Dow theory is one of the most important theories of technical analysis. This theory is taken from articles published by Charles H. Dow from 1900 to 1902. It is widely applied in financial markets in general and in forex in particular. Therefore, this theory is the first basic step you must understand carefully. Let’s join Learn Forex Trading to learn about Dow theory and the 6 basic principles of Dow theory. It will help you become a professional investor in the future.
History of Formation Dow theory
The father of Dow theory was Mr. Charles H. Dow at the end of the 19th century. He was the founder of the Securities and Finance Magazine, the predecessor of the Wall Street Journal.
While working at the magazine. Dow has made observations about price movements. And the general trend of the stock market. He found that stocks would tend to go up over the long term. If the main market indexes increase at the same time. This is the basis for his opinion that “The market reflects everything”.
By 1902, Charles H. Dow died suddenly. William Hamilton continued to research, improve, and produce Dow theory as it is today.
This theory not only provides basic principles in technical analysis. But it is also the foundation for many other methods in the financial sector. From technical analysis to value investing. With the development of technology and data, this theory continues to be used. Plays an important role in the investment decision-making process of stock investors.
Until today. The entire technical analysis theory that we know comes from Dow theory. Including the Ichimoku technical analysis tool. If you want to understand technical analysis in forex. You need to know the 6 basic principles of Dow theory.
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6 BASIC PRINCIPLES OF Dow theory
How many basic principles does this theory have? Immediately learn about the principles of Dow theory through the content below.
Principle 1: The market reflects everything
The first basic rule, all information about the forex market is reflected in the prices of stocks and indices. This includes information about the past, present, and future. Unforeseeable information such as earthquakes, tsunamis, or terrorism will not be taken into account. The risks of these events will be priced into the market shortly thereafter.
The information does not help traders or the market itself know everything. Which is only used to predict events that will happen in the future. Even the elements happened. Imminent and probable prime. All are priced into the market. When everything changes. The market is forced to adjust prices to reflect that changing information.
Dow theory doesn’t just focus on the price of a stock. It’s about changing the entire market. It also differs from mainstream technical analysis. It is concerned with making predictions trend of the market.
The market reflecting everything is nothing new. Many traders only need to look at price movements to determine market trends. Without paying attention to other factors such as indicators. This theory is still one of the basic and important principles in stock investing.
Principle 2: Three market trends
According to Dow theory, three market trends include the main trend (level 1 trend), secondary trend (level 2 trend), and minor trend.
Primary trend – level 1 trend in Dow theory
The main trend, also known as the level 1 trend, is the largest in the market cycle, lasting from several years to several decades. The primary trend is defined by an ongoing series of peaks and troughs.
The main trends are divided into two types: bullish and bearish.
If the main trend is an uptrend. The price will be continuously broken through a series of price sets including both tops and bottoms. The market wants confirmation that it is in an uptrend. Then the next peak must always be higher than the previous peak (HH) and the next bottom must always be higher than the previous bottom (HL).
When a downtrend forms. This means there will be many sell-offs. Form price sets that include tops and bottoms. A downtrend will form subsequent peaks that are always lower than the previous peak. The next bottom must always be lower than the previous bottom.
When considering a trend. The hardest thing to determine is how long price fluctuations in a trend will last. Before the trend reverses.
Note: Once the trend has been identified, you must trade according to the trend. Don’t go against the trend. Often when talking about a level 1 trend, many traders think it is an uptrend. However, in many cases, the level 1 trend can also be a downtrend.
Secondary trend – secondary trend in Dow theory
According to Dow theory, a secondary trend can last only three weeks to three months. The secondary trend is usually the opposite of the main trend
For example, an uptrend will include accompanying secondary downtrends. This is a price movement from a higher high to a lower low. On the contrary, if the main trend is down, there will be accompanying secondary up trends. Secondary trends will be movements from lower lows (LL) to higher lows (HL).
Below is an illustration of a secondary trend within a major uptrend. Note how the peaks (shown by horizontal lines). Could not make subsequent higher highs, suggesting that there is a short-term downtrend.
Note: Level 1 trend is not necessarily only an uptrend. Similarly, a level 2 trend is not necessarily just a downtrend.
The minor trend in Dow theory
Small trends according to Dow theory do not last more than 3 weeks. This is a trend used to adjust or have price fluctuations. The minor trend goes against the secondary trend.
Due to its short-term nature. So small trends are not a big concern for traders. But this does not mean ignoring them completely. Small trends still have to be monitored. Because these short-term price fluctuations are also part of the main and secondary trends.
Most traders only focus on trading according to the level 1 trend. The remaining trends are often unclear or noisy. If you focus too much on small trends, it can lead to mistakes. Traders are distracted by short-term volatility. And lose sight of the bigger market picture.
Principle 3: Three stages of the main trend
Because the most important trend is the main trend. So the third principle of Dow theory is. Identify periods within the main trend.
Key uptrend periods include the accumulation phase (distribution phase), boom phase, and transition phase.
Conversely, the 3 phases in a downtrend include. Distribution phase, sharp decline phase, and panic phase.
Main trend up (Bull market)
The main uptrend is also divided into many other stages as follows:
Accumulation phase
The first phase of a bull market is called the accumulation phase. That was the start of the uptrend. This is also considered the point where investors seek to start participating in the market.
The accumulation phase is usually at the end of a downtrend. When everything seems at its worst. But this is also the time when the market price is extremely attractive. Because at this point, most of the bad news has already been released. Selling pressure has dissipated, making it almost impossible to reduce any further. So there will be no risk of prices falling. However, the accumulation phase is also the most difficult to detect. It is difficult for traders to notice. Has the downtrend ended or is it continuing?
Explosive phase
When investors join the market in the accumulation phase. That is, they begin to believe that the worst is over and recovery is coming. When this becomes a reality, the negative mentality begins to dissipate. Business conditions are marked by earnings growth. And strong economic data – improving. At this time, optimistic news began to be released. Pulling many investors back, pushing prices higher and higher.
This period is not only the longest but also the period with the greatest price fluctuations. This is the phase where most traders trade technical and trend. Start holding long-term positions. And profit.
Transition period
When the market increases too strongly, the buyers begin to become weak. This will move into the transition phase – the final stage in the uptrend. This is also the period when many accumulated speculators begin to look for ways to narrow their positions. Sell them to market participants. At this point in the market, as Alan Greenspan puts it, there is an “irrational exuberance.”
After achieving huge profits. This is also the stage where buyers finally begin to enter the market. Like sheep used for slaughter. Late entrants hope that. Profits will continue after missing many previous opportunities. But unfortunately, they are “swinging to the top” and the chance to escape “the goods” is quite slim.
During this period. Many signs are showing that purchasing power is decreasing or the trend is gradually becoming weaker. And it’s also a sign. The above trend is at the starting point of a main downtrend
False main trend (Bear market)
The main trend, also known as the bear market, is divided into the following stages:
G distribution phase
The first phase in a bear market is called the distribution phase. The period in which buyers announce the sale (distribution) of their position. This contrasts with the accumulation phase in a bull market. Informed buyers are selling, in an overbought market. Instead of buying in an oversold market.
During this period, traders are still very optimistic about the market. Expectations for market levels to move higher. This is also the stage where the last investors in the market continue to invest
wow. Especially those who missed the previous opportunity to participate. And hopefully, there will be a similar step soon.
But it’s a pity. Distribution phase in a bear market (down market). It cannot be like the accumulation phase of the bull market. Therefore, a downtrend will be confirmed. When the previous trend fails to create higher highs and lower lows. Instead, higher lows (HL) and lower highs can only be created.
period of sharp decline
Similar to the strong bullish period in the bull market. But instead of moving in an upward direction. The bear market phase will only move in one direction: DOWN. During this period, business conditions in the market became increasingly worse. Trader sentiment also becomes more negative. The market continues to decline with increasing selling pressure. Meanwhile, the buying trend has almost dried up.
Desperate stage
The final phase of the bear market was filled with panic. And it can easily lead to a sell-off in a short time. During this period, the market was all gray. Traders have a negative mentality. And there are fragile hopes for the company, the economy, and the market in general.
You will see many investors selling off their shares in a panic. Usually, these people are new to the market. During the transition period of the previous price increase.
But when things (seem) at their worst. This is when the accumulation phase of an uptrend is about to begin. And so the cycle is repeated. Continuously year after year, century after century.
Principle 4: Averages must confirm each other
In Dow theory. A reversal from a bull market to a bear market is in no way confirmed. If there is no confirmation from 2 indicators. Traditionally the Industrial and Railroad Average. This means the signals occurring on the chart of this indicator must match. Or correspond to signals occurring on another indicator’s chart.
For example, if an index like the Dow Jones Industrial Average confirms a new upward price trend. But the Dow Jones Transportation Average remains in a downtrend. Thus, it is impossible to confirm a possible upward trend.
Principle 5: Trading volume is a condition used to confirm a trend
According to Dow’s theory, signals to buy and sell are based on price movements. Therefore, volume is also used as an indicator. To help confirm what the market is suggesting to the trader.
From this principle, it shows that in an increasing price trend, volume will increase. When the price moves in the right direction. And decrease when the price moves in the opposite direction. For example, in an uptrend, volume will increase as prices rise and decrease as prices fall.
So in case the volume runs against the trend. That is, price increases but volume decreases, price decreases but trading volume increases. It is a sign of weakness in the current trend. And there may be a trend reversal soon.
Principle 6: The trend is maintained until a reversal signal appears
Identifying the trend is so that we do not trade against or against the trend. According to Dow theory, the sixth principle is also the last. A trend that remains valid. Until many signs appeared showing that it had reversed.
Traders need to patiently wait for a clear picture of a trend reversal. Because as in the second principle, we know that. The market will have many minor trends and secondary trends. So it’s very easy to get confused. Is it the main trend or just a trend correction?
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Notes on Dow theory
As shared above by Learn Forex Trading, Dow theory still has certain limitations. For example, it’s quite late and not always completely correct. Especially with short-term transactions. Due to the influence of crowd psychology and the development of the internet. Furthermore, the current market trades in minute and second frames. Not daily trading like the previous stock market. Therefore, the market will be more noisy and the information will be less accurate.
But Dow’s theory is really important. If you want to become a successful forex trader. It is very important to read and understand the entire principles of technical analysis. Dow theory will help you understand more technical analysis indicators. In the financial market in general and forex in particular.
