If you’re considering trading on the financial markets, whether that be through spread betting*, CFD trading, or trading directly on the markets, it’s vital that you understand as much about the markets as possible. Understanding the way the markets move is essential to making the right calls at the right time.

One of the central elements of stock market theory is Dow Theory, formulated by Charles H Dow over the course of 255 different editorials in the Wall Street Journal. If the name ‘Dow’ is familiar, it’s because Dow was also responsible, in part, for setting up the Dow Jones index.

Dow Theory has six basic tenets, these are relatively simple, and understanding them is crucial to not only understanding the market itself, but understanding how other people will analyse movements in the market.

Market Movements

The market has three movements. The first is ‘main movement’ a major trend that could last for years. The second is a ‘medium’ swing, a reaction to a previous market move which may last from between ten days and three months. The third is ‘short swing’ which may last an hour or a month or more depending on opinions. The moves can happen simultaneously, and a good trader will spot them early.

Market Trends

Market trends have three phases. These are the accumulation phase, the public participation phase and the distribution phase. The first of these, the accumulation phase is the period in which people in the know (or who have very good advice) are actively buying or selling stock against the general opinion of the market. It’s difficult to identify this phase unless you’re one of the people in the know, because those with the knowledge make a relatively small element of the market so their actions don’t move the share price very much. The second phase begins when people start to cotton on to the actions of those who are in the know, at this stage price changes can be extremely rapid as an increasing number of people make trades. This phase will continue until there is so much speculation that the price becomes inflated and at this point the astute investors leave the market anticipating a turn around, this is the distribution phase.

Stock Markets and News

Dow theorised that stock prices incorporate new information as soon as it becomes available, so as soon as news is released the stock prices will change to reflect this new information. To make the most of news then, you either need to predict it or wait to react to the secondary movement after a news swing because, according to Dow Theory, the market itself will react quicker than you will receive the news (this is particularly true if you’re spread betting).

*Visit the website of CMC Markets to find out more about spread betting.

L Hunter Lovins, founder of Natural Capitalism Solutions