Dow Theory uses Trend Analysis to understand overall Market Movement. The Three trends are:

i.                  Primary Trend

The Primary trend is the Most Important to be determined as this is the Major trend of the Market or Stock. Charles Dow believed Primary Trend last anywhere from 1 year to 3 year, but it may vary sometime. It can be an Uptrend, a Downtrend or a sideways movement.

ii.               Secondary Trend

While the Market tends to move in one Direction of Primary Trend, it doesn’t move in One Straight Line.  Within the Primary Trend of Up move or Down move, we may get a Secondary Trend which is always in opposite direction. So if the Primary Trend is of Up move, Secondary Trend would be of Down move and if the Primary Trend is of Down move, Secondary Trend would be of Up move. Secondary Trend lasts for 1 month to 3 months. This is also called intermediate trend where Index moves in opposite director for around 1/3^rd to 2/3^rd of the last primary trend move.

iii.             Minor Trend

This is fluctuation within the Primary Trend and Secondary Trend which last from intraday price movement to less than 3 weeks. Dow Theorists rarely focus on this trend as it may distract the traders and lead to irrational trading.

Here is Three Charts of Uptrend (Sensex from 2003 to early 2008), Downtrend (Sensex from early 2008 to early 2009) and sideways (Reliance Industries Limited from Mid 2014 to early 2017), where all 3 trends, Primary, Secondary and minor are also clearly visible.

3.       THREE PHASES OF PRIMARY TREND

Primary Uptrend in a Bull Market has 3 Phases

i.                  Accumulation

This happens right after a steep fall in the Index and the general mood of the Common people is of pessimism and stocks are trading at an attractive valuation. This is the time when acquainted investors starts buying the stocks.

ii.                Participation

Once the “Smart Money” buys huge quantity of stocks in first phase, short term trader can sense a support and starts buying. With the increase participation from many traders price tend to increase rapidly.

iii.             Euphoria

When everyone starts talking about stocks and even junk stocks start hitting 52-Week high, euphoria builds. This is the time when the “Smart Money” which bought at the accumulation phase starts booking their profit in distribution pattern.

Here is the Chart from early 2002 to 2008 of complete Bull market:

Primary Uptrend in a Bear Market has 3 Phases

i.                  Distribution

The Last phase of Bull market is the first phase of Bear Market; where markets are may be still going up, but the smart money starts selling their earlier trades of bull market.

ii.                Participation

Once the “Smart Money” sells huge quantity of stocks in first phase, liquidity in the market rapidly reduces. Sentiment starts going down as the time goes by and market discount even further weakness.

iii.             Panic

The last phase where buying dries, margin calls start triggering and nobody wants to touch the stock again. This is when people panic; index sees deep cuts and sometimes selling freezes.

Here is the Chart from early 2008 to Mid 2009 of complete Bear market:

4.      THE INDICES MUST CONFIRM EACH OTHER:

According to Charles Dow, every index should move in similar direction to establish a Primary Trend. So if someone is Bullish on ‘Sensex’, trend cannot be established based on that one Index only, rather all other indices should also confirm the trend. Similarly, if someone is bullish on Real Estate Stocks, they must all be bullish on Cement, Steel and other related stocks.

5.      VOLUMES MUST CONFIRM THE TREND

There are 4 possibilities for price and volume combination:

Price goes up with volume also going up

Price goes up without volume going up

Price goes down with volume going up

Price goes down without volume going up

Charles believed that the volumes must go up for deciding the trend; hence, if Price goes up with volume also going up; it is signalling a Bull Market. In the same way, Price goes down with volume goes up; it is signalling a Bear Market. If many participants are active, the volume is supposed to be high and price is also supposed to move in that direction.

When Price goes up without volume going up, it is just because of some over aggressive buyers and when Price goes down without volume going up, it is just because of some over aggressive sellers.

6.      TREND REMAINS UNTIL PROVED OTHERWISE

Within the same trend, say primary trend uptrend, we may some reversals, which are Secondary trend-where price contrast 1/3^rd to 2/3^rd of previous move. However, Charles said, price will soon resume to its primary trend until it is proved that trend has changed. Determining if the trend has changed or not is not easy and many analysts disagree with each other while deciding so.

And that’s why and that’s how market functions !