Knowledge, tools, technical analysis indicators need to be mastered when participating in the stock market - Part 1: Dow theory

June 25, 2021

The founder of Dow theory was Mr. Charles H. Dow, the basic tenets of the theory were established through a series of editorials he wrote in the Wall Street Journal. These articles represent Dow's beliefs about how the stock market reacts and how to measure financial market health in search of profits.

In 1902, Charles H. Dow died suddenly, leaving all the documents in an unfinished state. So one of Dow's associates, typically William P. Hamilton, who was also the one who replaced him as editor of the Wall Street Journal, continued to research, perfect and produce the Dow theory as it is today.

Dow believes that the stock market as a whole is a reliable measure of the overall condition of an economy. And by analyzing the whole one can accurately assess those conditions as well as determine the main trend direction of the market and the direction of development of individual stocks.

To do so, the Dow mainly relies on two indexes: the Dow Jones Industrial Average and the Dow Jones Railroad Index (now the Transportation Index), compiled by Dow and published in the Wall Street Journal. He thinks they can accurately reflect business conditions because they cover two main economic segments: industry and railways (transportation).

Although these indicators have changed over the past 100 years, the theory still applies and has become one of the most fundamental theories for forex trading as well as for modern financial markets.

All technical analysis theory as we know it today is derived from Dow theory. Therefore, if you want to understand technical analysis in forex, you need to know the 6 basic principles of Dow Theory.

Dow Theory Fundamentals

H. Dow has summarized into 6 basic principles which are:

The market has 3 main trends.

Market trends consist of three phases.

Prices reflect news.

Correlation must be shown

Trends are confirmed by volume.

Trends last until there are signals that they are over.

3 main trends

Dow stated in his theory that the market consists of three main trends:

Primary movement: This trend is very long from a year to several years. No one can really predict these cycles and it cannot be manipulated by large organizations.

Medium swing: The length of these types of trends usually lasts from 1 to 3 months, the points that are said to appear retrace are at 0.33% and 0.66%.

Minor movements: This is the smallest form of trend in Dow Theory, it usually lasts from 1 hour to less than a month. Due to its short-term nature, this type of trend has the potential to be manipulated with large groups of people or organizations.

3 main stages

Dow Theory states that long-term trends typically have three phases:

Accumulation: This phase the market moves slowly, very slowly, close to the minimum. Usually at this stage, panic engulfs uninformed traders, while smart money flows are quietly buying and absorbing sell orders from traders who are in a sell-off.

Trending phase: This is the moment when nearly all market participants begin to notice upward price movements and start buying. The overall market mood is hopeful and optimistic.

Distribution phase: This stage is when the market has become too hot. Thanks to the media, the crowd learned that the market was trending up and they couldn't wait any longer to buy. The initial optimism turned to over-excitement. The smart money purchased at the accumulation market stage began the process of distribution (sold) to retail investors who lacked information.

Prices reflect news

The content of this principle is that the price will reflect the news released "immediately" and also the rumors through the previous move. This phenomenon is known by the more familiar name “Buy Rumors-Sell the Truth”. You will immediately understand the problem when looking at the picture below.

Correlation must be shown

This is the fundamental principle of intermarket analysis. For example for this case, in the time when the industries develop, the transportation industry will have the opportunity to develop accordingly because they are correlated with each other.

A smaller example in the financial sector is the price of Gold and the price of Japanese Yen. They are often seen as havens when risks arise, so their prices often move in the same direction.

Trends confirmed by volume (Volume)

The next important principle of Dow Theory concerns specific volume: In a trend, volume must increase in impulse waves (in the direction of the trend) and decrease during a correction (counter-trend). .

When this happens, the market movement is being driven by new entrants thus increasing supply/demand.

Here is an example of a “volume confirmed trend:

You can see that the period of forming higher highs has reduced volume levels.

As for this next example, you don't have a clear trend and it doesn't have a relationship with volume as the theory suggests.

Trends last until there are signals that they are over

The final fundamental principle of Dow Theory is the identification of trends through the formation of peaks/troughs.

An uptrend is defined with higher highs and higher lows, the opposite of a downtrend.

An uptrend with higher highs and lower lows until they are broken.

A downtrend with lower highs and lower lows.

Limitations

Contrary to the fact that many people still consider Dow Theory as a form of guidance, a form of great secret for the field of financial investment analysis, many studies using modern statistical tools show that Dow Theory also has many limitations. Here are some basic limitations.

Dow Theory too late

This is a correct critique. It is sometimes even argued that if each major market move were divided into three parts, the Dow Theory would cost its adherents the opportunity to profit at the beginning and the end of the movement, sometimes. is to lose the whole opportunity.

Again, this is a true point about the Dow Theory, but in fact actions in accordance with the Dow Theory have also yielded great profits, and very few people have achieved this level of profit. The records and calculations show that the return will be very high if invested in accordance with the Dow Theory.

Dow Theory is not always correct

This is completely clear. The application of Dow Theory rests solely on the ability to interpret market conditions and assumes the accuracy of these explanations. Anyway, it should be recalled that history has proven that if the Dow theory is followed correctly, profits will be very high.

The Dow Theory often confuses investors

At any time, Dow Theory can provide answers that are reasonably based on the facts of the market. The answer may be wrong, but only for a relatively short time in the early stages of a tier 1 trend.

There will also come a time when a Dow analyst will say to an investor, “The underlying direction of the market will probably remain bullish, but the market has entered a dangerous period and I cannot recommend it. What exactly should you buy at this time? Maybe it's too late."

Often this objection only reflects reactions to the Dow Theory view that the average index reflects all stock market information and parameters. It is possible that this objection is made by people whose personal views on stock movements do not agree with the views of Dow Theory.

In other cases, criticisms of Dow Theory reflect only one thing: the impatience of the person making the criticism. It will be possible for weeks or months (typically with a market that is showing a horizontal pattern) Dow Theory cannot make a specific statement.

Then if an "active" investor reacts, it is completely understandable. But patience is an indispensable quality in any stock market because it will help investors avoid serious mistakes.

Dow Theory does not help investors when there is intermediate volatility

If you are a short term investor. The Dow Theory gives little (if any) indications of a change in intermediate trends. However, if these signs can be obtained, it is clear that the return will be much higher than investing only in the movements of the primary trend.

Some stock traders have relied on Dow Theory to provide sub-principles that apply to intermediate movements. But in general, there is not a single principle of this kind that really works.

The Dow Theory is just a tool - a machine that, when we put data in, it gives results about the primary trend - the main trend of the market. This is very important because most stocks on the market move in that trend. Dow Theory can't tell, can't help you determine which stocks to buy or sell.

Conclude

Thus, through this article, we have introduced the original source of the schools of analysis, as well as explained the Dow theory from hypothesis to basic principles. Hopefully, through the above article, you can somewhat understand the meaning and usage as well as limitations of Dow Theory.

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