Tools, technical indicators Part 1: Dow Theory

Dow theory is known as the foundation of all schools, indicators and technical analysis tools, created by Mr. Charles H. Dow, the basic principles of this theory have been formed through through a series of editorials he wrote in the Wall Street Journal. These articles represent his beliefs about how the stock market reacts and how to measure financial market health to find the best returns for investors.

In 1902, Charles H. Dow died suddenly, leaving all documents in an unfinished state. Therefore, one of Dow’s associates, typically William P. Hamilton, who also replaced him as editor-in-chief of the Wall Street Journal, continued to research, perfect, and produce the complete Dow theory. like nowadays.

Mr. Charles H. Dow believes that the stock market as a whole is a reliable measure of the overall state of the economy of a country or even the world. And by analyzing the whole one can accurately assess those conditions as well as identify the direction, the main trend of the market and the direction of development of each individual stock. Today, Dow theory is also applied to many types of economies both traditional and new markets such as the cryptocurrency market.

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

Although these indicators have changed more or less over the past 100 years, this theory is still very widely applied and has become one of the most fundamental theories for all forex trading as well as for the financial markets. modern mainstream.

All technical analysis theory, indicator tools, schools of analysis are derived from Dow theory. Therefore, if you want to understand technical analysis in forex, stocks, commodities, indices, cryptocurrencies you need to know the 6 basic principles of Dow Theory.

Dow Theory Fundamentals

Mr 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

– The trend is confirmed by volume.

– Trends last until there is a signal that they are over.

3 main trends

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

Primary Movement: This trend usually lasts very long from a year to several years. No one can really predict these cycles and it cannot be manipulated by large institutions. It is called a long-term cycle or a long-term trend.

Medium swing: The length of these types of trends usually lasts from 1 to 3 months, the points that are said to appear retracement lines are 0.33% and 0.66%. It is called the medium-term trend.

Minor movements: This is the smallest trend form 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. And this is the short term trend.

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3 main phases in the long-term trend

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

Accumulation: (aka sideway) This phase the market moves slowly, very slowly, near the minimum. Usually at this stage, panic engulfs uninformed traders, while smart money is silently buying and absorbing sell orders from selling traders.

Trend phase: This is the time when nearly all market participants begin to notice upward price movement and start buying. The overall market mood is hopeful and optimistic. Everyone believes in having a high profit after a purchase.

Distribution Phase: This phase is when the market becomes 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-excited. Smart coins are purchased at a market accumulation stage that starts the process of distribution (selling) to uninformed investors and the price starts to fall.

Prices reflect news

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

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Correlation must be shown

This is the basic principle of intermarket analysis. For example, in this case, in a time when 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 the Japanese yen. They are often considered a haven when risk arises, so their prices often move together.

Trend confirmed by volume (Volume)

The next important principle of Dow Theory specifically concerns volume: During a trend, volume must increase in impulse waves (in the direction of the trend) and decrease during corrections (against the trend). ). .

When this happens, the market movement is being driven by new entrants, so the supply/demand will increase.

Here is an example of a “confirmed trend in volume:

You can see that the higher level formation phase has a decreasing volume level.

For this next example, you don’t have a clear trend and it doesn’t have a relationship to volume as the theory suggests.

Trends last until there is a signal that they are over

The final basic principle of Dow Theory is to identify trends through the formation of peaks/troughs.

An uptrend is established only if and only when the following peak is higher than the previous one, the latter trough is higher than the previous trough, and opposite to the downtrend.

A trend is broken when there are conditions that no longer satisfy the previous trend.

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Disadvantages of DOW theory

For many investors, they see the Dow Theory as a form of guide, a great secret to the field of financial investment analysis. But many studies using modern statistical tools show that Dow Theory also has many limitations. Here are some of the most basic limitations that investors need to know to be able to adjust and invest in the smartest way.

Dow Theory too late

This is a correct critique. Even if sometimes each major market move is divided into three parts, sometimes the Dow Theory will cause its followers to lose the opportunity to profit at the beginning and the end of the movement and immediately is suboptimal profits and sometimes a total loss of opportunity.

Again, this is a true point about Dow Theory, but in fact actions that are consistent with Dow Theory have also yielded great profits, and very few people achieve this level of profit. The records and calculations show very high returns if invested for the long term and consistent with Dow Theory.

Dow Theory is not always correct

This is also partly true. The application of Dow Theory relies entirely on the ability to interpret market conditions and assume the accuracy of these explanations. And if considering the long-term trend, the probability of the DOW theory being correct will be much higher. History has also proven many times that if the Dow theory is followed correctly, the profits will be very high.

Dow Theory often confuses investors

At some point, the Dow Theory can reasonably provide an answer based on the facts of the market. The answer may be wrong, but only for a relatively short time during the early stages of a level 1 trend.

There will also come a time when a Dow analyst will say to an investor, “The underlying trend is likely to remain bullish, but the market has entered a dangerous phase and I cannot recommend it. What exactly should you buy right now? Maybe it’s too late.”

Often this objection refers to parameters that respond to the Dow Theory view that the index reflects all stock market information and parameters. It is possible that this objection was raised by people whose personal views on stock movements disagreed 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 can happen over a few weeks or months ( going in a short or medium term cycle). Dow Theory cannot make a specific statement.

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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) indication of a change in intermediate trends. However, if there are these signs, it is clear that the profit will be much higher than just investing in the direction of the main trend.

Dow Theory is just a tool – an indicator that when we put data in, it gives results about the main trend – the main trend of the market. This is important because most stocks in the market move in that direction. Dow theory is an indicator tool for investors to refer to to be able to buy and sell goods more accurately.

Conclude

Thus, the article also clarifies Dow theory questions from hypothesis to basic principles. And also show the limitations of this method. Hopefully, through the above article, you can partly understand the meaning, usage and limitations of Dow Theory and apply it thoroughly to bring high profits for yourself.

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