Let’s finish our look at the principles of Dow Theory...

Market Averages Must Confirm Each Other

Dow’s theory on market averages was based in a time now passed, but the idea remains solid. In Dow’s time the US was still a growing power, due to the distances between population centres. Factories had to ship their goods, meaning that rail companies would receive a fair amount of custom. Therefore, if factories were to do well, so the railways would have to perform well also. Whilst both groups share prices were moving in the same direction, it would be evidence that the trend would continue but if factories or railways started performing badly, this would be an indication that a change was in the air.

Nowadays, predicting market averages is a lot more complex as there are so many more markets to consider, but the principal remains the same. Generally speaking, for example, a weak Stirling leads to improved manufacturing in the UK, so the two prices may trend together. If you can identify markets that trend with your own chosen market, it’s a good way to make the most of your investments, and to identify when changes are coming.

Volume of Traffic

Dow hypothesised that the best way to confirm a trend was by the volume of trades being made. When a relatively low volume of trades are being made, the price can move quickly and randomly for any number of reasons, someone could be particularly keen to sell, for example. If, however, there is a high volume of trades heading in one particular direction, this will mean that a trend is strong, if, however, there is a trend and volume suddenly declines, it probably indicates that a trend is more or less over.

Trends Last Longer Than You Think

Dow believed that trends exist and continue regardless of individual fluctuations in the market. In a ‘main movement’ for example, there could easily be shorter term movements in the opposite direction, but this does not mean that the trend has finished. Dow argued that the trend should always be given the benefit of the doubt until there is absolute proof that the trend is over. This can be extremely difficult to prove, and for the investor can be costly if you miss a turn over in a trend. It’s better to use other tools to make a call on the end of a trend rather than waiting for the price to turn definitively.

Dow theory may have been created over a hundred years ago, but the principles remain largely the same and make a good foundation for anyone looking to trade. Spread betting companies like CMC offer their customers a range of advice and information, including further advice on stock market theories and technical guidelines on how to trade. It’s a good idea to make the most of these resources if you want to make the most of your money. Have a look at the CMC website to find out more about CFD.

L Hunter Lovins, founder of Natural Capitalism Solutions