Trading Education

The Role of Dow Theory in Trading

Between 1900-1902, Charles Dow published a series of articles in the Wall Street Journal, in which he described the main principles of his theory. In his work, Dow tried to describe human psychology through the chart patterns and mathematical indicators. He made significant strides in this respect. At least to this day, traders around the world use the core components of his theory. All the main modern concepts of technical analysis (TA) are based on his studies.

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The idea that the market can be predicted by using only charts was revolutionary and was instantly criticized by many investors in the 20th century. But for now - with the help of technical analysis, built on the Dow’s concepts, people make money in a variety of markets, complementing it with many different tools.

Dow himself never considered his research a separate "guide". He said that for a qualitative analysis it is necessary to combine TA with other types of analysis (fundamental, indicator, etc.).

In total, the theory includes 6 principles, which will be discussed below.

The basics

1. The price reflects everything.

This statement suggests that any event - political, economic, natural disaster, or Covid-19 pandemic, etc. - all this causes an immediate change in prices. Simply put, the price has changed - it means that something has happened in the world. Price is a reflection of our life.

2. Market trends.

There are three types of trends in the market. They differ in terms of their lifetime and together they make up the big picture of what is happening. Every trader knows that trends are divided into:

  • Primary trend – Lasting from months to many years, this is the major market movement.
  • Secondary trend – Lasting from weeks to a few months.
  • Tertiary trend – Lasting ten days or less.

3. Phases of primary trends.

Each trend is based on three phases. Just as Dow split the market into 3 trends, here he used a similar approach. During the first phase, large players, professionals are involved in the market - they know the market well, have large funds and, often, have insider information. In this phase, its further movement is not obvious for the rest of the market participants. In the second phase, market movement becomes apparent and smaller investors enter the fray. The third phase is the final. Here everyone already understands that the market began to move in a certain direction and the rest of the “public” is entering the game. For professionals, this stage is a signal to close positions, since the market is saturated, it reaches its peak, which means it is time to take profits.

Bull market phases:

  • Accumulation;
  • Public Participation (phase of large movements);
  • Distribution (implementation)

The phases of a bear market are called: distribution, public participation, panic (despair).

4. Volumes should support (confirm) the trend.

For example, we have an uptrend in full swing, which means that trading volumes should increase, especially in reverse points. The trend develops - the volumes grow, and in the counter-trend, the “volume” indicators are not so high.

In fact, volume analysis is a separate field, which should be given a lot of time and effort to understand and achieve competence.

5. Market indices must confirm each other.

For the USA, the key indices (averages) are DJA (Dow Jones Composite Average), which tracks 65 major companies; S&P 500 (Standard and Poor’s 500) - 500 largest companies NYSE and NASDAQ, covering about 75% of the stock market by capitalization; NASQ or NASX, indices of the largest stock exchange NASDAQ.

There is no need to understand all the indices, it comes as you gain experience. Although the indices include different companies, the quotes of the “averages” behave in the same way.

6. The trend is considered unchanged until a reversal confirmation signal is received.

This is the basic rule of trading on the exchange markets, which every trader must comply with. At the same time, the main mistake of beginners is that they open positions against the current trend in the market.

Closing Line

Markets do not stand still, they are constantly changing as analysis tools, but the basis remains the same as 100 years ago - after all, the market is still governed by emotions and the desire to make money at all costs.

The overview presented in this article must be adapted carefully. You cannot blindly apply the knowledge gained. The ideal option would be to work out any trading tool for a certain period of time until you will feel fully prepared to use it in reality.

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