In 1882, a man named Charles Dow and his partner Edward Jones founded the Dow Company.
Charles Dow published his ideas in a series of articles in Wall Street Journal, as Dow theory, which eventually formed the basis of technical analysis.
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Dow Theory is in fact a series of concepts that describe the main framework of technical analysis. The principles of this theory are derived from Charles Dow’s writings on financial markets. Charles Dow was the founder and editor of The Wall Street Journal and co-founder of Dow Jones Company.
As part of the Dow Jones, Charles Dow helped to create the first Dow Jones stock index in the transportation sector.
Charles Dow did not present his theory in a written and constant way and did not mention it as theory at all, but many people were able to be inspired and use his ideas in the market. William Hamilton, co-author of The Wall Street Journal, later collected Charles Dow’s papers to create what is today known as Dow Theory.
In this lesson, we will present and study this theory with all the details, and off course, we are going to mention before anything that this theory, like any other premise or theory, is by no means complete and saint and will not be errorless, and all the sections and its aspects can be interpreted in different forms and shapes.
Basics of Dow Theory
The basic principles proposed by Charles Dow are very close and compatible with another theory called the Efficient Market Hypothesis (EMH) market. Charles Dow believed that the market always fades the reality and that all the information we have has previously affected the market.
Imagine a company expected to report its revenue very promising and positively. This will have the impact on the price before it even happens, so in such a situation, the demand for that company’s stock before release of news and report goes up, so it is normal that as the expected report comes out, the price will not move much. Of course, this is not a general rule, but it is most often true.
One of the greatest discoveries of Dow, as described in Dow’s theory, is that he discovered that sometimes the price of a company or the stock price still falls, even though it is a good news. Dow’s discovery was that the report had already affected the price as expected, but with the release of the actual figures, the market realized that the price should not have risen as much as it had, so the market has corrected itself.
These rules have been fully approved by many traders and investors, especially those who use technical analysis professionally to analyze the Forex market, but there is also an opposite opinion because there are those who use fundamental analysis. Because they believe that the value and price of the market do not affect the price of a stock.
Principles of Dow Theory
Here are some basic principles in Dow’s theory:
⦁ all we need are prices.
⦁ There are three types of market trends.
⦁ In big trends we have three steps.
⦁ When analyzing indicators, the indicators should confirm each other.
⦁ Market trends are confirmed by trading volume.
⦁ Trends in Forex market continue unless they receive a definite signal indicating a reversal.
In this article we will talk about each of these cases in detail.
⦁ Price is the only thing that the market affects. Never forget the fact that any kind of report or news or announcement that can have a positive or negative effect on the market will always affect the consequence on price. Never complicate the issues since the prices talk to you.
⦁ We have only 3 types of trends in the market. These three trends include the uptrend and the downtrend and the neutral trend that we tackle them in the Trends section.
⦁ Each major trend is composed of three steps, which we want to explain for you.
Dow’s Theory states that there are three kinds of trends in the market:
⦁ Main trend or the initial trend: The main trend will remain between a few months to several years and determine the main and major market movement.
⦁ Secondary trend or Major corrective trend: The secondary trend lasts between a few weeks to several months.
⦁ The third trend is the small corrective trend: these trends tend to disappear in less than a week or ten days. In some cases, these trends disappear within a few hours or intraday.
In other words, the trends in the market can be divided into three categories in a simple word.
⦁ Long-term trends
⦁ Mid-term trends
⦁ Short-term trends
Each of these trends can be placed next to the other. For example, in the long term, the market may be in an uptrend, and at the same time in the mid-term, it may be in a range domain or neutral trend, and itself is a major corrective. And still the short-term trend is a small uptrend or a small downtrend.
What we need to pay special attention to is that in what kind of trading system have we analyzed this?
If our strategy is a short-term strategy, it is certainly useful for us to pay attention to the mid-term and short-term trends, and if our strategy is a mid-term trend, it will be very important to pay attention to the long-term trends.
In future, we will talk more about how we can have safer and less risky trades in terms of trends, but in this article, you should also know that a professional analyst for the mid-term, based on the long-term trend, is never looking for entering a trade against the long-term trend.
So if he sees the long-term as uptrend and his strategy is based on a mid-term, he is not looking for taking SELL positions at all and is only looking for the best points to enter trades that are confirmed with the long-term trend.
The Main or Initial Trend in Dow theory
According to Dow’s theory, there are three stages in an initial trend that we refer to it as the main trend. We illustrate these three steps with an example of Uptrend:
First Step: Accumulation
After a downtrend is formed, in fact, the falling rate of an asset, such as gold, in the first stage, will result the public tendencies and market sentiment moving in a direction where the market is mostly negative or in a downtrend. A professional analyst at this time begins to accumulate to buy the asset at a low price, in this case gold.
Second Step: Public Participation
At this time, other people will be found and come to know what a professional analyst has seen in the market and so they start to buy. By doing this, the market will grow according to the general idea of rushing to buy gold and the price will dramatically increase.
Third Step: Distribution
A professional analyst who has opened buy position at low prices, at this stage, knows that the market has faced an increase due to public participation, so he will astutely sell the gold which in fact he had bought it at cheap prices previously. he sells it at a high price to people who are just thinking of entering the market at the participation stage! (“which is wrong because the market is now abolished regarding participation”) so they sell and exit the market.
You can imagine the same example for yourself in a bear market where a professional analyst starts to sell gold against the USD at the beginning of the downtrend and then buys it again at a lower price in an appropriate time with greater volume.
⦁ Accumulation and create mass
⦁ The stage of public participation and the formation of a big uptrend
⦁ The stage of public distribution and approaching the end of a trend
As you can see, the three stages that dominate the market from Dow’s view are clear in the image above, this is chart of Gold.
Interestingly, the market will always move from stage three to stage one, which means that three-stage re-formation may occur at any time at the end of stage three, and may, of course, be accompanied by a trend reversal or a correction.
I remind you once again that there is no guarantee that these rules will always come true, but by studying the chart you will certainly confirm that this generally happens and you can observe the above mentioned three steps over and over again in your chart.
In the image below, you can see the same one, this time a downtrend in D1.
Indicators Should Confirm Each Other
Dow’s theory states that when a major trend occurs in a chart or in an indicator, the trend should be confirmed by another indicator in the chart.
For example, if you discover the main trend in a dollar-base currency pair, then you should also confirm the appreciation of the value of the dollar by other currency pairs to make sure that this is the dollar really strengthening, not that the quote currency in the pair is depreciating against it!
Let’s say the USD/JPY is experiencing the formation of a major trend leading to the strengthening of the dollar, so naturally this currency pair is on the rise. In this case, it is better to get a confirmation from one or more USD based currency pairs. for example, the USD/CHF should be bullish if USD is strengthening.
Dow believed that the relationship between the indices is always maintained. At that time, the index used by Dow Jones, which was one of the transportation indices, was considered together with the industry indices. Today, comparing the indices or indicators with currency pairs is still very practical. They both are important.
It should be noted that this relation with indices is not widely used in the cryptocurrency market and is mostly used in the Forex market.
Confirming Market Trends by Trading Volume
Dow Theory states that the higher the trading volume, the more likely it is that the current price affects market movement.
According to Dow, a strong trend must be accompanied by a high volume of transactions or trades in order to continue, otherwise it will not be a strong trend.
So if we have a strong buying volume in an uptrend, it is very likely that we will have a strong uptrend. Charles Dow used volume as a secondary indicator and believed in it a lot.
Or let’s say we have a trend, no matter uptrend or downtrend, but the trading volume in the direction of the trend is not so powerful. This shows the investors are not interested or do not believe in the existing trend. So they wait before entering market. Altogether we can say that the existing trend is not strong and the price movement will not be high due to the low volume of trades.
So, for example, if we consider price of a stock that has faced an increase due to the release of positive news, this increase will only continue as long as the investors are buying the stock with high trading volume, otherwise we will see a decrease in price.
One Indeed Hard Point:
Being able to distinguish a major trend from a secondary reversal trend in the market is such difficult that it sometimes confuses many to the point that a secondary downtrend or market price correction is confused with a price reversal and the start of a new major trend.
So to avoid this mistake, try to always trade in the direction of the current trend, and IF there is no trend at all, be patient and wait until a new main trend is formed.
A Trend Continues until Otherwise is Proven
Charles Dow believed that trends always continue unless there found enough reasons to reverse them.
Study again what we said a few minutes earlier. Never trade in the opposite direction of the existing trend unless you make certain that the new trend formed, is a new major trend, in fact it is not a corrective trend.
Summary of Dow Theory
Some traders in the Forex and in the financial markets in general believe that Dow’s Theory is expired and no longer works, and this group of critics in some parts, especially the confirming of the indices, strongly believe that this theory no longer works.
On the other hand, many theorists and financial market activists strongly defend Dow’s theory and believe that this theory, although not complete, is the basis of technical analysis.
The fact is that I personally studied so many advanced articles on Dow theory that I could even write a book about it, whether con or pro of the theory.
In my opinion, Charles Dow is one of the main pillars and foundations of technical analysis in financial markets, and Dow’s theories are really practical, although they look simple in surface, but they are rich and sophisticated inside and learning them is so very useful for you.