What is Dow theory? Principles and Limitations

What is Dow theory? Principles and Limitations
What is Dow theory? Principles and Limitations

In trading, everyone knows about technical analysis. So have you ever wondered where technical indicators on the chart come from? It is developed from the foundation of the Dow theory which was first published more than 100 years ago. If you know the Dow theory well, then your trading results are sure to be extremely good. It’s like you’ve got the key to success in the Forex market. So what is Dow theory? Why is it so important?

What is Dow theory?

Dow theory is considered to be the first building block for the development of technical analysis, discovered by Mr. Charles Henry Dow. At first, it was just the idea of basic principles in an editorial of the Wall Street Journal in 1899.

However, in 1902, he died suddenly, leaving this theory unfinished. One of Dow’s associates, typically William P. Hamilton – who replaced him as the editor of the Wall Street Journal, continued to research and perfect the theory as it is today.

Dow Theory is considered by many traders in the world as the foundation or first systematic basis for all market research. Dow believes that the stock market is a reliable measure of an economy as a whole.

What is Dow theory?
What is Dow theory?

Six principles of Dow theory

All technical analysis theory as we know it today is derived from Dow theory. Therefore, if you want to understand technical analysis in Forex, you need to know the following 6 basic principles.

Principle 1: The market reflects everything

According to Dow theory, information from the past, present, and future affects the stock market and is reflected through the share price and related indices. These include interest rate, income, inflation, etc. Only objective conditions such as earthquakes, tsunamis, and terrorism are excluded. However, soon the risks of objective factors are priced into the market.

The market reflects everything. This is something that no one can deny. There are many traders who just need to look at the price movement to determine the direction of the market.

Note: According to Dow, the information does not help traders know everything about the market. It is used to predict events that have already happened, are about to happen, and are likely to happen. All will be priced into the market in the future.

Principle 2: Three kinds of market trends

Based on the basis of Dow theory, the market consists of 3 basic trends:

Three kinds of market trends
Three kinds of market trends

The main trend (level 1 trend) usually lasts from 1 to 3 years. It will be difficult to know exactly when this cycle will occur. Because the market right now is not manipulated by any individual or organization.

The secondary trend (level 2 trend) lasts from 1 to 3 months. Especially, the secondary trend always tends to go against the main trend.

The minor trend (level 3 trend) will last no more than 3 weeks. It is usually in the opposite direction of the secondary trend.

– In the investment process, traders will often focus on the main trend and rarely pay attention to the secondary trends and minor trends because they have very high noise.

– If investors are too concerned about the secondary trends and minor trends, they are distracted too much by short-term fluctuations in the market. This detracts from the big picture and they can miss out on great opportunities in the long run.

Principle 3: The main trend consists of 3 phases

Dow Theory says that the main trend will be divided into 3 basic phases including:

– Accumulation phase: at this time the market moves very slowly or not at all. That would be the start of an uptrend that has investors looking to jump into the market. Before this phase, it is usually the end of a downtrend so the risk will be very low. However, this is also the most difficult stage to recognize when it is not known whether the downtrend has ended or is still continuing.

– The boom (public participation) phase is when investors have gathered a certain number of stocks in the accumulation phase. They patiently waited for positive signs from the market then the boom phases began. This is the time when the price has the strongest volatility when investors begin to hold a certain position in the market and make huge profits.

The transition (distribution) phase is when the market has rallied to a certain level where buyers begin to weaken. This is the final stage of the uptrend. At this time, investors tend to sell to new entrants in the market. The market will now start a downtrend.

Principle 4: Trends are determined by volume

The volume will be proportional to the uptrend or downtrend. That is, in a market trend, volume increases when the price increases, and volume decreases when the price decreases. There are also some cases where volume still goes against the trend. It shows that the trend is difficult to continue and has a high probability of reversing in the future.

Trends are determined by volume
Trends are determined by volume

Principle 5: Averages must confirm each other

According to Dow theory, a market reversal from a bull market to a bear market must be confirmed by two indices (traditionally the Industrial Average and the transportation). That is, if the general market falls, the index (individual inside the market) will decrease. On the contrary, if the general market increases, the index will also increase. This means that the signals occurring on the chart of one indicator must match or correspond to the signals occurring on the chart of another indicator.

Principle 6: The trend is maintained until signs of reversal appear

A trend will continue until signs of reversal appear. That is why investors need to be patient and observe carefully to recognize the trend reversal to make the right decisions.

Limitations of Dow theory

Dow theory helps investors understand the market. However, it also has the following limitations.

Limitations of Dow theory
Limitations of Dow theory
  • The Dow theory is not always correct. Because it also depends a lot on the actual situation of the market and the analytical ability of investors who are applying the Dow theory.
  • The Dow Theory is too late when the market is always moving second to minute.
  • Usually, the Dow Theory does not help investors when there is intermediate volatility.
  • Dow Theory often confuses investors
  • Dow Theory gives logical answers based on actual market movements. However, in some cases, based on the principles of Dow theory, the market may still be bullish but in fact, it has entered a dangerous phase.

Conclusion

Through this article, hopefully, you have answered the question of what Dow theory is, its 6 principles as well as its limitations in the most general way.

I recommend that you only use Dow theory after you have understood the whole 6 principles. It will help you better understand technical analysis indicators in the financial market. There have been many individuals who have made huge profits from it. Do you want to be the next? Don’t procrastinate when opportunities come and regret them when they’re gone. I believe that you are a wise trader to choose the Dow theory as a guide in your trading.

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What is Dow theory? Principles and Limitations
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