Article contributed by Jeremy Whaley

In the last article, Part 5 of our series, we focused on the fourth tenet of Dow Theory: the averages must confirm each other. In this article we are going to focus on the fifth tenet: volume must confirm the trend.

As a quick refresher, the 6 tenets of Dow Theory are:

1. The price discounts everything.
2. The market has 3 trends.
3. Major trends have 3 phases.
4. The averages must confirm each other.
5. Volume must confirm the trend.
6. A trend is assumed to be in effect until it gives definite signals that it has reversed.

Volume Must Confirm the Trend

The fifth tenet of Dow Theory is strongly linked with the third tenet. If you remember, the third tenet states that a trend has 3 phases, Accumulation, Public Participation, and Distribution. The middle phase, public participation, is tightly connected with the fifth tenet concerning volume.

When a group of investors begin to accumulate a new position, they are generally working on contrary opinion. Consequently they are all alone. This is the time when most of the money has been pulled out of a stock and there are few people left to trade it. But as the accumulators begin to take their position and the price of the stock rises, it grabs the attention of the public. As the public takes note of the rising prices and begins to enter their own positions, the volume of shares traded begins to rise.

Dow theorized that a rising price without rising volume was not a confirmation of public participation. Since the public participation phase is when the largest moves are garnered, the ideal scenario is to get in at the beginning of the public’s participation and get out at or near the end. But if volume does not rise as well, then the rising price may not be sustainable, and it is a sign of a weak trend.

Volume is one of the easiest indicators to work with. It’s quite simple in that it merely reflects how many shares trade hands on that particular day. Whether the trend is rising or falling, volume should be rising to confirm the general public has jumped into the trade and is helping to perpetuate the move. If volume does not support the trend, it does not mean the price will not move. It simply reflects that the number of people trading is low and the trend may be a weak trend.

If you would like to learn how to apply Dow Theory and the importance of volume to your own trading, please visit our website and sign up for a free class. In Part 7 we will look at the sixth and final tenet of Dow Theory and explain how you can use it to better time your trades and understand the next move of a stock.


Jeremy Whaley is co-founder of Trade Smart University, an education company dedicated to helping everyday people learn to trade the stock market for consistent profits. If you would like to learn how to trade your own money for steady profits, visit www.TradeSmartU.com and experience affordable, accessible stock market education.


Bibliography:

Kirkpatrick, Charles D. and Julie R. Dahlquist. Technical Analysis: The Complete Resource for Financial Market Technicians. Upper Saddle River, New Jersey: FT Press, 2007.

Murphy, John J. Technical Analysis of the Financial Markets. Paramus, New Jersey: New York Institute of Finance, 1999.