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Q3. Briefly explain the Dow Theory


Answer:
The Dow Theory was originated by Charles Dow. He was the founder of the Dow Jones Company and editor of the Wall Street Journal. The Dow Theory presumes that the market moves in persistent bull and bear trends. Dow Theory was originally used for market as a whole, but it is now used for individual securities as well.

The Dow Theory recognized that it is the actions of the people in the marketplace responding to news that cause prices to change rather than the news itself, and that once established a market trend tends to continue. The theory had originally focused on using general stock market trends as a barometer for general business conditions. It was not originally intended to forecast stock prices. However, subsequent work has focused almost exclusively on this use of the theory.

The Dow Theory comprises the following assumptions:
1. The averages discount everything: An individual stock’s price reflects everything that is known about the security. As new information arrives, market participants quickly disseminate the information and the price adjusts accordingly. Likewise, the market averages discount and reflect everything known by all stock market participants.
2. The market is comprised of three trends: At any given time in the stock market, three forces are in effect: the Primary trend, Secondary trends, and Minor trends. The Primary trend can either be a bullish (rising) market or a bearish (falling) market. The Primary trend usually lasts more than one year and may last for several years. If the market is making successive higher-highs and higher-lows the primary trend is up. If the market is making successive lower-highs and lower-lows, the primary trend is down.

Secondary trends are intermediate, corrective reactions to the Primary trend. These reactions typically last from one to three months. Minor trends are short-term movements lasting from one day to three weeks. Secondary trends are typically comprised of a number of Minor trends. The Dow Theory holds that, since stock prices over the short-term are subject to some degree of manipulation (Primary and Secondary trends are not), Minor trends are unimportant and can be misleading.
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3. Primary trends have three phases: The Dow Theory says that :
· The first phase is made up of aggressive buying by informed investors in anticipation of economic recovery and long-term growth. The general feeling among most investors during this phase is one of "gloom and doom" and "disgust." The informed investors, realizing that a turnaround is inevitable, aggressively buy from these distressed sellers.
· The second phase is characterized by increasing corporate earnings and improved economic conditions. Investors will begin to accumulate stock as conditions improve.
· The third phase is characterized by record corporate earnings and peak economic conditions. The general public (having had enough time to forget about their last "scathing") now feels comfortable participating in the stock market–fully convinced that the stock market is headed for the moon. They now buy even more stock, creating a buying frenzy. It is during this phase that those few investors who did the aggressive buying during the first phase begin to liquidate their holdings in anticipation of a downturn.

4. The volume confirms the trend: The Dow Theory focuses primarily on price action. Volume is only used to confirm uncertain situations. Volume should expand in the direction of the primary trend. If the primary trend is down, volume should decrease during market declines. If the primary trend is up, volume should increase during market advances.

5. A trend remains intact until it gives a definite reversal signal: An up-trend is defined by a series of higher-highs and higher-lows. In order for an up-trend to reverse, prices must have at least one lower high and one lower low (the reverse is true of a downtrend).

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