Any efforts to track down the beginnings of technical analysis will lead the reader to an introduction to Dow Theory. Today, Dow Theory is the foundation of everything we know about technical analysis. In principle, it is a set of general rules and principles to help you take action on different price action data in the market.
Charles H. Dow founded Dow Theory in the 19th century and initially used it to describe stock price movement. But, because Dow Theory helps establish the direction of the market it makes for a universal tool that can be applied to other asset classes like Forex.
Dow Theory compares the Dow Jones Industrial Average to the Dow Jones Transportation Average. When used it could identify if we’re in a technical bull market or in a technical bear market. To confirm if the market is in a technical bull market or a bear market, the trend for the DJIA should match the trend for the DJTA.
The basic premise of the Dow Theory is to serve as an indicator of the general health of the market. For traders, Dow Theory is a good introduction to the way the market moves. It gives traders ideas of where to find trading opportunities, based on some basic principles. The following are the six principles of the Dow theory:
- The price discounts everything.
- The market has three trends.
- Trends have three phases.
- The averages must confirm each other.
- The volume must confirm the trend.
- A trend is assumed to be in effect until it has given a definite signal that it has reversed.
Price discounts everything
Dow theory states that all information that can be known, has already been factored into the price. So the news has been discounted and the only remaining influence on the price is our human emotion.
Dow Theory would imply that we are then only studying human emotion and not the statistical data. Because studying the price action is only a reflection of human emotion.
A Market has three trends
Dow Theory stipulates that there are three important trends in a market. An uptrend is defined as successive higher lows followed by successive higher highs. While a downtrend is successive lower lows followed by successive lower highs.
- Primary trend.
- Secondary trend or Intermediate trend
- Minor trend or daily fluctuation.
The primary trend generally lasts between one and three years. This is the most important trend because it will impact the secondary and minor trend as well.
The secondary trend generally lasts between three weeks and three months and moves in the opposite direction of the primary trend.
The minor trend generally lasts less than three weeks. The minor trend will remain relative to the secondary trend in the same way that the intermediate trend remains relative to the primary trend.
Three Phases of a Trend
A trend has three phases as follows:
- Accumulation Phase.
- Public Participation Phase
- Distribution Phase.
The accumulation phase is the first stage of a bull market and represents smart buying by the most informed traders. Generally, the accumulation phase appears at the end of a bearish trend and is characterized by extreme negative sentiment.
On a price chart, the accumulation phase is characterized by a period of consolidation in the market.
The public participation phase occurs when the price starts to move rapidly. This is the phase where most trend followers start to take part and it is the phase that lasts the longest and has the largest price movement.
The distribution phase is the first stage of a bear market and represents smart selling by the most informed traders. This is the opposite of the accumulation phase and is characterized by optimistic sentiment and fundamental data that looks better than ever.
Averages Must Confirm Each Other
This principle states that the overall direction of the trend must be confirmed by a correlated pair, thus confirming each other. If for example, the EUR/USD is moving in an uptrend, we should also see the primary GBP/USD trend moving upward. But if the GBP/USD doesn’t confirm the EUR/USD trend, we have divergence and something is not right. This could signal that there can be a big change in the trend coming soon.
Volume Must Confirm the Trend
According to Dow Theory, volume should move in the direction of the primary trend. If we are in a bull trend we should see an increase in buying volume. And if we’re in a bear trend we should see an increase in selling volume. Weak volume indicates a possible weak trend.
A Trend is Assumed to Continue Until it Has Given A Definite Signal that it Has Reversed
According to Dow Theory, a trend is expected to remain in effect until a major event takes place that would cause a reversal. This is the starting point of the trend following systems.
As with the law of physics, we assume that an object in motion will continue in motion until an external force causes it to change direction.
Traders should keep trading in the general direction of the trend until it’s given definite signals that the trend has reversed.
Understanding Dow Theory will give you a better grasp of technical analysis and make you a better trader. The principles are very basic but give any trader a strong foundation for how to trade the markets. These principles give traders rules to follow, so helping a new trader remove emotion from their trades.