Dow Theory

Dow Theory is a concept developed by American journalist Charles Dow that allows you to recognize trends in the market. It was she who served as the foundation for modern technical analysis. The essence of the theory is that all the necessary information is present on the asset charts. Dow argued that only by analyzing charts can you learn about past events, as well as develop fairly accurate forecasts for the future.

A brief historical excursion

Charles Dow is an American who lived in the years 1851-1902. He began his career as an ordinary journalist who covered economic events in the country. Despite the fact that Dow did not have any special education and did not even graduate from high school, in his work he delved much into the subject, conducting professional analysis. Therefore, very soon, the journalist was noticed by representatives of the then "financial elite" of America (bankers, large exchange players, industrialists). Once in this environment, Charles Dow quickly entered the backstage course of the financial market. Not without the help of his new entourage, in 1874 he founded the newspaper The Wall Street Journal, which to this day remains one of the most influential publications in the business sphere.

The term "Dow theory" appeared after the death of its creator. Its principles were concluded in the editorial column of the Wall Street magazine, where the journalist examined the structure of the financial market, analyzed what was happening and made forecasts for the future. After the death of Charles Dow, his followers (Robert Ria, George Schaefer, William Hamilton and others) conducted a thorough analysis of all the issues of the newspaper he founded. Based on a compilation of disparate information, a unified theory of analysis of financial markets was developed, which was named after its actual creator.

Dow Theory Review

At the time of Charles Dow, the idea that graph analysis was enough to forecast stock prices in the future was truly revolutionary. Prior to this, exchange players believed that for a successful trading, a trader had to follow economic news. However, the American journalist clearly demonstrated and proved that the data available on the chart are quite enough for high-precision forecasting.

The Dow theory is based on 6 axioms, which are as follows:

There are three types of trends long-term, medium-term and short-term.
Each trend consists of three phases accumulation, participation and implementation.
Any news, even those that have nothing to do with finance, is influenced by the market situation.
Signals given by stock indices must be consistent. First of all, we are talking about the Dow Jones Industrial and Transportation Index.
The truth of trends is confirmed by the volume of trading. Charles suggested that the true trend is always accompanied by significant trading volumes. If this indicator is insignificant, then we are talking about a short-term correction.
Trends are valid until there is an explicit signal about the cessation of movement. Prices are more likely to continue to move in the established direction than they unfold. In the case of a deviation of quotes, but the absence of a clear signal of a price reversal, this fact should be interpreted as a temporary adjustment, rather than the end of the trend.
Some of the above postulates require a separate clarification. So, three types of trends were classified, they differ in their duration. Primary (long-term) is a trend in price movement that has been forming over the years. The secondary (medium-term) trend is formed over a period of several months to a year. Small trend - short-term price movement for several hours, days or weeks.

Three phases of a trend

This issue requires a more detailed consideration. Charles Dow classified three stages of trend development. The first is the accumulation phase. Outwardly on the chart, it manifests itself in the form of some stabilization of the exchange rate with a small amplitude of fluctuations - a lateral price movement. As a rule, this phase is observed after the end of the previous trend. At this time, approximately the following situation is developing on the market: a significant part of market participants have already analyzed the latest news, and are preparing for the upcoming or descending trend.
At this stage, it is very difficult to recognize the trend, because it must be differentiated from the correction period, temporary pullback and short-term secondary trend, which will quickly stop. If the price has not beaten the previous maximum or minimum values ​​(depending on the direction of the trend), then this is a signal that a new trend is currently emerging.

The stage of participation is the trend itself. During this period, the most pronounced movements in the value of the asset occur. At this time, the trend begins to be determined by all means of technical analysis, so a large number of investors enter the market. Upward trends are usually accompanied by positive news; downtrends usually occur against a background of negative informational background. For example, the news about the increase in the percentage of profit in the past quarter and the increase in sales volumes will lead to an increase in the company's share prices.

The implementation phase is the time when the market is in an overloaded state. During this period, the number of participants and trading volumes begin to approach a critical mark, which will serve as a point of stopping the trend, stabilizing the course or even reversing the trend. On the chart, this stage is displayed as a cessation of movement. Often, the implementation phase is preceded by sharp surges in the value of the asset. If the price could not beat the previous maximum (or the difference is significantly less than the previous values), then this is a characteristic signal for a trend reversal.

Summary

The Dow theory makes it possible to accurately recognize the beginning and end of a trend. However, the issue of the duration and intensity of the upcoming price movement is not given due attention. Charles Dow certainly needs to be given credit. Because it is he who is actually the founding father of modern technical analysis strategies that are used by millions of traders around the world.